Seriously, if you download movies from file sharing services or know how to extract the content from a DVD and save it to hard disk or you have a large collection of codecs Apple doesn't support than the Apple TV wasn't targeted to you.
Which begs the question, who IS it targeted to? The people with no video on their computer in the first place, or the (probably non-existant) people with massive collections of iTS movies?
I have to agree with idhk and others, the restrictions are too severe on the AppleTV. Making the AppleTV only play mp4 files is like making an iPod that only play AACs. Totally worthless to most of the market.
I don't even rip my own DVDs to mp4, because doing so makes them less playable in QuickTime! (That's because in an mp4, QuickTime will use Apple's own MPEG4 decoder, which doesn't support all of the MPEG4 spec and is very slow. If I rip as an AVI, it'll play with whatever GOOD MPEG4 codec I have installed, be it Divx, Perian or something else, which is fast and supports all sorts of goodies like B-frames.) Really, nobody likes the mp4 format, and Apple's done nothing to change that with their own half-hearted implementation in QuickTime...
Does any of this mean it's a bad move for Apple? Not necessarily. Apple did not release the AppleTV to be an instant hit. The fact is, they don't need this thing to sell. They've established a presence in the market, and they will surely sell at least a few of these things. That's good enough for now. Apple takes things slowly. Just look at their first push into video: they released an iPod capable of playing only tiny movies in mp4 format, and they sold a few compatible shows on iTunes. Then they released a new version with full SD resolution (which, IMO, makes it Not Suck). Apple's doing the same thing here: releasing a half-baked (let's face it) product just to establish their presence in the market.
From a business perspective, that might not be bad. But I am a consumer, not an employee of Apple, so I'll call it what it is: a half-baked device that's overpriced and has no market appeal aside from rabid Applephiles.
As for what
I think Apple should do, that's simple: make it play anything I can play on my computer. Put OS X on it, and unlock the full power of QuickTime. If it could stream video directly FROM my computer, like an Airport Express for video, that would be awesome (802.11n should provide enough bandwidth for that).
This is a device I would have loved to have if it had been implemented well. But as it is, I wouldn't buy one even if it were dirt cheap.