In Round 1 of this week's edition of Vs. Mode, we wrote that Microsoft was shafting early adopters with its introduction of the $479 Xbox 360 Elite (ditto by charging $199 for the 120 gigabyte hard drive add-on) and that savvy gamers would likely reject it at that price just as they had rejected the $299 Core Pack. San Jose Mercury News technology columnist and blogger Dean Takahashi agreed that the pricing of the Elite was a mistake. But he ultimately chose to accentuate the positive, suggesting that with Microsoft planning to software upgrade Xbox 360s to support IPTV, we could soon see the Elite priced at $279 or lower with a two-year subscription to services like AT&T's U-verse.

Today, in Round 2, no more Mr. Nice Blogger. We take apart Microsoft's arguments that its multi-SKU strategy can be plausibly compared to those of iPods and mobile phones, and posit that Microsoft's quest for higher ARPU runs the risk of alienating its early adopter base. Takahashi, however, absorbs our verbal jabs with ease, counter-punching with the unassailable argument that the Xbox 360's early launch gives Microsoft more flexibility on pricing--and that we've yet to see the full range of that flexibility. In the battle of What Is vs. What Could Be, which side will you take? Let us know what you think in the Level Up message boards.

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To: Dean Takahashi

Fr: N'Gai Croal

Date: April 5, 2007

Re: The Kings of Wishful Thinking

Dean,

I'm having flashbacks to another 1999 movie. Is there a hidden doorway at the San Jose Mercury News that leads directly into [Microsoft president of entertainment and devices] Robbie Bach's mind? Because your post almost certainly captures Microsoft's thinking behind the Elite. If I didn't know better, I'd swear you've written a pair of books on the company's two consoles.

Microsoft's strategy, as you've laid it out in your previous post, is, um, interesting.

1. Start with a console--well, two actually; one $299, one $399--only one of which (the more expensive of the pair) is adopted en masse by gamers.

2. After the second Christmas, when the PlayStation 2 dropped its price from $299 to $199 to start bringing in a wider audience, don't cut price. Instead, introduce a higher-priced $479 black version, long after your early adopters have bought their machines, with a pair of features "a larger 120 gigabyte hard drive and an HDMI port "that Microsoft itself has long insisted have nothing to do with gaming. This is what the company has termed its iPod strategy.

3. Later, when Microsoft rolls out its IPTV service, you propose that we may see a $279 Xbox 360 Elite with a two-year service commitment--the mobile phone strategy--alongside a $199 Core, a $299 Premium and a $399 Elite.

This isn't a strategy. This is wishful thinking--and a recipe for consumer confusion.

Just as anyone who buys an iPod is doing so primarily to listen to digital music, anyone who buys a videogame console is doing so primarily to play disc-based videogames. There is additional functionality to both devices, like video and photos, but those are the main reasons to purchase each one. (Besides, when it comes to the Xbox 360's additional functionality, the appeal of video and photos is nowhere near as proven as it is on the iPod. Especially given the reasonable assumption that Xbox 360 early adopters are quite familiar with file-sharing protocols like BitTorrent and LimeWire.) Increasing the size of the hard drive on an iPod lets you store more music. Increasing the size of the hard drive on an Xbox 360 doesn't let you play more disc-based videogames, and you don't need 120 gigabytes worth of storage for Xbox Live Arcade games. No, 120 gigabytes of storage is all about one-upsmanship and digital video--which, as I've pointed out, is still largely unproven market share driver for the console.

What else have the folks at Microsoft done? They've added HDMI, which they've said ad nauseum isn't necessary for gaming. They've changed the color, a la iPod or Nintendo DS. But those are portable devices, where color and style matter far more. Did they do anything more fundamental, like redesign it or shrink it, as Sony did with the slimline PS2; as Nintendo did with the DS Lite; as Apple did with the iPod Mini and the Nano; or as RIM did with the BlackBerry Pearl? No. Did they improve the internals to reduce fan noise or heat? Nope. It's the same old Xbox 360, in black, with an additional video port and a bigger hard drive. So why exactly would a savvy gamer buy the Xbox 360 Elite--and why should we or anyone else believe Microsoft's absurd analogies to iPods and mobile phones, when they've done none of the things that generally convince such devotees to repurchase and such aspirants to buy in? Truth be told, Microsoft doesn't expect savvy gamers to buy the Xbox 360 Elite--at least not the ones who've already bought a Premium, according to what they're already saying privately. But if not savvy gamers and early adopters, then who?

I fully believe that early adopters and hardcore gamers are amenable to paying more for consoles than they have in previous generations. But in my opinion, Microsoft is completely misreading that willingness with the Elite, and not only at its introductory price point of $479. If Microsoft cuts its prices across the board as you've suggested--$199 Core, a $299 Premium and a $399 Elite--I'll bet anything but my dreadlocks that droves of consumers still opt for the Premium over both the Core and the Elite. Why? Because even though I've advanced the theory that the large numbers of yet-to-buy-a-360 Halo and Halo 2 fans may be far more price-sensitive when it comes to hardware than anyone has previously suggested--largely because most of those who bought the Xbox for Halo did so at $199, and most of those who bought the Xbox for Halo 2 did so at $149 or less--the Premium is still by far the best value.

This can be explained by another point you made in your last email. After hemorrhaging billions of dollars during all but one quarter of the Xbox unit's existence, there is clear pressure on Robbie Bach and [corporate vice president] Peter Moore to turn a profit this generation. Nowhere is this more clear than the cost of the company's Xbox 360 accessories: $100 for a Wi-Fi add-on. $100 for a 20 gigabyte hard drive. $50 for a 512 megabyte memory card (originally $40 for a measly 64 megabytes.) Add to that now $179 for the 120 gigabyte hard drive, and it becomes clear that Microsoft's strategy can only be described by a single word: price-gouging. Now, there is a more polite term I could have used. It's called ARPU, or Average Revenue Per User, which Microsoft is clearly trying to drive up in its battle for profitability. But when the pricing strategy is so completely out of whack with that of comparable hard drives and flash memory, the price-gouging T-shirt clearly fits, and Microsoft will have to wear it with pride.

