Microsoft Does an Xbox One – Eighty

by Mark W. Hibben

DRM Backlash

It's only been a week since E3, and Microsoft's DRM approach for Xbox One has utterly collapsed under the pressure of angry gamers everywhere. Today Microsoft announced a policy that essentially mirrors that of its rival in the coming next-gen console wars, Sony.

In today's (6/19) announcement, Microsoft reversed all the essential elements of the DRM system it had intended to impose with Xbox One (XB1). Gone is the requirement to be always connected to the Internet, or check in with Microsoft once a day. Any disk based single player game will be playable offline after installation, although the disc will need to be in the tray. Also gone are the new limitations on used games. Sharing, lending, or giving disc based games will work as it does on Xbox 360.

The speed with which Microsoft caved on DRM has been truly breathtaking. I really didn't expect it to come before Sony's PS4 and the XB1 had an opportunity to go toe-to-toe in the market place, and that wasn't going to happen before the end of the year, since Sony had announced a late December release.

Apparently Microsoft read some of the polls I mentioned in my last post on the subject, "Sony and Microsoft Battle for Hearts and Minds at E3". The response to Microsoft's DRM approach was resoundingly negative, and continuing to pursue it would have set Microsoft up for a flop of epic proportions.

As it is, Microsoft still has an uphill battle to win over prospective console consumers. XB1 still has a higher price tag ($499 compared to $399 for the PS4), as well as the burden of the Kinect sensor, which so many gamers loathe. Well, maybe it is a little creepy having a live, Internet-connected camera staring at you full time when you're in front of the TV.

Here, Microsoft's best option might be to allow users to substitute some other control device for the Kinect. The XB1's Windows 8 based OS needs some form of gesture recognition for things like swiping between screens, but it's possible that the game controller could stand in for these functions. I wouldn't be surprised if a Kinect-less option for the XB1 appears before the end of the year.

Xbox One DRM and Kinect have been the major complaints about XB1, but by no means the only ones. Most people find the XB1 bulky and unattractive compared to the PS4. And then there are the skeptics who believe that both the Sony and Microsoft consoles will be junk compared to PC gaming platforms.

The skeptics are right that the consoles won't perform as well as a PC with a high end graphics card. What the skeptics don't understand is that the consoles don't need to. What the consoles need to do is provide sufficient HD TV frame rates for responsive gaming, typically about 30 - 60 Hz. Based on the demos at E3, this is exactly what the consoles will provide.

The intensity of the consumer response and Microsoft's reaction demonstrate how high the stakes are for both Sony and Microsoft. For instance, in 2012 Q4 Microsoft introduced the Surface RT as well as the Windows Phone 8 mobile operating system. In that quarter 900,000 Surface RT devices were sold (according to IDC) and 6.2 million Windows Phones were sold (according to Gartner). In Q4 of this year, Microsoft will sell about 5 million XB1 consoles, as a conservative estimate, and possibly more if Microsoft does a good job of addressing remaining consumer concerns about the device, since Sony won't be in the market until the end of the year.

The big Losers

Microsoft's DRM reversal is a big win for console consumers, but a big loss for game developers. Here I'll frankly admit to some bias in favor of the developers. But beyond personal sympathy, the game software industry has been in the doldrums, as the chart of revenue and earnings for the two major game developers, Activision and Electronic Arts, shows below.

Based on the interest level in the new consoles, I expect about a 10% uptick in game software revenues in the new year, but Microsoft's DRM approach, if it had become a standard for both new consoles, would have ensured greater near term growth for the developers. Since Microsoft maintains its own game development group within the Entertainment and Devices division, Microsoft was naturally sympathetic to their desire to curtail the trade in used games, from which they derive no additional revenue.

Not that gamers didn't have the legal right to buy, sell, or trade used games. Copyright law in the U.S. has a long established "right of first sale" that allows consumers to resell copyrighted works such as used books, CDs, or videos that have been legitimately purchased. Software companies and digital content providers have been nibbling away at this right for years, especially for digitally downloaded content. In this area Microsoft held fast to its existing policy of not allowing trading, reselling or loaning of downloaded games.

In the very long term (2-5 years), I'm not sure that the DRM issue really matters. The entire software industry is moving to digital delivery, and the convenience of digital delivery inevitably comes with DRM strings attached. Game consumers have at most a temporary (2-5 year) reprieve from this, since the Internet is still a little slow in some places for downloading 25 – 50 GB of game content, the capacity of a Blu-ray disc. But eventually, the game software industry will migrate fully to Internet delivery, since it's the most cost effective way to distribute software.


The Consequences of Apple Losing its Ebook Trial

by Mark W. Hibben

Why the Complaint?

