Microsoft ( MSFT) aims to blow away Sony ( SNE) in the video console universe with the new Xbox 360, scheduled to land on store shelves Tuesday. But it'll take more than the largest consumer launch in Microsoft's history -- which will include a Burning Man-style gamers' mecca in the Mojave desert -- to succeed. Despite all of the build-up, industry observers doubt that the world's largest software maker will be able to take down the second-largest electronics maker in this latest clash of the titans. "For me, there is no doubt that Play Station 3 will be the clear winner, hands-down, even in this next generation," says James Lin, managing partner of Los Angeles-based video game consultancy Simba Group. ( TheStreet.com this week also looked at how Microsoft's
rivals will weather the ballyhooed rollout; how far Microsoft will make it into consumers' living rooms ; what all the new game machines mean for investors ; and what a game is worth .) However, that doesn't mean Microsoft won't reap rewards. Lin, a former analyst, says, "There's no question that Xbox 360 will likely do better than the Xbox 1." A main reason is that Microsoft has had a lot more time to strategize this time around. The company has been planning Xbox 360 since the original Xbox launched in 2001. Microsoft has used that time to create a sleeker box and put more thought into hardware specs, says David Reid, director of marketing for Xbox. "We feel like we can win this generation," he says. "We feel like we're very much on par -- and we're out there earlier." Further adding to the Xbox 360 buzz are expectations of shortages, since Microsoft has said it won't immediately flood retailers with supply but will instead use a "rapid replenishment program" to provide steady inventory. The strategy has prompted speculation about production constraints -- or Microsoft trying to make itself look better. "I would say either way it's brilliant marketing," quips Wedbush Morgan video game analyst Michael Pachter.
The Numbers GameMicrosoft expects to sell as many as 3 million consoles in the first three months after launch and 4.5 million to 5.5 million consoles by the end of its fiscal year on June 30. Those sales will be key to accelerating the company's top-line growth. In the December-ending quarter alone, Goldman Sachs software analyst Rick Sherlund estimates Xbox hardware and software sales will soar 36% to $1.5 billion from $1.1 billion a year earlier. (Sherlund has an outperform on Microsoft and his firm has done banking with the company.) Microsoft has forecast its home and entertainment division, including Xbox, will grow 50% or more in fiscal year 2006, helping total annual revenue growth climb to about 11% from 8% a year earlier. However, that won't immediately translate to the bottom line, because Microsoft loses money -- an estimated $50 to $100 -- on every console sold. The company expects the Xbox business to swing into the black in fiscal 2007. "Going from unprofitable to profitable is probably a part of the margin story that many investors don't appreciate," says Tony Ursillo, an analyst with Loomis Sayles & Co., which holds Microsoft shares. Ursillo estimates Microsoft's video-game business will generate an additional $500 million in operating income between this fiscal year and next fiscal year, which translates into an additional 3 cents a share in earnings. Although that only amounts to a 2% increase in earnings, Ursillo says that's the difference between earnings growth of 10% and 12%. "I'd say of all of Microsoft's emerging business efforts in the past five years, to me this has clearly been the most successful one -- better than MSN, better than business solutions, better than their mobile device effort," he says. But that doesn't mean Xbox 360 will be able to unseat Sony, whose Play Station 3 is expected to have even more technical horsepower than Microsoft's when it launches next spring. For one thing, Sony has a far larger installed base of fans to tap for next-generation sales than Microsoft. Sony has shipped 90 million Play Station 2 systems worldwide as of June, more than three times Microsoft's 21.9 million Xbox consoles. And the Play Station 2 commands nearly 60% of the U.S. market, far higher than Xbox's 23% share.
"It seems like Play Station 3 will launch in June and that will be the end of Xbox," says Jane Snorek, a senior analyst who covers technology at U.S. Bancorp Asset Management. However, "I don't really think it will affect the stock price
of Microsoft much. That's not why you buy Microsoft." Her firm's $30 billion in equities is underweight Microsoft. While Snorek is one of the more pessimistic observers, others believe some impatient Sony fans may give in and buy an Xbox 360 while they wait for Play Station 3. " Microsoft has a good shot at pulling even," says P.J. McNealy, an analyst who covers video games for American Technology Research. "Part of it is it's coming out earlier. It would be a different scenario if they were both launching this holiday."
It's the Software, StupidDespite the attention on the consoles, the real money in the video game business is in software. A popular analogy is the razor blade business, in which manufacturers lose money on their razors but then make money on the refills. Of course, refills are still tied to the number of total razors sold. Microsoft makes the most money on games developed in-house, but also draws royalties from games developed by third parties such as Electronic Arts ( ERTS) and Activision ( ATVI). Microsoft is launching Xbox 360 with many more third-party titles than it had with the original Xbox. While some argue there's no blockbuster like Halo 2 in the starting line-up, others say that the 18 titles should be enough to appease gamers. And in another sign of strength, Microsoft is gaining more support from Japanese game developers, a huge weak spot for the original Xbox that contributed to its flopping in that crucial market. But there are splinters of weakness, says Simba Group's Lin, who noted that Korean PC game developer NCSoft is expanding its focus to other next-generation consoles but not the Xbox 360.
"It just underscores some of the sentiment that we've seen out there," Lin says. "The publishers will not come out and ignore the 360,
but you really have to look whether they'll be designing exclusive content aimed at the Xbox 360 target audience." Winning exclusive third-party games is a real measure of success because it shows publishers are betting Xbox 360 will be such a big hit that they can initially forgo sales on rival consoles. Not surprisingly, the hottest game exclusively for the original Xbox, Halo 2, was developed by Microsoft itself. The game was such a blockbuster at launch that it helped Microsoft's home and entertainment division post its first profitable quarter. But outside of the Halo franchise, Microsoft's in-house games have suffered from mixed reviews. "They had a couple of phenomenal successes and a bunch of very poor performances," Pachter says of Microsoft's in-house games. On the other hand, "Sony's first-party capacity is about 10 times what Microsoft's is," he adds. And "Sony has the Japanese boy's club" of developers, who Pachter expects will still throw more weight behind Sony than Microsoft. Microsoft is remaining tight-lipped about its timeline for releasing Halo 3. But Chairman and Co-Founder Bill Gates has suggested timing it to coincide with Play Station 3's launch would be perfect. Such a move would steal some thunder from Sony and take the next-generation battle up to another level, while bringing Microsoft that much closer to accomplishing its conquest in this next-generation console battle.