How Much is Too Much?

Microsoft says it will stick with Xbox. But with years of heavy losses behind it, the pressure’s on for the gaming division to make good

Earlier this week, an interview with Microsoft COO Kevin Turner affirmed that Microsoft is willing to stay the course with its videogame business, despite the fact that it hasn’t been profitable on an annual basis since the original Xbox launched in 2001.

For some, the reaction to the interview was surely, “’Duh.’ Of course Microsoft plans to stick with the Xbox business.” That reaction stems from the fact that it’s easy to see Microsoft’s successes as the lone next generation console on the market. The games library is good, upcoming titles are looking great, Xbox Live is a robust service with many appealing features and Microsoft is insistent that it will move 10 million hardware units by the end of the year.But all of these successes and admirable plans have come at great expense—greater than Microsoft had expected initially. For fiscal year 2005, Microsoft’s home and entertainment division posted a $485 million net loss.After its third fiscal quarter ended March 31, 2006, when Microsoft posted a $388 million operating loss for its home and entertainment division, Microsoft CEO Steve Ballmer issued an internal e-mail that stated, “…The cost of producing Xbox 360 consoles was higher than expected...”In fiscal 2006, ended June 30, 2006, the division lost $1.26 billion, mainly due to Xbox 360 launch expenses.Of course, these losses represent investment—heavy investment that Microsoft hopes to turn into profit by fiscal 2008, the target date that Robbie Bach said the home and entertainment division would become profitable.The question is, how much loss is too much? Microsoft’s resources for supporting the Xbox 360 business seem unlimited, as other profitable divisions rake in the dough. But what would it take for Microsoft to throw in the towel?Xbox as a defensive maneuverWe posed that question to company-specific research firm Directions on Microsoft analyst Matt Rosoff. His answer in short:“I don’t know.”Still, he explained his uncertainty. “Remember that Microsoft partly entered the game console business for defensive reasons,” Rosoff said. “The company was concerned that a PlayStation successor would become the default gateway to networked entertainment in the home—Ken Kutaragi promised as much—and cut into consumer PC sales.”He continued, “It's very hard to calculate the worth of a defensive business. I personally think Sony will have a really hard time with the PS3—fewer games at launch, $200 price premium, and yet they're losing more money per console than Microsoft is on the 360. More long-term, imagine no PlayStation 4 and how Microsoft might profit from such an environment.”So according to Rosoff, one of the main rewards that the Xbox business can provide Microsoft is the ability to block Sony’s encroachment on the living room and PC sales, the software for which is Microsoft’s bread and butter. The value of these areas seems immeasurable to Microsoft, so it’s no wonder the company wants to stick with the Xbox business despite its steep near-term costs.

’08 the magic number?But why is Microsoft saying that fiscal 2008 will be the coveted time by which the home and entertainment division will be profitable? After all, according to Directions on Microsoft, the company previously said that the division would be profitable by the beginning of fiscal 2007, which began in July. The company missed that goal by a long shot (see the aforementioned $1.26 billion loss).Again, heavy investment in the Xbox 360 in the face of the PS3 combined with faith in the first-mover advantage drove spending to high levels.“First, they accelerated production of Xbox 360 consoles when they found out that the PS3 would be late, in order to reach their goal of being the first console in this generation to reach 10 million sales,” explained Rosoff.

“So, because production was frontloaded, costs hadn't come down as quickly as expected in fiscal ‘07. Second, the home and entertainment group was starting up at least one business—Zune—that Microsoft hadn't anticipated when they made the fiscal ‘07 prediction.”The 10 million unit raceThe large majority of spend has everything to do with Microsoft’s oft-mentioned race to 10 million Xbox 360s sold by year-end. Building loads of Xbox 360s at an estimated $125 loss each puts a bit of a dent in a company’s financials. Lazard Capital Markets analysts Colin Sebastian reminds us that once a really significant installed base is established for the Xbox 360, it’s all about software sales.“I am not sure if the hardware will ever turn a profit for Microsoft or Sony," he said. "However, what the manufacturers can count on is an increasing contribution of royalties from third-party software sales, which is where the real profit potential lies. …With a high software tie ratio they can earn a significant return over the course of the five- to six-year cycle.”Rosoff concurred: “Peter Moore and others at Microsoft believe that getting to 10 million first will ensure dominance through this generation of consoles. When you hit that number, you get more exclusives from third-party developers, more support for your from retailers, and so on, and that leads to more game sales. And, again, there's the defensive aspect to keep in mind.”Xbox in contextSpeaking of defense, Microsoft’s going to have to crank up its defense to ensure that profitability target. The market’s about to get pretty crowded with the additions of the Wii and PS3, and come mid-November, we’ll all get a perspective shift, and will be able to view the Xbox business in the context of an all-out next generation console war. We think Microsoft’s heavy investments will pay off, and we couldn’t be more excited about this upcoming three-way race.

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