Vendors Struggle With Netbook Enigma

Why netbooks? Why now? The easy explanation for the popularity of these small, low-cost laptops is that the recession is driving demand for cheap alternatives to more expensive personal computers.

Yet netbooks were becoming a full-fledged phenomenon even before the stock market tanked last fall. And while it's true that economic uncertainty existed prior to last September's financial meltdown -- think the housing bubble and out-of-control gas prices -- some industry insiders think the netbook success story represents something more impactful on the high-tech industry than just temporary belt-tightening on the part of consumers.

The emergence of netbooks -- buzzworthy because of the diminutive size of both their form-factors and their price tags -- creates a potential problem for vendors in the notebook space, even as they jump on the netbook bandwagon. Netbooks are already cannibalizing sales of higher-priced notebooks, according to Microsoft, which has pointed to netbooks as a culprit for declining margins during recent calls with financial analysts.

So the question becomes: Are netbooks just a sign of the financially challenged times or do they represent a dramatic shift in what customers want from their mobile PCs?

"It's a big deal, a big change in the way the market is," said Roger Kay, president and founder of analyst firm Endpoint Technology Associates. Kay points to major strategic shifts by Microsoft and Intel as the venerable "Wintel" partnership has been forced to deal with the popularity of inexpensive netbooks, even as their sales of higher-margin products have fallen sharply in the recession.

"The value proposition for a netbook is pretty simple," Kay said. "It's basically a cheaper version of a full-blown notebook. That's easy to understand, because, hey, I've always wanted a smaller notebook, but smaller notebooks used to always cost more, not less, and all of a sudden they cost less."

Stumbling Toward A Strategy

The surprising success of netbooks, combined with the severity of the current economic downturn, has forced some of the biggest players in high tech to adjust their strategies. The cold, hard truth is that many of the strongest evangelists for netbooks -- from PC titans like Hewlett-Packard, Dell and Lenovo to components makers like Intel and Nvidia to software giant Microsoft -- would really much rather be seeing strong demand for their higher-margin products.

Customers, it seems, have different priorities and are now balking at the aggressive refresh cycles vendors are pushing. They'd rather see vendors improve existing technology than come up with new high-cost gear for them to buy.

"What we're hearing in the market right now is, 'Mend it, don't make it,' " said a source at one major components manufacturer, speaking on condition of anonymity about customers' reluctance to purchase new high-end client and server systems.

Netbooks might not be the sort of products that the big vendors and channel players want to be pushing, but having something to sell in this economy is better than having nothing, the source said.

Something may be better than nothing, but the margin pain vendors and VARs are feeling in this economy is nothing to sneeze at, said Joe Toste, vice president of marketing at Equus Computer Systems, a Minneapolis-based white-box builder.

"In the past when we introduced a new Intel part [like the Core i7], we had this big gap to sell at a higher margin, but in this economy the window is narrower," Toste said. "Hey, I want to sell more $1,000 desktops because it's a good market and there always will be some demand, but we're selling [fewer] desktops in that range because of the economy."

Enter netbooks and a chance to ease some of the pain caused by falling demand for higher-end products. Equus has teamed up with Intel to produce the first "white" touch-screen tablet netbook based on the chip maker's Classmate PC in North America.

Equus unveiled its 8.9-inch Nobi Convertible at January's Consumer Electronics Show in Las Vegas. The new unit is built on Intel's 1.6GHz Atom N270 processor and 945 GSE chipset, weighs just 2.5 pounds and is targeted at the K-8 education and specialty retail markets. The Nobi Convertible comes with a 60-GB hard drive, 1 GB of DDR2 memory, an 8.9-inch 1,024 x 600 resolution touch screen and either a 4-cell or 6-cell battery.

How bad has the recession been? Worldwide PC microprocessor unit shipments were down 17 percent in the fourth quarter of 2008 against the previous quarter and slid 11.4 percent year over year, according to research firm IDC. And if you remove Atom shipments, which saw marked growth in the fourth quarter, the numbers are even starker -- a 21.7 percent decline in worldwide PC processor shipments quarter over quarter and 21.6 percent year over year.

NEXT: The Numbers Don't Lie

The Numbers Don't Lie

Microsoft, for its part, hasn't been exactly secretive about the damage it feels netbooks are doing to its bottom line. That includes client revenue dropping 8 percent year over year in the software giant's most recently concluded fiscal quarter, OEM revenue falling 12 percent and OEM license units falling a point.

Even prior to the full impact of the recession hitting last quarter, Microsoft CFO Chris Liddell was well aware of the downside to growing netbook shipments.

"Client revenue grew 2 percent with growth impacted by the expected reduction of Q4 channel inventory and a shift of the sales mix to lower-price netbooks and the units sold in emerging markets," Liddell said last October.

All of this has come on the heels of some fairly disappointing product introductions for Microsoft. Following the widespread non-adoption of its Windows Vista operating system in commercial settings, Microsoft couldn't have been pleased to see Linux-based netbooks like the Eee PC from Asus start to really take off. So the company did move relatively quickly to get Windows XP onto newer versions of the Eee PC and other netbooks.

The problem -- Windows XP Home for netbooks brings Microsoft only $32 per license from local OEMs, compared to $65 for the desktop version of Windows XP Home. And Microsoft is in a tricky position, because if it tries to charge too much for XP or for its upcoming Windows 7 SKU for netbooks, customers may opt for Ubuntu Linux configurations already available from many netbook manufacturers.

Open-source OS makers like Ubuntu are getting better at replicating the familiar Windows user experience, say many reviewers. Add in the advantages Linux-based netbooks already have, such as faster boot times, and Microsoft will have to tread carefully in this explosive new segment.

