Microsoft And The Complicated Gaming War That Is Unfolding

| About: Microsoft Corporation (MSFT)
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Mr. John Carmack, known for his work on gaming titles such as Doom, was able to set the internet ablaze with speculation with one simple tweet following Advanced Micro Devices' (NASDAQ:AMD) GPU 2014 Event.

This tweet was posted shortly after my article on "Mantle" was published. Rather than trying to be quick to the keyboard, I wanted to take a step back, do some digging, and think about the announcements made this week as a whole.

There are several disruptive events happening concurrently in the gaming market. In this first article I will explore the implications of these changes on the overall market, with the main focus on Microsoft (NASDAQ:MSFT). In a future article I will discuss the impact on the hardware suppliers.

Enter SteamOS

Valve, a prominent company in the gaming industry, is releasing an operating system next year which will be a direct threat to Microsoft's Windows OS.

I feel the most appealing feature of this OS is the price tag -- free.

A quick glance at the Steam Hardware Survey reveals that Windows 7 is the OS of choice for the vast majority of users, followed by Windows 8, and then more distantly by various flavors of Apple's OS X and versions of Linux.

The reason I feel SteamOS has the potential to be a disruptive force to Microsoft is the sheer size of the user base. As of 2012, Steam had 54 million active users. The graph above depicts that roughly 10% of this user base is logging into Steam daily.

Many gamers belong to the DIY community of computer builders. An individual builder buying a single copy of a Windows license is spending roughly $100 on a copy of either Windows 7 or Windows 8.

Newegg users give Windows 7 five "eggs" on average, whereas Windows 8 fares far worse with only three "eggs", barely enough for an omelet.

You have Windows 8, an operating system that has received mediocre reviews, competing against a free OS designed specifically for gaming.

Directly, this could take revenue from Microsoft in the form of fewer Windows licenses being sold. DIY builders could save money on the OS to sink more into the hardware. Retail PC builders could offer cheaper hardware by opting for a free OS over Windows.

Indirectly, this will give a major boost to competing operating systems. There are already free Linux based operating systems. This week both AMD and Nvidia (NASDAQ:NVDA) have announced they are stepping up Linux driver support as the Linux community is gaining traction. The better support these operating systems receive, the more competition Microsoft will have from free operating systems.

I feel the indirect threat I have outlined above is the bigger threat to Microsoft. Currently, Microsoft is trying to push into mobile in a more meaningful way. Better support for competing operating systems could mean Microsoft is losing traction in their traditional business, which could offset any gains seen from a push into mobile.

A Brief History of Mr. Gabe Newell's Prior Success

Image Courtesy of ExtremeTech

Sebastian Anthony has a write-up on ExtremeTech regarding the history of gaming on Windows Mr. Newell's efforts when he was a member of the Microsoft team.

Mr. Newell left Microsoft in 1996 to co-found Valve, the company that gave us the Half-Life franchise and the Steam platform, and is now poised to launch SteamOS.

When Windows 8 was launched, Mr. Newell described the new OS as a "catastrophe." After he announced this, the general speculation was that it was due to the fear that Microsoft would move to more of a "closed model."

Consider Apple's App Store in iOS. Developers sell apps in the App Store, and in turn Apple receives a cut. The fear was that eventually Microsoft would make it difficult to install third party software by forcing apps to be installed through the Windows market place.

This is important because you have an ex-Microsoft employee, that while at Microsoft, helped turn Windows into a viable gaming platform -- making an OS capable of running games is charted territory for Gabe. Although Valve's success with SteamOS is not guaranteed, it should not be dismissed either.

How Will A SteamBox And SteamOS Impact Existing Consoles?

Articles on ExtremeTech and AnandTech also explore the implications for gaming on a SteamBox and the launch of a new OS.

On traditional consoles, games are coded for a specific hardware set. This ensures equal performance across all hardware, while at the same time preventing random incompatibilities in the system.

Contrast this against PCs, where users at different points along the performance/price spectrum are free to choose hardware that will suit their gaming needs. But throughout the entire hardware gamut, both budget and power users are stuck dealing with random incompatibilities, driver updates that break their specific hardware, etc.

In my opinion, if you consider the free price tag attached to SteamOS as a big advantage, the fact that a SteamBox will likely be upgradeable is by far its biggest pro. Both of these features will serve to lower the TCO of a Steam device. I will come back to this thought at the end of this section.

According to Mr. Carmack's statement, he feels Sony (NYSE:SNE) and Microsoft may be hostile toward Mantle. If these companies are hostile toward Mantle, they should be fearful of a SteamBox and SteamOS.

Whether or not you are a subscriber to the idea that console gaming is in trouble, in my opinion there is at a minimum "techtonic" shifts going on throughout the gaming industry. As an aside, I feel at least in the near term demand for consoles will be strong, and could remain so if Sony and Microsoft actively embrace free-to-play titles. I will come back to this thought as well.

Starting with the casual users, there are lightweight gamers that can have their appetite satiated by games like Mario Bros. or Sports Resort on the Wii. I feel these are the users that are going to gravitate toward CandyCrush and Cut The Rope. Moving on, you have hardcore gamers that can never be satisfied by Angry Birds. Smart phone and tablet games will serve to pass the time while we are unable to play our more demanding titles. And fitting in more with the hardcore genre of gamer, you have those that enjoy the advent of free-to-play (or pay-to-win) titles such as League of Legends.

