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When Will Microsoft Own Up to the XBox 360 Bomb?


JPickford (retired mod)
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http://ce.seekingalpha.com/article/32642

When Will Microsoft Own Up to the XBox 360 Bomb?

Posted on Apr 18th, 2007 with stocks: MSFT

Roger Ehrenberg submits: The success (or lack thereof) of Microsoft's (MSFT) Xbox 360 has been a hotly debated topic across both the blogosphere and mainstream media, with an amalgam of sober and utterly confused views depending upon one's vantage point: analyst, investor or gamer.

After taking a step back and looking at some objective numbers - those taken from Microsoft's own financial statements and comparative console sales figures extracted from VGChartz.com and Wikipedia.org - I have concluded the following:

Gaming has been a disastrous endeavor for Microsoft, particularly from an investment perspective;

The seeds of this failure are evident from their sales performance in Japan, particularly when comparing their 18 week sales figures (which is about how long the Wii and PS3 have been out) relative to those of the most successful console releases; and

This early failure in the key Japanese market has a compounding negative effect on worldwide console sales, as game developers are less willing to invest in high-risk projects for console platforms that are shaky out-of-the-gates, which makes it less attractive for gamers to buy these consoles, and so on.

Before digging into the data, I'd like to clarify a key point: my perspective is that of a financial analyst. Therefore, my primary interest is in the strategic and financial implications of business decisions, in this case the Xbox 360 and Microsoft's Home & Entertainment strategy, and NOT whether or not the Xbox 360 is a rocking product.

As I've stated before, I have many friends who think the Xbox 360 is awesome. This, however, is not my concern. And to state the obvious for those who know me and/or are regular readers, I am neither a fanboy nor an investor in single stocks, so I have no interest in partisanship one way or the other. I am only interested in truth and understanding, and if a few people get their noses bent out of shape in the process, sorry.

Hemorrhaging Home & Entertainment

Let's first consider Microsoft's Home & Entertainment Division ["H&E"], which includes Xbox 360, Xbox, Xbox Live, Consumer Software and Hardware Products and IPTV. I have used a set of numbers from historical annuals that seem to change by $100 million or so year-to-year; I'm not sure why this is, but the numbers are close. Regardless, it is not a pretty picture from a financial perspective.

Making money, e.g., the creation of long-term shareholder value, has got to be the ultimate driver of Microsoft's gaming (and H&E) strategy, right? Well, after five years and over $21 billion invested all they've got to show for it is $5.4 billion of cumulative operating losses, and Xbox 360 doesn't appear to be the silver bullet to turn things around. I think it is also interesting to note that Microsoft's actual disclosure shows only Revenues and Operating Losses; I backed into and show EXPENSES below for explanatory purposes.

Why might it be that Microsoft has strayed from the classic Revenues - Expenses = Profits (Losses) disclosure? Perhaps because they don't want investors to focus on the fact that over $21 billion - the market cap of a sizable independent company - has been invested in a business that has performed so poorly, with unclear prospects for improvement. Could this be the reason? Hmmm.

Sometimes these cold, stark facts seem to get lost in the shuffle. Xbox 360 (a meaningful part of H&E) might be a fine product, but if so, why is it so financially disastrous to its maker? I understand the concept of selling a console at a loss in order to lay the foundation for recoupment of original investment + operating losses + attractive financial return through gaming, but what is it going to take to turn things around? Nothing short of a tectonic transformation in perception of the Microsoft offering relative to its competitors.

Sure, the Xbox 360 can be righteous and cool with hard-core gamers, but this is not a sufficiently large user base to recoup the magnitude of investment Microsoft has made in its gaming platform. So if this is the strategy, they've got a problem. And if their strategy is really more mass-market, then they've got some serious re-positioning to do relative to the Nintendo's (NTDOY.PK) Wii, which is both cheaper and more accessible to Ma and Pa and Timmy and Tammy gamer. In short, I am at a loss. Correct that: Microsoft is at a loss. $5.4 billion and counting.

The Importance of Japan

It is interesting to consider a few key points about Japan and its role in the gaming world after a little thought and analysis of historical figures:

Success in the Japanese market is a key determinant of success in the worldwide market. In fact, one might say that is a necessary but insufficient condition for a globally successful console platform. Sony and Nintendo have absolutely thrashed Microsoft in Japan, and it shows in the global console sales figures. For historical reference, consider that over 19 million PS1s and 20 million PS2s were sold in Japan alone, close to the worldwide sales figures for the original Xbox console.

