Commentary: Xbox Problems? Microsoft's Not Singing the Blues

By Jay Greene

When Microsoft Corp. (MSFT ) launched its Xbox game console 18 months ago, Microsoft watchers braced for a long, costly slog. The company had started years behind the leaders, Sony (SNE ) Corp. and Nintendo (NTDOY ) Co. And when the billions spent began to drag on earnings, analysts wrung their hands over the Xbox "black hole."

Xbox may be a money drain, but it's hardly a black hole. Worldwide, 7.84 million Xbox consoles were sold through Mar. 31, vs. 7.78 million Nintendo GameCubes. Now Xbox is looking up only at Sony, says market researcher International Development Group. Emboldened, Microsoft is moving the Xbox beyond the $27 billion video-gaming industry. On May 12, Microsoft will unveil Music Mixer, a karaoke product for Xbox that lets users sing along. "We think of ourselves as being in the interactive entertainment business, not the game business," says Robert J. Bach, chief Xbox officer.

That puts Microsoft in direct competition with Sony to be king of the digital living room -- where it has little expertise. Not only has Sony's PlayStation 2 outsold Xbox sixfold, thanks to its superior portfolio of games, but it's also a leading brand for TVs, stereos, computers, and digital cameras. "Should King Kong take on Godzilla in Godzilla's backyard?" asks Michael Pachter, a video-game analyst at Wedbush Morgan Securities.

The answer: Yes. Most analysts don't expect Microsoft, which lost nearly $250 million on Xbox in the first half of the fiscal year, to turn a profit on its video-game foray until at least 2005. And Microsoft may never dislodge Sony from its throne. But the spoils of the digital living room are too lucrative, and strategically vital, for Microsoft to cede them to Sony. Microsoft is hungry for growth markets. And the digital revolution in entertainment is taking root. Video on demand and online music alone will generate $3.3 billion by 2006, says researcher GartnerG2. Microsoft says its software expertise will be the key to manipulating and enjoying digital entertainment. And Xbox leads the Microsoft rush into the living room, helping it sell software for PCs and home-networking gear.

There's a crucial difference in Microsoft's approach this time that bodes well for its chances: It hasn't attacked in the usual way, by leveraging its Windows monopoly and copying rivals' technology. That won't cut it in the entertainment business. Instead, the company has out-innovated the competition, creating a technically superior console to PlayStation 2 and GameCube. Its well-conceived online-gaming service, Xbox Live, is also more sophisticated than the approaches taken by rivals.

For Microsoft, Music Mixer signals another step forward on the innovation front. For $39.99, customers get a disk and a microphone and can do their best imitations of everyone from Sting to Sinatra. And Music Mixer lets users load photos onto their Xbox and create slide shows to their tunes.

Microsoft is plotting new ways to pack Xbox with consumer punch. The updated version of Xbox Live, due this fall, will let users talk with each other online even if they're not playing a game. And the company is working on technology to let users copy TV programs onto PC hard drives and use Xbox to play those recordings on TV. "You just need software," says Bach's technical lieutenant, J Allard. "It's all right there, waiting to happen."

Sony doesn't aim to be left behind. It's working on PlayStation 3, with eye-popping technology analysts expect will, among other things, let users record and replay TV programming.

Microsoft is showing it can succeed in the digital living room without using Windows as a crutch. The key is to replace force with innovation. That's welcome news for consumers -- and for shareholders.

Greene is Seattle bureau chief.

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