MSFTextrememakeover

Wednesday, November 29, 2006

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?

12 Comments:

  • XBox does add to the Microsoft brand value. As you say, it was a successful project in delivering a great console, if not the expected profits. So I think there is some intangible benefit in customer loyalty. Of course, if it was worth 4B is another matter.

    By Anonymous Anonymous, at 9:40 AM  

  • Microsoft lost 4 billion on xbox.

    OK we get it.It's time to move on.Other companies have lost even more through stupid acquisitions that never pay off.

    By Anonymous Anonymous, at 10:43 AM  

  • Part of the MS transformation taht is going on is that we are bcoming a consumer company. This is a long term transformation into unchartered waters.... but one that needs xbox if it is to be made successfully. and one that needs capturing the market for people's living rooms for gaming, content management and delivery (tv, pictures, music, etc).

    And don't forget, at the end of the day it's still all about windows. Can you see media center edition. 360 has great support for this.

    So while I find the numbers troubling, I do support the xbox business decision. More questionable and a more interesting discussion is the general proposition of microsoft becoming a consumer company and getting into pretty much everything hed is into....

    By Anonymous Anonymous, at 9:28 PM  

  • I think, you MSFTemo, have to analyze another alternative MSFT tried with original Xbox.

    I do not know the factors which added to the failure original Xbox was, but I just want to highlight what MSFT might have improved in new Xbox, but for some reason has chosen not to.

    Software. The point of original Xbox was to use existing MS' expertise in PC programming. Problem: in all the grandiosity of MS it has decided to redevelop OS/framework anew. And failed. (Why MS hasn't used WinMCE for Xbox360 is beyond my programmer's understanding.)

    Hardware. Instead of choosing hardware platform based on PC and designed for CE market, MSFT has chosen to stick with old PC allies who might cut a good deal. Instead of making platform moderate - MS tried hard to get high-end platform. And it got it. (Why Xbox30 doesn't use new cheap high-perf low-voltage from Intel is also beyond me.)

    Games. That's different kind of failure. Basically it all boils down to simple fact that all decent game designers left MSFT and all what game division does - it executes business plan. No, it doesn't designs new interesting games, but executes business plan: extracting money from existing titles is more predictable business than trying to design new game.

    What MS might have done to improve situation with Xbox360. Hardware. Take ready PC based CE platform - nVidia, VIA and ATI put such offers on table, but were dismissed. Software. Use existing one - Windows Media Center Edition fits the bill perfectly, you just need to add another menu item: "Games". People know MCE and many like it. Games. Plain and simple, MS needed to open up its shop to independent developers. (That was main advantage of Sony PS2) MS needed to establish Xbox as platform, but has chosen to keep it closed (going against its own principles which in past had won it PC market from Apple).

    Conclusion. MS has to stop reinventing wheels (even if they look sometimes round), but focus on improving existing product. Where's our beloved "embrace and extend"? It worked wonderfully for MSFT for decades.

    From my personal experience and feeling - take Zune as recent example - MSFT has forgotten how to make simple product for people for everyday use. Obesity is what MSFT has to cleanse itself of.

    By Blogger Ihar Filipau, at 6:26 AM  

  • I disagree with just two things:

    1) The discussion is *moot* not *mute*

    2) I believe it was "only" $30 billion in shareholder value that was destroyed, not $300.

    Other than that...

    I fully accepted the reason for getting into the console gaming market. I've simply been completely underwhelmed by the execution.

    With few exceptions, many of the top execs in Xbox came from existing posts within Microsoft where they had no exposure to gaming or gamers. They came over with the same attitude that they had in Office where "we'll just put 'Microsoft' on the label and people will buy it." So they put out junk like Azurik (good-looking junk, I'll warrant), MLB Inside Pitch, NHL Rivals, Kakuto Chojin, etc. etc. etc. The gamers, being more sophisticated than the average Xbox exec expects, don't bite and soon MS announces they're drastically cutting back on the number of titles they'll be producing (never mind that you make money in the console biz through software, not hardware) and getting out of sports games entirely, including selling off the one studio that actually did sports games well (Indie). Meanwhile, the "finger on the pulse" marketing mavens come up with the impossibly infantile slogan "It's good to play together" for the entire brand. Aside from how Care Bear it sounds, it doesn't exactly make a lot of sense when you play it at the end of a commercial for a single-player game like Fable, does it?

    So that's the quality of the folks steering the ship. How about the middle management? Many of them came over from Sony or Nintendo and shockingly I can't think of a single case where Sony or Nintendo would have put up much of a fight. MS got the dregs, the "vesters" who were on the verge of being pushed out and accepted the offer to jump ship for a substantial increase in compensation.

    (None of this is to suggest you couldn't find a decent high-level or mid-level manager in Xbox. They exist, but their numbers and willingness to resist "assimilation" have dwindled substantially).

    My conclusion: Xbox wasn't a terrible idea. It simply was a case (like MSN) of the people being entrusted to spearhead the effort being incapable and/or unwilling. After all, what kind of message does it send to management when you lay off 76 FTEs (almost a tenth of the total headcount at the time) and within a couple weeks you announce you're increasing the number of General Managers from six to nine? If anything, a couple of token heads in management should have rolled by now, but just as the partners soak up bonus packages throughout Microsoft while the company as a whole is flatlining, the execs at Xbox continue creating fiefdoms and introducing additional unnecessary layers of management even as they cut the rank and file by roughly a third.

    You know what? I take it back. These guys are good at playing games.

    By Anonymous Anonymous, at 1:15 AM  

  • "1) The discussion is *moot* not *mute*"

    Thx. Changed.

