Tuesday, July 25, 2006

Why Microsoft Won’t Abandon Zune

There have been a huge number of articles on the web recently about Microsoft’s proposed “iPod killer” music player, code-named “Zune.”

The typical article talks about how lousy Microsoft is at interface design, how well entrenched iPod is, and how difficult it will be for Microsoft to take away market share. Many authors then wonder how long Microsoft will stick with the project if it is losing money.

These articles miss the point, Microsoft will stick with Zune for a long time, even if it hemorrhages money.

Apple doesn’t pay a dividend, so right now all the cash flow from iPods goes back into new products. For Apple that means new iPods, new hidden projects, and Macs. Most of those products conflict directly with the interests of Microsoft (including any new Apple cell phone). Microsoft won’t cancel their music player because they see every dollar of revenue as a dollar taken out of Apple’s pocket that won’t be used to compete with Microsoft in computers or cell phones.

Microsoft is facing one of the classic business strategies. If company A neglects one market then the competitor can extract extra revenue from that market and use the extra revenue to supplement competition in the product line that company A has. The result is that company A will be undercut because the competition has extra funding from the market where they don’t have competing products. This is the reason car companies try to have a full line of cars, even if some don’t seem to sell well.

Microsoft is very familiar with this strategy. A few years ago they saw Sony as threatening the “home PC” market with their Playstation presence. The result was the strategic move into the Xbox. For years Microsoft has been losing huge amounts of money on the Xbox (some estimates put it in the billions). Recently they have actually managed to get some business success with the Xbox but the important detail to Microsoft is that they are strongly in the living room, and Sony has lost a strategic exclusivity.

We can imagine the meeting at Microsoft where the new music player was conceived. As far as Microsoft is concerned they can lose money on every unit and every song and they don’t care. I bet Microsoft would love to pay a dollar to take 70 cents out of Apple’s pocket, and that’s exactly the goal of the Zune. Microsoft sees this as a way to weaken the Mac and try to extend their digital home position.

How does this affect Apple in the long term? It depends on the market penetration Microsoft gets. I’m sure Microsoft will get at least some sales: they will no doubt have a huge marketing effort and they may be selling incredibly cheap (at a loss). From previous products we can expect that Microsoft will probably have pretty lousy design. Fortunately Apple seems to have a firm defense in the non-portability of iTunes. If Microsoft cracks open iTunes somehow (which another company did a while ago but got shot down in court) Apple is in trouble. I think if Apple continues to innovate and extend their products they should maintain a comfortable position in the market, although iPod growth is probably reaching a maturing point later this year due to competition and natural market cycles no matter what.

Frankly I think much of the work Apple needed from the iPod is already accomplished. People are now more aware of the Mac and the Apple is established as being “lifestyle friendly”. Mac still only needs to take a few percent of the PC market to double Mac sales, which is all we need as investors to be happy for a while.

Ultimately Microsoft will stick with Zune even if it is considered a dismal failure. They will hope for Apple to trip and give Microsoft an opportunity (as Sony has done with it’s PS3 delays). But Apple is in a pretty good position and it looks like Mac sales should make investors happy for at least another 9-12 months.
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