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Weekly Column

Free Flight: How the Advent of Free PCs Makes Life More Dangerous for Microsoft

Status: [CLOSED]
By Robert X. Cringely

This time last week, I was writing a column in which I confused Huckleberry Finn with Tom Sawyer — an error that 139 readers have pointed out to me so far. I have no excuse for this mistake, really, other than my being in a hurry to get up to Boeing, where I was scheduled to fly the 777 flight simulator for an upcoming show. I made it to Boeing, flew the simulator, and enjoyed it immensely. What amazed me the most was how easy it was to fly the big plane. In fact, I'll risk alienating the airline pilot community by saying that a 14 year-old Microsoft Flight Simulator fan could be perfectly proficient to fly the 777 in only a few days. In this case, all those computer controls have taken what would normally be a lifetime learning process and turned it into a summer school course. It seems to me that advancing technology is having this effect on more and more activities, which now replace muscle memory and hard-earned judgment with computer memory and good programming. There goes another profession. Column writing will be next.

Technology is moving so swiftly, in fact, that it is even surprising me. Suddenly, we have this rash of free PC offers even though I predicted only six months ago that we were then two to three years from everyone having a free computer. In many ways, I think the real free PC phenomenon is still down the road, but these recent events are certainly worth comment.

Just in case you haven't noticed, there are suddenly a lot of advertisements for subsidized PCs. If you'll only sign up for three years of Compuserve or MSN, you'll get about $400 in rebates. This brings Compaq and HP machines down to the $300 range and (with other rebates) puts those el cheapo eMachines boxes squarely at zero, nada, free. The future has arrived. These are perfectly capable machines. I have a friend who just bought a 366-MHz eMachine for $500 and it is just as good as the 266-MHz no-name Pentium II I bought 18 months ago for $1,700.

There are two questions that immediately come to mind now that we have these free PCs: 1) How can they be free? and; 2) What does this mean for the future?

The rebates are linked to committing for three years of Internet service at $20 per month, or about $720 in fees to get $400. Does this make economic sense or is it, as some people are claiming, likely to be a short-term phenomenon?

I don't think it is short term at all, otherwise MSN and Compuserve would have limited the offer to the first n-thousand customers, or better still the first n-thousand customers with some particular qualification. But they haven't limited the offers in number of prerequisites. If one million or 10 million people take the deal, it's fine with AOL (Compuserve's parent) or MSN. The more free PCs, the better.

Right now, I am poised to launch into an explanation of the business aspects behind this latest pricing phenomenon. Some nerdier readers have complained recently that I write too much about business and not enough about technology. In this case, I claim they are the same things. Unless we can understand the forces underlying this new price structure, we won't have the information needed to figure where it is all going. So please bear with me, nerds. It will be worth your effort.

How can either AOL or Microsoft afford to give $400 rebates in exchange for $720 in Internet service spread over three years? Heck, they aren't even asking for the $720 up front. What gives? Well, it turns out that guaranteeing three years of service (that is three years of having a specific, identifiable customer) is easily worth $400.

Every magazine or newspaper publisher knows exactly what it costs to obtain a new subscriber. They also know what it costs to retain an old subscriber. These two numbers are part of the key to print media economics. In either case, it is cheaper to retain a subscriber than to get a new one, simply because the odds of an existing customer responding positively to a renewal request are vastly higher than those of a complete stranger signing up in the first place. In either case, it is usually a letter the new (or old) subscriber is responding to, but the "yield" of that letter is always much higher for renewals than it is for new subs.

Averaged out, magazine and newspaper publishers are generally willing to spend up to the entire cost of the subscription to get or retain a good subscriber. If the subscription costs $20 per year, the publisher is probably willing to spend that whole $20 on ads and nagging letters. With this in mind, $400 for $720 in Internet subscription revenue isn't a bad deal at all.

Of course, the newspaper subscription analogy is dependent on advertising. Without advertising income, it wouldn't be worthwhile to even produce the paper. And though the Internet certainly has advertising, the percentage of total ad dollars received by Internet Service Providers can't be very big. So advertising alone isn't enough to justify the rebates.

What if we consider this deal not as a newspaper or magazine subscription, but as a cable TV subscription? The dollar amounts for monthly service are comparable. And while both service providers receive ad revenue, in each case it isn't a large part of the total revenue picture — at least not yet. In the cable TV example, the market thinks not in terms of revenue but capitalization; what the cable company is worth per customer, or even per potential customer (the houses past which the TV cable runs, even if those residents haven't bought cable TV service). In the cable TV business, the local franchise is generally considered to be worth at least $1,000 per potential subscriber. Given that 70 percent of us have cable TV, that's around $1,500 per actual subscriber.

Would it be worth a $400 rebate to gain $1,500 in market capitalization? Yes, it would. In this time of crazy Internet stock prices, the actual numbers are even better. Why? Because AOL is valued by the market at $8,000 per subscriber! It is certainly worth $400 to generate $8,000 in market capitalization. And this isn't such a fluky situation, since these kinds of numbers (and this type of thinking) have prevailed for years in the cable TV and cellular phone and satellite TV markets. The stock markets have always richly rewarded a growing subscriber base. And this appears to extend to Internet service even though, unlike cable TV and cellular service, ISPs have nothing like a monopoly or shared monopoly position. That's all the more reason why these rebates are tied to three-year commitments, which is a lifetime on the Internet.

Okay, so it makes financial sense to give away free PCs in exchange for an Internet service commitment. What does this mean for the future? For one thing, these offers won't be going away ever. And like the cellular phone business, we are probably going to start seeing a different type of computer designed from scratch as a free Internet PC.

This is key and explains in large part why these early offers are coming from AOL and Microsoft. The emerging trend is free hardware in exchange for an Internet service commitment. Implied in this is that Internet service is essential. In fact, it will soon be that a PC will be rated more than anything on its ability to run Internet applications. The particular hardware standard, even the underlying operating system, will make less and less difference over time as applications become server-based and the client standards that matter are HTTP and HTML rather than Windows or Macintosh.

Bill Gates knows this, which is why he wants MSN to encourage Windows-based clients while developing Windows NT-based server applications. AOL, for its part, is pushing its ownership of Netscape as a logical alternative to Microsoft.

But the truth is that the future is set no matter what these two companies do. The further rise of Internet standards is clear no matter what a free PC looks like or what marketing ploys any major player does from here on out. Now that there is an economic justification for free hardware, Internet service has no reason not to grow to parity with phone service at nearly 100 percent. Microsoft, AOL, Apple and the other platform champions can say all they want, but in fact they are like those graying 777 captains, clinging to their "Right Stuff" images when in fact they could be replaced almost instantly by something new.

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