Will Microsoft lose the living room?

The key ingredient is games. The big software maker is busy putting the pieces together to make Windows CE a premier gaming platform.

Ultimately, the idea is to have multifunction set-top boxes that not only can play games, but surf the Net, control home entertainment, and play DVD movies.

There's only one hitch: Sony (NYSE:SNE) seems to have beaten Microsoft (Nasdaq:MSFT) to the punch.

When the Japanese consumer electronics maker announced details of its heavily anticipated PlayStation 2 two weeks ago, its plans went far beyond just another game machine.

"If Sony makes it out with a cable-ready version of their PlayStation 2 before Microsoft comes out with a Windows CE-based gaming box, Microsoft is in trouble," said Jeremy Schwartz, game market analyst at industry watcher Forrester Research Inc.

Sony rising ...
On Sept. 13, Sony announced the pricing and support for PlayStation 2. And with hardware specs far ahead of the competition's -- 10 times faster than Sega's Dreamcast and three times faster than Pentium III, claims Sony -- PlayStation 2 is the game console to beat.

But more important, Sony execs used the announcement to admit something they'd previously denied: The electronics maker is aiming the PlayStation 2 at becoming the new household entertainment center.

Sony stressed the device's ability to tie together living room components - such as a VCR, stereo and TV -- play DVD movies, and eventually surf the Web via a broadband modem. To top it all off, Sony has designed the next-generation device to look more like a stereo component than a game device.

"Sony was calling (the PlayStation 2) a "Trojan horse" entertainment appliance," said Forrester's Schwartz. "They've just dropped the Trojan horse part."

Other game console makers are joining in the game as well, but for the moment, Sony appears to have the lead. They're all racing to grab as large a piece of the living room pie as possible.

Going beyond the $7 billion that the interactive entertainment industry will pull in this year, their strategy threatens to subsume the $300 million generated by DVD player sales in 1999, a hefty portion of the $5 billion in annual revenues for consumer Internet access, and at least a fraction of the future PC systems market, valued this year at $20 billion.

Changing channels
"The PC industry in general should be worried about PlayStation 2," said one industry insider, familiar with Microsoft's plans, who asked to remain anonymous. "It would be crazy for Microsoft to just sit there."

Whatever else Microsoft can be accused of, being a couch potato is not one of them. Since roughly half the U.S. homes still don't have a PC, the software giant has been rethinking its PC-centric strategy for some time.

From Universal Plug and Play -- a Microsoft-led initiative designed to link all sorts of appliances in one huge data network -- to the company's WebTV set-top box bringing Internet into the living room, Microsoft has signaled its intent to be a major player in the coming home appliance market.

"There are three major sources of revenue (in the living room): Games, Internet and TV," said Alan Yates, director of marketing for the WebTV platforms division. "The people that put together the most compelling product based on a combination of those subsidies will be very successful."

In August, at the European Computer Trade Show in London, Microsoft reportedly gave private demonstrations of a hybrid game console and DVD player -- code-named X-box -- running its Windows CE operating system.

While Microsoft has not confirmed the reports, Yates admits the software giant's WebTV subsidiary has the ability to make an X-box device.

"We definitely have the technology internally in software and hardware to develop such a device," he said.

Moreover, Sony's weakest piece -- connecting the living room to the Internet -- is where Microsoft is strong. Through its WebTV Internet TV service, Microsoft has already driven 800,000 TV-centric consumers online.

Cooperation between EchoStar and Microsoft will result in a WebTV-enabled satellite receiver that can also pause programming up to 30 minutes (shades of TiVo and Replay Networks), thanks to a very PC-ish hard drive.

And deals with cable providers have made a special version of Windows CE a viable set-top box operating system and Windows NT servers a key component of several cable services' two-way digital backbones.

Plus, every month, Microsoft strengthens its vision. Last Thursday, the Redmond, Wash., giant announced a new PC-based product to bring Internet into the home. Called the MSN Web Companion, the device will be a cheap way to drive consumers onto Microsoft's Internet service. (See: MS goes hardware: MSN Web Companion)

Competition heating up
Yet, having all the pieces and figuring out the consumer jigsaw puzzle are two different things, and Microsoft is running out of time. Already, hybrid consumer appliances bringing Internet access or games or both are in the works.

For example, consumer electronics giant Toshiba Corp. has announced support for the relatively unknown VM Labs and its DVD-Internet-game player, Nuon. Matsushita Electric Industrial Co., known to U.S. users through its Panasonic product line, has placed its bet on game console maker Nintendo. The two companies' combination game-DVD-Internet devices are due to hit shelves in the fall of 2000.

And, as if there weren't enough competition, last Thursday, set-top box maker Scientific Atlanta announced a deal with ICTV to put allow users of their Explorer 2000 cable set-top box to play arcade games over the company's high-speed cable connection.

Such devices will account for 12.3 million units in sales their first year on the shelves, according to a report by games market analyst Fairfield Research Inc. That's far higher than the less than 1 million WebTV boxes that have been sold to date, and the few million DVD players that will be sold this year.

Getting game
That business model is the "why" behind Microsoft's push for Windows CE game development on Dreamcast. Games drive consumers to new hardware faster than any other platform.

"DVD took 3 years to reach a million units -- we've sold half a million in two weeks," said Charles Bellfield, director of marketing at Sega. And Sony's original PlayStation has sold more than 23 million units in the four years since its U.S. launch.

That phenomenal sales rate has games makers concentrating far more on games for the living room than the den.

In 1998, two-thirds of entertainment software revenues came from console systems rather than the PC. Microsoft has pushed development on consoles as well -- more than 75 titles are being developed for Windows CE on the Sega platform.

That exodus will continue, said Forrester analyst Schwartz.

"The PC market is being cannibalized by (the success of consoles)," he said. "PC games have a finite future -- living room-based entertainment is wide open."

And Microsoft has just begun to stake its claim.