Microsoft (NASDAQ:MSFT) was still in damage control mode at this year's E3 (Electronic Entertainment Expo) held this week in Los Angeles regarding Xbox One (XB1), following the marketing debacle that was the Xbox One unveiling at E3 last year. The reason is that in the first quarter of the year, Xbox One sales fell seriously behind Sony's (NYSE:SNE) PlayStation 4 with 1.2 million units vs. 2.8 million for PS4.
XB1 and PS4 had gotten off to a reasonably even start during the holidays at 3.9 million XB1s vs. 4.2 million PS4s sold as of the end of the year. At the time, it appeared that Microsoft had put the unveiling behind it, but flagging sales call this into question. Coming out of E3, there is the sense that Sony is very much leading the console race.
At its introduction, I felt the strategy behind the positioning of Xbox One as a multi-media device was sound. The strategy recognized that the consumer desktop PC was becoming obsolete in the age of increasingly powerful mobile devices. Immersive gaming was the only area left that was effectively out of reach of mobile devices by virtue of the greater electrical power required for the graphics processing of immersive games.
If the game console was to replace the desktop PC by virtue of offering the only thing that mobile devices could not, then it made sense to endow the console with other PC qualities in order to hasten the process of replacement. Microsoft would offer not only a game console but a substitute for the general purpose desktop PC and the home theater PC, with functions all accessible from the couch.
The Microsoft vision of the Xbox One also folded in many of the desirable features of the always connected mobile device:
1) A pre-installed and largely fuss-free operating system regularly updated over the Internet.
2) A platform that exists to drive digital content sales, often purchased over the Internet through the device.
3) A social media device that links users with friends and enables sharing of game play.
If Microsoft had been able to do all that while being price competitive with the PlayStation 4, Xbox One would have made a good value proposition for console consumers, even ones mainly interested in games. That didn't happen, primarily because of the additional cost of the Kinect sensor (about $100) that was required to bring much of that added PC functionality to the Xbox.
What happened with Kinect really demonstrates the difficulty of adapting the functionality of a touch screen device for use on a non-touch screen home television. Microsoft gave Xbox an operating system based on Windows 8, replete with Modern UI tiles. Kinect was to provide the substitute for gesture recognition (swipes, pinches, touches) so common to touch screen platforms, without the need of a remote device.
Kinect constituted an elegant solution to the problem of finding a substitute for a touch screen interface, and I give MS a lot of credit for fielding something that works reasonably well and only costs $100. But it was $100 too much for many in the key target audience of console gamers. Bundling Kinect with Xbox One made sense from a technical standpoint, but it antagonized gamers who felt they were being forced to buy something they didn't need. It was all down hill from there.
Since the 2013 E3 debacle, Microsoft has backpedaled on virtually everything that gamers found objectionable. They've retracted most of the digital rights management provisions that gamers objected to. They've removed the requirement to be connected to the Internet in order to play disk based games. But only recently has Microsoft removed the feature that most gamers found objectionable and unbundled the Kinect sensor, bringing the cost of Xbox One into line with PS4.
This year's E3 presentation by Phil Spencer, head of Microsoft's Xbox division, was almost obsequious to the gamer community. Phil emphasized that "we're listening to you" and that Xbox One is first and foremost a gaming platform. Most of the Microsoft presentation consisted of previews of upcoming Xbox games with nary a mention of Kinect.
Falling on Deaf Ears
It remains to be seen whether unbundling the Kinect sensor has come in time. I get the impression that most gamers have simply turned away from Xbox One for a number of reasons beyond what I've already mentioned:
1) Graphics quality. Admittedly this is a subjective impression, but after viewing the previews for Xbox One games and PS 4 games shown at E3, the PS 4 games do look better to me. This actually came as a surprise, given that both consoles use roughly equivalent AMD processors. There could be a specific technical reason for this, once again traceable to Kinect. MS reserves a certain amount of processing power for Kinect in the current Xbox One system, whether developers use it or not. A new SDK that MS is releasing allows developers to tap into this additional horsepower, but no games are available yet that use the new SDK.
2) Impaired Modern UI. Removing the requirement for Kinect left the Windows 8 Modern UI, which serves as the basis for Xbox One, with nothing much to work with except the game controller D-pad. Navigating Modern UI with a D-pad is cumbersome at best.
3) Unattractive Packaging. There is a way to make things out of plastic that doesn't look cheesy, but clearly the designers of Xbox One never mastered this skill. It astonishes me that Microsoft wanted to position Xbox One as the centerpiece of a home entertainment system, yet gave so little thought to how it looks.
Saving Xbox One
Some Microsoft investors might wonder whether saving Xbox One is even worth the effort. Consoles are strictly small potatoes compared to PC licensing, the main business of the Devices and Consumer Segment. In the most recent quarter, D&C licensing generated $4.38 billion in revenue, while D&C hardware (which includes Surface and Surface Pro as well as Xbox) generated $1.97 billion.
However, if Microsoft is to be an integrated devices and services company, it needs the hardware side of the business, which also helps generate content sales revenue. One way to think about Xbox One is that it's Microsoft's sole non-mobile PC.
Even though XB1 has fallen behind PS4, Microsoft points out that it's selling 60% better than Xbox 360 at this point in the release cycle. And XB1 is helping drive content sales, with Xbox combined platforms racking up the most console game sales, 4.1 million games, of any console platform. Certainly, Microsoft will not give up on Xbox One.
It may be that the recent change on Kinect, combined with new game releases such as Titanfall, will be enough to spur sales to PS4 levels. Investors can watch the revenue performance of the D&C hardware segment, as well as compare unit sales of Xbox One with PS4 to see whether the Microsoft Xbox One strategy is succeeding.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.