Xbox May Prove an Expensive Pastime for Microsoft

Is the Xbox, Microsoft's (MSFT Quote) billion-dollar entry into video gaming, a good bet to dominate the industry or doomed to be an expensive also-ran?

With Microsoft's core PC business slowing, the company needs the promise of a new revenue stream. And with the $20 billion video-game market growing at 10% to 20% a year, Microsoft is hoping the snazzy green and black box it plans to launch this fall will help the company expand beyond the PC and into the living room.

However, according to Merrill Lynch analyst Henry Blodget, Microsoft's first real foray into consumer electronics will be anything but profitable and will face a dicey future against two solid competitors in Sony (SNE Quote) and Nintendo. In a 56-page report and concurrent phone conference Tuesday, Blodget took the view of most other analysts -- that Microsoft will spend billions for what is likely to be a second-place finish to Sony, at least for a few years.

"We estimate [that Microsoft will lose] $2 billion before breaking even in 2005," Blodget told investors. He added that Xbox will generate only $500 million to $1 billion of operating income by fiscal year 2006 -- a small fraction of Microsoft's total. Blodget rates Microsoft an accumulate, and his firm hasn't done underwriting for the company.

Microsoft's Xbox will be competing against Sony's PlayStation consoles, which have dominated the home market since 1995. And it will be coming out at the same time as Nintendo's GameCube. Hamstrung by delivery shortages since its introduction in October, the new PlayStation 2 still has built an impressive lead.

The video-game business model creates powerful advantages for the leading company, and Sony clearly dominates. By the time the Xbox is released in the fall of 2001, Sony will already have an installed base of roughly 20 million PlayStation2 units, said Blodget.

Since video-game sales drive console sales, Microsoft is at a further disadvantage. By next fall, Sony's PlayStation2 will have an estimated 250 games available. The Xbox will enter the market with about 20 titles.

The Xbox will bring in some technological advantages, including a hard drive, broadband connection and a more powerful processor than the Sony. Both have a DVD player, although the Xbox's will require a separately purchased remote control. But many analysts agree that no matter how much cash Microsoft throws at the problem, it won't be able to unseat Sony at least until the next generation of consoles, in four or five years. Most think it will battle Nintendo for second place.

"We hope to see Microsoft in the No. 2 spot over the next few years," said Crowell Weedon analyst Jim Ragan, who rates the stock a buy. His firm hasn't done any underwriting for the company.

Blodget concluded that if Microsoft isn't able to show signs of success within the first two years, the company may choose to abandon the product altogether.

"This will be a tough, expensive market for the company to crack," said Blodget. Going up against Sony "is a little like going up again the Windows operating system," he said.