Well-written OP. I've given thoughts on where MS could take Xbox in the future in the past, and I think we mostly agree on them solidifying their focus as an (actual) 3P publisher. However, where we diverge I feel is what they do with Xbox in hardware terms.
IMHO, especially with what looks to be a dead deal in ABK, there is less incentive for Microsoft to continue operating Xbox on the traditional console business model. At some point they're going to get tired losing money on the hardware, and will want to see some actual changes. They have faced constant comparison to Sony & Nintendo for 20+ years and for the better part of most of that, they have come out looking the weakest in almost all measurable aspects. I only imagine what that could do to the psyche of the employees within the division who have been there long-term.
So why keep going through that? Why not just adjust the Xbox hardware model into a mini PC NUC one, and move the hardware team and resources under the Surface division? Remember, Surface hardware sales also saw a drop last fiscal quarter, and I think MS value the Surface hardware team a LOT more than the Xbox hardware team or the entire Xbox division TBH. So any salvaging of the Xbox hardware would most logically be done by moving it under the Surface division, after all members of the Surface team helped in the Series S & X design process.
Shifting Xbox hardware to a mini-PC NUC style business model affords Microsoft many things. First, it allows them to price the Xbox hardware at a healthy profit margin. No more losses on hardware being sold. Second, having it handled through the Surface division will benefit the hardware with Surface brand association and provide crossover of the Xbox hardware to buyers in the Surface market. Third, it would allow Microsoft to comfortably reduce the volume of annual hardware production. Instead of needing to manufacture and ship out say 8-10 million Xbox consoles a year (that are costing them revenue on each unit sold), they can instead ship out 2-3 million Xbox NUC-style devices a year with big profit margins on each unit, and more built-in value simply through virtue of also running the latest Windows on them (currently due to multiple reasons Series S & X cannot run full-on Windows, that would conflict with their current business models for those systems).
Fourth, it helps Microsoft focus on their ACTUAL gaming roots, which is PC, not console. While they've been trying and failing to dethrone Sony in the living room the past 20+ years, they let Valve sneak up on them and seize the PC gaming market with Steam. Microsoft have made the same mistake in gaming that they made in ignoring the mobile market when they could have focused on it in its infancy (focused instead on winning the PC OS and app/plug-in wars against Netscape, Real, Java etc.). But they have an advantage when it comes to turning back focus on PC gaming: they own Windows. So, double-down on your PC gaming footprint and take your Xbox console experience with you. Built out sleek Surface-influenced NUC mini-PCs with console-like form factors and console-like R&D on some customized specs, that you can put at volume larger than competing OEMs and price competitively to boot, at healthy profit margins that tightly integrate and optimize PC gaming performance from the hardware to the OS and still allow for some of the upgradability unique to the PC space.
That is what I think Microsoft should do going forward with the Xbox hardware. They can even transition to it with the current systems; just offer a $200 or so upgrade fee to a full Windows 11 install. I'm sure quite a few Series S & X owners would bite, and it'd get them wanting similar functionality out of the box with the next Xbox. You could even use that as a means to gauge (in part) the size of such a market so you get a feel for what volumes can be realistically put out annually.
Meanwhile, if they move Xbox hardware under the Surface division, they could probably splinter Game Pass off into its own division or make a new division with it and other "entertainment services", or just shift it under their current services division. Main point being, Game Pass should have the autonomy to make its own deals with other companies, and maybe also focus on providing a subscription and cloud streaming service backbone for client companies looking to make their own sub & streaming services. I'm sure they've put the iD Origin tech to good use by now; FWIW I've suggested similar in terms of something Google should do with Stadia tech (specifically with Sony, but really any other company as well).
Alongside such, the Game Pass (& entertainment services) division could continue to offer Microsoft Gaming content on PC and mobile the way they currently do via Xbox Game Pass & PC Game Pass, though just with 1P content. I imagine they would make it functionally closer to an EA Play rather than how it currently is, though. It may also make sense to use this as a chance to restructure at least a part of the Windows Store on PC into something with Game Pass branding, so now Game Pass would be seen as not simply a subscription service but also a storefront for buying 1P & 3P PC games.
Speaking of which, Microsoft Gaming in such a restructuring, would just keep the XGS and Zenimax teams, and focus on making the actual gaming software. And, yes, focus on bringing their games to multiple platforms in the truest sense. PC/Windows (so, by extension, Xbox devices), PlayStation, Nintendo (at least for the games that can realistically run on the hardware), as well as iOS & Android, though in those cases perhaps as through their own storefront. There will still be outliers of games that are temporarily PC exclusive, like the Flight Sims and AoEs, but eventually those would go to consoles like PlayStation. Funny enough, in that sense Xbox would have some actual (timed) 1P exclusives, since this is now an Xbox that is effectively running normal Windows.
Should Microsoft make these changes? I genuinely think so. PC gaming is a mess right now between GPU cards that are pricing out the lower end, and various stutter issues plus slow adoption of MS's own DX12U gaming features like DirectStorage. If by making a console-like gaming NUC mini-PC at good enough volumes, Microsoft could tailor a tightly integrated hardware & software package that is fully optimized for PC gaming with none of the growing drawbacks, and offers a full package that can actually appeal to the lower end, then I think they have a healthy, decently sized audience of customers. It would also allow them to diversify Xbox hardware with periodic refreshes, actually giving some extra use of that All-Access program, and try some form factors for truly innovating PC gaming that they cannot do with Xbox as it currently is.
And I think that future, where they're doing maybe 21 million Xbox devices lifetime over a course of seven years (with hardware refreshes every two years), is a LOT more profitable and better for their optics as well as securing & growing/innovating the Windows/PC space than floundering to sell 45 million or so Xbox consoles on the current console business model. Where they don't have to be compared constantly to Sony & Nintendo anymore, and be mocked and looked down upon as inferior because of such. Where they have no inhibitions to let their games actually reach their audiences regardless of where they are, or what platform they're on.
That is an Xbox with an actual sustainable future.
