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Jay Livens weighs in on the Microsoft/Xbox debate

The debate, Should Microsoft be in the Console Gaming Space continues, this time with Jay Livens weighing in.

The Scoreboard so far:

One of the best things I like about Twitter is the people I have met, and follow. As I have declared here several times, the people I follow on Twitter enrich, and educate me.

Jay Livens, (Twitter: @SEPATONJay), is one of them. He blogs personally at About Restore

His thoughts are below.

Thoughts on Microsoft and the Xbox.

Thoughts on Microsoft and the Xbox
Jay Livens
@SEPATONJay; About Restore

John Obeto and Rob Enderle are debating whether Microsoft should have entered the videogame market. Obeto’s position is that Microsoft (MS) made the right decision releasing the Xbox, but that the process was mismanaged. Enderle’s position is that MS made a mistake. I believe that Microsoft made the correct choice to enter the videogame segment and will explain my reasoning in this post.

Microsoft realized early on that a presence in the family room was important and tried to build a credible product to target the segment. They tried to address it in a couple of different ways including partnering with cable providers for set top box software and acquiring WebTV for web browsing appliances for TVs. Neither of these strategies was successful and Microsoft had to look for other options.

As Microsoft was pondering their strategy, they saw the rise of Sony’s original PlayStation launched in 1995 and the PlayStation 2 (PS2) which was released in October of 2000. MS thought that they could leverage their software knowledge to cost-effectively enter the adjacent market. As you would expect, Microsoft leveraged their PC expertise and the original Xbox was based on standard PC hardware.

Point 1: MS had a valid and rational reason for entering the console market. I believe that it was the right choice.

The videogame business is all about a razor/razor blade model. Manufacturers expect to profit on the games and price the consoles at or near cost. The problem with the Xbox is that it entered the market about a year after the PS2 and its component cost was higher since it was using generic hardware as compared to the PS2’s custom solution. Sony also had a time to market advantage which allowed them to leverage production efficiencies to further reduce costs. In order to remain competitive, MS was forced to keep their console prices in line with the PS2 resulting in a loss on every console sold. Eventually, as MS volumes increased they were able to reduce costs, but the situation created a lasting impact.

MS’ problems with the Xbox were clear and so they must have recognized the requirement to improve the situation in the next generation platform. An initial decision was whether to stick with commodity hardware and its greater flexibility or go with a custom solution like the competition. The commodity approach would have been more OEM friendly and allowed them to potentially enable computer manufacturers to sell their own versions of the Xbox360. However, the challenge was that the costs could still be higher than the competition resulting in another Xbox-like situation where the MS platform was at a cost disadvantage.

The OEM model had another potential problem. As previously mentioned, the videogame profit model is revolves around game royalties. This creates a challenge since OEM manufacturers would want to make profits on the game system. A previous videogame manufacturer, 3DO tried the OEM approach and failed miserably due to the resulting high system price. This is not to say that MS could not have created a new OEM friendly videogame model, but it would have been a difficult path.

MS chose to go with the proprietary hardware approach. This was the same model used by all of the competitors and was expected to provide the most compelling economics. However, the decision limited MS’ their ability to sell the platform to the OEMs.

Point 2: MS decided to use a proprietary designing for the Xbox360. The result was lower costs and a less OEM friendly solution. I believe that this was required to be competitive.

Enderle also argues that the Xbox360 has driven OEMs away from Windows because they feel threatened.

I disagree. OEMs have seen a continuous erosions in product prices as consumers have become increasingly price sensitive. The trend towards small and low cost netbooks further exacerbates the situation since price is one of their biggest selling points. Yet, as OEMs experience decreasing hardware differentiation and shrinking margins, they saw Microsoft maintaining strong profits as they sell high margin Windows and Office software. OEMs were always looking to increase profitability and differentiation and they saw an opportunity to take dollars from MS. These vendors naturally embraced other OSs such as Linux and Chrome in an attempt to generate increased profits and reduce MS’ dominance.

Point 3: OEMs are looking to improve profitability and take revenues from MS and their experimentation with different OSs is a natural market evolution. I do not believe that the release of the Xbox360 meaningful impacts this trend.

The final point relates to profitability. The argument is that if Microsoft focused Xbox resources on Windows then this could have had a near term impact on revenue and profits.

This argument is true, but misses the point. I believe that MS sees the Xbox as an important part of their strategy to broaden their presence in the house. Starting a new business like this is can be costly and challenging. If MS is committed to the Xbox, then they must invest consistently. Re-deploying assets away from the console gaming division and to other market segments is a recipe for failure.

Point 4: MS is committed to Xbox and must invest to be successful even if it costs revenue and profitability in other product areas.

In summary, I believe that Microsoft made the right choice entering the videogame space. The entry was driven by their desire to broaden their product portfolio outside of their traditional computer-centric model. While the business may be a fraction of the size of their traditional Windows OS and Office apps, I believe that it represents an important adjacent market that is complementary to their traditional business.

About Jay
Jay Livens works as a Director of Marketing at SEPATON. SEPATON is a manufacturer of high performance disk-based data protection solutions including deduplication and replication technology. Prior to joining SEPATON, He worked for Cambridge Computer Service a storage and backup centric VAR. Jay also spent seven years working as an equity analyst performing quantitative and qualitative analyses of technology companies. He holds an MBA from MIT’s Sloan School of Management and the Chartered Financial Analyst designation from the CFA Institute.

Jay’s posts represent his personal opinions, and do not reflect the thoughts, intentions or plans of his employer.

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