Microsoft Vs. Sony – It aint over

“The idea was to destroy the Japanese hegemony for game consoles by making the PC a viable competitor,” says a former Microsoft (nasdaq: MSFT – news – people ) games engineer, who requested anonymity.

That was just the first shot fired in the battle Sony and Microsoft are waging to own the $13 billion videogame business. Sony’s weapon of choice is the PlayStation 2, which went on sale in October 2000 and has since sold 41.2 million boxes. Microsoft’s Xbox console, launched a year after the PS2, has sold 6.5 million units worldwide.

This Christmas season seemed to bang another nail into Microsoft’s coffin. The hottest game on the market, Grand Theft Auto: Vice City, was available only on PS2, driving millions of holiday dollars to Sony through sales of its PS2 console. The company also gets royalty payments from Take Two Interactive (nasdaq: TTWO – news – people ), the publisher of the enormously successful Grand Theft Auto series.

“Consumers are concerned about three things: price, variety of games and exclusive content,” says Michael Gartenberg, research director at Jupiter Research. “The prices [for the consoles] are the same [$200]. Sony is leading everywhere else.”

But experts say no one should dismiss Microsoft. With $40 billion in cash, the company simply considers this Phase 1 of its grand plan to dominate the digital entertainment world.

“Xbox is the starting base,” says J. Allard, the loquacious manager of Xbox. “This is how we get our feet wet. It will lead to something bigger.”

That something bigger is Microsoft’s plan to own the home entertainment experience. Today, electronic fun is split between the den and the living room. Microsoft controls the den, where PCs link to the Internet and some entertainment (music, videogames and short films) can be downloaded.

Sony controls the living room with its televisions, stereos and DVD players. Eventually, those two worlds will merge, and music, movies, games and the Internet will all be funneled through one box. If that box is a Windows-based PC, Microsoft has nothing to worry about. If it’s something in the living room, like your cable set-top box or stereo, Microsoft could be in trouble.

The Xbox might be the golden product that gives Microsoft a spot on top of the television. Microsoft’s other attempts to put a Trojan horse in your living room, WebTV and UltimateTV, were dismal failures. Xbox might not be selling as well as PS2, but it has made a mark.

Microsoft has an opportunity to pull ahead on the next battlefront: online gaming, where two or more players compete against each other on the Web, in real time. Although online gaming is still experimental, both companies sell kits to hook their game consoles up to the Internet. Sony has sold 400,000 network adapters since August at $40 a pop, and for now most games are offered free. Sony is leaving it up to the game publishers to charge for online play.

Microsoft is taking more direct control over the online gaming experience. The company started selling online gaming kits in November for $50, including a one-year subscription to Microsoft’s online game service, and has sold 250,000 of them.

If Microsoft can create a compelling online-gaming experience, the company could be well positioned to move ahead when the next round of game consoles hit the market sometime within the next five years.

Allard hopes people will eventually watch, pause and rewind television, play videogames, purchase music and movies–even talk on a videophone–using Microsoft’s software.

Sony insiders say the company is concerned about the Microsoft threat, but to the outside world, the company is showing its poker face. “They don’t enter into our strategic thinking,” says Sony’s Tretton. “They’re not going in the right direction.”

Sony might want to be a little less blasé about its attitude toward Microsoft. “Put it this way,” says Lin of Jeffries & Co. “Microsoft is never the underdog.”