    "2) I believe it was "only" $30 billion in shareholder value that was destroyed, not $300."

    No, it's ~$300B destroyed since MSFT's peak.

    By Blogger MSFTextrememakeover, at 12:43 PM  

  • I believe it was "only" $30 billion in shareholder value that was destroyed, not $300."

    No, it's ~$300B destroyed since MSFT's peak.


    Ah, I was thinking too short-term (and in fact that loss has already been covered, though it never should have occurred in the first place). But yeah, there is still quite a mountain to climb before the stock can be seen as a positive investment for anyone who bought it five years ago or so.

    By Anonymous Anonymous, at 2:22 PM  

  • Just a couple responses to Ihar:

    1. Use of MCE OS - The biggest complaint by every single game developer about programming for Windows is the fact that there is no good way to know what the machines performance will be like from moment to moment. The reason console games are usually less buggy and are somewhat easier to ship is the explicit knowledge of the hardware/software. By having a full blown OS present at all times that could decide to switch your priority or bring up a random background indexing is not something a console developer wants to test against. (And the Xbox 360 OS is a stripped down NT kernel with a lot of the multi-user/multi-process mechanics removed and new security added)

    2. Hardware for the original Xbox was picked to be very much stock PC parts. This has exposed the xbox to two problems - hacking and insufficient performance due to generalization. The hacking problem resulted in very easy ways to copy console games. Since the console business is selling hardware at the lowest possible cost and making money on the games, it was very bad for business. Additionally, the PC hardware has evolved together with the OS to make sure that lots of small processes can co-exist together, slicing the time. On the game console, there is only a single important process that should be active at all times - the game and you don't need to worry about lots of other tasks.
    Additionally as MS has learned with original Xbox, using stock parts becomes really hard to revise the designs. There was no interest by NVidia to create a cheaper version of their Xbox video card two years after the release because their developers were focused on the next video card generation. It was also impossible to convince Intel and NVidia to share their respective design to create a single CPU/Graphics chip like Sony was able to do with their design. Those limitations of the hardware made it impossible for MS to reduce the manufacturing cost of the console at the same pace as Sony. With the 360, they were able to make the contracts with ATI/IBM to own the full designs for future cost reduction/redesign.
    (Note: in console world, you don't want to create different classes of consoles within a generation because that will confuse the consumer with respect to their capabilities. Will Halo2 play on my release day Xbox or do I have to buy Xbox-lite or Xbox-renewed hardware for this game is a bad question)

    And there is a good reason to keep the console as a closed environment from a business perspective. If you have an open console, you are competing with the PC and the game developers would be unhappy with high chance of piracy. It would also impact the major source of revenue - console development licensing money. Looking at the recent sales of PC games, it seems that games that do not have a subscription model are on the decline while console sales are going up. (And 360 is being opened up with XNA Express for the hobbyist who can try his hand at game development, possibly turning the game into Live Arcade release.)

    Overall I would suggest reading Xbox 360 Unraveled (I think that was the name of the book) for a good discussion on the reasons behind the 360's hardware choices and what mistakes were made with original Xbox hardware.

    By Anonymous Anonymous, at 12:37 PM  

  • The big problem with XBox is that you can become a highly esteemed SVP without ever generating positive cash flow for shareholders.

    I think the division is a shining example of innovation and am more optimistic than most about whether it can/will return a postive NPV. But what message are we sending to other aspiring MSFT execs? Unless you're Ballmer, Lidell, Turner, Johnson or Raikes (and already a multi-millionare with no downside career risk) generating free cash flow is someone else's problem.

    No other Fortune 500 firm that I know of (except possibly Google) holds P&L stewardship in such low regard. You just cannot allocate capital efficiently when only 5 of 70,000+ people are goaled on it.

    Sure, other execs give plenty of lip-service to ROIC, but if it isn't measured, it's not important. And if you look at GM-to-CVP-to-SVP career progression across the company, it is crystal clear that it is not.

    Even if Robbie Bach is doing all the right things, and he may well be, the precident set for the rest of the company is a bad one. Because if you can't hold him accountable for generating profits, you certainly can't expect [any VP or team in "investment mode"] to either.

    By Anonymous Jeff, at 10:10 AM  

  • When the VP in charge sends for a directive that Xbox titles are supposed to be "fun to play for 25 minutes," because that's how long an influencing reviewer takes to form his opinion and start writing his review, you realize that the utility being optimized here isn't that of the gamer or consumer.

    By Anonymous Anonymous, at 12:51 PM  

  • Compare to the MBS acquisitions... Xbox is justified!

    By Anonymous Anonymous, at 8:22 PM  

  • The key point is what was said about "Why enter this business in the first place?

    Every company goes through cycles of expansion and then refocusing. The problem at Microsoft is that losses are hidden, and then the refocusing never happens. Will there ever be some other SoftImage story?

    Why buy MBS? Why then link Office with SAP? The answer to the second question: that is what customers are asking for, instead of the Dynamics line of products, which even Microsoft doesn’t dare to put into production.

    The funny thing is that, in one side, you have some teams saying that "building is better than buying, because in the end you have a team that you know". Then, why buy several companies and bring into Microsoft a lot of people in outrageous level, most of which would never succeed in a Microsoft interview loop?
    Look at the pathetic acquisitions of companies like ProClarity (5 Excel developers could do the entire code such company ever created), Massive (Why did we build Xbox again?), Wininternals (Who is looking at this: money was given a while ago for a site license of their software, and then again to buy the company?!). And the list goes on and on. Any real independent auditing of Microsoft acquisitions would not go well with investors.

    By Anonymous Anonymous, at 12:53 PM  

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