The Xbox Sideshow Is Likely to Pump Microsoft This Year, Part 2

This is the second part of Jim Seymour's column on Microsoft's Xbox. Please be sure to read the first part if you haven't already.

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The Stock and Its Burdens

It's all too easy to assume that a smash-hit product of the sort I think Xbox will prove to be for Microsoft will make an immediate contribution to the bottom line. After all, how can you sell a million and a half of anything in six weeks and not make money?

Easy: You lose money on every one.

Which is exactly what Microsoft will be doing on the Xbox. Of the $299 list price for the unit, let's assume Microsoft will net maybe $150 to $165 (and that's probably high), ignoring the $500 million Microsoft has said it will spend promoting the machine over the next 18 months.

But that's much less than the unit's production cost. A friend at E3 who specializes in production-line "rationalization" hefted it, played some of the games on display and did his own little bill-of-materials estimate. He thinks Microsoft will spend somewhere between $280 and $315 in contract-manufacturing costs for each machine (and that's probably low).

With his lower estimate, that means Microsoft is looking forward to losing maybe $125 per Xbox. Multiply by the 1,500,000 units Microsoft says it will sell by Christmas, and that's almost $200 million down the drain. (Remember, I think that's low.) Add in the $500 million in marketing costs, and Microsoft is pushing a loss of three quarters of a billion dollars on the Xbox by the end of this year.

Why would it do that?

At least two reasons: profits from games themselves and market hegemony.

Everyone loses money on game consoles. But through licensing fees, co-branding games and producing your own games for your console, you can make a killing. The cost-of-goods-sold number for a $40 to $50 game is just a few bucks (excluding software development costs). When games start selling in the millions -- and you have a lot of them out there -- you get a license to print money.

Microsoft has made it clear that an awful lot of the games for the Xbox -- at least a third, Bach said Wednesday -- will come from Microsoft itself, both guaranteeing a steady flow of product and keeping the lion's share of revenues on those games for itself.

Market hegemony is just as important. With its Xbox investment, Microsoft is building a reputation with gamers -- probably the most demanding of all small-computer-systems customers -- as younger and hipper than it has been, and it is also assuring that it develops the same dominance it has had in Windows desktop and portable computers in gaming computers. Except that it doesn't have to share the booty with Intel this time around because Microsoft is the hardware supplier, as well.

With the growing importance of online gaming, Microsoft is also driving another stake in the ground in its campaign to be an even bigger seller of services than of shrink-wrapped software.

With the combined costs of developing both hardware and software and the hugely expensive launch of Xbox, Microsoft has no expectation of seeing gaming revenues fall to its bottom line anytime soon. But by the middle of next year -- say, its third and fourth quarters in 2002 -- it should start seeing a serious contribution to profitability from Xboxing.

Until then, factors such as the courts' handling of Microsoft's appeal of Judge Thomas Penfield Jackson's harsh antitrust ruling against the company and the uptake rate on OfficeXP and then WindowsXP are going to be far more important to Microsoft's profitability and share price than Xbox. The game business will be a nice little sideshow and an investment in Microsoft's future -- and will certainly bring glowing bursts of good press as the company approaches that November shipping date for its new wonderbox.

The perception that Microsoft has broken through on a second front and is about to own the gaming business, too, will spread in the land, and that will surely be a share-price-increase driver during this time too ... no matter whether that perception is accurate, nor whether the underlying financials line up that way just yet.

I continue to think Microsoft is a buy now, and is likely to continue to be a buy for the rest of the year. The anticipation of a good, or at least better, result from the Court of Appeals in Washington and the little running Xbox sideshow will give you reasons to stay in the stock this year.

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To return to the first part of this column, click here.