• Illustration: Xbox 360

Xbox 360, the second generation of Microsoft's game console, is meant to usurp Sony's leadership position with a combination of high-definition games, new digital media functions, and opportunities to expand and customize the console. By releasing the console worldwide in 2005—at least six months before the successors to Sony's PlayStation 2 (PS2) and Nintendo's GameCube—Microsoft could establish a market advantage and garner wide support from game developers and publishers. But unless the company can do a better job of keeping hardware costs under control in this generation, the price of any success will be steep.

Key Features: Expandability, Digital Media

Microsoft unveiled the Xbox 360 on May 12, 2005, in a special broadcast on MTV, then followed up with demonstrations and briefings at the Electronic Entertainment Expo (E3) the following week. The console, which will be released in North America in fall 2005 and in Europe and Japan by the end of the year, boasts many improvements over the current Xbox. The console itself is smaller, lighter, and sleeker; is designed to be used in either a horizontal or standing position; and will be customizable with detachable faceplates. Unlike the first Xbox, which incorporated off-the-shelf components found in many typical PCs available at the same time, Xbox 360 will be more powerful than contemporary top-of-the-line PCs and will be built around a three-core 3.2GHz PowerPC-based processor designed by Microsoft and IBM. (For more details about the console's hardware specifications, see the illustration "Xbox 360".)

Xbox 360 will also incorporate improvements such as high-definition games, modular hardware that supports swappable accessories, a four-pane onscreen interface available from within any application, enhancements to the Xbox Live service, and new digital media features—including built-in Media Center Extender functionality. However, Microsoft has not revealed pricing for the console, and it might be available in several SKUs with different hardware.

High-Definition Games

All Xbox 360 games will support both high-definition and regular television sets. Microsoft is pitching the console to retailers as a way to sell more high-definition televisions, and Samsung will provide 25,000 high-definition sets for display in retail kiosks.

Games will also support surround-sound audio output (5.1 or higher), voice communications, and the ability to play a custom soundtrack from the console's media player.

Microsoft said that between 30 and 45 games will be available within 90 days of the console's launch and announced broad third-party support. For instance, Electronic Arts will ship more titles for Xbox 360 at launch (including several sports and racing games) than it has shipped for any previous console launch, and Square Enix will ship Final Fantasy XI, a popular role-playing game in Japan that was previously a PS2 exclusive. There's no word yet on when Microsoft's highly successful Halo franchise will appear for Xbox 360, but Microsoft Chief Software Architect Bill Gates told Time Magazine that it will be timed to coincide with the launch of archrival Sony's PlayStation 3 (PS3).

Initially, Xbox 360 will not be backward compatible with all Xbox games. Instead, Microsoft said it would add backward compatibility on a game-by-game basis, starting with popular titles such as Halo and Halo 2. It's not clear whether consumers will have to buy new editions of these games or some other add-on software in order to make them playable on the new console, or whether Microsoft will make this functionality available for free.

Modular Hardware

Besides its streamlined appearance, the most striking aspect of the Xbox 360's hardware is its modularity—the ability for users to swap and add hardware and peripherals in a fashion similar to a PC—as exemplified by the following features:

Detachable hard drive. The console's 20GB hard drive will be detachable, allowing users to transfer material, such as saved games, game levels, songs, and digital photos, among multiple Xbox 360s (such as a console at a friend's house). After launch, Microsoft will allow game publishers to ship low-cost versions of Xbox 360 with a single game preinstalled and no hard drive, and users will eventually be able to upgrade their console with a larger hard drive.

USB ports. Three USB 2.0 ports will let users attach peripherals such as a specialized 802.11 wireless network adapter or Web camera designed for the console (both will be sold by Microsoft). Users will also be able to stream (but not transfer) content from portable digital media players (including Apple's iPod) or digital cameras via the USB slots.

Memory cards. Two slots for removable 64MB memory cards will let users save games, exchange them among consoles, and transfer other types of information from memory cards, such as photos from a digital camera, to the console.

Remote control. A remote control will let users control Xbox functions, such as DVD playback and Media Center Extender functionality, as well as TV functions, such as channel changing and volume control, for most common TVs.

Four-Panel User Interface

When users turn on an Xbox 360, they will see a user interface (UI) that is accessible from within any game or other application and includes four panes:

• The Home pane will include detailed, information about the user, a link to the Xbox Live Marketplace, the user's Friends list, a Message Center, and a music player. (For an illustration, see "Next Generation Xbox Guide" on page 25 of the Apr. 2005 Update.)
• Games will track all games the user owns and the user's status on each one (measured by how many game achievements the user has accomplished)
• Media will manage digital media, such as ripping audio CDs and creating playlists
• System will contain console configuration information.

Xbox Live Service Enhancements

Xbox 360 users will be represented on the Xbox Live service by a Gamer Card, which includes user ratings based on the player's previous performance, feedback from other Xbox Live gamers, and the user's style of play (e.g., competitive, relaxed).

The Xbox Live Marketplace will let users download game trailers, demos, levels, and add-ons (such as special vehicles for a race game). Eventually, Microsoft says, other types of entertainment content, such as digital music and movies, will be available through this Marketplace. Users will be able to "store" credit in their Live account, reducing the number of credit card transactions required for purchases.

With the release of the new console, Microsoft will begin to offer two tiers of Xbox Live service: Gold, which will probably cost about the same as today's service (Microsoft has not revealed pricing), and a free Silver tier. Gold customers will be able to play all Xbox 360 games head-to-head over the service, watch other players compete on games that support a new Spectator Mode, and engage in video chat over the service. Silver customers will be limited to simple arcade-style games, the Marketplace, real-time voice communications, and the ability to receive text and voice messages.

