Microsoft Risks Retailer Rage with Disc-less Xbox

Video games are expensive. Big-budget titles for machines like Sony’s (NYSE:SNE) PlayStation run consumers $60 or more at retail. Those $60 games are even more costly for game publishers, though. Annual franchise games in series, like Electronic Arts’ (NASDAQ:EA) Madden NFL and Activision Blizzard’s (NASDAQ:ATVI) Call of Duty, can cost anywhere from $40 million to $100 million to create, and that’s before production costs for boxing and shipping those games to stores like GameStop (NYSE:GME).

This is why low-cost digital distribution models like Apple’s (NASDAQ:AAPL) App Store have become so popular and profitable. New rumors suggest that smartphones and PCs won’t be the only platforms relying solely on digital distribution of games, though. Should Microsoft’s (NASDAQ:MSFT) next Xbox game machine drop discs entirely, it would play to the logic that says, “Goodbye production costs, hello profits,” but the world’s retailers may not be ready for Microsoft’s grand transition just yet.

A rumor originating at U.K. trade website MCV said that, according to unnamed game developers under “the strictest” nondisclosure agreements, Microsoft will forego using disc-based media in its new Xbox, which it will release in 2013. Both the original Xbox and the current Xbox 360 have used DVDs as their primary form of media. Previous rumors have suggested that the next Xbox would use Blu-ray discs.

Building on Xbox Live

There’s compelling evidence that Microsoft will indeed drop physical media in its next device. The company pioneered digital distribution in the home game machine market with its Xbox Live online network. What started as a service for distributing low-cost add-on content for games on the original Xbox has grown to a network of 40 million users. Subscriptions to the Xbox Live service and sales of digital games through the network contributed greatly to the $4.2 billion in revenue made by the company’s Entertainment & Devices Division.

With that groundwork in place, other rumors about the next Xbox suggest a download-only game sales model is in the works. First is the suggestion that the next Xbox will not play pre-owned games, which would be close to impossible to block with physical media. There have been hints that Microsoft will go head to head with Apple by making its next home entertainment product a smart TV rather than a game console.

Microsoft would certainly risk locking out on a huge portion of its audience with such a machine. Microsoft has sold a total of 66 million Xbox 360s worldwide since 2005, but with just 40 million registered Xbox Live users (many of whom likely share a console with family members), there is still a significant audience doing its game buying offline.

Retailers are watching closely

The greater risk, though, would be ostracizing retail partners. Microsoft relies on the likes of GameStop, Best Buy (NYSE:BBY), Walmart (NYSE:WMT), and Amazon (NASDAQ:AMZN), among others, to get the Xbox into consumers hands, but the greatest portion of profits have always come from game sales for these companies.

Used game sales especially have figured prominently in the past decade. GameStop alone relies on used-game sales for 50% of its profits on a quarterly basis, and those other retailers mentioned have started their own used game programs in the past four years to supplement their electronics business.

Now other commentators, like Rob Fahey in an editorial at Games have been quick to point out that MCV’s story only says that Microsoft would drop optical media as its format, moving instead to solid-state flash cards for physical retail copies of games not unlike Sony’s recently released PlayStation Vita console.

Even if Microsoft did follow this model, despite the high cost of production with the format, it would still be emphasizing digital business over physical retail. Sony’s new machine is putting far greater emphasis in its marketing to consumers on digital distribution and the flash cards sold at retail is largely a concession to those partners that need something on shelves.

Considering the state of flux the broader games industry is in, it seems likely that Microsoft will release a version of its gaming machine that foregoes physical media altogether, but it will likely be just one model of the device introduced later down the road. If there is a new Xbox in 2013, expect it to still support physical of one stripe or another, and you can guarantee it will be the cheapest type to produce.

As of this writing, Anthony John Agnello did not own a position in any of the stocks named here. Follow him on Twitter at @ajohnagnello and become a fan of InvestorPlace on Facebook.

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