Updated from 9:19 a.m. EST

Intel's ( INTC) chip inventory is piled high enough to see netbooks sharply altering the landscape for PC giants Hewlett-Packard ( HPQ) and Dell ( DELL).

With inventory growing 10% sequentially since the September quarter and revenue falling 19% during the same period, Intel is clearly feeling the crush of its slumping PC customers. And given the direction the industry and the economy -- the liquidation of Circuit City on Friday jumps to mind -- there's plenty of downward pressure still building.
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Businesses aren't buying loads of new gear, and with rising unemployment and falling home prices, consumers aren't nearly as free-spending as they once were. But within the gloomy big picture is a vibrant corner at the low end of the market that is growing. So-called netbooks, the under-$500, stripped-down laptops from Asian upstarts like Acer, MSI and Asus, have caught on with tight-fisted consumers.

Not only do these smaller, sleeker devices threaten conventional notebook sales, but they also don't use Intel's most advanced chips or Microsoft's ( MSFT) huge Windows Vista operating system. In other words, netbooks represent the long-predicted undoing of what's commonly referred to as the Wintel empire.

Maybe symbolically, anyway. The current crop of netbooks, while fine for kids and business travelers, don't pack enough processing speed or graphics power to make video fans and gamers happy. But more robust machines are coming, and that will be a big problem.

Suppliers have to go where the orders take them. For chip manufacturers and other component vendors, when orders for cheaper parts come in, they have to shift production away from more lucrative widgets.

Intel is trying, albeit uncomfortably, to straddle both segments of the market. It's Atom chip is designed as a netbook processor, but for every cheaper Atom sold, Intel sells one fewer full-featured multi-core chip.

"I wouldn't say it's a death spiral, but it's certainly a negative trend," says Collins Stewart analyst Ashok Kumar, referring to the margin erosion that comes when lower revenue levels go out of whack with current costs.

Intel said on its earnings conference call Thursday that it is seeing some cannibalization but characterized most netbooks as incremental sales. That would mean some netbooks sold last quarter would have Intel chips, presumably a mix of newer and older ones. The company promised to provide more details at a later date.

Intel chip rival AMD ( AMD) has been trying to adjust to the falling netbook economics. AMD said Friday it will cut another 1,100 workers or 9% of its staff. This would be the third time the ax has come down at AMD in the past year.

Chip shops aren't the only ones feeling the netbook pressure. PC makers are in a similar position. If consumers are smitten with cheaper laptops, higher-priced computer makers face a difficult decision: Either watch your core business decline, or jump into the big new opportunity with a reward of smaller revenue.

Apple ( AAPL) has yet to answer the netbook call, and H-P and Dell have also been sitting on the sidelines watching the netbook party. But probably not for long, says Kumar.

Netbooks sales are on a pace to hit 40 million units a year, Kumar says. "They can't afford to ignore it."

Intel shares were falling 5.4% to $13 in Tuesday afternoon trading.