CES 2006 - sell or give away the razor?

Differing strategies lead to big sales for MP3 players and video-game consoles

The iPod and the Xbox 360 are the two hottest selling electronics items this holiday season. Several models of the iPod have been hard and sometimes impossible to obtain. The Xbox 360 instantly sold out and now is available only at highly arbitraged prices through resellers on eBay.

At the 2006 International Consumer Electronics Show (CES) in Las Vegas in January, many companies will launch new products within or related to these markets, hoping to get in on the sales rush. Among them will be Sony Corp., with new company chairman Howard Stringer expected to reveal details on the launch of his company's PlayStation 3 (PS3) during his keynote.

Yet, ironically, these two markets operate using completely opposite business models. In the MP3 player market, the leader, Apple Computer Inc., follows a "reverse razor blade" approach. That is, Apple eschews profit on the razor blade, i.e. the music and video sold through its iTunes store, to make money on the razor, i.e. the iPod players.

However, in the video game console market, equipment makers like Microsoft Corp. and Sony Corp. pursue a more traditional razor-blade model. In this case, they sell the razor, i.e. the console, at a loss to generate profits from the blade, i.e. games and royalties.

Apple's iPod leads a red-hot MP3 market that will swell to 93.6 million units in 2005, up from 36.8 million in 2004. But why is Apple willing to forego profits from iTunes, especially when the service recently crossed the 600 million download mark?

A recent iSuppli teardown analysis revealed that Apple earns an estimated $95 and $137 margin on the 2Gbyte nano and 30Gbyte video-capable iPods respectively. With expected sales nearing 30 million iPods this year, Apple stands to make a lot of profit. But without the popularity of iTunes, which does not work with non-iPod players, Apple would be very unlikely to achieve such sales.

Meanwhile, the strong growth of the MP3 player market is attracting new semiconductor suppliers that want a share of revenues, which will increase to $7.2 billion by 2009, up from $5.8 billion in 2005. Most of these chips will be either multimedia processors for the emerging Portable Media Player (PMP) segment, or inexpensive controllers for the low-end flash-memory-based segment.

Suppliers in that last category want to emulate the success of Actions Semiconductor Co. Ltd., whose controller shipments surged to 30 million units during the first nine months of 2005 alone. Meanwhile, SigmaTel Inc. and PortalPlayer Inc. are working hard to protect their leadership positions against new entrants. PortalPlayer also is expected to make a major announcement at CES regarding its expansion into a non-MP3 market.

The video-game console market is also attractive to semiconductor suppliers, but for different reasons. There is some growth due to the start of a new product generation, and unit shipments will expand to 46.1 million units by 2009, up from 28.5 million in 2005. However, the main incentives are a high level of semiconductor content and, most importantly, the willingness of the console makers to lose money on hardware sales.

Microsoft illustrates this latter point and once again falls on the opposite end of the spectrum from Apple.

iSuppli's teardown team dissected an Xbox 360 and determined that Microsoft initially is losing at least $153 per console for each Premium system sold in the United States. The company plans to make that money back on royalties and games.

Microsoft also plans to reduce costs by improving production yields for key semiconductors. These chips include a custom IBM-designed microprocessor and an ATI Technologies Inc.-designed Graphics Processing Unit (GPU).

At the time of the Xbox 360 launch, iSuppli estimated that the two chips cost $106 and $141 respectively. However, those costs should drop by as much as 35 percent per year. Unlike with the original Xbox, Microsoft has said it eventually plans to make profit directly from the Xbox 360 exclusive of software and licensing.

Microsoft also plans to improve sales in Japan, which were dismal for the original Xbox. Competing with Sony and Nintendo on their home turf is challenging enough. But Microsoft also launched the Xbox two years after Sony's PlayStation 2 and without much Japan-specific content.

However, this time around, Microsoft opted for a global launch, with the Xbox 360 debuting in North America, Europe and Japan within a period of three weeks. Furthermore, the company has lined up several Japanese game developers to release titles for the launch. Unfortunately for Microsoft, any potential payoff is coming slow; an estimated 50 percent of Xbox 360s shipped to Japan remain unsold on store shelves.

Of course, Microsoft's success in Japan depends largely on when Sony launches the PS3. Any delay might drive otherwise reluctant Japanese consumers to try the Xbox 360 instead. In any case, that launch date, which will also have an impact on the battle for next-generation DVD, will be one of many exciting announcements coming at CES. And iSuppli will be there to cover it all.

Chris Crotty is senior analyst, consumer electronics with iSuppli Corp. Contact him at ccrotty@isuppli.com