Stung by criticism of the marketing and functionality of its Zune portable media player, Microsoft this past week revealed its plans for the device and--in a rare disclosure--its expectations for sales during Zune's first holiday season. According to David Caulton, a member of the Zune team who briefed me about these plans recently, the company expects to ship more than one million Zune players by the end of its fiscal year, which ends June 30, 2007. That's enough to give Zune 10 to 20 percent of the market currently dominated by the 30 GB Apple iPod, the iPod with which the Zune most closely competes.

Assuming that happens, Zune wouldn't be a total wash, because during last year's holiday season the number-one non-iPod product in the more than-$200 MP3 player market sold only a fraction of that number. It's also worth noting that Zune went from its first whiteboard scribbles to a finished product in about 10 months--a monumental feat for a company that isn't particularly well known for moving quickly.

Many--myself included--have criticized or even decried Microsoft's entry into this market, the underwhelming marketing of the device, and the lack of certain features. Microsoft has admitted to making some mistakes--I believe the Zune's viral marketing scheme has have fallen flat with consumers, for example--but the company defends its decision to enter this important market now and says it's here for the long haul. Caulton told me that Microsoft will ship numerous functional updates to the existing Zune player and launch new Zune devices with new form factors and unique features in the next year.

Why Zune?

The key to Microsoft's decision to make the Zune, I was told, is that although Apple controls 75 to 80 percent of the overall MP3 player market, Apple almost completely controls the only parts of the market that make money (large-capacity MP3 players). For all its work creating the underlying technologies for the PlaysForSure initiative, Microsoft watched as its numerous hardware partners managed to collectively steal only tiny amounts of share in the low-end flash memory player market. This business model clearly isn't sustainable, given the amazingly low numbers that even all $200-plus PSF devices combined sold over the last holiday season. "There is still a future for PlaysForSure," Caulton said. "But we can't just wait for the iPod to blow over." Eventually, Caulton says, the portable MP3 player market will settle down into a less rapidly evolving, less innovative space. This will allow consumer electronics companies to commoditize things, as happened with the personal computer industry. But the personal computer market was vertical for at least 25 years, before the IBM PC and its compatible clones took hold.

Speed was another problem. Although Microsoft could do the plumbing work to support new features (e.g., podcasting) as they arrived--and then revise Windows Media Player (WMP) to support those features--getting all its hardware and services partners lined up at the same time to support new features proved to be impossible.

To ship a product quickly, Microsoft had to look at core functionality and try to deliver some key differentiators. Although the Zune does lack several features that the iPod boasts, customers rarely use most of those features anyway, and Microsoft intends to close the gap in time. Furthermore, the Zune does include a few unique features of its own, such as Wi-Fi connectivity and a Send feature (codenamed "Squirt") that lets Zune users wirelessly share content. "Send was our Big Shot," Caulton said.

Finally, Apple had proven that there were billions of dollars to be made in portable music. Thus, the people behind the Zune could champion the potential to Microsoft's leaders. The market, clearly, was maturing and was a viable money maker. Suddenly, the barriers were down and Microsoft could proceed.

Why now?

This holiday season is a "beachhead" period for Microsoft, during which it's trying to change people's perceptions of the MP3 player market from "Apple and everyone else" to "Apple and Microsoft and everyone else." From this perspective, the company has been somewhat successful. Despite lukewarm reviews, the Zune is a hotly debated product among digital media influentials. Looking forward, Microsoft intends for Zune to be profitable. "This is the fuel we need ... [for the] long-term," Caulton told me.

As for the one million number, Caulton said that Microsoft was issuing this guidance now so everyone would know what the company's internal goals were. That way, in mid-2007, when Microsoft inevitably reveals that the Zune's sales figures were right on track, no one can accuse the company of retroactively matching the announcement to the sales numbers, whatever they might be.

Caulton also highlighted the fact that Microsoft is well aware of how difficult it will be for it to enter and succeed in a market that is dominated by a company like Apple. "This is a huge challenge and a long-term investment," he said. "We'll see what happens."

What about those missing features?

With all deference to the many critics who have pointed out the sweeping list of iPod functionality that the Zune lacks, Microsoft knows exactly what's missing and why. The company has spent a tremendous effort on gathering consumer data to determine which features people are actually using, and coincidentally, a report this week in the New York Times corroborates some of the information that Caulton told me previously. That is, people aren't doing very much with their iPods. They're not even buying much music online, despite the fact that enjoying music, overwhelmingly, is the number one task people enjoy with those devices.

"Just by playing MP3 files, we have an excellent percentage of what people are really doing with iPods," Caulton joked. "It's all about music. On the iPod, 99.5 percent of people are using the devices for music. The number two most often used feature is podcasting, which is used by only 15 to 20 percent of users." Apple's podcasting experiences isn't all that great, and while the Zune team currently plans to add podcasting support, Caulton admitted that was the most obvious feature missing from the initial version of the product. "Among those who use podcasting, it's their majority activity," he said.

