When Microsoft on September 15 launched its next-generation Zune HD media player, the software giant billed the device as “a significant step forward,” touting its ability to play high-definition (HD) video and receive HD radio signals, along with a state-of-the-art, organic light-emitting diode (OLED) screen.

Experts at Wharton say that the Zune HD will need to be a big step forward in the eyes of consumers, because it faces the nearly impossible task of competing against Apple and its iPod player. “The iPod is clearly the leader,” says Lawrence Hrebiniak, a management professor at Wharton. “The iPod has become the generic name for this type of product, like Xerox and Kleenex [became for their product categories].”

Microsoft’s Zune line of music and video players debuted in 2006, but it has failed to capture significant market share. According to research firm NPD Group, Apple’s iPod had 73% of the market as of July 2009. Milpitas, Calif.-based SanDisk had 9% of the market, followed by Sony at 3%. Microsoft trailed with 2%. Peter Fader, a marketing professor at Wharton, says that Microsoft’s Zune HD has no chance against Apple. “The Zune does a lot of marginal things well, like digital radio, but none of them is enough to get a consumer to say, ‘Hey, I’ll buy that thing,'” Fader notes. “The Zune HD is absolutely doomed to fail, and I don’t think Microsoft should continue to push in this direction.”

Other experts at Wharton stopped short of saying Microsoft should give up on the Zune, but they question whether the company is wasting resources by chasing the iPod juggernaut, which Apple refreshed earlier this month by adding a video camera to the popular iPod Nano. Meanwhile, Microsoft has cut the Zune lineup to one model, the Zune HD. The company previously offered Zunes at multiple price points and configurations. “Microsoft has to ask whether the Zune is strategically important,” Hrebiniak says.

Following the Microsoft Playbook

Microsoft, however, is likely to continue with the Zune experiment, largely because it is showing improvement with the device — at least from a product perspective, say experts at Wharton. The Zune product evolution follows Microsoft’s usual playbook: Start out with a so-so device and improve each generation. What’s unclear is whether the new HD features will be enough to help the device gain traction.

“Somewhere in there is a business strategy for the Zune,” says Kendall Whitehouse, director of new media at Wharton. “Microsoft will try and try again and throw money at it until they get somewhere.”

Indeed, the Zune HD has received positive reviews from the technology press and it has features that the iPod doesn’t. For instance, Microsoft has bet on high-definition video to differentiate the device. The Zune HD is among the first handhelds able to play high-definition video and receive digital HD Radio signals. Apple’s iTunes software supports high-definition video, but only when displayed on Apple TV (a set-top box) and on PCs. The Zune HD’s OLED screen is more vibrant than typical touch displays — a potential selling point for tech-savvy consumers looking for state-of-the art features. Microsoft has also differentiated its Zune line with a subscription service called Zune Pass. For $14.99 a month, Zune Pass subscribers have unlimited streaming access to 6 million songs in the Zune Marketplace and are allowed to permanently download 10 songs a month. (Apple’s iTunes store allows listeners to hear samples of music, but they must pay for each download.)

Microsoft executives acknowledge that the Zune is a work in progress. “We [are continuing] to expand the brand presence for Zune and … to build our capability in the music and video delivery marketplace,” said Robbie Bach, president of Microsoft’s entertainment and devices division at a July 30 financial analyst meeting.

However, Microsoft is going to need more than new features to boost the Zune’s presence. Saikat Chaudhuri, a Wharton management professor, notes that other competitors are likely to follow Microsoft’s HD lead relatively quickly. The company will need savvy marketing and strategic positioning for the Zune HD to be a contender. The biggest challenge, he says, is out-marketing Apple. “Apple made the iPod a fashion item. The problem is that Microsoft doesn’t have a fashion-oriented approach to marketing. Microsoft is very functional [in its approach], but somehow it has to tap into fashion sense.”

Free Marketing Advice

Solving the Zune HD marketing conundrum isn’t easy. According to Fader, the Zune moniker has been tainted by Microsoft’s consistent failure to gain traction with the device. Microsoft originally launched the Zune with a series of taglines such as “Music the way it wants to be” and “Welcome to the social.” That initial Microsoft marketing effort was “muddled” and never really resonated with its target audience, Fader points out. Market share for the Zune topped 10% in late 2006, when it was introduced, according to NPD, but it has gone downhill since. In May 2008, Microsoft said that it had sold two million Zune players, but then retailer GameStop announced it was going to stop carrying the device due to insufficient demand. In contrast, Apple on September 9 (when it announced its video-enhanced iPod Nano) said that it has sold 220 million iPods to date.

Given Apple’s lead, Fader says that Microsoft’s best move with the Zune would be to scrap the name and start over, much like it did with Bing, its rebranded search engine. “First, don’t call it a Zune. A ‘Zune’ is just a misconceived mess…. Start with a clean slate.”

