I predicted years ago that what would eventually do Microsoft in was white-box PC makers defecting because they needed to claw back profit margin as the Windows license became the largest single item in their bills of material.

And here’s the confirmation I’ve been awaiting: Microsoft Missing Netbook Growth as Linux Wins Sales. The boring biz-journalism headline is guarding some startling facts.

Nov. 6 (Bloomberg) — Small laptops are becoming a big problem for

Microsoft Corp.’s Windows business. […] Acer Inc. and Asustek

Computer Inc., which together account for 90 percent of the netbook

market, are using the rival Linux software on about 30 percent of

their low-cost notebooks.

30% is significant share, well above the single-digit range that desktop Linux has been stuck in for the last decade and larger than ISVs can afford to ignore. And it’s hitting Microsoft’s bottom line:

The devices, which usually cost less than $500, are the

fastest-growing segment of the personal-computer industry — a trend

that’s eating into Microsoft’s revenue. Windows sales fell short of

forecasts last quarter and the company cut growth projections for the

year, citing the lower revenue it gets from netbooks.

The phrase “sales fell short of forecasts” is deadlier than it sounds. The profitability of Microsoft’a businesses is consistently poor outside of the core OS and office products; their ability to sustain a broad product strategy and frequent acquisitions against investor pressure has been dependent on their ability to deliver figures indicating smooth sales and revenue growth in the core business. If investors stop trusting that guidance, Microsoft’s room to maneuver (for example, by moving further into software-as-a-service businesses) will be sharply limited.

Later in the article we learn that Microsoft has cut its forecasts of Windows growth for the rest of 2008 to 2% from 9%, effectively flat. Investors had already been taking a warning:

The stock has declined 41 percent this year.

Microsoft has fought back against the tide of netbooks by talking netbook manufacturers into making XP available on products initially designed to run Linux. But it has fallen far short of its obvious goal, which is to drive Linux netbooks off the market entirely. This in turn suggests that waving the big stick didn’t work and Microsoft had to settle for dangling carrots, probably buying share with

discounts.

Linux, equipped in 30 percent to 40 percent of Eee PCs sold, will

probably sustain a market share of about 30 percent, said Samson Hu, a

general manager at Asustek. The company estimates it will ship at

least 5 million Eee PCs in 2008 after selling about 4 million since

the product’s debut. […] Acer, which is aiming to sell 5 million to 6

million AspireOne laptops this year, estimates that Linux-equipped

models account for about 20 percent of its shipments,

That will be at least four million netbooks running Linux by year’s end. The truly deadly news, however, is at the end of the article:

Equipping Linux on a computer costs about $5, compared with $40 to $50

for XP and about $100 for Vista, according to estimates by Jenny Lai,

a Taipei-based analyst at CLSA Ltd. […] “The engineers designing

computers understand that if they want to cut costs, the only way to

do so is to get rid of Microsoft,” IDC’s Chang said.

When even financial analysts are figuring this out, you can bet Microsoft is already in deep trouble.

Among other things, it is effectively certain that the netbook makers have already used the threat of Linux to bargain Microsoft down to price parity with Linux, though each one doubtless has a signed-in blood agreement not to discuss it in public and the price drop may be disguised as bulk discounts or rebates for marketing support. The initial threat to Redmond’s monopoly from Linux-only products put Microsoft’s nuts in a vise; there is no way the netbook makers, operating on the tight margins they do, would miss the opportunity to extract equally favorable terms of business.

This means that Microsoft’s per-sale revenue on netbook XP licenses has probably dropped by at least a factor of 10 relative to what it makes on PCs. That’s a hell of a margin hit, and as netbooks displace a larger slice of traditional PC sales it’s going to get worse. And we can count on that happening; what we’re seeing here is a classic disruption-from-below of the PC market, just as PCs disrupted workstations and minis in the early 1990s.

There’s another problem. Vista is so dead that Microsoft is already touting its successor “Windows 7”. Not end-of-lifing XP on schedule means they’ll actually have to support three different operating systems for at least the years until Windows 7 ships, and some time afterward. Even Microsoft is going to feel the strain, and ISVs are likely to play safe by writing to the minimum (XP) specification.

Netbooks also put Microsoft in a strategic bind about its future product direction. For System 7 to be lean enough to run on netbooks, it will have to give up backward compatibility with Vista and many of Vista’s features. That means that at the same time Microsoft’s profit margins are being hammered, it will lose a significant portion of its application base.

Fundamentally, what’s going on here is that Microsoft, long used to effective monopoly and to the profit margins and strategic maneuvering room monopoly brings, is losing all three of those. Microsoft is no longer a price-maker; the hardware manufacturers hold the whip hand now, and all they have to do to beat Redmond into making ever less money per sale is to push Linux harder.

Until relatively recently, Microsoft had good prospects for buying itself maneuvering room simply due to cash hoard in the neighborhood of 60 gigabucks; Bill Gates used to boast that he could run Microsoft for five years of zero revenue with the money in his piggybank. But that’s gone, now; they spent it on acquisitions and stock buybacks. Which still haven’t kept the stock from dropping 41% in 2008. So they’re running out of options.

There are only two ways for this game to end. One is with the visible collapse of Microsoft’s monopoly in new systems, but allowing it to retain price levels on a niche market of PCs running legacy applications. The other is with Microsoft bargaining its own margins away to retain netbook market share and collapsing when its reduced run rate can no longer sustain new-product development.