Microsoft Not Concerned About Fate of HD DVD, Bach Tells Analysts

But analysts pressed Bach on the issue. Microsoft’s main reason for supporting HD DVD at first was the company’s investment in its own HDi format, chosen for the authoring layer of interactive content on HD DVD discs, Bach said. HD DVD took a major blow Friday, when Warner Home Video dropped the format and said it would back only Blu-ray (CED Jan 7 p1). Despite that, “it’s important for us to continue to support Toshiba,” Bach said, adding that Microsoft intends to “continue to support our partner in whatever direction they choose to go.”

But Bach stressed that HD DVD represented only “a small percentage” of Microsoft’s business. Because Microsoft offers HD DVD only for Xbox 360 as an external peripheral, “if HD DVD somehow is successful, that’s fine for us” -- but “if for whatever reason” HD DVD loses the format battle and this “becomes a BD world,” Microsoft won’t be affected much because all it has invested product-wise is the peripheral, Bach said. He stopped short of saying whether Microsoft would back Blu-ray if HD DVD loses the war.

The $179.99 Microsoft HD DVD drive is also “not an accessory that has a big attach” rate, Bach said. He didn’t give the rate. But only about 269,000 Xbox 360 HD DVD drives had been sold in the U.S. through November, according to NPD data, compared with about 8 million Xbox 360 consoles (CED Dec 17 p5). That means only about one in every 30 Xbox 360 console owners had bought the external HD DVD player. The best-selling accessories for 360 and other consoles are typically controllers.

The vast majority of consumers are buying the 360 console to play games and “if they can do some other things with it fine,” Bach said. But “as it’s been demonstrated in the market, people don’t want to pay $50 to $100 more to have the accessory included,” he said, predicting that will continue. That was apparently the latest sign Microsoft has no intention of incorporating an HD DVD drive into a new 360 SKU, as had been widely rumored before CES. Rival Sony includes a Blu-ray drive in every PS3 sold. But that’s a central reason the console remains more expensive than 360, which has probably kept the PS3’s sales much slower than its rivals’.

Microsoft still sees digital downloading of HD movies and other video content as a much more significant way than disks for it to profit from HD content. The addition of MGM movies, as well as ABC TV and Disney Channel TV programs, to the slate of HD content available from Xbox Live was among the biggest 360 news in Gates’ keynote.

Bach also provided the strongest sign to date that Microsoft doesn’t plan to jump into the portable game market soon. Microsoft executives had indicated earlier they were weighing their options. But in the dedicated game hardware arena, Bach is glad his company is focusing on 360, he told analysts. “I think that has helped us a lot,” he said, adding “I think trying to get into the portable gaming market would be a very, very tough battle” -- one that “Nintendo is very good at.” PSP continues to lag far behind Nintendo DS in sales. “I think it has hurt Sony to be in that space” because Sony is now “fighting on multiple fronts,” Bach said. If Microsoft got into handheld systems, it couldn’t just port over Xbox titles, he said, saying his company would need to offer unique content for the portable. “It’s a full new business, it’s a full new investment, a full new set of hardware -- it’s not something you can just sort of inch your way” into, he said. Therefore, “we don’t see that as a big area of focus for us,” he told analysts.

Microsoft dabbled a little bit” in games for mobile phones by licensing content to other game makers, Bach said. But “I haven’t seen it as a big strategic initiative for us, nor have I seen it as a big profit driver for us,” he said. That’s a “tough business for us to be in,” he went on, noting the major challenge of developing versions of each title for all handsets.

Providing mobile games on Microsoft’s Zune line of digital audio devices is “something in theory we could do,” similar to what Apple had done with iPod, Bach said. Zune’s control mechanism would also be superior for gaming to what Apple offers on iPods, he said. “But we haven’t seen a lot of traction in that space around gaming and the Zune team is super focused on music and video,” he said: “I think you're not likely to see a lot of activity” for Microsoft in games for Zune, despite rumors to the contrary.

The Zune devices have “done exactly” what Microsoft expected in sales, Bach said, without providing figures. But he said the company has seen “better performance” on its 80- GB Zune “than we expected” and the 4- and 8-GB models have fared a little worse than expected. There has also been “a little bit of cannibalization” by the 30-GB Zune, whose recent price cut “made the 4- and 8-gig look a little less attractive,” Bach said. But he said as inventory on the 30- GB model declined, Microsoft had seen an uptick in sales of the lower-capacity models.

Bach was also pressed on what happened to the planned launch of its IPTV platform, now known as Mediaroom. Bach had said during the 2007 CES keynote by Gates that the move would come by the holiday season (CED Jan 8/07 Special CES Supplement p6). But the launch never happened and all he said during Sunday’s keynote was that Microsoft and telecom BT agreed on such an effort for this year. Microsoft is, however, “talking to other network operators about that functionality,” Bach told analysts, and “I think you will see us continue to build new opportunities with other network operators” after BT. Network operators indicated through much of 2007 they “definitely want” the offering and it was taking time for them to prepare for the move, he said. Microsoft has attracted about 20 Mediaroom partners worldwide, he said.

Microsoft remains focused on trying to get to “neutral” on the Xbox 360 console’s gross margin as quickly as possible, Bach also told analysts. “Sometimes we'll be right-side up on that because we'll be at a point where we haven’t lowered prices but console costs have come down, and sometimes it'll be the other way around,” he said. But “over time, you should see that sort of level itself off… absent the warranty charges we took last year” when Microsoft extended 360’s warranty due to excessive repair rates, he said.

Bach wouldn’t speculate on when Microsoft or its rivals would introduce new consoles, saying only “we're constantly scanning the technology, looking for things that could be breakthrough for next generation.” But he said “there isn’t anything meaningful to discuss there” now, and “there is a ton of business to be done this generation.” That’s “where all the resources of the team are currently focused,” he said.

The 360 continues to perform well in the U.S., Australia, New Zealand and Northern Europe, especially the U.K., Bach said. But he told analysts sales are slower in central Europe and weaker still in Southern Europe, especially Italy and Spain. The first Xbox did “very poorly” in South Korea and the 360 is faring “a little bit better now,” but that’s “not a large console market.” Japan, he conceded, continued to pose a challenge for Microsoft, although “we are performing better” on the 360 than the first Xbox.

Recent 360 challenges for Microsoft included widely reported problems that many Xbox Live users had during the end of December, when traffic apparently surged beyond the company’s capacity to handle it. Many users couldn’t use the service more than 10 minutes at a time, Bach said. That was resolved, but “there are still some spot issues that we have and we're tracking those down and pushing those out,” he disclosed. The company believes it’s in “good shape” on its ability to handle large traffic in the future and believes it has the capability to handle traffic “well beyond where we are now,” Bach said. But he conceded “we're going to have to think more about capacity planning in a slightly different way and shame on us for having things advance faster than expected and not being ready for it.” Microsoft is “going to have to step up and put a little bit more capacity in” now to avoid such problems in the future, he added. At least one lawsuit was filed against the company early this month over the issue. Three Texas residents sued Microsoft in the U.S. District Court in Houston on Friday, accusing Microsoft of breach of contract, breach of warranty and negligent misrepresentation. They sought class-action status and damages exceeding $5 million.