Gateway Still in Talks to Buy EarthLink

Gateway is seeking an ISP edge to combat the trend toward heavily discounted hardware in exchange for Internet access.
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Gateway

(GTW)

may be getting ready to finally commit to acquiring

EarthLink

(ELNK)

, with dialogue between the companies still going strong, according to two people familiar with the situation.

It's just another sign of how brutally competitive the box business has become. The free PC is almost upon us, with

AOL

(AOL)

,

Microsoft

(MSFT) - Get Report

and

Prodigy

(PRGY)

all promising to give PCs away, effectively, in exchange for a three-year commitment to use their services.

The business model is similar to the one used for mobile phone sales. Hardware is heavily discounted or offered for free if the user signs a contract to use the service for a minimum period, and three years seems to be what the ISPs are going for.

"It's got to be scary for PC manufacturers, but this cellular phone model will bring in a recurring form of revenue for Gateway and others," says a technology banker in the PC industry who requested anonymity. "Telecom service providers also realize that the value-add is in the subscribers."

Which is why Gateway, a profitable, fast-growing PC maker, is interested in buying an ISP that is expected to lose about $18 million, or 56 cents a share, this year.

EarthLink and Gateway spokespeople both declined to comment on takeover talks.

When the Gateway-EarthLink talk first surfaced, the initial reaction was one of dismay among PC analysts on the Street. "We believe this transaction would be a disastrous decision on Gateway's part," wrote

Warburg Dillon Read

analyst Charles Wolf.

The Gateway-EarthLink deal could still fall through. Long-distance phone carrier,

Sprint

(FON)

, which has a 26.5% stake in EarthLink, has the option to buy a controlling interest in the ISP in October 2001, according to EarthLink's proxy filings. Its stake in EarthLink -- now worth around $550 million -- would increase substantially if Gateway acquired the ISP. But according to Sprint's 10-year deal with EarthLink, initated in June 1998, it has 10 days to top any offer made to buy EarthLink. A Sprint spokesman had no comment.

Yet, for Gateway, the EarthLink deal would provide it with tremendous opportunity to access EarthLink's 1.2 million subscribers, says Randy Befumo of the Baltimore-based money management firm

Legg Mason Fund Adviser

. "Nobody explored the potential synergies between Gateway and EarthLink," says Befumo, whose firm has a long position in Gateway stock. He points out that Gateway could save $500 million in synergy costs. The San Diego, Calif.-based PC seller currently loses a few dollars per

Gateway.net

subscriber.

Too Pricey

Yet observers are concerned that EarthLink, with a market capitalization in excess of $2 billion, is too pricey. On Friday, EarthLink closed up 4 to end at 67, while

Mindspring

(MSPG)

climbed 2 3/8 to close at 48 5/8. The takeover frenzy over the past three weeks has pushed up the stocks of EarthLink and Mindspring by about 70%.

"A deal goes through and I may be inclined to downgrade," says Warburg Dillon Read analyst Charlie Wolf.

"Gateway would be paying $2,000 per subscriber -- it's stupid," says Warburg's Wolf, who says EarthLink currently values each subscriber at only around $200 and pays slightly more than that in marketing and subscriber fees to keep them. Moreover, Gateway's earnings would take a big earnings hit. "A deal goes through and I may be inclined to downgrade," says Wolf, who currently has a buy on Gateway.

By acquiring EarthLink, Gateway would end up with an additional 1.2 million subscribers to add to the 400,000 subscribers of Gateway.net. It may need every single one of them. Gateway, which is keen on developing revenue beyond the PC, is anxiously monitoring moves made by

Dell

(DELL) - Get Report

, the Austin, Texas-based PC direct seller which is launching its own ISP service,

Dell.Net

, later this summer.

And there is AOL, which is offering a $400 rebate on

eMachines

PCs (the bargain-basement Korean-built type) to those subscribing to its

CompuServe

subsidary for three years. Prodigy, meanwhile, has a discount deal with the

Best Buy

(BBY) - Get Report

chain, while Microsoft has been running a test offer with

Staples

(SPLS)

.

With the economics of the PC business changing rapidly, Gateway may want to strike first rather than wait for the hostilities to commence.