On the face of it, the stakes in Apple's ebook trial may not seem very big. During the trial, Apple (Nasdaq: AAPL) executive Keith Moerer claimed that Apple has 20% of the U.S. ebook market. That market was estimated to be worth about $1.4 billion, which means that Apple makes about $280 million a year, small compared to total iTunes revenue. In contrast, Amazon (Nasdaq: AMZN) is estimated to have about 50% of the U.S. market. In fact, the consequences for Apple of losing the trial may extend well beyond iBooks.

After reading through the government complaint and some of its evidence, I've started to worry that Apple may have miscalculated in this case, and that the stakes are higher than just ebooks and the price Apple charges for them. In order to explain my concern, let me back up a moment a provide a capsule summary of the case for those who may not have been following it closely.

In the Department of Justice (DOJ) complaint, Apple is alleged to have violated Section 1 of the Sherman Antitrust Act (SAA) by conspiring with numerous book publishers to set the price of ebooks well above its competitor Amazon. As Apple prepared to launch the iPad in 2010, Apple persuaded the major book publishers in the U.S. to sign contracts with it to publish book through iBooks, which featured prominently in Steve Jobs' introduction of the iPad.

These contracts specified that Apple would serve as the book publishers' agent (the so called agency model) and sell the ebooks at a price set by the publishers, with Apple taking a 30% fee. The agency model was a departure from the wholesale model under which the book publishers had operated in selling both hardcopy and electronic books. The publishers sold books at a wholesale price, and then it was up to the retailer to decide on the retail price.

The wholesale price model had started to break down for ebooks as Amazon achieved great success with the Kindle, introduced in 2007. Amazon was selling many ebooks at $9.99, below the wholesale price paid to the publishers.

Publishers' Conspiracy

Why should the publishers care? Two reasons. First, the publishers were concerned that the steeply discounted ebooks were canibalizing sales of physical books. Second, the publishers were concerned that consumers would become so accustomed to Amazon's ebook pricing that it would become the norm and Amazon would begin to demand lower wholesale ebook prices rather than continue to take a loss.

The DOJ concludes in their complaint that the publishers had formed a conspiracy by late 2009 to "do something about Amazon" and fix prices at a more acceptable level. There's little doubt that this conspiracy existed, since all of the publishers have already settled with the government, although the settlements didn't require admission of wrongdoing. The publishers just had to refrain from trying to fix prices in the future.

The DOJ alleges that Apple proposed the agency model specifically to address the publishers' concerns about Amazon, as well as ensure that iBooks would be profitable from the beginning. Crucial to the government's case is the role of a so-called "most favored nation" (MFN) clause in the Apple contracts. This clause would allow Apple to lower the price of any ebook to match that of a competitor such as Amazon. The government claims that MFN was intended to compel publishers to either withhold ebooks from Amazon or force Amazon to accept the agency model as well, since publishers would lose serious money if Amazon continued to sell steeply discounted ebooks at $9.99.

The presiding Judge, Denise Cote will decide the case in this non-jury trial, based on whether she believes the government's view or Apple's. Apple's defense rests largely on a claim that it proposed the agency model based on its iTunes experience. It was just business as usual for Apple.

Eddy Cue, now in charge of all Internet services, proposed the MFN provision, and has defended it as simply a way for Apple to defend itself against Amazon, and not as a tool to enforce price fixing. Perhaps Apple, in its rush to bring a full plate of services with the iPad, walked into the middle of something it didn't fully understand.

The Consequences of Losing the Case

I wouldn't pretend to understand the legal issues well enough to predict the outcome of the case, but I have to say that the signs aren't good. Judge Cote expressed the opinion at the outset of the case that Apple would probably lose. Plus there are numerous email exchanges between Apple executives and various publishers that seem very damning. Sure, it's mostly circumstantial, but the government doesn't have to prove its claims "beyond a reasonable doubt" for a civil antitrust case.

The concern I have about Apple's losing the case is not in its immediate impacts. If Apple loses, it signs some form of judgement agreeing to play nice from now on, and coughs up some money to cover the government's legal expenses. Apple will of course, appeal, would could defer any final judgement for another year.

The problem with Apple losing is its "business as usual" defense. If Apple's iTunes business practices served as a model for iBooks, and these practices were found to be anticompetitive, this opens the door to a wide ranging DOJ investigation into iTunes pricing, especially Apple's relationships with music and video content providers. Since Apple makes about $4 billion a quarter from iTunes, now the business stakes are much higher.

iTunes pricing has uncomfortable parallels with what happened with iBooks. Once again, Apple's agency model has produced virtually uniform pricing for digital music and video content across the industry. Every song's a buck, wherever you go on the Internet. Most videos are released at the same time and have the same pricing, whether for rental or purchase. The only area where there seems to be genuine price competition is in apps, because here the developers do set their own prices and do compete on price.

If Apple were a normal company, the announcement of further DOJ investigations would not have much impact on its share price. Look how many times Google has been investigated. But Apple isn't a normal company, and with its abnormally high short interest, the Apple bears will have a field day in the media. Apple's Fall product announcements are starting to look like the light at the end of a very long, dark tunnel.