In fairness to Microsoft's executives, they didn't invent this strategy. Sony did precisely the same thing by charging $34 for its 8 megabyte memory cards when the PS2 launched in 2000. But with the Playstation 3, Sony has completely changed its strategy by doing away with memory cards entirely in favor of support for not just its own proprietary Memory Stick format, but also SD and Compact Flash, along with standard 2.5-inch laptop hard drives. This means that gamers who want to upgrade the hard drives in their PS3s can do so for far less--all they have to do buy a 2.5-inch drive from the retailer of their choice and follow the instructions in the manual--because Microsoft has chosen to wrap its standard hard drives in a proprietary enclosure. Ditto for Microsoft's proprietary wireless controllers and headsets, as compared to Sony's use of Bluetooth, which allows gamers' wireless mobile phone headsets to work with their PS3s. None of this is great for Sony's bottom line or its shareholders, but it's terrific for educated gamers and early adopters--who are also precisely the audience for the Xbox 360 Elite and the various accessories. Again, a quick scan of various message boards shows that Microsoft's decision, on this front at least, to fight the last battle is costing it the goodwill of a good number of its most valuable customers.

As for as the Elite bolstering Microsoft's IPTV strategy, I'll just repeat that a) the early adopters, who are more willing to radically switch where they get their content, have already bought the Premium; and add that b) I'm very curious to see who will be marketing your $279 Xbox 360 Elite with a two-year U-verse subscription: Microsoft or AT&T.

But enough about the Elite, for me, anyway. Sony has recently cut the price of the PlayStation Portable from $199 to $169, and is currently in the midst of a re-branding campaign. Is that going to have any impact on the PSP's anemic software sales? I know you haven't written a book on the Playstation--yet?--but I'd still like to get your take.

Cheers,

N'Gai

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To: N'Gai Croal

Fr: Dean Takahashi

Date: April 5, 2007

Re: The PSP Elite

Such a brief response and sent at so early an hour? I must have talked you out.

Thank you for the compliment on my ability to pretend that I am inside the mind of the man of many golf shirts. Now while I said that I think this is what Microsoft is doing, I didn't say it was really smart. And I didn't say they were going to have no trouble rolling up the competition. This is one of those real-time strategy games where the players send a lot of soldiers into the meat grinders, only to see them get chewed up to no gain.

I'll point out one more thing. The advantage of going first is that Microsoft is under less pressure to worry about price. It can try to milk the market at the higher $400 price for the Premium as long as consoles are still moving and the competitors are supply constrained. As soon as console sales slow to an unacceptable pace and the competitors get a lot of product on the shelves, it's time to lower the boom on prices. But Microsoft has more options on pricing.

Now here's what I would do. I would do a reality check on costs. If they're turning out as predicted, nothing affects my usual strategy. But if they're higher because Microsoft is experiencing so many bad system returns, then I'd have to wait on cutting prices. In any case, as the cost reductions come in, as the 65 nm chips come in, I'd start slashing the prices. Microsoft should balance the twin concerns of profits and market share. It hasn't gained quite enough market share yet to apply pressure to the other guys. So it should dwell on market share in the short term. It should cut its price, particularly when the 65 nm chips come.

I don't think we should judge Microsoft as if it has played all of its cards. When the 65 nm chips arrive, presumably in the fall, that's when it can start whacking costs and prices. So your point about No. 2 is a little too judgmental at this point. I think they're going to cut price. I think they can do that in the second half of the year.

The point about No. 3 isn't a good one, I'd say, since consumers don't get confused about mobile phone pricing these days. They know they pay more if they get no service contract. They know they get a discount if they sign up for two years.

The amusing joke I didn't mention about the IPTV strategy, and possible alliance with AT&T, came from George Harrison at Nintendo of America. If AT&T offers a subsidized Xbox 360 in exchange for an IPTV service contract, Harrison said, "Maybe Microsoft can transfer its losses to AT&T."

Now, back to reality. You are the wise man here in some respects. I agree that Microsoft does not have a compelling product with the Elite at the price of $479. But what would you say if the Elite were priced at $400? I guess we'll debate that point if it happens. Again, you are right about the dangers of milking profits. Sony and Microsoft are trying to charge what the market will bear. Nintendo is moving in and seizing the opportunity to grab the consumers who want reasonable and historical prices. If Nintendo gets too much momentum, the tables will turn, Microsoft will squander its advantage, and Sony won't get liftoff.

As for the PlayStation Portable, I think Sony made its price move out of a position of weakness. As you know, it cut the price from $199 to $169 on the Core pack. They are close to the $129 price of the Nintendo DS Lite. But as we all know, it's 35 million for the DS, and 25 million (or more like 20 million sold) for the PSP. Sony had to close the gap on pricing. The fact they waited until after the close of the fiscal year on March 31 shows how much they are hurting. The question remains: where is the content that will beat the DS? Where is the Brain Age, the Nintendogs, Animal Crossing, etc.? Sony can turn it all around with good games, but it's getting harder to do that as companies such as Electronic Arts shift their weight to developing more DS games. With 20 million units sold, the PSP's situation isn't as dire as, say, Microsoft's Zune situation. But Sony can't let Nintendo pull too far ahead.

Can anybody say PSP 2?

Cheers,

Dean

Next: In which we finally switch gears and take on the problems facing Sony's PlayStation Portable.