Why netbooks are killing Microsoft

Computerworld - When Microsoft laid off 5,000 people in January, analysts and pundits pointed to plenty of reasons for the first major layoffs in the company's history. The obvious culprits included the overall economic meltdown, Apple's continued success and Wall Street's desire to see a leaner Microsoft.

But the real cause of the layoffs can be summed up in a single word: netbooks. These lightweight, stripped-down laptops that sell for between $200 and $400 have taken a big chunk out of Microsoft's bottom line. Unless the company comes up with a plan to handle them, its revenue will stagnate.

In announcing the layoffs, Microsoft said that its revenue had increased an anemic 1.6% in the quarter that ended Dec. 31 compared to the same quarter a year earlier. But that number doesn't tell the whole story. Windows took the biggest hit, while systems for servers and related tools had hefty increases in sales. Windows sales were down an eye-popping 8%; server and related revenue grew 15%.

Microsoft clearly blames netbooks for the drop in Windows sales. Here's what it said in its statement: "Client revenue declined 8% as a result of PC market weakness and a continued shift to lower priced netbooks."

Netbooks have become the only bright spot for PC makers, with sales accelerating while the rest of the PC market stays in the doldrums. According to IDC, 10 million netbooks were sold in 2008 and that number should double to 20 million in 2009.

Why is all this bad news for Microsoft? First, an estimated 30% of all netbooks ship with Linux. That means Microsoft doesn't get a penny for Windows from 30% of all netbooks being sold. Given that netbooks represent the fastest-growing PC market segment, the company's problem may get worse with time.

In addition, netbook owners who buy Linux machines won't be buying Microsoft Office, handing Microsoft an additional revenue hit for every Linux netbook sold. So it's not surprising that in the most recent quarter, sales of Office were anemic. Overall, sales for Microsoft's business division, which is in charge of Office, were up slightly, at 1.9%. But sales of the consumer version of Office plummeted 23% -- and consumers are the people buying netbooks.

Microsoft faces other netbook-related woes as well. The company doesn't get paid as much for a version of Windows sold on a netbook as it does for a version of Windows sold on a laptop or desktop PC. There's very little margin on a machine selling for $200 to $400, and so Microsoft simply can't charge full freight for Windows on one. And given the price that Microsoft charges for consumer versions of Office -- usually about $200 for the lowest-priced version -- netbook owners who use Windows aren't likely to pay for Office either. It doesn't make much sense to pay as much for a piece of software as you did for your entire PC.

Microsoft clearly recognizes the problem and is taking action to try to solve it. First, it built Windows 7 to run on netbooks, something that Vista doesn't do. When Windows 7 ships, expect Microsoft to spend plenty of money promoting it for use on netbooks, in an attempt to drastically cut into Linux sales.

In addition, Microsoft is working on low-cost, ad-supported, Web-based versions of Office. That way, it can start to get Office revenue from netbook owners.

Will these steps be enough to make up for the overall shortfall in revenue caused by netbooks? Probably not. That's why the company is desperate to figure out a way to make its online businesses succeed. If it can't, the days of big revenue growth are behind Microsoft, thanks in part to netbooks.

Preston Gralla is a Computerworld.com contributing editor and the author of more than 35 books, including How the Internet Works (Que, 2006).

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