Windows 7 and netbooks: Separating fact from speculation

Is Microsoft going to take a revenue hit when it releases Windows 7 because of the changing mix of PCs in the market? That's the expectation of many company watchers, though I have to admit I'm not quite so sure. Here's why.

Even though Microsoft is trying to stir up excitement for Windows 7's prospects on new (and most likely more expensive) multi-touch-enabled PCs, there is more interest among users and industry watchers around the next release of Windows running on netbooks. Microsoft officials demonstrated a full-fledged version (we don't know which pre-beta build number) of Windows 7 running onan Asus Eee with 1 GB of RAM. Netbooks  -- which I'll use here to refer to low-cost, low-end PCs capable of running email and a Web browser, but little else -- are quickly becoming an increasingly large part of the overall PC market.

Here's where the speculation comes in. Many are assuming that because netbooks cost a few hundred dollars, Microsoft will charge netbook makers less per copy of Windows preloaded on these machines than they will charge OEMs for Windows 7 running on full-power laptops. They are basing this assumption on the (seemingly logical) conclusion that PC makers won't be willing to pay one-fourth or more of the price per machine for the operating system.

Some also are basing their calculations on the fact that Microsoft admitted during its most recent earnings call that its Windows client business was down, in part, because the company is licensing the less-pricey Windows XP to netbook makers because Vista is too big to run on most netbooks. (A distinction lost on some: Microsoft's revenues were down because XP is cheaper than Vista per copy -- not because it charged netbook makers less than full-fledged PC makers per copy of Windows.)

Microsoft won't talk publicly about how much it charges OEMs per copy of Windows they preload on new machines. As a result of the company's settlement years ago with the U.S. Department of Justice, we do know that Microsoft can no longer use the price of Windows to discriminate against its top 20 PC maker partners. All of these partners pay the same per copy of Windows. (Below that top tier, there is more variance in pricing, based on volume of machines sold and other factors.)

"Getting an answer to what Microsoft charges an OEM is nearly impossible," said Michael Cherry, an analyst with Directions on Microsoft. "Neither Microsoft nor the OEMs like to talk about this. Anecdotally, I have heard from the OEMs and Wall Street Analysts that the Windows OS could be the emost expensive single element in a PC. I have also heard people suggest it is the only element that never goes down in price. But I cannot vouch for the truth of these assertions."

I've heard the same "anecdotes" as Cherry. Back in the Windows 95 days, I do know Microsoft was charging the top PC makers roughly $60 to $70  per copy of Windows on new machines. Each subsequent version of Windows typically cost OEMs a few dollars more -- regardless of how much the PC sells for at retail/in volume. Microsoft argued that it was including more features and functionality in each new release, so even if consumers weren't willing to pay more per PC, OEMs should have to cough up more money for each  new version of Windows.

Microsoft's relationship with its PC-maker partners is not totally adversarial. With Windows Vista, for example, Microsoft and the OEMs were in cahoots to find a way to get users to buy "premium" PCs running "premium" releases of Windows. (A plan that backfired, by the way, as the ongoing class-action suit over "Windows Capable" has made all too clear.) With Windows 7, Microsoft and certain PC makers are looking to offset plummeting PC revenues with higher-priced touch-enabled PCs.

Once Windows 7 does launch -- which increasingly looks like next next summer/fall -- PC makers at both the high and low ends of the market will be jockeying for position, analyst Peter O'Kelly, pricinpal analyst with O'Kelly Consulting, notes. But that doesn't mean Microsoft necessarily will take a revenue hit, he says.

"I frankly think it's going to be a very different landscape in the 'netbook' market next year, especially after Windows 7 is released, with the incumbent hardware vendors taking the lead, and vendors such as Asus having to get creative in terms of feature/function and price differentiation.  While small form factor laptops were priced as premium business road warrior PCs a year or two ago, at this point Dell, HP, and others are very aggressively competing for what most people would define as the 'netbook' market.

"So while Microsoft may need to get more aggressive on pricing, e.g., if a hardware vendor is able to deliver a compelling non-Windows 'netbook,' I expect the pricing will probably stay in line with other Windows form factor pricing/licensing models."

There's just under a year to go (if the Softies get Windows 7 out for back-to-school 2009) until we see how this all plays out. What are your predictions? Will Microsoft be willing to do what it seemingly has never done before and reduce the price-per-copy it charges PC makers for Windows? Will users be willing to pay a premium for touch PCs?