Microsoft's complex Netbook dance

With Windows 7, Microsoft has done the technical work to make the operating system work on Netbooks, but the low-cost laptops still pose a challenge to the way Redmond does business.

As the only fast-growing part of an otherwise sluggish PC market, Netbooks are clearly a product category that Microsoft can't afford to ignore. At the same time, computers selling for only a couple hundred dollars don't give Microsoft the opportunity to get the kinds of revenue for each copy of Windows that it is used to receiving.

Microsoft is hoping Windows 7 provides an opportunity to move Netbooks up the food chain, with the distinction between such devices and traditional laptops eventually going away entirely.

"Our position is that Netbooks are small notebook PCs," said Don Paterson, a director in Microsoft's Windows unit. "The distinction that has existed around Netbooks is, to some extent, a creation of the industry's mind."

Although it will offer a low-cost version of Windows 7--Windows 7 Starter--to compete with Linux to power the cheapest of Netbooks, Microsoft is ultimately hoping consumers and PC makers will pay more to get the "home premium" version of Windows Vista, which supports things like a touch screen or the Media Center interface.

"We're pretty squarely focused on thinking the sweet spot moving forward on Netbooks is going to be home premium," Paterson said. "We are going to try (to) rally the industry around that vision."

Key question
But analysts say that could be a tough proposition. The key question is whether consumers really want more bang from their Netbooks, or if they just want to spend as little as possible on a machine that can do the basics of Web browsing and e-mail.

Michael Cherry, an analyst with Directions on Microsoft, thinks that Netbooks are fundamentally about the latter.

"I think its a computer that is about price," Cherry said. "I don't think it is a computer that is about features."

That Microsoft is even in the game technically represents something of a reversal of fortunes. Microsoft has been playing catch-up since the market took off with the introduction of Asus' Eee PC several years back. Many of those first machines ran Linux, representing the open-source operating system's first big shot at powering the mainstream desktop.

At the time, Microsoft was moving from Windows XP to the far more demanding Windows Vista, whose memory and storage needs were ill-suited to the low-end Netbook. As a result, Microsoft kept around the aging XP to compete against Linux on Netbooks.

When it came time to build Windows 7, Microsoft focused on creating a product that can run on the kinds of hardware being used in today's Netbooks. Ultimately, Microsoft says that all of its versions of Windows 7 should be able to run comfortably on a standard Netbook configuration with 1GB of memory and a 1GHz processor.

Now, Microsoft would like to see what it can do as far as making some money off the machines. At the low-end, Microsoft is bringing over Starter Edition, a severely limited version of Windows that has historically only been sold in emerging markets. Machines running Starter, for example, can only run three applications at any one time.

Netbooks of the future
But really, Microsoft is aiming to make the Netbook market more like the traditional PC market, with Home Premium being the standard option. Paterson said Microsoft thinks Netbooks can evolve to handle more media-playing capabilities, the kinds of things that require Windows Home Premium.

Cherry, though, thinks that what consumers really want is the cheapest possible PC. And just the fact that Microsoft can get its highest-end versions of Windows 7 running on a Netbook doesn't guarantee a market.

"Although Microsoft can get it to run on Netbooks," Cherry said, "the economics on the bill of materials probably limits what Microsoft can make on each one."

But Sandeep Aggarwal, an analyst with brokerage firm Collins Stewart, thinks that many people are underestimating Windows 7's Netbook opportunity. In a research note this month, Aggarwal said Microsoft stands to make as much as $680 million more next year on notebooks by having a range of products that can run on the machines.

Before Windows 7, Aggarwal estimates that Microsoft was getting $23 for each copy of Windows XP that sold onto a Netbook. With Windows 7, Aggarwal said he is estimating revenue as high as $58 per unit for home premium, with Windows 7 Starter fetching around $25. Aggarwal figures that four-fifths of Netbooks in mature markets will ship with the pricier version, compared to just 20 percent running Starter Edition.

In emerging markets, Microsoft will also have a Home Basic option that Aggarwal figures will account for the bulk of sales. Even still, though, Aggarwal is assuming Microsoft will get $17 more for each copy of Windows 7 Home Basic than it did for Netbook sales of Windows XP.

Paterson said that adding more features ultimately means that consumers get a better experience and helps computer makers avoid competing solely on who can offer the lowest price.

"What's the industry's advantage in saying lets drive this thing to rock bottom," Paterson said. "What we are enabling with Windows 7 (is the ability) to try to maintain higher average selling prices...This doesn't have to be about who can get to $199 first."