Analysis: Where do Kinect sales go from here?

[Gamasutra analyst Matt Matthews takes a look at Microsoft's global Xbox 360 business, which has remained resilient even amid the downturn in the retail video game market.] I want to move past the gloom over the U.S. retail video game market and focus on Microsoft's Xbox 360 business, both domestically and globally. Even with the current downturn, I certainly can't deny Microsoft's success with its second console, which is about to reach a milestone of 35 million systems in the United States. After a half-decade of competing against the white-hot Nintendo Wii and the fiercely competitive PlayStation 3, it is a testament to the Xbox 360 and Microsoft's execution that it's still the top-seller in May 2012. If we exclude the PSP and the PS2, both of which are essentially irrelevant today, the top-selling console in today's market is also the oldest, the Xbox 360 which launched in November 2005. On top of that, it was the system with the highest average price at $287, at least $15 higher than the average prices for the PlayStation 3 and PlayStation Vita. To maintain its strong sales record, Microsoft will have to make some changes in the coming year. To be specific, I expect that Microsoft will adjust its pricing strategy from top to bottom and simultaneously consider adding Kinect to all systems that it sells. The first move is to get its $100 Xbox 360 out to as many big-box stores as possible. We already know that it will be rolling out to GameStop and Best Buy stores this month, probably because these are the stores with the best-prepared employees for selling the two-year Xbox Live Gold contracts required for the $100 price. According to a report in the Wall Street Journal, Microsoft is still working to "set up a credit-checking system for customers" who sign onto the two-year contract, which may explain why Target and Walmart aren't yet part of the program. Once the $100 console program is in place, Microsoft can extend the program to systems other than the minimal Kinect-enabled system which typically retails for $300. If Microsoft were willing to make a non-Kinect system part of the program, one could imagine a $50 or even free Xbox 360 system with an Xbox Live Gold contract for two years or more. However, I think Microsoft is actually interested in going entirely the other way, to offering only Kinect-enabled systems. The fact is, Kinect sensor sales have tapered off in 2012, and I don't think Microsoft wants that to continue. The figure below tells most of the story. It shows the total shipments of Xbox 360 systems and the total shipments of Kinect sensors since the Kinect launch in November 2010. We can look at these figures at least three separate ways: absolute Kinect sales, Kinect sales against new hardware sales, or the total Kinect attach rate. In terms of absolute figures, 1 million Kinect units were sold in the first 10 days, followed by an announcement of 2.5 million in the first 25 days. After four months, the figure was up to 10 million. The next announcement I'm aware of was made at the beginning of 2012, by which point 18 million Kinect sensors had been shipped. Then in May of this year Microsoft announced that the figure was over 19 million. In five months, an additional 1 million sensors, give or take, had been shipped. If we compare Kinect sales to new system sales, we see that Microsoft sold two Kinect sensors per each console early in the system's life, but is now down below one new Kinect sensor per new console. In terms of attach rate (i.e. the fraction of the entire installed base that could have a Kinect sensor) that figure went from zero to 19 percent in the first four months that Kinect was available. By the beginning of 2012, it was up to 27 percent and has held steady there for five months. If current trends continue, I expect the numbers to show that 3 out of 10 Xbox 360 systems has a Kinect sensor, or an attach rate of 30 percent. Microsoft believes it can attract a non-traditional gaming audience with Kinect, and the $100 console is designed to appeal to that same audience. The plan, I believe, is to eliminate the Kinect-less models and put a Kinect in the box with every new console, across all prices and configurations. With service plans to subsidize lower entry-level pricing and the higher bill of material costs that comes with the Kinect hardware, Microsoft can reach out to consumers of all stripes, but casuals in particular. This is important because Microsoft's Xbox 360 division has been showing tremendous growth over the past two years. According to the company's SEC filings, the Xbox 360 business is now generating over $8 billion in revenue for the company each 12 months. The figure below shows this growth through trailing 12-month (TTM) revenue totals, i.e. each bar represents the revenue of the previous four quarters. (Viewing the data this way smooths out seasonal effects.) If you look carefully, there was a 22 percent increase in TTM revenue for the Xbox 360 division during the last calendar quarter of 2010, contemporaneous with the Kinect launch. Over the course of 2011 that TTM revenue increased another 21 percent to $8.8 billion every 12 months. Doing some rough estimations like backing out the hardware revenue and figuring in installed base size, that works out to an average of $60 - $70 of revenue from every installed Xbox 360 every 12 months. But, again looking at the figure above, the company's Xbox 360 revenue fell last quarter and will likely do so again this quarter. That will likely put its annual software and service revenue per installed system below $60, continuing a downward trajectory that started in mid-2011. Sure, Microsoft has taken 40 percent of the entire retail video game market in the U.S. so far this year, and is likely performing similarly well in the UK, but as we've seen previously those markets are contracting very rapidly. Half of an ever shrinking pie is not the way to grow a business. It would be ironic indeed if Microsoft finally conquered the video game business it dared to enter just over a decade ago, only to find that industry an empty husk, abandoned for tablets and social games dominated by a completely new set of players. Which brings us to where the company will go once it really has tapped out its current system. The answer I believe is a bit more sophisticated than just releasing new hardware, call it Durango or Xbox 720 or whatever. Microsoft is clearly not oblivious to the changes happening in the retail market and the growth of ex-retail sources of revenue. Launching new generation of hardware presents the company with an opportunity to change how it does business, and there I think there are some intriguing prospects. Look for a column on those opportunities in the coming weeks. (Next time: May 2012 software, in detail.)