If the rumors are true, the next Apple TV will be a cloud-connected, iPhone-based device. Not only it makes sense, but it's the only way they can create a best-of-breed gadget that can best Google TV, and be truly successful.
In order for that to happen, this is what the new Apple TV should be:
It should be infinitely expandable and customizable using applications
Everyone is familiar with the applications model, which has become a natural way to add new functions to our gadgets. Of course, the Apple TV applications' user interface and controls would need to be tailored for the new device, but that's not hard to imagine, since Apple is already pushing two interface models with iPhone/iPod and iPad.
It will play any video file in any format in your network
Applications like Netflix, the ABC player, and Hulu (whenever it comes) would be there, providing with on-demand access to tons of content. Apple's own video library will be there too, and probably others—like Amazon's.
But the key for making this a completely successful device should be the ability to play any video format present in your network, from a DVD in your desktop PC to any ripped movie in a network disk. And the beauty of the apps model is that Apple doesn't need to provide with this ability. Thanks to third-party applications, users would be able to play whatever they want in their Apple TVs, streamed over Wi-Fi.
It will be a video game console
Given the amount of games available for iPod touch, iPhone and iPad, this is a given. The only problem here is the user interface, but Apple has already solved that. First, the existing developer tools support external controlling devices via Bluetooth. There have not been any of these out yet, but it's only logical to think that the new Apple TV would play games using external controllers, but also...
It should be completely integrated with the iPhone, iPod touch and iPad
The current iDevices will make perfect controlling surfaces. Developers should be able to use them in new ways. Like with the iPad, a family would be able to play a game like Risk or Scrabble, using their iPod touch or iPhones as controlling devices, with the main display on the TV. Or you could be able to play a racing or a space combat or a strategy or a role-playing game using an iPad or iPhone as your control device.
And of course, it only makes sense that you would be able to take total control of the Apple TV using the iPad or iPod touch, like you can take control of iTunes using the Apple Remote application. I can imagine browsing Netflix on my iPad, choose a movie, and have it play automatically in this new Apple TV. In fact, given its rumored $99 price, it's not hard to imagine people getting the Apple TV as a complement to their iPad.
Apple needs to do the above to have a successful presence in the living room before Google TV takes over it. They can't afford to have the crap they have right now. If they can nail the wishlist above for $99, they will have a winner.