January 18, 2002 3:40 PM PST

Xbox drags on Microsoft profit

While Microsoft is touting strong initial sales for the Xbox, analysts say the new video game console will be a drag on the company's bottom line for at least another year.

see special report: Microsoft plays for keeps That's because Microsoft is selling each console for less than it costs to manufacture--a widely copied practice in the video game business. Makers of game consoles typically count on sales of their own software and licensing revenue from third-party software to partly subsidize the cost of making game machines.

Such subsidies--which don't happen in Microsoft's core software business--are built into the price of the Xbox and will undercut Microsoft profits for some time to come.

Microsoft hailed the successful launch of the Xbox in reporting earnings Thursday for its second fiscal quarter. The company reported it sold 1.5 million units of the console in the quarter, at the high end of internal estimates, and said it was on track to sell 4.5 million to six million units by the end of the 2002 fiscal year on June 30.

While Xbox sales helped boost Microsoft's overall revenue, the company also said high launch costs cut into profits.

"Xbox is the first step in Microsoft's long-term strategic vision for the future of home entertainment, and it too met with great success," Microsoft Chief Financial Officer John Connors said after the earnings announcement.

But that success comes at a price. Each Xbox console sells for $299, and analysts estimate it costs the company anywhere from $20 to $150 more than that to get it on store shelves.

One of the most widely publicized estimates of Microsoft's subsidy was Merrill Lynch analyst Henry Blodget's report last March that Microsoft would lose $100 for each console sold. Subsequent estimates have been more conservative, but nobody can say for sure without knowing how much Microsoft pays for Xbox components, many of which are standard PC parts subject to fluctuating prices.

Prudential Securities analyst John McPeake now estimates the company is losing about $30 per unit, a number that's unlikely to change much. "The consoles themselves they'll never make money on," he said.

So far, software sales for the new system have been unusually strong, with Microsoft reporting an average of three games sold for each console. That means the overall Xbox operation should be in the black in less than two years, which would be considered a solid performance by game industry standards, McPeake said.

"I think the tie-in rate is definitely encouraging," McPeake said. "I think by the fourth quarter of next year, they'll be able to make money in this division."

Besides the software numbers, it's also telling that many of the initial Xbox hits, such as shooting game "Halo" and racing title "Project Gotham Racing," were published by Microsoft, said Gartner analyst P.J. McNealy.

"A lot of the early sales were on first-party titles, which will help turn them cash-flow positive," McNealy said. "Clearly they're still not making any money yet on the hardware, but that's to be expected. You usually don't turn a profit on the hardware until year two or three."

Credit Suisse First Boston analyst George Gilbert estimated Microsoft's hardware subsidy at $20 to $40 per Xbox, putting the company on track to make money on the Xbox sooner than expected.

"It should start kicking in some time this year," he said. "You're in the razor-blade and razor business with game consoles. You make nothing on the razors, but you sell enough blades, and you've got a good business."

Besides, Microsoft's real intention with Xbox is more complex than just turning a profit. Microsoft plans to have an online gaming service built around the Xbox ready by the end of this summer. Once that service is up, Xbox will start to become a part of Microsoft's grand .Net strategy for online service, Gilbert said.

"The Xbox in the next two to three years is not really about making a lot of money on the bottom line," Gilbert said. "It's more about getting penetration in the consumer arena to accelerate the .Net initiative. The way we view the Xbox is as a delivery platform for .Net services."

Success from any perspective, however, depends on maintaining excitement about the Xbox as a game format, said McNealy.

"It's a marathon, not a sprint," he said. "Their start is strong, but they need to produce compelling games over the next four years, and that's not the easiest thing to do."

 

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