Success in the Japanese market is a key part of getting the game developers to buy into a platform, for which they invest substantial sums and create titles, which makes people want to buy consoles with better game libraries. Success in Japan is frequently a precursor to success globally, which makes it particularly attractive for game developers who are looking to amortize their development costs over as large an installed base as possible.

If, for instance, the Wii is hot, you get shops like Electronic Arts (ERTS) turning themselves into pretzels to build their title libraries for the Wii console. And if your particular console isn't hot? Well, let's just say that developers aren't going to be laying out big bucks to invest in the platform.

Success in the Japanese market creates a virtuous cycle - sell consoles, which induces developers to create titles, which makes it easier to sell more consoles, more games, more consoles, etc., etc., etc. In the absence of such a cycle, a console maker is fighting an almost impossible uphill battle towards success on the global stage.

It is instructive to look at where the last major console releases were 18 weeks after launch in Japan. Basically, if you did well in Japan during this time frame, you had a chance to have a blow-out product. If you didn't, well, you didn't.

See how the Xbox did better than the Xbox 360? Even the PS3 has done better than the Xbox 360. But success in Japan is not a guarantee of a run-away success, as the GameCube proved. Without question, Japan is an important and critical market for building a globally successful gaming platform, and an early read of the tea leaves does not bode well for the Xbox 360.

And this is clearly not lost on Ballmer's Boys in Redmond. Remember the promise of runaway success in Japan back in 2005?

From Afterdawn.com 12/04/2005:

By next summer Microsoft hopes to have sold one million Xbox 360 consoles in Japan. This is a pretty high target when you consider that the first Xbox console has not yet even sold half a million units in Japan. Japanese gamers also seem to be more interested in Sony's upcoming PlayStation 3 [PS3] console than the Xbox 360. Japanese Xbox business manager Yoshihiro Maruyama, revealed this target to one-time publication Dengeki Xbox 360.

"It's only a target," Maruyama said, "but the one million mark is a figure we'd like to reach by next summer. And then, we'd like to go to 1.5 million, then 2 million in next year's end of year sales rush. We believe the one million mark to be an important figure. If we cross one million, it will be easier for developers to do business, so we'd of course like to reach it quickly."

Fast forward to today: Mr. Maruyama's words ring hollow. As we approach Summer 2007 Xbox 360 still isn't even at 1 million units. The Japanese launch was a dud, and Mr. Maruyama was subsequently replaced. From Gamesindustrybiz.com 02/16/2006:

Yoshihiro Maruyama, the Microsoft executive who oversaw the launch of the Xbox 360 in Japan, is to take on a new role in the company's entertainment and devices division.

He will be replaced by Takahashi Sensui, who has been at Microsoft Japan for four years and worked closely with Maruyama on the Xbox 360 launch. Sensui, who was previously director of Xbox Japan's marketing department and game content group, will hold the title of general manager.

Quick: Can you name another senior gaming executive that was kicked upstairs after a disappointing product launch? You guessed it, Mr. Ken Kutaragi of Sony (SNE). I feel like we've seen this movie before. And these movies tend not to end well.

An Issue of Strategy

Microsoft management has been talking about cultivating a more global, diversified user base for quite some time. Consider the words of Peter Moore, Microsoft Corporate VP, when speaking at the ELSPA International Games Summit way back in the middle of 2005:

Speaking at the ELSPA International Games Summit in London, Microsoft corporate VP Peter Moore has predicted that the company's first-mover advantage with Xbox 360 will allow the console to reach 10 million installed base "very quickly."

********************

He reiterated his colleague J Allard's comment, made at E3 last month in Los Angeles, that the next-generation could touch a "billion consumers" - but clarified slightly, saying that he was referring to the industry as a whole, including all three next-generation consoles, rather than simply to Xbox 360.

Speaking about the factors which will drive the growth of the next generation, Moore talked about the industry's need to broaden its audience, both geographically and demographically - and highlighted the growth of high definition television as a key factor which will drive next-gen consoles to new consumers.

It seems to me that there is a disconnect between stated objectives, strategy and execution. Microsoft's vision of the gaming console as the window into the living room is a big, big bet, and one that clearly hasn't paid off thus far. Mr. Moore talks about the need to broaden its audience across both geographies and demographics, yet the emphasis on HDTV as being a key factor driving broad-based console sales kind of misses the point.