According to Wharton marketing professor Jerry Wind, Microsoft has to “design a strategy that centers around the Zune HD’s key benefits over the iPod.” Those benefits appear to be the ability to play high-definition video and capture HD Radio signals, the next-generation technology for broadcasting. The problem? Microsoft isn’t competing against just the iPod as much as it is against an entire ecosystem of applications and developers that go along with Apple’s device. The number of applications available for the Zune HD pales by comparison with those available for the iPod through Apple’s App Store: The Zune HD currently has nine free applications available, while Apple has 85,000 applications available on its App Store for the iPod and iPhone. “Apple’s success is a combination of multiple factors,” says Wind. “Microsoft could go after a niche, but it has to answer the key question: Why should anyone use a Zune HD?”

Wharton marketing professor Eric Bradlow agrees that Microsoft will likely have to adopt a niche approach, given its lack of market share. It will need to position the Zune as strong in one area — say, as a player focused on music and video — and then make consumers advocates for the product. Conversely, Microsoft could push the Zune HD as one device that can do multiple things. “Microsoft has huge brand equity to leverage and [it has] large mindshare,” Bradlow notes. “The Zune HD needs to generate enough buzz to attract feature-savvy and high word-of-mouth people.”

Attracting those consumers may require drastic tactics, like giving the Zune HD away at a low price or even free just to get consumers to try it, says Wind. Another option would be to bundle the Zune with the Xbox, Microsoft’s popular game console, both Bradlow and Chaudhuri suggest. The Xbox has garnered success, and the Zune HD’s screen is ideal for displaying game applications.While Microsoft has indicated that there will be games for the Zune HD, the company will still be a distant rival to Apple’s iPod Touch, which is partially positioned as a handheld video game console.

Experts like Wind, Bradlow and Hrebiniak note that Microsoft could use its sheer girth to cut pricing and give consumers a 60-day trial period. The point would be to just get consumers to try something other than the iPod. Wind says there is precedent for a try-it-for-free marketing strategy, citing Ford’s recent U.S. launch of the Fiesta, where it gave away 100 cars for a six-month trial period. These consumers then uploaded videos of their impressions of the Fiesta. “Those people became great advocates for the car. It would not be unheard of if Microsoft gave away millions of free units just to get people to talk about it.”

Microsoft hasn’t deployed such marketing tactics, but Hrebriniak says it should if it is serious about gaining share. The low-price game is risky because it almost ensures Microsoft would operate its Zune HD unit at a loss; however, Microsoft has already indicated it is willing to lose money initially to enter a new category. After all, Microsoft’s Xbox division lost money for years before turning a profit.

For the fiscal year that ended on June 30, Microsoft’s Entertainment and Devices division reported operating profit of $169 million on revenue of $7.75 billion. In 2008, that division, which is primarily dominated by Xbox, turned an operating profit of $497 million on revenue of $8.2 billion. Although the entertainment and devices unit, which also includes the Zune business, is profitable, it pales in comparison to the Microsoft Business Division (which includes Office and SharePoint) and the Windows divisions, two businesses that delivered operating profits of $12.1 billion and $10.86 billion in fiscal 2009. In fact, Microsoft’s Entertainment and Devices unit is the second least profitable division at the company behind the software giant’s online business (including MSN and search), which had an operating loss of $2.25 billion in fiscal 2009.

Playing the Convergence Game

Given the financial picture for the unit that includes the Xbox and Zune relative to Microsoft’s other cash cows, it’s reasonable to ask whether it makes sense for the company to even bother. “Microsoft is throwing a lot of resources at this,” Hrebiniak notes. “I’m not saying Microsoft should pull out, but I do question whether these markets are really strategic [for the company].”

Other experts agree, but say that Microsoft should continue — for now. Why? Devices are converging, and the Zune HD and Xbox could give the software giant a foothold into the so-called “digital living room” where multiple devices would be tied together in networks. Microsoft counts the Xbox, software for digital set-top boxes and its PC dominance as assets for this convergence of the Internet, television and digital content.

Meanwhile, Microsoft is increasingly tying the Zune HD to the Xbox. For instance, Zune HD users will have access to the Xbox Live Video Marketplace so they can acquire the movies and television shows available for Microsoft’s game console. “Microsoft has been good at moving the Xbox forward with audio and video downloads,” Whitehouse notes. “The Xbox was launched as a gaming console, but has become a multiplatform entertainment system. Convergence is the real ‘secret sauce’ here.”

The Zune HD, or its successor, could have a chance if it emerges as a cog in the digital living room — a screen that can take content from the PC, game console or Internet. Experts at Wharton say the Zune HD could morph into a portable Xbox or a favored screen for video. “As we move toward convergence of computing and consumer electronics, there’s going to be a huge market. Microsoft doesn’t want to leave Apple and Sony to fight it out,” Bradlow says. In other words, the Zune HD has some role for Microsoft — even if it’s unclear at the moment. “It’s hard to ignore a massive market and not leverage it as a cross-selling opportunity.”