SAN FRANCISCO -- Take away the marketing hype about innovation, and the computer business looks strikingly staid. For decades, customers have had two flavors to choose from: desktop PCs and laptop PCs.

That menu is now set for a major revamp.

In the past year, virtually every big PC maker has introduced or announced plans for a so-called netbook, a shrunken, laptop-like wireless gadget designed for email and Web browsing -- but not much else -- and priced significantly cheaper than a traditional laptop.

Dell ( DELL), the world's second-largest PC maker, jumped into the fray earlier this month with its Inspiron Mini 9, which is available for as little as $349, following in the footsteps of Hewlett-Packard ( HPQ) and Acer. China's Lenovo is expected to release its first U.S. netbook in October.

The sleek devices promise a new avenue of growth in a business that some believe is maturing, as PC ownership tops out in certain markets and customers see little pressing need to upgrade to new machines.

But in opening the door to a new market, netbooks also tip the PC industry further toward commoditization -- and threaten to alter the established business model.

And with Wall Street already skittish about demand for PCs and price pressure amid a rough economic backdrop, it's not clear whether netbooks ultimately represent a benefit or a curse for the industry.

The danger was on display last week when Quanta, a notebook contract manufacturer, reported an 18.5% drop in August revenue - the company's worst performance in at least two-and-a-half years -- even as its overall shipments increased from 2.9 million units to 3.1 million units. The culprit, the company reportedly said, were low-priced netbooks.

The picture looks worse on the bottom line.

David Carey, CEO of Portelligent, a firm that dissects electronic devices and catalogs their internal components, examined one of the initial netbooks introduced by Taiwan's Asus last October.

According to Carey, the cost of the components of the Asus Eee PC he examined represented about two-thirds of the device's $300 retail price, compared to the 50% ratio he says is common in traditional notebook PCs.

That leaves little room to make a profit once other costs like marketing and retail distribution are factored in, Carey says.

In the time since Carey's firm examined the EeePC, Asus has come out with newer models that feature Intel's ( INTC) Atom microprocessor, which is specially designed and priced to be viable for netbook PCs.

Even with the benefit of the Atom chip, though, netbook economics are not ideal.

Humble Roots

Netbooks weren't conceived as money-making machines. The initial idea, as envisioned by the One Laptop Per Child program, was to create a $100 notebook for schoolchildren in developing countries -- an initiative motivated more by altruism than profit.

Taiwan's Asus, best known for making the printed circuit boards used in computers, commercialized the concept by creating a netbook that cost more than $100 yet was substantially less expensive than traditional laptops. As the first company to market with a netbook, Asus effectively defined the category.

"The whole margin structure for netbooks is based on a Taiwan margin structure," says Gregor Berkowitz, President of Moto Development Group, a firm that designs consumer electronic devices, including netbooks.

PC vendors in Taiwan, he says, are accustomed to living with much lower profit margins than some of their Western counterparts.

"The margin structure in netbooks is going to challenge everyone, especially traditional PC brands," says Berkowitz. But he says "everybody needs to get into the business to ensure that they don't cede the market."

An H-P spokeswoman would not comment on the profit margins of its Mini-Note netbook, but cited past comments by Todd Bradley, executive vice president of the company's personal systems group, that H-P is only interested in profitable growth. She also noted that H-P's Mini-Note netbook, at $499, is not as inexpensive as rival netbooks, and features a slightly different feature set than some of its competitors.

Dell did not return calls for comment.

One advantage that PC giants like H-P and Dell can harness in the netbook game is their considerable size, which allows them to drive down component and distribution costs, and could improve the profitability equation somewhat. And the significant brand awareness and marketing muscle that the top PC makers bring to the table means there's a potential to move particularly large volumes of netbooks, offsetting the lower profit margin.

Indeed, among the main targets for netbooks are consumers in developing nations who would never be able to afford a traditional PC. With so much of the world's population falling into that category, the potential market for netbooks is immense.

Most industry estimates for netbook shipments in 2008 range between 5 million and 8 million units, in an overall market for PCs and servers that research firm IDC reckons will total 311 million units this year.


In the meantime, there's a danger that netbooks could catch on as PC substitutes in markets like the U.S., offering consumers a bargain option when it comes time to replace an existing PC and, more importantly, robbing PC makers of more lucrative notebook sales.

"For all intents and purposes they are a line extension of the notebook PC market at a very low price point. So there is going to be some cannibalization of notebook PC sales ", says Gartner analyst Van Baker.

That trend will eventually wear off as consumers learn the difference between the various products, Baker believes. But he notes that in the near term, PC makers may have to deal with increased product returns from disappointed consumers who didn't understand how limited netbook capabilities are compared to laptop PCs.

"A lot of people have described the netbook as a notebook that gets returned," Baker says. "That's going to be the case for a little while."

Keeping customers happy will mean offering them an experience that is satisfactory and distinct from that of a full-fledged laptop, something PC makers are trying to do by tightening the link between the netbook and the Internet.

Dell has teamed up with, an online storage firm, to create a special service for owners of its Mini 9: the netbook includes 2GB of free online storage, expandable, for a fee, to 25GB.

European telecom firm Vodafone ( VOD) has announced it will sell the Mini 9 directly at its stores with built-in broadband wireless connectivity. The company has yet to announce pricing, though the deal suggests that the Mini 9 may be available at a cheaper, subsidized price, similar to cell phone plans, when consumers sign-up for a service contract.

PC vendors have toyed with subsidized plans before, with little success. The rules of the game may now have changed.

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