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The Internet/PC provider
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July 8, 1999: 12:34 p.m. ET
With profits shrinking, computer makers look to Internet service market
By Staff Writer John Frederick Moore
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NEW YORK (CNNfn) - The computer industry goes through more changes than Whoopi Goldberg on Oscar night, so it shouldn't come as a surprise that the Internet service provider of the future may not be the Internet service provider of the present.
These days, according to Forrester Research, about 35 percent of first-time PC buyers purchase their machines primarily for Internet access, which helps explain why computer prices have broken the sub-$400 barrier.
It also explains, in part, why PC makers are moving in on territory traditionally occupied by Internet service providers (ISPs).
Gateway Inc. 's (GTW) gateway.net Internet service, launched in 1997, currently boasts more than 200,000 subscribers; Compaq Computer Corp. (CPQ) established compaq.net last month; and Dell Computer Corp. (DELL) will soon join the fray with its own Internet service.
With PC prices plummeting - and dragging computer makers' profit margins down along with it -- PC makers are searching for other ways to bring in revenue.
Massive attack
"The basic hardware profit business is under attack," said Don Young, hardware analyst at PaineWebber. "These companies are all looking for opportunities to make money outside of the box, so to speak. It's become critical for them to take advantage of the ISP market."
The Internet access market provides not just additional revenue for PC makers, it provides renewable revenue, since most consumers pay a per-month fee for Internet access.
While it's hard to turn a profit when customers shell out a one-time charge of $700 for a new computer, an additional $19.95 each month from those customers for Internet access can help pad a computer maker's coffers.
"It's essential in the consumer market for PC makers to offer Internet access," said Jimmy Johnson, PC analyst at A.G. Edwards. "When you walk into a store, companies are not just selling [computers] anymore. They sell printers and services and all these other things on the back end."
A brand called Internet
The current battle cry in the Internet industry is that the brand is everything. Apart from AOL, however, no ISP has the brand awareness of, say, Compaq or Dell, and that could spell trouble for traditional Internet access firms.
"In effect, the consumer thinks of the Internet experience as a unified whole -- the hardware, the software, the service," said Adam Schoenfeld, senior analyst at Jupiter Communications. "No one wants to be the commodity piece under the brand radar."
Over the last few weeks, rumors have made the rounds on Wall Street that Gateway is in talks to acquire Earthlink Network (ELNK), one of the leading ISPs.
Neither company will confirm negotiations, but the speculation surrounding the companies has made one thing clear: If competition from computer makers doesn't swallow up companies like Earthlink, consolidation certainly will.
"The ISP market has been consolidating for a long time," Schoenfeld said. "Unless you have tremendous scale with great branding and advertising and e-commerce revenue, the only revenue these companies get is through monthly access fees. ISPs need partners."
But not all analysts are convinced PC makers should tie the virtual knot with ISPs.
PC makers that currently offer their own Internet service typically buy Internet hosting services from a company like UUNet, MCI WorldCom 's (WCOM) Internet services division.
Computer makers buy hosting services wholesale and sell them at retail price to consumers, transforming themselves into "virtual ISPs." It's a model that works well, analysts say, because PC makers get to act like Internet providers without the overhead of actually being an ISP.
"Does buying Earthlink pay for itself over the cost of purchasing hosting services from UUNet? I don't think so," Young said.
Nonetheless, analysts say PC makers are well suited to take on the ISP role -- in some ways even better suited than traditional ISPs. That's because computer makers offer consumers something Internet providers don't: computers.
"PC makers have the advantage in that everything comes preloaded on the machine," Schoenfeld said. "People will know whom to call for technical support for everything that comes with the computer."
A few years down the road, however, computers may not be the vehicle of choice for accessing the Internet.
The one scenario in which it would make sense for computer makers to acquire ISPs, according to Young, is if the PC no longer becomes the dominant tool for Internet access.
Already, consumers can access the Internet from their TV sets, from "smart" cell phones and from such devices as 3Com Corp. 's (COMS) PalmPilot handheld computer. In a few years, just about everything except your bathtub will be able to connect to the Internet, and the crew at MIT Media Labs is probably working on that, too.
If consumers look to other devices for Internet access, Young said, then it makes sense for PC makers to cover their bases by owning ISPs, which are better equipped to expand their services to be accessible through a variety of devices.
Analysts say the main obstacle to PC makers doing double duty as ISPs is the latest gimmick to capture consumers' attention: giving computers away in exchange for Internet service.
In late June, America Online Inc. (AOL) signed a deal with eMachines under which customers who sign up for a three-year membership with AOL's CompuServe 2000 service will get a $400 rebate toward the purchase price of an eMachines PC.
A basic eMachines unit costs $399, essentially making the PCs free to those who choose CompuServe.
Analysts like to call this strategy the "cell phone" model -- giving away the hardware in exchange for locking the customer into using a particular service for a particular time frame.
If ISPs are able to thrive in giving away computers that include their services -- and not all analysts believe they will be successful -- then that could thwart PC makers' efforts at cracking the market.
It could, however, also be a sign that Internet providers are scrambling in the face of a new competitive threat.
"The ISP business by itself is hard to sustain," Schoenfeld said. "Only AOL is highly profitable. The days of the traditional ISP with access fees as their only revenue stream are over."
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