All new Xbox 360 owners who sign up for Xbox Live will get a 30-day free trial subscription to the Gold service before being converted to Silver. Existing Xbox Live customers will automatically be converted to Gold customers.

Digital Media Spoke, Not Hub

The Xbox 360 will boast many new digital media features, but will not have capabilities that PC users take for granted—for instance, users can play, but not transfer, songs from a portable media player that they attach to the console. Instead, the console will fit into Microsoft's home entertainment strategy by serving as a digital media "spoke" that functions best when used in conjunction with a PC, which will serve as the "hub."

Media Center Extender. All Xbox 360s will be Media Center Extenders. Any user with a PC running Windows XP Media Center Edition and a home network will be able to use a remote control to access Media Center functions from the Xbox 360, including watching or recording TV shows; accessing audio, video, or pictures stored on the PC; and downloading content from Media Center partner sites on the Internet. (Xbox 360, like all Media Center Extenders, grants access only to those functions available from the Media Center interface—for example, users cannot access Office or other desktop applications.) Customers with Media Center Edition 2005 will need to download a free update to their PCs in order to use the Xbox 360 as an Extender, but future versions of the Media Center OS will have this function built in.

DVD playback. Xbox 360 will play video DVDs (although Microsoft has not said which regions it will support) as well as video from recordable and rewritable DVDs. The current Xbox requires a US$29 add-on to play DVDs. However, Xbox 360 will not support either of the proposed high-definition DVD video formats (Blu-Ray or HD-DVD) that are due to be available at about the same time.

Music playlists. Like the current generation, Xbox 360 will let users "rip" music files from regular audio CDs into the Windows Media Audio (WMA) Format and arrange them into playlists, which will be playable from within the Media interface at any time (the current Xbox only plays custom playlists within supported games). Xbox 360 will also support ripping music from recordable and rewritable CDs, including WMA files and MP3 files—a feature that isn't fully supported on the current generation.

But Can It Make Money?

Sony and Nintendo have shown that console gaming can be profitable. For instance, Sony's gaming division earned US$2.2 billion on US$23.0 billion in revenues between Apr. 2001 and Mar. 2004. But Microsoft's Home and Entertainment division (which consists primarily of Xbox and games) lost US$3.0 billion on US$8.7 billion in revenues between Apr. 2002 and Mar. 2005—a roughly analogous time period from a business perspective, given that Xbox was released a year to 18 months after PS2 (depending on geographical region).

With Xbox 360, Microsoft says that the Home and Entertainment business will be profitable in Microsoft's 2007 fiscal year (which ends June 30, 2007). Several factors will determine whether Microsoft can reach this goal.

Hardware costs. Although Microsoft has never confirmed its cost of goods for the current Xbox, analysts estimate that the company was losing US$100 or more per Xbox when it was launched in Dec. 2001, and is still losing money on each box more than three years later. In contrast, the company says that the Xbox 360 hardware will be revenue-neutral over its full life cycle, which is expected to be four or five years. However, Microsoft has not detailed how it will keep Xbox 360 costs down, except to say that custom-designed components such as the CPU and graphics processor will be less expensive to manufacture than the off-the-shelf components used in the first Xbox.

Scale. Sony's PS2 had no comparable competition when it launched, which translated into high game sales, helping Sony cover its costs more quickly. It also helped Sony convince third-party publishers to create PS2 exclusives, further driving console sales in a "virtuous cycle."

By beating Sony to market in this generation, Microsoft believes it can reverse this equation. For instance, Xbox Vice President Peter Moore has said that selling 30 million Xbox 360's would not be "good enough," indicating that Microsoft is hoping to come closer to PS2's 87 million units sold. (The first Xbox will have sold between 21 and 22 million units by the end of June 2005.)

However, PS3 will be a formidable competitor when it launches in spring 2006. It will use the new Cell processor, co-designed by Sony, IBM, and Toshiba, which Sony says is twice as fast as the Xbox 360's processor on some calculations. In addition, PS3 will support up to seven wireless controllers (versus four for Xbox 360), will have six USB ports (versus three), will play high-definition DVDs in the Blu-Ray format, and will support simultaneous output to two super-high-definition (1080i) displays. Perhaps most important, given the PS2's huge installed base, PS3 will be fully backward compatible.

Given these specifications and the unclear backward-compatibility story for Xbox 360, publishers and gamers might hold tight and wait for Sony's PS3—a potential disaster for Microsoft, as few consumers are willing to buy two dissimilar game consoles within a year. To overcome this gap, Microsoft would have to attract users who are not heavily invested in any of the current consoles—that is, technology and home entertainment enthusiasts rather than hardcore gamers.

Make or Break

Even if Xbox 360 is profitable, it's unlikely to enjoy the margins of the company's core software businesses: for example, Microsoft's Windows Client business earned US$9.3 billion on US$12.0 billion in sales in its last four reported quarters.

Nonetheless, if Microsoft can duplicate Sony's success, Xbox 360 could become a welcome addition to the company's bottom line, especially as growth tapers off in more mature businesses like Windows and Office. If not, then a third-generation Xbox is unlikely.

Resources

Microsoft's official Xbox 360 site is at www.xbox360.com.

More details about Xbox 360 can be found at www.xbox.com, www.gamespot.com/features/6124293/index.html and archive.gamespy.com/landing/xbox360.

Microsoft's digital media entertainment products and technologies, such as Media Center Extenders and the PlaysForSure logo program, are covered in the Feb. 2005 Research Report, "Microsoft's Home Entertainment Strategy."