Is the Wii successful because of its zippy graphics and technological superiority? No. It is successful because it is fun. And because it appeals to a broad audience. And because it is comparatively cheap. The Microsoft strategy sounds more like a niche strategy for hard-core gamers, in which case its investment in a console strategy should be smaller and more targeted. Would Lamborghini try to sell to everyone? Of course not; it would target those who the company knows value its features and are willing to pay for them. This is basic stuff.

They are just not in sync with the Consumer Era of Computing thesis I've written about, something that Apple (AAPL) and others have done quite well. A hard-core high-end gaming console or a console for everyone? The Zune as the answer to the iPod? I don't know who was in those focus groups but clearly that was a misread from a market perspective. Are these miscues a function of unwieldy size or simply flawed strategy? I don't know, but something is clearly amiss. And these weaknesses are apparent all across the firm.

Bottom line, Microsoft needs to take a long, hard look at its gaming strategy - and, in fact, its entire H&E strategy. At what point, regardless of its virtually endless financial resources, does it say "enough is enough." Would we have been better served by returning the extra cash to shareholders rather than investing it in a franchise that seems to have questionable prospects for turning around? These are the kinds of questions Microsoft management should be asking. And hopefully, for shareholders' sakes, they are.

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It's all a bit doom and gloom, isn't it?

I'll be a bit miffed if the 360 dies a quick death in a couple of years time, what with the considerable monetary investment I put into it. But, at the end of the day, it stills has plenty of decent exclusives in 2007 alone to justify its existence... maybe.

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After taking a step back and looking at some objective numbers - those taken from Microsoft's own financial statements and comparative console sales figures extracted from VGChartz.com and Wikipedia.org - I have concluded the following:

As much as I love Wikipedia, I can't take a report that uses it as a source seriously.

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It's all a bit doom and gloom, isn't it?

I'll be a bit miffed if the 360 dies a quick death in a couple of years time, what with the considerable monetary investment I put into it. But, at the end of the day, it stills has plenty of decent exclusives in 2007 alone to justify its existence... maybe.

My take on this is that the top brass at MS funded (or thought they did) a mass market product but the Xbox team went away and created a superb niche console. Great for us but they basically pissed several billions up the wall. With the 360 doing worse than the Xbox it doesn't look good long term.

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He's missing the fact that console gaming and the 360's main purpose to Microsoft is nothing to do with making money.

Microsoft know full well that CE is rapidly improving to the point that it won't be very long before most people can use something sitting under their TV to do the things that they've had to use a Windows PC to do in the past.

If their console division puts this date forward by 10 years, and give them a brand so they can diversify when it does happen, it's worth throwing money at for them.

EDIT: actually, it's more like killing the competition. They're going to bleed Sony so dry they'll never be able to hurt Microsoft's core products.

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Riiight. Why don't they just give them away for free then?

Ryan is sorta right. Microsoft, with the original Xbox built up a brand extreamly quickly. Everyone knew what the Xbox was a year or two after launch. Of course, every business is out there to make money but MS are seeing this as an investment. Look at the 360 now, in america you can download high def films and tv shows. It isnt really about the games but getting that set top box under your tv. Add in MSN support, video chat and what ever else they decide to chuck in there and you can see what they are aiming for.

Still its surprising to say a console thats sold/shipped 10 million units in a year and a half is a failure. The Wii though is already at 6m with only 5 months gone. Is that because the Xbox is failing or the Wii is doing better than ever expected?

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Riiight. Why don't they just give them away for free then?

The plan isn't to throw away money. It's the Chelski system.

With a built in harddrive, keyboard, mouse and internet connection a console can cover 90% of the uses of a PC. Especially if it has 80s-style peripherals (i.e. printers) released. Same thing as happened in the 80s with Commodore and Spectrum but with the Sony brand.

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Is that because the Xbox is failing or the Wii is doing better than ever expected?

Both I think.

For those who think MS will not give up, how much of a loss do you think they will take? 10 billion? 15 billion? If this generation actually does worse than the last are they seriously going to go for a third?

I'm finding it hard to believe MS have a 15-20 year plan. They just don't think that far ahead. Shareholders certainly don't. I think they expected to be making money now.