I feel the success of the next generation consoles will depend largely on this final category of user. Whether or not Sony and Microsoft are able to effectively monetize in the beginning is almost irrelevant. These free-to-play titles are wildly popular, and by not embracing this change, console makers could alienate their respective companies. The good news is that both the PS4 and Xbox One seem to support free-to-play titles.

As these companies are embracing one change, they should also brace for another. The idea of a SteamBox is a complete departure from the norm in consoles. Unlike traditional consoles, a SteamBox will be user upgradeable. If low level APIs are successful at boosting PC gaming performance, consoles will lose one edge they have had over traditional PCs. Low level APIs were able to prevent consoles from being completely outgunned by PCs, and Mantle represents a chance that consoles will lose this edge.

There are two points I would like to make. In the near term, hardware differences between the consoles and a SteamBox will likely not be that large at the same price points. Both traditional console makers are willing to make very little profit, or even take a small loss on hardware sales and will make profits on licensing and games. If SteamBoxes are made by third party vendors there will be no motivation to lose money on hardware sales.

The benefit of the SteamBox in that is user upgradeable means that in a couple of years when the SteamBox is outdated by PC standards, a user can swap out a couple of components and have faster machine. But typically, consoles go down in price after launch. This will create a larger divergence in price vs. performance. Users that do not want to spend money will be better served by a Playstation or Xbox after a price drop. Those that are willing to pay top dollar for performance could gravitate toward a SteamBox.

The other unique aspect of the shift in the gaming market is that this is the first time I can think of where there is such a high level of unification among various platforms. Many hardware review sites point out that low level APIs have been tried before, but eventually DirectX and OpenGL APIs were invented to unify them.

What I have not seen is the mention of the fact that back when there was such a division among programming models, there was little overlap between PC and console games. If you wanted to play Quake or Doom, you were on a PC. If you wanted to play Mario 64, you were on Nintendo. Fast forward to today, and if I want to play Battlefield I have to decide if I want to do so on a PC, Xbox, or Playstation.

On the outgoing generation of consoles, these games were run on very different architectures. This year, console makers are largely sacrificing backwards compatibility and proprietary standards to unify the gaming industry and move toward a more unified architecture. Also, games are common to both PC and consoles, which is a departure from ~10 years ago. As consoles have moved to a more standardized architecture, there will likely be greater levels of backwards compatibility going forward.

This means we could see the refresh cycle between consoles shrink. This is a second way, other than price, in which consoles can compete with a SteamBox moving forward, made possible by moving to a stable architecture that is shared between consoles and PCs. I will not be surprised in 3-4 years if the SteamBox is successful to see Sony and Microsoft answer with beefed up consoles, or consoles modified to have select components be user upgradeable.


I feel the biggest change that is going to occur is that Microsoft will have increased OS competition from SteamOS.

The Windows division of Microsoft is currently the company's third largest revenue driver. Increased competition from SteamOS has the potential to directly, and negatively, impact revenues moving forward due to fewer licenses for Windows being sold as both DIY builders and PC builders save money by choosing a free OS. Microsoft has been attempting to push into mobile, but could lose traction in traditional markets, which could offset gains seen by increased mobile sales.

SteamOS also means Valve is building out the software infrastructure to support a Linux OS, which will strengthen Microsoft's competition. A typical barriers to entry for software is ease of use. Windows 8 received a lukewarm reception because consumers did not like the change. To make SteamOS a viable operating system, it not only needs to be functional, but also easy to use. The Steam platform on Windows is very easy to use. I much prefer it over EA's Origin service. Valve making an operating system that is free, fully functional, and easy to use represents the worst case scenario for Microsoft.

A SteamBox will most likely not have an immediate effect on consoles. First, there is currently nothing stopping users from building their own SteamBox. There are even tutorials on how to do so. Steam has created a GUI (graphical user interface) designed for the big screen. A consumer can build a SteamBox, load Windows or Ubuntu now, and later wipe the hard drive or setup a dual boot system with both Windows and SteamOS.

SteamBox prototypes will be available by the end of the year, so actual devices are likely at least a few months past the prototype phase. However, one caveat I know of so far is the Xi3 piston. I brought up the Piston in my first Seeking Alpha article several months ago. Apparently, we will find out more information about Piston on Monday. Valve has also stated we can expect more details on hardware specifications next week, so I expect some of the speculation to become more concrete in the near future.

There are several factors that lead me to believe the impact on consoles will not be felt until later in 2014. First, based on the dates and information available, it seems like we will be well into the first quarter of next year before we start seeing Steam hardware become commonplace. Second, Sony and Microsoft are shooting more to break even on hardware rather than turn a profit. If a SteamBox is made by a third party vendor, there will be little incentive to compete on price. To prove a point, the Xi3 current pre-order price is listed at $999. If Xbox One's price tag ruffled feathers, $999 will likely not go over well. Sony and Microsoft seem to be actively embracing free-to-play titles. Failing to embrace free-to-play would be my absolute biggest concern for the companies, but this does not seem to be the case.

Lastly, and most excitingly, unifying the architectures and games between consoles and PCs should serve to minimize the time required to port titles, allowing developers to spend more time optimizing and polishing titles, which will be good for the industry. In turn, they could also minimize production costs. This would allow developers to lower prices on games, as well as make it easier for Microsoft and Sony to refresh console hardware faster.

In summary, I feel the impact on consoles is at least several months away, and there are ways that Sony and Microsoft can counter a direct threat by a SteamBox. In the more immediate future I feel the focus should be on the impact SteamOS will have on Windows.

Disclosure: I am long AMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long AMD both shares and options. I actively trade my position, and may add or liquidate shares or options at any time.