What's the Deal: Gateway Milks AOL, Squeezes Yahoo

Baldwin Louie — Sun, 14 Nov 1999 17:00:00 -0500

America Online (dossier) announced last week that it had gained another million members in the U.S., raising its total base to 19 million. But the deal it cut a week earlier with PC maker Gateway might indicate AOL's concern about future growth.

The South Dakota cow folk outdid AOL's CEO Robert Pittman, famous for devising the strategy whereby AOL has extracted millions for prime selling space. In this particular deal, AOL agreed to buy 5 percent of Gateway for $800 million. AOL gets prominent promotion among buyers of Gateway PCs. But it's not exclusive. AOL also agreed to handle the operation of Gateway's ISP service, Gateway.net, and to share top billing with it in Gateway's marketing. Ouch! AOL had to be anxious about making that concession. It's like Coke agreeing to bottle RC Cola and paying to share storefront display space with it. In addition, AOL agreed to pay Gateway $30 million for an ownership stake in Gateway.net and 50 percent of the profit from it.

In a CNBC interview, you could almost hear Pittman swallow hard describing the 600,000-subscriber Gateway.net as serving yet another market segment from those of AOL ("premium") and CompuServe ("value"). He said that Gateway.net is for those who desire a "customizable" service. Huh? Is the 'My AOL' feature chopped liver? Pittman didn't elaborate.

And, in a precedent-setting departure from the industry practice of paying PC manufacturers a one-time bounty for each signup, AOL will give Gateway a continuing share of the profit from AOL accounts obtained via Gateway marketing channels. "Yahoo," as cow folk say.

Speaking of which, the deal squeezes Yahoo to the background. Since February, a co-branded 'Gateway My Yahoo! (YHOO)' has been the start page for Gateway.net. It will continue to be available. But now a new portal featuring content from AOL, CompuServe and Netscape will become the default.

Regarding another possible squeeze, Gateway says that it doesn't know if it will replace Microsoft (MSFT) Explorer with AOL's Netscape Navigator as Gateway.net's default browser.

A Matter of Balance

In a contrast that may be telling, Gateway trumpeted the idea that the deal would add nicely to its earnings starting in 2000. AOL, for its part, offered no forecast of the impact on its own bottom line.

Still, the Gateway-AOL deal isn't one-sided. Gateway will pay AOL to operate Gateway.net and $85 million to market PCs via AOL. The companies also will create a major co-branded software store that will be marketed to their customers, including AOL's Netscape Netcenter portal and CompuServe. Profits are to be split 50-50.

Also announced was a collaboration on unspecified methods of developing and marketing unspecified information appliances - an area in which Gateway has no experience, and would be competing with powerhouses such as Sony (dossier) and Motorola (MOT).

But it looks like Gateway stands to do better than AOL with the info appliance and software store deals. AOL brings a much larger audience of potential buyers. Gateway reported five million customers and contact with just 50,000 consumers each day, including its Web site, telephone, and physical store traffic. Meanwhile, Media Metrix reports that AOL's services attracted 52 million unique visitors in September - 1.7 million per day.

Nor is it clear that the deal will translate to significantly more AOL signups from buyers of Gateway PCs than AOL would get anyway. Even though Gateway leads domestic consumer PC sales, its share of that fragmented market is just 15 percent, or about two million units in calendar year 1999. The immediate potential for online subs is lower. Industry-wide, two-thirds of unit sales are made to repeat buyers, many of whom already subscribe to online services such as AOL.

That explains why Gateway.net, despite being exclusively front and center to Gateway buyers since November 1997, has snagged just 600,000 subscribers, which we estimate is no more than 20 percent of Gateway U.S. consumer unit sales during the period. Meanwhile, AOL may have signed nearly as many Gateway buyers without Gateway's help.

Of course, AOL gets Gateway stock for its $800 million; it's not as if the company were shelling out that much just for marketing exposure. AOL has also effectively shut MindSpring, Prodigy (PRGY) and others out from gaining competitive face time via Gateway.

Bean-Counting Conflict

One thing on which Gateway and AOL apparently did not agree is accounting. The press release says AOL will treat its $30 million payment to Gateway as a one-time charge. But in its Oct. 20 earnings conference call, Gateway said that its side of the deal ledger would amortize the $30 million from AOL, "which should allow us to have a recurring revenue stream."

There are accounting arguments for each approach - but not for using both at once. Neither company responded inquiries about the incongruity. The SEC has nailed AOL and AtHome for similar accounting disconnects in the past.

Amortization helps Gateway more than a charge-off helps AOL. Gateway said it would amortize over "somewhat greater than a year." If that's five or six quarters, we estimate it would add $0.04 per share after tax in 2000 - not much when compared to Wall Street's $1.75 forecast prior to the deal announcement. But with high-flying stocks, every penny carries weight. Because AOL has four times as many shares outstanding as does Gateway, AOL would lose essentially nothing by amortizing the $30 million as an ongoing expense.

Meanwhile, there's another $885 million worth of as-yet-undisclosed accounting flying around in this complex deal.

David Simons is managing director of Digital Video Investments, an institutional research firm. Write to him at simonsd@digvid.com.

At the time of publication, neither DVI (DVI) nor any of its employees had securities positions in any of the companies mentioned herein. This column is solely for information purposes. Under no circumstances is it to be construed as a recommendation to buy or sell securities. Neither DVI nor the author can provide investment advice to individuals.

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What's the Deal: Gateway Milks AOL, Squeezes Yahoo