Xbox Could Mark the Spot for a Microsoft Smash

Merrill Lynch's Henry Blodget is trying to prove that he can be negative on something -- anything! -- so he's going after Microsoft (MSFT Quote). And he's trying to prove that this time his call is based on more than just hand-waving. So today, he released a gigantic 56-page report on a single Microsoft product that doesn't even exist yet: Microsoft's new Xbox gaming console.

Related Stories

Xbox May Prove an Expensive Pastime for Microsoft

Surprise! Microsoft Says No Overtime for Office XP

Let me say at the outset that we're long Microsoft, so perhaps we have an ax to grind here. But at the same time, we're long mostly because we think Mister Softee is going to win its antitrust appeal. We're hardly irrationally exuberant about the overall strategic future of the company. But that said, we think that Blodget is wrong in his evaluation of the potential for the Xbox. It's one of the few things that Microsoft is doing right.

A Player's Perspective

My partner Dave Nadig, an avid gamer, loves the Xbox. He says, "Xbox is the 'convergence device' of legend. After decades of guru talk about how the consumer living room would be infiltrated by the PC, this is the box that could actually do it."

That's because the Xbox isn't just a game console, it's a stealth PC -- what Sony's (SNE Quote) PlayStation 2 only pretends to be. Dave says it was designed for "geek and nongeek households alike, for 8-year-olds and 80-year-olds to use with equal ease. It will connect to a broadband world, right out of the box. As a gaming console, it's not an end in itself; it's the thin end of a two-sided wedge -- the other side is Microsoft's recently launched Ultimate TV -- that could result in Microsoft's branded dominance of the modern living room."

Blodget complains that Microsoft will likely spend $2 billion in losses before the Xbox breaks even in 2005. Revelation? Not. Any major new consumer electronics product requires that kind of investment, and Microsoft has the deep pockets that make it possible.

And Blodget forecasts that Xbox, at best, will only generate $500 million to $1 billion of operating income by fiscal year 2006, and that's a small fraction of Microsoft's total. But Dave counters that this is "based on Blodget's assumption that Xbox will never sell more than half as many units as Sony's PlayStation 2. This is a failure scenario, which Blodget puts out as the best case."

No Second Fiddle

Blodget's analysis is based on the assumption that Xbox will always play second fiddle to PS2. He argues that the video-game market operates on so-called network effects that give unbeatable advantages to the first mover in any new platform. Analysts talked a lot about network effects back in the go-go Net-stock era, as perhaps you will remember to your sorrow. Blodget thinks that PS2 is so far out in front that the best Xbox can hope for is to beat Nintendo's GameCube, which is even further behind in development.

But Dave argues that "platforms actually matter very little. It's games that win the day. And games come from developers, not boxmakers. Microsoft has signed up a huge list of developers for the Xbox, and they are the creme de la creme. They've acquired several top-notch developers such as Bungie, and the big boys like Electronic Arts are already flocking to the Xbox because they were so badly burned by Sony's botched PS2 launch."

And flock they should. Ultimately, the Xbox is a PC, not a game console. Its graphics system will use modified PC drivers, pushing hardware from PC-graphics chipmaker Nvidia (NVDA Quote). Developers estimate that the transition time from PC title to Xbox title (or vice versa) is going to be two months or less, vs. the six to eight months typical in a console port.

And as for a supposed network effect, Dave says, "This is just flat-out wrong. All there has been to date in console gaming is standard market-share battles. Where the network effect kicks in big time is in PC-based games because many of the best sellers are multiplayer, where each player has to have the game installed in order to participate in the online mayhem."

Online Power

It is only when gamers go online that these effects have power. And so far, the Xbox is the only console platform with a chance of benefiting from those effects because inside, it's pretty much a PC, ready to get on the Internet and start shooting right out of the box. The PS2, for all of its cool, lacks both a hard drive and a data connection, which are strictly necessary ingredients for online multiplayer gaming. The Xbox will ship with both.

And the most exciting titles in development are "massively multiplayer" games, in which tens of thousands of players all come together online to compete simultaneously. Microsoft already has expertise in this specialized area with its hugely popular Asheron's Call. (I personally have a small private equity stake in a nonpublic company called Turbine Entertainment, which develops Asheron's Call.)

Can the Xbox save Microsoft from its thorny strategic dilemma, as it struggles with the migration away from the PC and onto the Net? No. But Dave is willing to bet that the Xbox will be a smash, and that it can elbow PS2 aside without much problem.

For Blodget to spend 56 pages to declare the Xbox a failure before it's even born is ludicrous -- even more ludicrous than calling for Amazon at $400.