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Consider two recent bits of news from Microsoft:

1. Microsoft extends life of Windows XP for Ultra-Low-Cost PCs
2. Microsft Vista successor Windows 7 rumored to be released in 2009

What do these mean? Two things: Microsoft recognizes that Vista has not been well-received in the market, and Microsoft recognizes an emerging threat from Linux.

Consider the various markets for computers: enterprise (corporate) systems, high-end (gaming, graphic design, etc.) systems, standard consumer systems, and ultra-low-cost PC (ULCPC) systems. Other niche markets also exist, as well.

Even more than a year after its release, Vista has not been well-received in any of these markets. By all accounts, the corporate adoption rate has been dismal. Due to hardware/software compatibility issues, users of high-end systems likewise have stuck with Windows XP. ULCPCs do not meet the system requirements for Vista. The other niche markets include MacOS and Linux users who don’t use any version of a Microsoft operating system.

This scenario leaves the standard consumer system market as the only viable growth option for Vista. This market includes the pre-configured computers purchased through retail outlets or manufacturers’ direct-sale web sites. The vast majority of Microsoft’s claimed, more than one hundred million Vista license sales come from this market. However, consumer backlash against pre-installed Vista has led to a resurgence of sorts in sales of Windows XP installation media. Windows Vista has trailed Windows XP in these so-called boxed-copy sales from the week Vista was released - and many of those XP copies are being installed over pre-installed Vista.

Microsoft’s business model for Windows depends upon the operating system becoming a commodity - that is, for the average computer user, Windows equals computer use, and computer use means Windows.

In this model, corporations standardize on Windows, and follow the upgrade path defined by Microsoft: when Microsoft releases a new OS, corporations dutifully upgrade their systems all at once. In the consumer market, the business model assumes first that users will view the operating system as an unchangeable part of the computer, and second, that those users will replace their systems every 2-3 years, by purchasing another pre-configured computer at retail.

Similar to Microsoft’s Office business model, in which Microsoft ensured product lock-in by creating an environment in which their proprietary document format was used by 99% of productivity suite users, Microsoft’s Windows business model ensured product lock-in by creating dependency on Windows-only third-party applications and by creating an environment in which consumers could only purchase PCs with Windows pre-installed.

Previous threats to this business model have been relegated to servers, high-end systems, and certain niche markets: Linux is incredibly popular in the server market, MacOS owns the market of those for whom their computer is a fasion statement or status symbol, the computer-geek market often favors GNU/Linux, etc.

However, the emergence of the nascent ULCPC market poses a serious threat to Microsoft’s Windows business model. ULCPCs appeal to lower-income PC owners in the US and Europe (the largest PC markets), but are also being targeted at impoverished and third-world communities - especially as an educational tool for children in those communities (see: OLPC and similar projects). These ULCPCs open up a market segment that could, theoretically, dwarf either the corporate or consumer market segments; not to mention, the ULCPC would have an impact on at least the consumer market segment, given its attractive price.

This emerging market would not threaten Microsoft’s business model, were it not that almost all such PCs currently come pre-installed not with a Microsoft operating system, but rather with GNU/Linux. These PCs favor Linux for two reasons:

1. Hardware capability: ULCPCs, due to their hardware specs, are better-suited to running Linux. In almost all cases, they cannot run Vista at all. In most cases, though many are capable of running XP, they perform better under Linux.
2. Cost: Linux distributions are almost all free; Windows requires licensing - a cost which directly impacts the bottom-line cost for the consumer, and which is counter-intuitive to a product positioned as “very low cost.”

Thus, the ULCPC market segment poses a serious threat to Microsoft’s market share. This short-term threat, if realized, would have long-term impact on Microsoft’s Windows business model.

Should Linux-based ULCPCs become the norm, then what is potentially the largest market segment would be brought up in an environment in which Microsoft Windows is not equivalent with computer use. If the ULCPC brings the computer to those segments of the world population that could not otherwise afford a computer, then this entire population would be brought up in this non-Microsoft Windows environment.

Currently, one of the most popular ULCPCs is the EeePC, sold by Asus. This computer has proven to be popular: sales are expected to be around four million units for 2008 - and while Asus now makes a Windows XP model, the EeePC originally only came pre-installed with Linux. Granted, Asus expects the XP model to take up about 60% of expected 2008 sales, but that still leaves 40% - or nearly two million units - of those sales for Linux-based units.

Microsoft has conceded that increasing Linux pre-installation poses a threat to its Windows market share, due primarily to the ULCPC market. (Linux pre-installation in the consumer market segment, while not insignificant, still remains a niche. It may yet pose a threat to Microsoft’s dominant market share, but that outcome will take significant time.) Note that, in order to break into the ULCPC market, Microsoft had to make two important concessions: Microsoft first had to offer discount XP licenses to ULCPC manufacturers, and then had to extend the end-of-life date for XP at least another year.

Microsoft has found itself caught in an untenable situation: take reduced profits (due to licensing discounts) on OEM sales of a product the company wants to end-of-life (Windows XP), in order to prevent a potential hemorrhage of market share, meanwhile trying to cut losses on the product into which the company has most heavily invested in the past seven years, but which has been mostly rejected by the market (Windows Vista) - all while being forced to put all long-term hope in a product the company must now rush to get out the door early in order to stem the tide (Windows 7).

Microsoft is facing a complete upheaval of its operating-system business model. Could this scenario be the reason that Microsoft is all of a sudden so interested in buying Yahoo?