Can someone please justify the Xbox business? Anyone?
When I penned my recent Xbox post, I thought I was done with that particular topic for the time being. For those who missed it, I tried to estimate actual losses to date, realistic payback timeframes as a result, and how that compared to initial expectations expressed by executives, including Robbie Bach.
But then Bach went and opened his mouth again. This time, to Mercury News. During that interview, in addition to further hedging when Xbox would become profitable (FY '08 now looking less likely despite repeated previous guidance to that affect), he responded to a question about the $3.8B spent to date (fyi, it's significantly higher imo - again, see the original post) and whether he has a "blank check", as follows:
A: No. I think the things you have to look at is you have to look at, sure, the dollar investment, and the asset value that's created and then look at the P&L. You have to look at all three of those things. So, yes, the amount of investment, in particular on Xbox, has been a large number. So, compare that to the alternatives and some of the alternatives would have been, "Well, go buy somebody big." So, you could have looked and said, "Go buy Nintendo." And Nintendo at the time would have been a $15 billion acquisition. So, by any stretch of the imagination, a much bigger investment. And if I look at the asset we've built, it's a different asset than Nintendo has, and they certainly have got a great company, but it's an asset that we can be proud of. So, the first thing I'd say is, we went in knowing it was going to be a big investment, but the size of the marketplace and the importance to what we're doing justify that. Second thing I’ll say comes to the asset value point. People like to say we have invested many billions of dollars in that. But what they don’t point out is what is that asset worth? If we spent that money and there was no business there, I would say I should be working out on a farm someplace. The fact is there is a business there.
Now, compare this to Ballmer's justification when he presented at the Sanford Bernstein event in May of this year:
I know somebody will want to know, do you like your Xbox investment. Let's say we go negative $4 billion before we start going positive, I'll tell you that was one of the great creations of shareholder value of all time. If we had bought a company, say, like a Nintendo, and paid $10-12 billion for it, we would have had a business we didn't understand as well, wasn't as good, wasn't as well positioned, and essentially would have cost our shareholders an additional $6 billion or $8 billion.
Okay, so MSFT's executive are at least capable of reading from the same corporate-approved script (like there was any doubt), but what have we learned? Well, ostensibly, the justification offered is that building was cheaper than buying. That's probably true. The problem, of course, is that it implicitly assumes it was necessary to enter this market in the first place. But it wasn't. It was a discretionary choice made by the management team and selected over other competing opportunities. And, in addition to potential gains foregone via those lost alternatives, it's a decision that has resulted in more than $4B in subsequent losses to date with no firm idea of if/when we'll see profitability, and at times has decreased EPS by ~.10/share - or approximately $2.00/share in foregone stock price (on a typical P/E multiple of 20).
A good investment for shareholders (far less "one of the great" ones) is only good if it can be realized in a way that directly benefits us. As per my original post, I think it's clear that Xbox will never pay back the original investment over any reasonable timeframe. Certainly not over the fantasy "less than 5 years" originally espoused by Bach (which has come and gone), or even a decade, since Bach is now waffling on whether profitability will be reached by FY '08 - seven years after the initial launch (fyi, my original post argued why it will in fact be decades, if at all). So scratch being a good investment by virtue of generating outsized future returns over a reasonable timeframe (the main reason most businesses invest). How about Bach's new argument that a viable business has been created which is an asset that has value? That has some merit. Of course, the problem here is twofold. One, the only way to monetize that value for shareholders is to sell it. Does anyone actually believe that MSFT would do so? Two, what would the business be worth? Left out of Bach and Ballmer's comparison, for example, is that teeny tiny detail that Nintendo is in fact profitable. Would anyone really plunk down the $4-5B invested to date (plus some premium to make it all worthwhile) for an as yet still unprofitable business that isn't forecast to generate a return until at least FY '08, and that requires the wherewithal to absorb multi-billion losses every new console cycle? How many companies can afford to do that even if they were stupid enough to want to? The answer is very few, and therefore MSFT would likely be hard-pressed to find a buyer (and hence lucky to recoup even a fraction of the money invested to date). Plus, the entire discussion is moot since the likelihood of the division going up for sale is slim to none. So scratch being a good investment by virtue of selling it for an outsized return. Okay, so it can't generate a sufficient return on its own, and it's unlikely to be sold or capable of generating one even in that scenario. Hmmm...what does that leave? Well, there's the argument that it was really a defensive move to protect the cash cow of Windows. I know, not exactly what you want to tell the DOJ (we spent $5B to keep SONY out of our Windows monopoly) or shareholders (oops, we lied about our intent), but possible? Was SONY really a threat to that business? Maybe, but it's a stretch and certainly not to tune of $4B+. Indeed, I could easily make the argument that they put Windows at more risk by taking their eye off the ball while focusing on Xbox and other "emerging businesses". So scratch being a good investment by virtue of defending existing cash cows that otherwise were at risk.
So what's left? How about that Xbox somehow adds to the perception of value that investors are willing to pay for MSFT? While that's scary on many dimensions (e.g. managing for perception vs results), the most obvious weakness is that it isn't borne out in the stock price. What about the argument that w/o it, MSFT would have been worth even less? After all, while it's been unprofitable growth, Xbox sales have been the bright spot in MSFT's overall top line results. Without it, you would have been left with the reality of cash cows growing at 5% or less, versus the overall impression of a company growing at double-digits. Leaving aside the counter-argument (that it may have seriously undermined confidence in the management team's business savvy), that's true. But is it really what we're down to when forced to justify the Xbox investment? That w/o it, the stock would have fared even worse? If so, should that warm the hearts of shareholders? BTW, if I've overlooked a viable justification, feel free to bring it to my attention.
Is the Xbox a kick-ass console? Is Xbox Live one of the few clear examples of MSFT innovation? Is becoming #2 in 5 years a huge accomplishment? Does Xbox represent the only coolness MSFT has? Yes to all, but that alone doesn't make it a good investment for shareholders. In my view, they simply lost too much money in round one to accomplish the latter. But heck, maybe Bach himself might deign to wade in and, for the first time in MSFT history, offer shareholders a compelling business justification for this massive and to date unsuccessful investment.
For now, his advice appears to be that if this performance isn't imbuing you with confidence in your management team, you should sell and move on:
If you don’t think the management team is investing wisely, you should put your money elsewhere.
That's certainly one option. I have another. Now that the management team has managed to wipe out ~$300B of shareholder value and badly underperform the major indices for the past 4 years, at least in part due to Xbox and other massive investments that have yet to pay off, how about they stop thinking their past glory in the 90's exempts them from having to justify themselves and their decisions this decade to shareholder owners - or we replace them?