While a typical consumer might not know what a podcast is, maybe they've heard about it on "The Daily Show" or whatever. So they may want it someday. "We will be aggressive there," Caulton said.

Other activities, like video, see only niche usage. And people do these things less and less over time. They may download a song or TV show once to try it out, but virtually no one is going back again and again to buy new content. "The attach rate of videos to iPod is very low," Caulton said, "somewhere on the order of .25 videos per iPod per month."

"Look, some features matter," he said. But some don't. Caulton alleges that Apple quickly added games to the iPod repertoire only after Microsoft announced its XNA and Zune initiative. But games are just a distraction from the iPod's core values, and Apple's behavior in this market has alienated third party game makers, many of whom say they are shut out from creating iPod games.

Another feature users sometimes bring up is the ability to use the Zune as a portable storage device. That feature, which was briefly in pre-release versions of the product and then pulled at the last minute, will be brought back in a future update. "We killed it as a tradeoff," Caulton said. "But it will make it back in. It's a good checkbox feature only. Very few people use this functionality."

At the end of the day, people are just using the iPod for music, and most people are loading iPods with music ripped from their own CD collections (or, as the music industry believes, downloaded from illegal file sharing networks). "We're certainly doing that," Caulton said, referring to the core music experience most people use. "We'll get better over time. But people shouldn't but a Zune based on promises of features to come. Once you add all those features, it's like [Microsoft] Office: People buy it because it does so much, even if they never use all those features."

What's next?

In 2007, Microsoft will update the existing Zune and ship new Zune versions and form factors. Microsoft is being careful not to simply ship new devices that offer new functionality, because they don't want to alienate people who purchased the first Zunes, and the company is conscious of previous hardware devices, like the Media Center Extenders and Portable Media Centers, which held the promise of updates but were never improved.

"The people who buy the device now are our best customers," Caulton said. "So we don?t want to screw them over. There is no hunger at all to not upgrade the first product. Yes, we will make a cool new device with an updated design, size, battery life, and so on. But we will customers upgrade naturally, not artificially."

Second generation Zune features can be categorized in two groups. In the first group are the features that can be brought downlevel to the initial Zune device, such as DVR-MS (Microsoft recorded TV) and DivX format support. In the second group are features you can't bring downlevel. While Caulton wouldn't confirm that these are actual features, the addition of a digital camera or GPS circuitry to a second generation Zune device wouldn't mean that first generation hardware would somehow get those features as well.

"Sometimes there are subtle reasons why certain features can't be brought downlevel," he said. "Maybe the DSP chip on the first device isn't powerful enough or whatever. But we will bring every new feature we can to the first Zune. We'll also make next year's products so compelling that, hopefully, people will want them. We're just not going to cheat [to make customers upgrade]."

Can Microsoft defeat the iPod?

Looking at the iPod market today, it's a little hard to believe that Microsoft stands a chance. After all, Apple's products are exceedingly well-made, beautifully designed, and highly desirable. But the religious mania that many people attribute to both the Macintosh computer and the iPod may be somewhat exaggerated, suggesting that if Microsoft can field a worthy challenger, it can compete. "During planning for the Zune, our consumer research said there was far less religion around the iPod than you might think," Caulton said. "Yes, there are the techie, blogging guys and Apple fanatics, and to them, the iPod is a religious icon. But those people, it's literally about the iPod. A much larger group of consumers love the iPod, but love having their music with them even more. For these people, it's not the brand, it's the value proposition."

The point here is that while it may be impossible for Microsoft to dislodge the Mac faithful from their iPods, that's a very small group of people anyway. The iPod, ultimately, is like the TiVo. That product, too, was off the scale for customer satisfaction. But today, the DVR pioneer is struggling because the DVR market is becoming commoditized thanks to integrated DVR solutions offered by cable and satellite providers and PC-based solutions like Windows Media Center. See a trend anywhere? If it can happen to TiVo, it can happen to the iPod too.

Final thoughts

While it remains to be seen whether Microsoft can pull off such an impressive feat, I'm intrigued that they're even trying. Historically, Microsoft hasn't performed very well in markets in which a single strong competitor controls a dominant position. But Caulton has reassured me that Microsoft is in this market for the long run and the company has given a financial commitment to making the Zune a success. Apple's products are superior today, there's no doubt about it, and the slew of iPods and iPod accessories I've bought over the years testifies to how a superior product can sway even a diehard Windows guy like myself. I'm not ready to recommend the current Zune device to anyone per se, but I'll be tracking the Zune's improvements over the coming year. This could prove to be an interesting battle sometime in the future.