Microsoft's Latest Video Game Gamble

On June 15, at a video game convention in Los Angeles, Microsoft (MSFT) will unveil a little box of outsize importance. Code-named Project Natal, the device will be an add-on to Microsoft's aging Xbox 360 game console, which has shipped 40 million units in five years. Xbox sales have been slowing since Sony (SNE) cut the price of the PlayStation 3 console last summer, but Microsoft hopes Natal will revive the Xbox—because it lets users play games without a controller. Just drive your pretend car or swing your virtual baseball bat and Natal, which sits in front of the TV and has built-in sensors, picks up the motion. Following the event in L.A., Microsoft is launching an ad blitz leading up to a consumer release in October.

Microsoft needs Natal—or whatever it's called by the time it goes on sale—to be a hit. The technology is inarguably cool, and is a rare bright spot in Microsoft's decade-old—and thus far mostly disappointing—push to move beyond PCs and into game consoles, music players, and smartphones. Operating income at its Entertainment & Devices unit, which is responsible for those products, is expected to come in at $773 million for the year that ends June 30, according to UBS Securities (UBS). That's a 10 percent operating margin, compared with 72 percent for Windows, its most profitable business. While the Xbox is a strong No. 2 in the video game market (after the Nintendo Wii), the entertainment division has lost $8.6 billion on sales of $49 billion since 1999, estimates Katherine Egbert of Jeffries & Co. An initiative to build Internet-based TV systems has yet to take off, and its iPod-like Zune music players have bombed. While Apple (AAPL) just sold its two millionth iPad, Microsoft recently scrapped a tablet code-named Courier. In smartphones, Microsoft's share in the first quarter was 6.8 percent, down from 10.2 percent the year before.

The Natal device, which is expected to retail for about $100, won't sell in volumes high enough to matter much financially for the world's largest software company. But since it works with the current Xbox 360 console, it could reinvigorate sales of that device. That means Microsoft could put off having to field a new console, which would lose hundreds of millions of dollars for a few years; profits come from higher-margin sales of games it creates such as the Halo franchise, as well as its cut on Xbox titles made by other companies. Natal could also fuel greater interest in Microsoft's most impressive consumer play, the Xbox Live online service. More than 23 million gamers use it to play each other over the Net, as well as to download movies and music.

If Natal takes off, Microsoft might be able to extend its reach into other platforms. It could be built into PC monitors and big-screen TVs, allowing consumers to control those devices by speech or motion, moving family photos the way Tom Cruise moved pictures and videos around in Minority Report. Forrester Research (FORR) analyst Sarah Rotman Epps envisions families synching their Natal-based Xbox console with Windows-based tablets such as the new model just announced by ASUSTeK, so each family member could easily download movies or books. "That would make Microsoft relevant for the next decade," she says.

Even as the company hypes Natal and its new mobile software, Windows Phone7, investors don't expect smash hits; in fact, they'd settle for small losses on these and other gadgets. "It's hard to make the case this has been a good use of shareholder capital," says Todd S. Lowenstein, who runs HighMark Capital's value fund. "I don't fault them for trying this stuff, but investors are getting impatient." Other investors suggest that, like IBM (IBM) a decade ago, Microsoft should refocus its efforts on its massively profitable PC and corporate software businesses. Its cash from operations last quarter alone was $7.4billion, a company record. Yet its shares are down about 50percent since Steve Ballmer took over as CEO on Jan.13, 2000. "The stock would go up if Microsoft exited its consumer businesses," says Bill Whyman of ISI Group.

Whyman knows Microsoft won't give up on entertainment. The company has long poured money into maturing markets from word processing to Web browsers, beating market pioneers by underpricing them into submission. "Ballmer's answer is always, 'We'll keep coming,' " says Whyman. "That's not a very comforting answer."

The bottom line: Despite pressure from investors and a flat stock price, Microsoft will keep searching for hits in games, phones, and other devices.

    Before it's here, it's on the Bloomberg Terminal.