Microsoft struggles with WebTV pricing

When it comes to selling the Windows operating system, Microsoft can pretty much dictate the price to computer makers, which gives the company tremendous power in that market.

But with WebTV, the software giant is finding that the shoe is on the other foot.

To gain a foothold in the potentially lucrative market of selling online services and goods through the television, Microsoft has pushed WebTV aggressively, even offering manufacturers subsidies on their production costs to build a base of WebTV subscribers, sources say.

To keep its manufacturing partners appeased and the retail distribution channel happy, Microsoft essentially pays these companies to stay in the market, according to analysts and others. That is to say, if retailers claim they can only sell the device for $99, funds from Microsoft get funneled down so that the middlemen turn a profit. A single WebTV set-top box costs far more than $99 to build.

WebTV is a set-top box with a corresponding online service, which provides simple Internet access through the TV. The original box was introduced with a retail price of around $350 and a monthly service fee.

Shortly after Microsoft acquired the start-up in 1997 for $425 million, prices for the devices started coming down, in an effort to build a base of subscribers. There are currently about 800,000 WebTV subscribers.

"WebTV Networks pays the manufacturer back the difference after the box is sold," one source close to the company said. "And [WebTV], in turn, gets that difference back after the user has used the service for a while."

Microsoft recovers the subsidies in the monthly service fees. Still, this business model is in stark contrast to the leverage the company enjoys with its partners in the PC market. In that segment, Microsoft charges manufacturers relatively high, take-it-or-leave-it prices for its software and then lets them duke it out against each other in the marketplace.

"WebTV has been Microsoft's consumer education," said Richard Doherty, an analyst with The Envisioneering Group.

The relationships between Microsoft, its manufacturing partners, and their retail distributors is extremely complicated, analysts say. WebTV did not respond to calls for comment, but sources close to the company confirm that Microsoft reimburses manufacturers. In addition, none of the parties will discuss the specific licensing agreements.

The deals boil down to this: To sell a WebTV Classic terminal for $99, retailers will buy it wholesale for no more than $80, sources say. That means that for the manufacturers to make a profit, their total bill of goods must be around $63, an impossible proposition.

With a hard drive and integrated modem, these devices include many of the same components and perform many of the same functions as personal computers. It would be a near impossible feat of engineering to manufacture a device with these components and make a profit selling it for less than $99, analysts say.

"Very few consumer electronics companies can afford to manufacture, ship, and advertise a device they don't make some profit on," said Doherty, explaining that Microsoft's manufacturing partners saw their profit disappearing when the company decided to cut prices from $349 to $199 for the WebTV Plus and to $99 for the WebTV Classic terminals.

As low as $50
Today, the WebTV Classic can be found for as low as $59, or even lower. (See related story.)

So Microsoft reimburses the difference. This not only allows manufacturers to turn a profit on the hardware, but it keeps the only retail distribution channel for Microsoft's television offerings alive.

"Subsidization has always existed," Doherty said. "Microsoft is using its clout to compete on a level other companies can't. WebTV is doing something that other Internet start-ups can't do."

In a sense, WebTV resembles many of the subsidization schemes that are in vogue in the PC market. Just like subsidized PCs, Microsoft offsets its hardware losses by selling the more lucrative WebTV ISP and online service.

"WebTV is really the first incarnation of the cell phone pricing model applied to computing," explained one source close to WebTV. "In cell phones, you can often get the phone free by signing up for a service plan. Likewise, you can now sometimes get a computer for free by signing up with an expensive ISP."

This sort of arrangement greatly differs from business in the PC world. In PCs, Microsoft sets the price for Windows, which puts the risk of turning a profit from a Windows-based PC onto the manufacturers. Most PC makers, in fact, have very little control over the price. With WebTV, the consumer electronics companies can pretty much expect to make a profit while Microsoft has to contend with customers that may cancel the service or prove to be bad credit risks.

"It's a different business model, because it's a completely different business," said Kevin Hause, an International Data Corporation analyst, adding that Microsoft can't expect any ongoing revenues after it ships Windows 98, unlike its WebTV business. "At twenty-five bucks per month for the service, that's where they make the money back, well within a year."

Although Microsoft is probably already profiting from this business strategy, there are clouds on the horizon, analysts warn. With WebTV Classic prices dipping below $50, the product becomes unattractive for retailers to sell, as they are not benefiting from the subsidies that Microsoft offers to manufacturers.

"As the price drops down, it's harder to get a sales person to commit to selling it," Doherty said.