Microsoft

(MSFT) - Get Report

is trumpeting Tuesday's release of its

Halo 2

sci-fi video game as the "biggest 24 hours in entertainment history." Even if it isn't, the event undoubtedly will be a high point in the company's short history in the sector.

To be sure, it's difficult for a single video game, even as widely touted as

Halo 2

is, to have a meaningful effect on the world's largest software maker's overall financials, especially given that more than half of its nearly $40 billion in annual sales comes from its Windows and Office franchises.

But Microsoft CFO John Connors did cite, among other things, the expected success of

Halo 2

and greater sales expectations for Xbox when he raised fiscal 2005 guidance last month.

Halo 2

, one of two hot game titles launching this holiday season, will share the spotlight with

Take-Two Interactive's

(TTWO) - Get Report

next installment of

Grand Theft Auto

.

The most meaningful effect of

Halo 2

sales will show up in Microsoft's money-losing home and entertainment division. The division's operating loss shrunk substantially in the September quarter, to $142 million from $273 million a year earlier, partly because of an increase in software sales. Microsoft generates a profit from video-game software sales but loses money on every sale of the Xbox console.

Halo 2

sales are likely to help continue that streak of narrower operating losses in the division in the December quarter. The company already said

it has preshipped 1.5 million

Halo 2

games in the U.S. With a retail price tag of about $50, that amounts to $75 million in sales.

Assuming conservatively that Microsoft gets about half of that, the company nets $37.5 million in revenue. Microsoft has said it spends $5 million to $10 million to develop a game, meaning that the company will ultimately net between $27.5 million and $32.5 million on preshipped games alone.

Running Rings Around the Competition

That may sound like small potatoes for a company like Microsoft, but that profit from one title amounts to nearly one-quarter of the operating income of top video-game software maker

Electronic Arts

(ERTS)

last quarter.

"If

Microsoft can sell a couple million

Halo 2

games, they'll earn that back right away and that will become a very nice, profitable business," said Matt Rosoff, an analyst with Directions on Microsoft, a Kirkland, Wash.-based independent research firm that follows the company. "I think they should be able to post a solid

December quarter."

However, whether

Halo 2

will drive substantial sales of the company's Xbox console, meanwhile, remains an unknown. "If anything will drive Xbox sales, it will be

Halo 2

," Rosoff said. However, this late in the console game cycle -- a year before Microsoft is expected to launch the next-generation Xbox -- sales are already slowing down.

In the first nine months of this year, total

U.S. video-game console sales dropped 17%, while unit sales decreased by a little more than 1%, according to researcher NPD Group.

Sony's

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PlayStation 2, which debuted in Japan in March 2000, came out before Xbox (November 2001), and still commands a large lead of the console market with 58% of the installed base, compared with 23% for Xbox and 19% for

Nintendo's

GameCube, according to Wedbush Morgan analyst Michael Pachter, who covers the video-game industry. (Pachter does not specifically cover Microsoft, Sony or Nintendo.)

Even if

Halo 2

does drive some sales, however, it will be difficult to determine by how much because console sales typically do well during the holiday season, and Microsoft has recently cut their prices, Pachter noted.

And because

Halo 2

is coming out one year later than many gamers initially believed, some analysts believe that the consumers who will buy

Halo 2

already own an Xbox. "People have wanted

Halo 2

and were ready to buy it last year," said Dalek Capital portfolio manager Joe Spiegel, whose firm does not hold shares of Microsoft, Sony or Nintendo.

What's more important to Microsoft's video-game business, however, will be how the company does with the next iteration of its Xbox, widely expected to be unveiled next year at the Electronic Entertainment Expo (E3) confab. Connors has forecast that Microsoft's home and entertainment division, largely comprising Xbox console and game sales, will be profitable by 2007 -- only one to two years after the launch of the new Xbox.

"I think they're just expecting to get hardware costs down and hopefully sell more games and get more Xbox Live subscriptions," Rosoff said.

Third-Party Aura

Analysts agree that key to Microsoft's performance in the next console cycle will be its ability to sign on third-party game developers, an area where the company has been weak in the current cycle. Right now, about 400 game titles are available on Xbox, according to Microsoft. But that's less than half the number of titles PlayStation 2 offers, according to NPD. In addition, PlayStation 2 also can play games from the first PlayStation console, which brings the total game library to more than 1,000.

"Microsoft has to be to market early, has to get a lot of third-party developers on board and has to have a killer application that Sony doesn't have," Rosoff said. "It's going to be very difficult" to displace Sony.

Pachter echoed that thought, praising Xbox's hardware technology, which is widely believed to be superior to Sony's. But ironically, he noted, he would give the company a "D" in software development. Microsoft underestimated Sony's support from game publishers in Japan, a crucial market in which Xbox's performance has been characterized as a dismal failure. And both Sony and Nintendo's internal game development is far superior to Microsoft's, Pachter added.

In addition, Pachter fears that Microsoft may not be able to improve third-party game support in the next console cycle, in part because he expects development costs to soar to $10 million a game from $4 million in the current cycle. Pachter believes that higher price will discourage independent game developers to make titles for Xbox, especially because its sales this time around have trailed Sony's.

"They've spent an awful lot of money to finish a distant second in a race where the winner is the only one who made any money," he said of Microsoft. "It was a very expensive lesson, and I'm not certain that they learned the lesson."

Pachter suggests that Microsoft should increase over time its internal game development, buy a sizable outside developer and be more willing to pay those developers to create games exclusively for Xbox.

Whether Microsoft will take any of these actions is still unknown. The company is already singing the praises of

Halo 2

, but remains tight-lipped about its next-generation console plans.