Hindered by a failure to sell large numbers of digital music players, Microsoft is singing a new Zune.

A few weeks before releasing a new version of its MP3 player called Zune HD, Microsoft (MSFT) is taking extraordinary steps to court software developers to create applications for the device, which competes with Apple's (AAPL) hugely successful iPod and iPhone. One developer of a popular iPhone application for reading Twitter messages says Microsoft recently approached him about re-creating the software to run on Zune, with Microsoft footing the bill for development costs.

The programmer declined, but Microsoft's offer speaks to the company's legendary persistence at trying to make successes out of products that fail to excite customers the first or second time around. Along with Zune HD, Microsoft is making a Zune service available for delivering movies to Microsoft's Xbox video game console. A Zune-branded music service for the Xbox, cell phones, and PCs is in the works as well. "The business is entertainment," says Brian Seitz, group marketing manager with Microsoft Zune. "The mobile device or the MP3 player is just one screen that can use the service. To erase the iPod is not what the vision was. The business is the service."

A Seven-Year Project Microsoft's dogged pursuit of success with Zune is a classic example of the company's willingness to keep investing in markets it sees as strategically important, even if early attempts to capture share fall short. Microsoft kept improving its Windows operating system for servers, SQL Server database, and Web search engine for years before having respectable products in those markets. Same goes for Zune, according to Microsoft. "When Zune was born, it was looked at as at least a seven-year project," says Seitz.

The project may pay dividends beyond the actual device. Microsoft considers Zune important to its foray into handheld computer games and other mobile software. It envisions an Internet-based Zune service that can deliver entertainment content to a wide range of devices, including those that don't bear Microsoft's logo. And Microsoft is still hopeful it can grab the quarter of the digital music player market that Apple doesn't hold, analysts say.

Sales of Zunes have been meager. Microsoft has sold about 3 million Zunes in the player's three years of availability. By comparison, Apple sold 10.2 million iPods between March and June of this year.

As of June, Zune commanded a mere 2% share of the MP3 player market, compared to 73% share for Apple's devices, according to market researcher NPD Group. Revenues in Microsoft's entertainment and devices unit, which includes the Xbox and Zune, declined 25%, to $1.18 billion, in the company's fiscal fourth quarter ended June 30. Revenues from Microsoft's "nongaming business" declined by $292 million, or 12%, "primarily reflecting decreased Zune and PC hardware product revenue," Microsoft said in its July 23 earnings release. The division lost $130 million in the quarter.

Taking the Focus Off the Hardware Even the snazzy new Zune HD, which boasts features like high-definition video output to televisions, high-definition radio, and a touchscreen, is unlikely to shift that balance significantly, according to analysts. "If I were Microsoft, I'd just drop it," says Charlie Wolf, senior analyst at Needham & Co.

By repositioning Zune as an online service for a variety of devices, Microsoft hopes to reverse Zune's fortunes, and breathe new life into its handheld computing efforts.

The move to de-emphasize the hardware makes sense: The MP3 market's growth will likely ebb in the next couple of years, as more people use their phones to listen to digital music, says Sonal Gandhi, an analyst at Forrester Research (FORR). Today, much of the growth comes from the high end of the market, where Apple's iPod Touch is king.

Zune HD, with a 3.3-inch screen, high-definition radio tuner, and the ability to stream stored movies onto TVs, will compete on features and price with Apple's offering. Zune HD starts at $220 for a device with 16 gigabytes of storage, compared with $229 for the least expensive iPod Touch. But Apple is expected to unveil its next-generation iPods in September, and could lower their prices or offer better functionality.

Most likely, Zune HD customers will be current Zune owners looking to upgrade their hardware—a small addressable market, says Gandhi.

Wooing Xbox Users That's part of the reason why Microsoft is looking at the broader opportunity represented by digital entertainment services. This fall, Xbox users will be able to buy or rent movies for the console using Microsoft's Zune service, later downloading the files onto Zunes for no extra fee. The new collection for Xbox users will include an extensive library of music videos available for Zunes.

Eventually, the Zune digital store could make its way into everything from netbooks to cell phones. "You should consider Zune as proof of concept" of future efforts, says Ross Rubin, director of industry analysis at NPD Group.

Zune services could even come to be used on non-Microsoft devices. "Everything is on the table," says Microsoft's Seitz. Wireless carriers may, in the future, be able to use Zune services to sell content for all kinds of different handsets, for example. Any device with a Web browser may be able to gain access to the Zune store, too. According to a Microsoft want ad, it hopes to hire a Zune program manager responsible for "delivering a media service that millions of consumers around the globe enjoy on several end-points—Web, Xbox, Zune, and in the future, Windows Mobile."

Microsoft does claim some advantages in the music player market. Its novel Zune Pass service lets listeners stream as many songs as they want for $15 per month, and swap songs wirelessly with fellow Zune owners to sample, but not own. It's possible Zune could evolve into a business like Xbox, where Microsoft loses money on the hardware and recoups it on the software.

Zune's easy-to-navigate and intuitive menus may also help invigorate Microsoft's cell-phone software. The company's smartphone operating system, Windows Mobile, held just 9% of the smartphone market over the past year, according to industry consultant Canalys. Analysts blame Windows Mobile's clunky menus in part for sluggish adoption by handset makers and consumers.

Waiting for Windows Mobile 7 Augmented with Zune's snappier menus that allow users to navigate applications and services, however, the software—possibly in its Windows Mobile 7 version expected in 2010—may be more successful, says NPD's Rubin.

Microsoft is trying out various ways to reach cell-phone users who don't run Windows Mobile. On Aug. 24, Microsoft announced its new OneApp service, which allows workaday cell phones to gain access to sites like Facebook and Twitter.

A Zune store may even be able to sell Windows Mobile apps in a more user-friendly fashion. "We are not going to have our own app stores," says Seitz. "Windows Mobile right now is tackling that challenge." The Zune team eventually wants to sell applications that let Zune owners log onto popular Web services like Twitter, says Seitz. But Jack Gold, founder of consultant J. Gold Associates says it's not a sure thing that applications created for Windows Mobile would port easily to Zunes.

As with so much in the computing world nowadays, Zune's appeal will rest largely on the availability of innovative applications from third parties that make the hardware more compelling. But, as Microsoft has seen, getting developers to create Zune apps won't be an easy task. The iPhone developer Microsoft courted to re-create his Twitter-reading application says there's more money to be made writing for Apple's platform.

Microsoft will keep hammering away at the digital music market, but it's not dealing from a position of strength.

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