You the attentive reader might ask why VCs like yours truly are interested in netbooks. Hardware made in Taiwan, running Linux or Windows, low prices, even lower margins…Where are the opportunities for entrepreneurs, and for those of us who invest in their creations?

This is a different question from: Why are netbooks successful? We know the answer to the latter: price and, to a smaller degree (no pun intended), size. This picture and this list show how this new incarnation of the personal computer has proliferated. Because of the recession, yesterday’s manly “must-have” features are now suspect frills. Small has become virile. Users who wouldn’t be seen with less than a “plus-size” keyboard have now received cultural permission to travel with a 10” netbook, perfect for flying (the rediscovered) Coach class.

PC manufacturers aren’t too happy. Marc Hurd, HP’s CEO, blames the 19% decline in PC revenues for his company on customers “who [were] buying a more thickly configured notebook now buying a more thinly configured [machine].” Morgan Stanley’s analyst Kathryn Huberty sees a strong decline in PC revenues this year, 24%.

Let’s pause for a moment. PC revenues have never declined, let alone plunged by such a huge percentage of almost 25%. According to Huberty, the largest contributor to the fall is a 50% decline in ASP (Average System Price) caused by the rise, if that’s the right word in this context, of netbooks. The forecast says netbooks (22 million units) will represent 20% of all notebooks in 2009, versus  9% (10 million) in 2008, with shipments rising to 31 million in 2010, a 50% increase!

Netbooks started about two years ago as cheap laptops. Everything smaller: storage as low as 512 MB of RAM (main memory) and 2 GB of SSD (Solid State Disk) storage, screen down to 7” inches for the first Asus eeePC 2G (I bought one of those) and, to avoid the Microsoft Tax, Linux. These now fetch $100 or less on eBay. Microsoft, never asleep at the switch for too long, saw the problem and repriced Windows Xp, thus allowing Taiwanese manufactuer to ship low-price Windows netbooks (This was helped by customers who “misunderstood” Vista).  We now have a crowd of $299 netbooks with 1 GB of RAM, 160 GB of hard disk storage, 8.9” screen, WiFi, webcam, Windows Xp Home.  I just bought one from Acer.  This time, the keyboard offers a decent feel, unlike the Xp equipped Asus 900 I acquired and gave away a year ago after a field trip in Russia where keyboard quality became troublesome.

But why call this Acer machine a netbook, rather than a sub-notebook? It has all one needs to run everyday applications, enough storage, enough CPU power with a 1.6 GHz Intel Atom processor.  In my case, I didn’t want to pay another Microsoft Tax for this experiment, that is $239 for the Small Business version of Office (the Pro version goes for $403.99 on Amazon, discounted from $499...). Instead, I downloaded Open Office, it’s free (avoid offers to pay $30 for the same thing from other sites) and provides a suite of word processor, spreadsheet, database, presentation programs, offered by Sun. It works, not always smoothly, but at that price it would be churlish to complain.  As long as I’m careful to store the files in “standard” (read Microsoft Office) formats, I can exchange data with the rest of the world. (We’ll keep the file format debate for another day.)

Other applications are less free. I’m referring to what is now called “crapware”: software that’s pre-installed on the machine as a free 60-day trial (Carbonite on-line back-up, McAfee protection suite, even Microsoft Office).  One has to wonder: How much money did these vendors pay Acer to put their free-trial offers on my netbook, how much would it cost without these subsidies? A program exists to automatically remove these warts, it’s free and its name, Decrapifier, easily remembered.

For Microsoft Office, the 60-day trial pushes you to buy a full license. This is for the Home and Student version, no Outlook there and no visible way to convert to a fuller version.  Microsoft offers to convert the trial version for 139 €, about $185. Amazon sells the DVD, free shipping, for $94...   The Carbonite on-line backup service goes for $54 a year and the McAfee protection suite for $65 a year as well.  All solid products/services. And, showing how the “extras” quickly add up to a sizeable fraction of the price paid for the hardware.

