The Bug In Microsoft's Ear

It's mulling its own digital device that adds gaming to music and video

After getting trounced for four years in the digital music business by Apple Computer Inc. (AAPL ), Microsoft Corp. (MSFT ) finally seems poised to do something about it. BusinessWeek has learned that the software giant is working on plans to develop its own portable digital media device to rival the iPod rather than just providing technology to partners. Microsoft hasn't decided if it will go ahead. But sources inside the company and at its partners say Microsoft has put together a team that's considering the business end of such an initiative.

Going forward with it would be an acknowledgement that the current strategy isn't working. Chairman William H. Gates III has argued that consumers would prefer a vast choice of devices to the limited selection from Apple. That's why Microsoft has relied on dozens of partners to come up with sleek devices and clever online-music services that use its software. But each year, Apple extends its lead in digital music. In 2005, Apple's share of portable media devices sold in the U.S. grew to 67% from 52% in 2004, according to NPD Group Inc. Making its own device, despite an uneven track record in consumer electronics, may be Microsoft's only viable alternative.

What would it look like? Xbox boss Peter Moore says any Microsoft media device would have to leverage the company's most significant consumer strength, video gaming. "It can't just be our version of the iPod," says Moore, who nonetheless would not confirm that Microsoft is considering making such a device. So in addition to playing music and videos, a Microsoft device would include games. Microsoft would probably use the Xbox brand to market the gadget. "I think the brand is an opportunity," Moore says.

True, perhaps, but also risky. If the new device comes with the Xbox brand, most consumers will view it as a game player, like Sony Corp.'s (SNE ) PlayStation Portable. That might limit its appeal since the portable gaming market is much smaller than the one for digital media.


There's also the risk of alienating partners. If Microsoft fashions its own gadget, those device makers could abandon Microsoft's digital media technology and devise their own software. "Everybody will try to do their own thing to differentiate," says Sim Wong Hoo, chief executive of Creative Technology Ltd., the No. 2 digital media device maker. "What Microsoft was trying to build will collapse."

With $39.8 billion in annual sales, Microsoft isn't particularly interested in increments from the digital media device business or online music. It's after a spot in consumers' living rooms. The more consumers purchase iPods, the more they'll buy songs and videos from iTunes and the various iPod accessories to play music and video around their house. That in turn convinces more entertainment companies to partner with Apple. "The stakes are incredibly high," says Michael Gartenberg, vice-president and research director at JupiterResearch (JUPM ).

The question still remains: Will Microsoft really do it? It has abandoned efforts over the years to make everything from computer speakers to PC-connected telephones. The company gave some clues in December, when it put its digital media software unit and its MSN Music service under Robert J. Bach, president of the Entertainment & Devices Div. "It's a lot easier to talk about the end-to-end scenarios because it's all under Robbie," says Microsoft's Moore. Indeed, the soup-to-nuts approach has been the key to Apple's success. For Microsoft, it may be worth the risk.

    Before it's here, it's on the Bloomberg Terminal.