LED Lights & Accessories Wholesaler

Microsoft's Gamble With Xbox Business Has Turned Corner

Patrick Seitz Tue Mar 4, 6:16 PM ET

Microsoft's bet on its Xbox 360 video game console is finally paying off. ADVERTISEMENT

The high-definition video game device is beating its closest rival -- Sony's (NYSE:SNE - News) PlayStation 3 -- in hardware and software sales. And better yet, Microsoft's (NasdaqGS:MSFT - News) Xbox business is turning a profit.

The company's entertainment and devices unit has made money for two straight quarters and is on target to be in the black for the fiscal year ending in June.

Microsoft's E&D unit earned $524 million on sales of $4.99 billion in the six months ended Dec. 31. That compares with a loss of $423 million on sales of $3.98 billion for the year-earlier period.

After years as a money pit, the unit looks to be profitable going forward, says Robbie Bach, president of the E&D unit. Video games are the big driver, but the unit also includes mobile phone software, PC peripherals, TV set-top box software and Zune portable music players.

"There are times when we're making investments in one business and hopefully at that time we're reaping things from other parts of the business," Bach said in an interview.

Now, the Xbox business is reaping the rewards of Microsoft's long-term investments.

When Microsoft launched its first video game console, the original Xbox, in November 2001, it just hoped to gain credibility in the market. Meanwhile, it set its sights on leapfrogging Sony's industry-leading PlayStation 2 console with its follow-on console, Xbox 360.

Microsoft made several critical bets with the Xbox 360. First, it launched it a year ahead of the competition in November 2005. Second, it pushed its Xbox Live online services as a major differentiator. Third, it decided not to include a costly next-generation, blue-laser optical disc player in the console.

Sony was late to market with a more expensive device, the PS3, because it decided to incorporate a Blu-ray Disc player in the console. With the Blu-ray Disc drive, users can play high-definition movies and game developers can store more data on discs. Microsoft's Xbox 360 comes with a standard-definition DVD player. But Microsoft offers paid downloads of HD movies and TV shows via Xbox Live.

Microsoft has sold more than 17.7 million consoles worldwide as of Dec. 31. Sony has sold 10.5 million PS3 consoles as of that date.

Sony looks to be a more competitive rival this year, with a cheaper PS3 and a bunch of exclusive software titles.

But Bach says Xbox 360 still has the edge on PS3.

"Even though they've lowered prices on their hardware, you still have the basic economics of where their hardware is priced at," Bach said.

Sony's cheapest PS3 costs $399. The new model features a 40-gigabyte hard drive and was introduced in November. Microsoft's cheapest Xbox 360 costs $279, but it doesn't come with a hard-disk drive.

Xbox Live Attracting Subscribers

Plus, Sony hasn't found a good response to Xbox Live, Bach says. Its PlayStation Network service doesn't have nearly the take-up rate as Xbox Live.

"Xbox Live is a big differentiator for us. That drives a significant amount of energy around what's going on with Xbox," Bach said.

More than half of Xbox 360 users subscribe to Xbox Live, which has more than 10 million members.

Xbox Live lets users play against other people over the Internet. Plus, users can download game content such as new game levels and weapons.

Those capabilities help when gamers are comparing versions of a game available on different consoles, Bach says.

"You don't have the same experience (with other consoles) that you get with Xbox Live," Bach said. "That does drive people to the platform."

For instance, one of the most anticipated new games this year, Take-Two Interactive Software's (NasdaqGS:TTWO - News) "Grand Theft Auto IV," will have exclusive downloadable chapters for Xbox 360. "Grand Theft Auto IV" is set for release on April 29.

Microsoft makes money with the Xbox Live service through subscriptions, paid downloads and advertising, Bach says. Subscription fees are the biggest component now.

The Xbox is Microsoft's play in the digital living room. Since it's connected to the TV, Microsoft is able to sell and rent downloadable movies and TV shows.

The Xbox 360 is No. 2 among current-generation game consoles. Nintendo (Other OTC:NTDOY.PK - News) leads with its lower-priced, mass-market Wii console. Nintendo's machine doesn't boast high-end graphics and realistic game play like the new consoles from Microsoft and Sony. Instead of cutting-edge processors, the Wii has a motion-sensing controller and intuitive, easy-to-play games. Nintendo has sold 20.1 million Wii consoles as of Dec. 31.

Grabbing 'Wallet Share'

Microsoft focuses on "wallet share" when evaluating its place in the video game market, says Jeff Bell, corporate vice president of global marketing for Microsoft's interactive entertainment business.

"We're very proud that our share of wallet is disproportionately larger than either of our two competitors," Bell said Feb. 20 at the Kellogg Technology Conference at Northwestern University. The Xbox 360 has a higher attach rate for games and accessories per console than its rivals, Bell says.

The average Xbox 360 owner has bought seven games vs. four for Wii and three for PS3, he says.

"The Xbox 360 continues to sell well," said Matt Rosoff, an analyst at independent research firm Directions on Microsoft. "Some folks have underestimated how well it's going to sell. It's going to do very well."

The biggest issue Microsoft faces with the Xbox 360 involves lingering concerns about hardware failure rates, Rosoff says. Last July, Microsoft took a pretax charge to earnings of more than $1 billion for the quarter ended June 30, 2007, for anticipated costs to repair defective Xbox 360 consoles.

"We continue to see reports that defect and return rates are much higher for the Xbox 360 than they are for the other consoles, something like over 10%," Rosoff said. That could hurt the profitability of the entertainment and devices unit, he says.

Other things that could affect the unit's long-term profitability would be big investments in mobile phone development and perhaps work on a portable video game device, Rosoff says.

Microsoft announced Feb. 11 that it was buying consumer smart phone software developer Danger. Microsoft might be planning to use Danger's capabilities to respond to Apple's (NasdaqGS:AAPL - News) popular iPhone, Rosoff says.