Going back to the netbook vs. sub-notebook: So far, we have a bona fide notebook, one that won’t do well at running Photoshop but one with good potential for everyday use. Several names have been used to describe this smaller laptop: UMPC (Ultra Mobile PC), MID (Mobile Internet Device, an Intel favorite) but netbook seems to stick, even if Psion claims ownership of the term.  But, in theory, a “true” netbook, as in Internet Notebook, is a machine running little more than a browser and relying on on-line applications, on software running in the Cloud, such as the Zoho suite or Google Apps.  Of late, the on-line applications have started to offer dual-mode capabilities, Google Gears being the most visible example.  By dual-mode, I mean being on a plane, opening my netbook, answering Gmail, creating documents, editing a presentation or writing this column –- all off line.  We land, I get a wireless connection and everything syncs with the Cloud, the mail is sent and received, documents are updated or uploaded.

So far, this is more theory than practice.  Google Gears is “early”, meaning a little buggy, not inviting the kind of trust we have in its ancestor: Outlook in Cache Mode.  The next steps are well publicized, this is one thing, and believable, even better. First, 3G connections (the latest revision of higher speed cellular networks) continue to spread, and WiFi is more and more available in homes and offices.  Then, LTE (Long Term Evolution, the next generation of cellular networks) and WiMax (same thing, only incompatible), both referred to as 4G (4th Generation) start deploying.  Higher speed and more ubiquitous wireless connectivity cause netbooks to really become Mobile Internet Devices, MIDs.

But will netbooks continue to be like today’s, only better, faster, cheaper, following the PC tradition?  Probably not, because of smartphones, their form factors and business models.

We see the beginning of the business model part as we hear about carriers considering subsidies for netbooks using their networks (3G and Wifi in some cases). Then, we see how smartphones are evolving into MIDs: a recent study by AdMob, a mobile advertising company, pegged the iPhone as generating 50% of mobile Web traffic in the US, 33% worldwide. Extrapolate this in two directions, more and better competitors and more usage per device as everything improves, applications, universal connectivity, and you see how smartphones will become an alternative to today’s netbooks. In my case, with all “sample of one” caveats hereby stipulated, if I could write columns and email on a smartphone, my MacBook usage would drop to less than 10% of my time in front of a computer.  Which gives rise to two connected thoughts.

First, what about an Apple netbook?  We know Steve Jobs’ answer: We don’t do cheap products. With all due respect for Dear Leader, that’s not the question we asked.  If Acer can make a $300 netbook, admittedly with subsidies from Microsoft and other vendors, couldn’t Apple make a nice, clean $600 machine??  (Actually, Apple does. Apple and its, soon perhaps ex-exclusive, partner AT&T just started selling no-contract iPhones for $599 and $699. In comparison, no-contract top of the line Nokia smartphones go for between $540 and $639 in the US, more in Europe.  We’ll skip the many, sometimes entertaining theories for Apple’s latest price move.) Looking for an Apple netbook, Googling “hackintosh” and “OSx86” leads to enterprising hackers running MacOS X on various netbooks. Dell’s Mini 9 being an ironic favorite. (This conversion is not for normal humans as it involves replacing hardware bits and torturing many software ones.)  Many think Apple is wrong to be late in the netbook game because, like it or not, this is the only place where the PC market is experiencing growth today. See Kathryn Huberty’s numbers above.

Unless, second, there is even more growth in the smartphone business. For Apple, in less than 18 months, the smartphone business has reached between 25% and 33% of its overall revenue, according to recalculated “non-GAAP” estimates.
This recalculation is convoluted because official accounting rules force Apple to spread - some say hide - iPhone revenue including carrier payments, over the life of the subscriber’s contract.  An alternative to an aluminum netbook could be a larger variant of the iPhone, using the same OS and iTune App store distribution platforms.  Such a device could cannibalize notebook sales, as it happens in the Windows notebook world.  On the other hand, the apparent cannibalization would be more than compensated by not leaving that space to cheap netbooks and, even better, by generating additional revenue through the iTunes App Store channel, a nicer alternative to “crapware” subsidies.

Last, an ironic touch.  We easily agree smartphones are MIDs, that they (will eventually) use Cloud Computing applications as an alternative to local, native programs, that is code running on the device itself.  That’s the official thought.  The reality, at least on the iPhone, is more nuanced.  Yes, it uses the Internet more and better than its current competition.  But it also rides on a tremendous portfolio of “local” apps, games are huge on the iPhone, personal productivity tools also – all downloaded from, but not running on, the Net.

That’s why VCs are watching this turbulent space. We see in it one of the few growing markets, one where entrepreneurs, their new products and services have a chance against aging incumbents. —JLG

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