By Prince McLean

Published: 06:00 AM EST

PC sales are in free fall as the weak demand for Windows desktops and full-size notebooks in a poorly performing global economy is being compounded by an influx of low cost netbooks, which are gobbling up the remains of profitability in the PC industry.

According to an IDC report issued last week, worldwide PC processor unit shipments in the fourth quarter of 2008 declined –17.0% quarter over quarter and –11.4% year over year. Those tragic numbers were buoyed somewhat by sales of mini-laptop netbooks running low powered processors. Take out Intel's Atom chips that power netbooks, and processor unit shipments declined by –21.7% over the previous September quarter and –21.6% over last year's holiday quarter.

Shane Rau, IDC's director of Semiconductors in Personal Computing research, said the "decline in PC processor unit shipments in the fourth quarter was the worst sequential decline since IDC started tracking processor shipments in 1996. After hinting at a decline last September, the market fell of a cliff in October and November.''

IDC's report stated that "the decline of the PC processor market in 4Q08 was due to a precipitous drop in end system demand that quickly moved up the PC supply chain through OEMs and contract manufacturers to the processor vendors." In addition to tightening consumer spending, sickly PC sales have also been blamed upon weak interest in Windows Vista, which only runs well on desktops and full powered laptops. Most netbooks run the simpler Windows XP, and about a quarter run Linux.

Netbook erosion

That has hit Microsoft particularly hard, resulting in an 11% drop in profits over its year ago quarter and plans to cut 5,000 jobs over the next year and a half. On the other hand, Apple posted its best quarterly results ever, with 9% growth in its Mac sales over the previous year. How is Apple bucking the collapse of PC sales?

In large measure, Apple is sidestepping the fate of other PC makers because it sells machines differentiated by Mac OS X Leopard. While other PC makers are all diving to the bottom of the barrel to offer the cheapest Windows PCs at unsustainable prices, Apple is selling a product with unique value that isn't available elsewhere. The company is also leveraging its strong retail presence of 251 stores worldwide, which offer training and support that can't be found at big box retailers, preventing many Mac buyers from leaving its ecosystem to find a bargain among cheap PCs.

However, another component to Apple's healthy sales figures is its refusal to sell netbooks. While pundits have insisted that Apple jump on the netbook bandwagon, the company has consistently insisted that it can't offer any value in the sub-$500 PC market. That strategy has prevented corrosion of the Mac OS X market for desktops and full sized notebooks at the hands of low powered, ultra cheap Mac netbooks.

Apple's Netbook alternative

Instead, Apple has focused its interests in selling the iPhone and iPod touch to fill the demand for low-end, highly mobile devices in Mac market. The company doesn't break out iPod touch sales from other iPods, but iPhone sales growth in the fourth quarter exploded by 88% over the year ago quarter. Apple sold 13.6 million iPhones in the last year, well above the 11.3 million netbooks sold in 2008 by all vendors combined.

Pundits say there's no stopping netbook sales, with 21.5 million expected to be sold in 2009. However, analysts are also predicting incredible growth for the iPhone, with Gene Munster of Piper Jaffray estimating an installed base of roughly 60 million iPhones by the end of 2009. That would require sales of 44 million iPhones this year, well more than twice the number of netbooks expected to be sold worldwide. Additionally, that doesn't even include Munster's estimate of 23.4 million iPod touch users by the end of the year.

Rather than losing money to chase a fraction of the netbook market share, Apple is creating its own market for handheld WiFi mobile devices that is not only outpacing the entire netbook market in units sold but also in profitability. Because the iPhone and iPod touch are designed to sync with a computer rather than replace one like a netbook, Apple's desktop and notebook sales are not being cannibalized by its mobile sales.

Of course, the fear is that PC netbooks running Windows XP or Linux will soon impact Mac notebooks, too, unless Apple scrambles to release its own netbook competitor. While the company said it was keeping a close watch on the market for netbooks, any threat to the Mac might be well off in the future. Around 70% of all netbooks were sold in Europe, many subsidized by a mobile network plan. That makes netbooks more akin to glorified smartphone, and a more direct competitor to Apple's iPhone and iPod touch.

Macs moving upscale

Apple has migrated away from selling low end, simple Internet browsing computers over the last decade, repositioning the iMac from an appliance PC (it was originally intended to serve as a Network Computer) into a luxury desktop with a big screen aimed directly at higher powered tasks such as editing movies, working with high resolution RAW photography, and making music.

The company has also pushed its notebooks upscale, converting its entry level iBook line into MacBooks closer to the low end of its MacBook Pro models. That has resulted in Apple offering no new notebook models for much less that $1,000, but also taking the lion's share (66%) of the $1,000 and up notebook market, where most of the profits in notebooks are to be found.

Apple hasn't just been pushing its products up scale rather than into junk territory by raising its hardware prices; it has also developed software to make use of faster systems, assembling both the iLife suite for consumers and a series of Pro Apps. Netbooks are designed primarily to do text entry and browse the web, making them natural replacements for low end PCs the cost roughly the same and don't offer to do much more besides take up more space.

That's killing Microsoft's model for advancing Windows Vista on the sheer volume of new PC sales, because netbooks are making a large chunk of the low end market for new PCs obsolete, and replacing them with a low powered device that not only can't run Vista, but can run Linux. If netbooks continue to grow as predicted, they will cause a major erosion of the low end of PC market, forcing Microsoft to either scale down Vista to something closer to Windows XP, or to continue to develop the older XP code base.

Either way, that change will have minimal impact on Apple's business, the majority of which is well above the floodplain threatened by the promised wave of $400 netbooks. Apple's Mac business will be no more at risk than Microsoft's higher-end gamer PC users. However, if netbooks can manage to replace over 20 million low end PCs this year it will have a significant impact on the standing of Windows Vista and its successor due later this year as an increasingly large chunk of the 300 million PCs sold annually won't need a full desktop operating system.

Meanwhile, Apple is targeting the release of Snow Leopard as being fully 64-bit. In the last nine quarters since Apple transitioned its lowest end MacBooks and iMacs to 64-bit Core 2 Duo CPUs, the company has sold 19 million Macs. Apple's installed base of Macs running Mac OS X is approaching 30 million. That means that at around two thirds, or 66%, of the entire Mac installed base is 64-bit.

In contrast, the latest Steam survey of around a hundred thousand serious PC gamers' hardware, representative of the high end of Windows users, revealed that less than ten percent are running a 64-bit version of Windows 2003, XP, or Vista, even though gamers with fancy video cards and an appetite for RAM would benefit most from moving to 64-bit Windows. The majority, 65%, are still using 32-bit Windows XP, with nearly 24.5% using 32-bit Windows Vista, even though nearly all PCs sold in the last two years have shipped with Vista.