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"This early failure in the key Japanese market has a compounding negative effect on worldwide console sales, as game developers are less willing to invest in high-risk projects for console platforms that are shaky out-of-the-gates, which makes it less attractive for gamers to buy these consoles, and so on."

This isn't what has happened though, is it.

Isn't stopping Sony getting their box under everyone's TV part of Microsoft's strategy to keep people buying their operating systems as well.

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I stopped reading here - 'The seeds of this failure are evident from their sales performance in Japan'.

If it's not Japanese it's not going to sell.

The problem is the 360 has sold just under half the amount the original Xbox did with the same period and Microsoft have done an even worse job this time around in terms of content and getting developer support.

The Ipod isn't Japanese but thats been phenominally successful in Japan.

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Did you stop reading at that point?

I did actually, I'm too lazy to read that much when the football's on. My comment was just out of amazement that someone used Wikipedia to research sales figures, to no matter how small a degree.

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Halo 3, GTA IV and IPTV deals with big SPs are the last great hopes for 360. 2007 will make or break the device, and MS' whole media centre strategy. Vista doesn't have the uptake they'd like - nor does the 360...

I don't think Halo 3 is going to convert any non 360 owners, but GTA IV might. If they convince the PS2 owning masses (PS2OMs) out there that the next must have game is on the 360 and just as good (if not better with DLC) then they could clean up. However, I think there's a general impression that the PS3 is just 'better'. It might be too dear just now, but the PS2OMs are quite happy with their PS2s until the PS3 comes out. They might be told time and again that the 360 version of GTA IV is just as good - but they won't believe it and wait until the PS3 price drop.

MS have an uphill struggle... at the same time, they're facing a resurgent Nintendo who are firing on all cylinders (although perhaps a bit uncontrollably)

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So the Wii is the only one of the three doing well so far this generation? For some reason, I hadn't even thought about the 360 not doing well. I thought it was.

The amount of people who've been wanking on about the failure of the PS3 has probably paid ends to that. Like a decent distraction of sorts.

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But they are throwing away money aren't they? What's Chelski?

Competing with money.

Stagecoach did it in the early 1990s. They ran routes at an incrediable loss, things like running twice as many busses as required and running at a loss. They had the pockets to cover the loss but their competitors didn't.

Few years later and they'd totally cleaned up.

The Russian at Chelsea did something similar in the first years - raised the market values of player to levels his competitors couldn't afford. It cut the oxygen supply to other clubs.

In Microsoft's case the aim isn't so much the console market, but also an eye on protecting the PC market (where they print money).

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Competing with money.

Stagecoach did it in the early 1990s. They ran routes at an incrediable loss, things like running twice as many busses as required and running at a loss. They had the pockets to cover the loss but their competitors didn't.

Few years later and they'd totally cleaned up.

The Russian at Chelsea did something similar in the first years - raised the market values of player to levels his competitors couldn't afford. It cut the oxygen supply to other clubs.

Right. Stagecoach ran their rivals out of business. It worked. It isn't working for MS is it? So do you think they'll keep doing it forever? That's why I asked about giving the machines away. If they are really prepared spend their way to success why not do something the other can't compete with? So far they are selling similar consoles, similar games at similar prices. Sure their console is excellent and Live is quite special but they charge for that.

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So the Wii is the only one of the three doing well so far this generation? For some reason, I hadn't even thought about the 360 not doing well. I thought it was.

If it was making money then I think it would be considered to be doing okay. It's just that MS have sunk billions into this industry while Sony & Nintendo have made money. Not quite the 'Chelski' strategy.

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you could argue with the IPTV deal that they are doing that - subsidising the 360 purchase and treating it like a sky box or a cable box. Play a nominal fee to have one - pay a subscription for IPTV content.

Perhaps that is what will turn things around?

I'm surprised someone hasn't done a deal with Sky. Why not bung the motherboard into the next Sky+ box?

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Perhaps that is what will turn things around?

I'm surprised someone hasn't done a deal with Sky. Why not bung the motherboard into the next Sky+ box?

don't sky have deals with Sony? Sky+Sony bundles etc (http://www.pocket-lint.co.uk/news/news.phtml/3133/4157/sky-hd-sony-bravia-cashback.phtml).

Meanwhile - in cable land, Virgin HD boxes are Scientific Atlanta boxes (Cisco)

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