Can Xbox 360 succeed as a mainstream consumer electronics gadget?

Introduction

Redmond (WA) - For well over a decade, we've heard the word "convergence" used to refer to the evolutionary paths of digital electronics, communications, and computing devices. And yet nothing more clearly demonstrates the difference between the console gaming industry and almost any other consumer electronics category than this fact: Both retailers and customers are embracing the choice they're about to be given, between Microsoft's Xbox 360, which premiered yesterday; Sony's upcoming PlayStation 3; and Nintendo's upcoming Revolution.

For almost every other CE market, both customers and retailers demand either a single industry standard (as is the case with DVD) or a clear industry leader (as is the case with Apple's iPod). Where there's too much duality or multiplicity, the market looks for or even demands a shakeout (case in point: satellite radio) or some form of mutual compromise (Blu-ray vs. HD DVD for the next high-definition video disc standard). At least today, the gaming market is an exception to the rule. But how long can this continue to be the case?

As we reported this morning, electronics analyst firm iSuppli revealed today in its teardown analysis of Xbox 360 that Microsoft is spending as much as $550 per unit in equipment and manufacturing costs, for a unit whose base sticker price is $399. So here is evidence of one aspect of console game marketing that truly is showing signs of convergence with consumer electronics as a whole: The same way HP is willing to lose money on printers to secure future customers for inks and supplies, and Comcast and other CATV suppliers are willing to lose money on digital cable deployments in order to secure customers for premium programming, Microsoft is willing to invest as much as $150 per customer, perhaps even more, to secure a broader customer base.

"Right now, Microsoft is very interested in gaining market share," says Chris Crotty, iSupplies senior analyst for consumer electronics, and co-author of today's teardown analysis report. "In order to do that, they need to take advantage of the fact that their console is out before the PS3 launches."

The interval between Xbox 360's premiere and next spring's Sony PlayStation 3 launch gives Microsoft a window in which to grow its market share base. During that interval, there are very lucrative deals to be made in the licensing of rights to produce game titles for Xbox 360, as well as opportunities for Microsoft to produce a few more "Halo"-level mega-hits for itself. If the rate of such growth during this window is impressive, the company may be able to wield a pre-emptive strike against Sony by securing development deals with one or more top-tier game producers. Such deals can have explosive yields: Whereas in the 1990s, video game titles were created from licensing deals with movie producers for the rights to develop off of movie franchises, today, it's the other way around. "Halo," "Doom," and "Tomb Raider," among others, have become global entertainment franchises, with the game creators now calling the shots.

So for the near term at least, $150 or so per customer is not a bad investment to make, if you're looking at the potential for not just one, but perhaps a string of gold mines. And that cost will even out over time, believes Crotty and iSuppli. Microsoft's costs are so steep now, he told TG Daily, because Xbox 360's two core components - its CPU and its graphics processor - were in large part tailored for it. ATI's graphics processor costs Microsoft about $141 per unit, iSuppli estimates, because it was designed for Microsoft by ATI. But as the design costs are paid off within the next twelve months, Crotty told us, "I think they have the opportunity to potentially break even. There's still good opportunity to wring cost out of the two main ICs - the CPU and the GPU - as they improve the yields for production."

But rather than start reaping the harvest from $20 or $30 sales margins, Crotty believes, Microsoft will make a new set of investments in a particular kind of Xbox 360 upgrade. "At some point in early 2006," he predicted, "Microsoft is probably going to be adding next-generation DVD functionality. So that'll increase costs somewhat...but when they do that, I think it's more probable that the overall console price will just remain the same, and the additional cost of doing that would be offset by some of the cost savings. They have to put that in there because the PS3 will have Blu-ray support, and they really want to be competitive."

Along with Intel, Microsoft is a major supporter of HD DVD - one of the few remaining proponents not straddling the fence. Here is where the story starts to sound more like a traditional consumer electronics industry evolution tale, and where that term "convergence" re-enters the picture. As Crotty pointed out, the company co-developed, and maintains a major investment in, the iHD interactive layer, which is the XML-based language that supports the underlying interactive functions. Microsoft is interested in iHD for more than just HD DVD; it will reportedly play a role in the company's upcoming PC operating system, Windows Vista, as well as in its "Live" online services, which have received considerably more attention of late. Meanwhile, the Blu-ray standard which Sony championed, and which it will reportedly include in its PS3, utilizes BD-J, a competing interactive standard based on Sun Microsystems' Java.

All of which is why the company must, and probably will, introduce an HD DVD version of Xbox 360, Crotty believes, either at or just before the point it just begins to break even on its costs for the current version. "The new interactive layers will have functionality that will connect to online options," he noted. "So if you're Microsoft, that idea is probably very enticing, because you're always trying to expand your connection to your existing online businesses as well. And if you are Microsoft, and you're maybe envisioning a future in which you're part of whatever Media Center there is in the future, I think you want to be involved with that interactive layer, especially if it has some connection to the Internet.

"The other part of Microsoft's grand plan," continued Crotty, "seems to be that they are making a lot of investment and development in IPTV and IP set-top boxes. So again, this is an opportunity where Microsoft is seeing a future in which they are a key participant in the sort of next-generation living room device, or devices, and that future involves connection between the hardware and the Internet as well. You can think of it as Microsoft coming at it from a few different angles, hoping that everything will meet in the middle."