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Microsoft's Billion-Dollar Fix

In the face of staggering customer returns of the Xbox 360 console, the software maker announces a charge of at least $1.05 billion to address the problem

In the quest for supremacy in next-generation gaming consoles, Microsoft (MSFT) had a big advantage by releasing the Xbox 360 a full year ahead of competing devices from Sony (SNE) and Nintendo (NTDOY). But hardware failures on the device are forcing Microsoft to cede some of its hard-won ground.

After months of reports about unusually high hardware failures for the Xbox 360, the Redmond (Wash.) software giant on July 5 said it will take a $1.05 billion to $1.15 billion charge to extend warranty coverage on repairs and replacements. The company said a months-long investigation into an "unacceptable number of repairs" to Xbox 360 consoles has helped it identify several flaws that caused the system to crash—indicated by three flashing red lights on the front dubbed the "Red Ring of Death" by gamers.

Robbie Bach, president of Microsoft's entertainment and devices division, declined in an interview to say what specifically caused the failures or how high the failure rate has been.

But the disclosure follows weeks of online chatter about a high retail return rate for the console. While the normal console return rate is between 3% and 5%, online news site DailyTech on July 2 said it surveyed retailers and found that the Xbox 360 had a staggeringly high return rate of 33%.

Stalled Momentum

Microsoft will record the expenses in the quarter that ended June 30, compounding losses at a division that has yet to become profitable. Fallout from the admission won't end there. The hardware problems could undermine Microsoft's credibility with the hard-core gamers it has fought hard to court in recent years. The company is belatedly owning up to flaws that reach back to the November, 2005, Xbox 360 launch. Users complained then that the console scratched game discs and rendered them unusable. It took nearly a full year for Microsoft to admit that the original batch of shipments was failing at an unusually high rate. Last September, the company extended its 90-day warranty to a full year. This spring, it offered free shipping on returns.

What's more, Microsoft's pronouncement could further slow the momentum the company had built with its year-long lead over Sony's PlayStation 3 and Nintendo's Wii. Since January, the Wii has stolen the spotlight—and gamer dollars—from rival systems. Microsoft shipped 10 million units through 2006, but has sold only 1.6 million additional units since then. The company failed to reach its forecast of shipping 12 million units through June.

In June, the Wii outsold the Xbox 360 by a 2-to-1 margin and it outstripped PlayStation 3 sales nearly 4 to 1, according to product tracker NPD Group. Nintendo President Satoru Iwata predicts the company will sell more than 14 million units in its current fiscal year.

Design Issue

Microsoft said little about the causes of the hardware woes. It relies on two contract manufacturers to make the Xbox 360—Flextronics International (FLEX) and Celestica (CLS)—both of which make the finished product at plants in southern China. But Bach indicated the issue had nothing to do with the recent spate of tainted or defective Chinese imports. "You should think of it more as a design question," he says. "We had some design issues, and it's a combination of factors that led to the problems." Microsoft said it worked with the contract manufacturers to identify and address the problem, and has taken steps to make sure future shipments do not suffer similar issues.

Despite adding to the continuing losses for the entertainment and devices division, Microsoft executives pointed to a silver lining: "Most customers are going to look at it and say, 'Great, Microsoft stands behind the product,'" Bach says. "Ultimately, it becomes a positive thought in people's minds."

Game Releases Planned

Like other makers of consumer electronics, Microsoft is willing to accept losses on gaming consoles in hopes of recouping revenue through game software. And Microsoft plans to release some blockbusters later this year. Along with others in the games industry, it is expected to showcase many of those products at this month's annual E3 games expo held in Los Angeles. Microsoft is betting its core Halo franchise will give it a boost later this year with the release of Halo 3. The company also has stolen a march on Sony, getting Take-Two Interactive Software (TTWO) to drop its PlayStation exclusivity for the next installment of its Grand Theft Auto franchise.

Bach says there's another reason to cheer: Company surveys show 90% of current Xbox 360 customers would recommend the console to a friend. As all three console makers turn up the heat on their battle for supremacy, Microsoft will need as much of that word-of-mouth support as it can get.

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