"As far as strategizing for this netbook situation, Microsoft is dealing with it by pitching old product in the form of XP Home, and for Intel it means tolerating lower margins," Kay said. "From Microsoft's point of view, it can't really promote its best play, which is Vista, so instead they offer XP Home. That's last year's product, which is convenient, because Microsoft can price it low. So everybody takes a hit on margin, and now Microsoft just has to get through the desert of 2009. It has to deal with the netbook market as a positive experience and has in fact taken it largely back from Linux."

Both Microsoft and Intel have adjusted their strategies to fit the new reality in tangible ways, the analyst said.

"Microsoft has fixed costs in terms of payroll and Intel has fixed costs in terms of factories. Microsoft has announced some layoffs and Intel will mothball some factories, so you're seeing some reaction," Kay said.

Next: Blindsided By The Light

Blindsided By The Light

To what extent were the tech titans caught off-guard by the rising netbook tide? Microsoft and Intel now have the biggest presence in these devices, but that wasn't always the case. Take Santa Clara, Calif.-based Intel -- the chip giant puts so many of its Atom processors in netbooks that it might seem like all of this was planned.

Not so fast. It's easy to forget now, but Intel wasn't always so bullish on netbooks. Back in January 2008, Intel CEO Paul Otellini was evangelizing a different mini-PC form-factor altogether -- the mobile Internet device. Intel envisioned MIDs as Linux-powered devices selling in the $400 to $600 range, according to Kay.

But makers of MIDs have found themselves in a no-man's land between the smartphone and the netbook, with the mass market for their products never quite materializing. Apple's iPhone accelerated the trajectory of the smartphone as the pocket-size platform of choice, and Acer, Dell, HP, Lenovo and others jumped aboard the netbook train without looking back at all those MID reference designs.

Intel reacted quickly, repositioning its low-voltage Atom processors for the growing netbook market. The chip giant never gave up on MIDs, but it's interesting that Intel is now working with LG Electronics to build a very smartphone-like MID, complete with voice capabilities.

Meanwhile, Intel executives have spent the past several months parrying questions about the potential of netbooks to eat into the sales of more profitable notebook PCs. It's a fair assumption, given Intel's own fourth-quarter financials and the fact that mobile PC sales are in the process of overtaking desktop sales worldwide, if they haven't already done so.

If Intel has a checkered history with netbooks, Microsoft's love-hate relationship with the little PCs is the stuff of legend. In the fall of 2007, PC component maker Asus introduced its Intel Celeron M-based Eee PC, the success of which is generally regarded as kick-starting the netbook explosion. All on a Linux-based operating system, no less.

Prior to the Eee PC, Nicholas Negroponte's One Laptop Per Child project had developed its "$100 laptop," a netbook antecedent called the XO-1. At the time, the concept of an extremely small, low-price notebook was criticized -- even mocked -- by one of the biggest names in the PC industry.

"Geez, get a decent computer where you can actually read the text and you're not sitting there cranking the thing while you're trying to type," complained Microsoft's Bill Gates in early 2006.

Consumers haven't shared Gates' pessimism. Global netbook sales could reach 8 million this year and 50 million in 2012, according to Gartner analysts. ABI Research is even more bullish, projecting 35 million netbook shipments around the world in 2009 and 139 million in 2013.

NEXT: Making The Best Of It

Making The Best Of It

For Equus' Toste, smart business is accepting the reality of the marketplace. Right now, Intel's new high-performance Core i7 desktop parts -- which introduce a new processor socket and attendant platform upgrade costs -- aren't enjoying the channel success that new Intel products have in previous, healthier business cycles. Few computing products are selling well at all right now, but XP Home-flavored netbooks built on Intel's Atom processor have bucked the downward trend.

"For our customers, it's always less about the technology and the processor, and more about the relative value of what they're buying. It's just that more obvious in this economy," Toste said. "With the Nobi Convertible, I see a lot of this, where we're taking it to real innovators in the public and private sectors. So emphasizing the value of things like 1-to-1 computing initiatives, when you spin it like Intel's doing, you see real opportunities."

Complaints about falling margins are quickly becoming a waste of energy in a new economic reality, said Bill Paschick, president of Rain Recording, a Ringwood, N.J.-based system builder that focuses on high-performance desktop and mobile audio workstations.

"There's a new middle, that's what's happening here. Margin is one thing, certainly it's important, but more important is margin volume. I'd rather have more dollars than more margin points," Paschick said.

Rain Recording, incidentally, does not make or resell a netbook. But Paschick said his company is doing something similar at the pricier segments it works in -- using older, proven technology like Intel's dual-core Pentium chips to build more affordable versions of its high-end mobile workstations.

"With this economy, Rain has decided to leverage the recession and the other companies that we use. The smarter they get in helping us, the better," he said, stressing that the strategy of only targeting a small but free-spending enthusiast market just doesn't make sense in this economy.

"Look, there's always the lunatic fringe and the mainstream, the people who chase zero. In better times, you could make a good living selling to the lunatic fringe. Not now."

And what if the recession has simply sharpened an already emerging pattern in both the consumer and commercial markets against buying more technology than you need?

Kay won't go so far as to say that there is a discernable backlash against "too much technology" occurring. But he does believe that netbooks and other evidence of people scaling back on some of the high-tech excess of recent years could be a net positive for all of us.

"Maybe it would be a good thing for humanity to cool it a little bit in terms of purchasing too much technology, to learn that resources are limited and that this burn rate of late is unsustainable," he said.