Tuesday, November 21, 2006

Portrait of the emerging business as an older dog

Xbox, one of MSFT's most expensive "emerging businesses" to date, is now some 5 years old and no longer a young dog. In 2001, when the original unit was launched, there was already concern that MSFT was being far too optimistic about its prospects:

When Microsoft expects to break even is moot. Henry Blodget, Merrill Lynch's celebrated internet analyst estimates it could take as long as five years for the company to recoup its investment - essentially the life-cycle of the product.

In the same article, Robbie Bach, Xbox division head, took issue with Blodget's assessment, saying (among other things):

Microsoft does not go into businesses that make losses for five years. I have my own profit-and-loss account.

"Five years" have now passed, and the Xbox division has made annual losses over that entire period (albeit that it did have one profitable quarter on the back of the Halo launch). So, while props to Blodget are due, even his assessment ended up being recklessly optimistic.

Before determining how long it will actually take MSFT to "recoup the investment", let's try and determine what that investment has been. That's more difficult than it might appear, since MSFT didn't break out segment P/L in the earlier years. However, according to this article in '05, Forbes estimates losses for the first 4 years at approximately $4B. Add to that what we know from MSFT's subsequent earnings reports (which do break out segment P/L), and that total rises to at least $5.3B and possibly higher (depending on what Forbes included in their calculation). So, minimum $5.3B investment to date and counting, since the division still isn't profitable.

Now to the return part. How much profit could MSFT potentially generate from Xbox? Well, we can't look to MSFT for input because they've never bothered to even roughly estimate it publicly. However, we can look to SONY, the segment leader, for some idea of what's possible. From what I can see (and admittedly I couldn't locate the source I recalled), in their best year ever, SONY appears to have generated some $1B in profit from their PlayStation-led gaming franchise. Let's be hugely generous to MSFT by assuming they can supplant SONY tomorrow, and get to that former level of record profitability (SONY currently being expected to lose as much as $1.7B on the back of the PS3 launch). At that rate of return, it would take another 5+ years to breakeven, for a net total of 10+ years just to recoup the investment - twice what Blodget predicted, and more than twice Bach's estimate. But wait, it gets worse. In reality, while MSFT might ultimately be able to generate more creative options for monetization than SONY (TBD), assuming $1B in profits, or even half that, any time soon, has a likely probability of zero when rounded to the nearest decimal place. So, actual time to recoup the investment, assuming it ever occurs, will likely be measured in decades. Keep in mind that Ballmer's characterization of this business, as recently as May 31, 2006, was:

I'll tell you that was one of the great creations of shareholder value of all time.

My question would be: Based on what evidence?

All of which raises the question of what MSFT's broader strategy wrt emerging businesses is, and how success is measured. Are they worthwhile standalone efforts, meant to be profitable in typical industry 3-5 year timeframes (or less), but MSFT just can't execute properly? Or are they always, at least in part, defensive plays aimed at protecting the existing crown jewels and only justifiable (financially at least) on that basis? I think the answer is a combination of both, which explains why MSFT's "investments" continue to be viewed by many externally as hopelessly unsuccessful, especially when they weren't sold to the street or shareholders on that basis. Net net, MSFT needs to start rationalizing its efforts and ensuring that if new ventures are being touted as making standalone financial sense, that they in fact do so, and over timeframes that most would consider reasonable. Otherwise, the street and investors will continue to focus on the order-of-magnitude better risk/reward investment choices of competitors (e.g. AAPL's in Ipod, GOOG/YHOO's in search/advertising), and conclude that Ballmer and team are either inept, bullshitting about the true purpose of these investments, or working on timeframes that even the longest of "long-term" investors would balk at.

Update: note that in the linked webcast, Ballmer infers that Xbox losses hadn't yet reached $4B (as of May '06). Specifically, he says:

Let's say we go negative $4 billion before we start going positive

That's at odds with Forbes' estimate and seemingly MSFT's own reported financials, but possibly true if there's some discrepancy in what H&E losses were directly attributable to Xbox (let's ignore the possibility that losses may well have been understated by charitable interpretations of what costs to bill to G&A and R&D versus the unit). Suffice to say, that $4B vs $5B (or somewhere in between), while substantial, doesn't change the underlying analysis that materially (i.e. minimum payback period becomes 9+ years vs 10+, and likely still decades under any more-realistic scenario).

Update #2: And the expectations for Xbox profitability get pushed out even further:

When asked how long it will be before Microsoft starts making money on Xbox, Bach replied, "To be clear, we have said that in fiscal 08, entertainment and devices makes money. That’s not exactly Xbox. We don’t break profit down by business. And there are parts of entertainment and devices that make money. Xbox doesn’t. Xbox has to make significant progress to enable E&D to get there."


  • Conclusion two, "bullshitting," is correct. The true purpose of the Xbox is "hurt Sony, kill them if possible."

    Recall the back in the late 1990s, Ken Kutaragi said that Sony would make the consumer PC irrelevant. Imagine a closed c.e. box with Web access, great games, and home entertainment capabilities. And remind me again why any consumer would ever again buy a buggy, more expensive, less reliable Windows PC?

    To this end, Sony steadfastly refused to play ball on Windows Media and the PC-centric connected home, insisting on its own digital media standards (ATRAC, OpenMG), stalling on interop groups, and so on.

    So Microsoft said "fuck Sony--use the Windows subsidy to hit them in their most profitable business."

    So now Sony finally came out with said device, the PS3, but is losing $200 per unit, won't break even for the foreseeable future. Microsoft can sustain such losses as long as its two 70%+margin monopolies are strong. Sony cannot.

    Now Microsoft trying for a repeat with Zune vs. Apple. Same strategy--start tiny, build slowly, and be willing to sustain losses to undercut the competition. One difference though: there's no endgame! There's not any software to sell! Curious how this one will come out....

    By Anonymous Anonymous, at 2:58 PM  

  • One could argue that XBox, like Zune, is a Mircosoft platform extension loss leader, designed more to protect revenue streams than to generate them.

    It's not hard to see how Vista and Live will chain to these loss leaders and drive incremental revenue at high margins to help offset the capital losses.

    The bigger question is why leadership at Microsoft continues to be so oblique about this.

    We're treated to assurances that things are rosy when the P&L says it isn't. We hear murky (at best) business justifications that lead to thinking that it's really predatory (at worst) business reasons. To cap it all, leadership seems unwilling to share the big picture with employees, shareholders and customers, even under NDA. "Staying the course" and actively ignoring fiscal reality is the order of the day, and we're told to wait and trust without being asked how long or how much.

    By Blogger Collision Domain, at 5:58 PM  

  • "Staying the course" and actively ignoring fiscal reality is the order of the day, and we're told to wait and trust without being asked how long or how much.

    That sums it up exactly.

    By Blogger MSFTextrememakeover, at 9:47 PM  

  • Quoting Collision Domain:

    "We're treated to assurances that things are rosy when the P&L says it isn't. We hear murky (at best) business justifications that lead to thinking that it's really predatory (at worst) business reasons. To cap it all, leadership seems unwilling to share the big picture with employees, shareholders and customers, even under NDA."

    Why won't they share the real reasons? Antitrust. If they said "we're going to use the profits from our Windows and Office monopolies to kill [competitor X] by undercutting them on pricing," I think even George W Bush's DoJ would have to stand up and take notice, and certainly the EU would swing another bat.

    By Anonymous Anonymous, at 11:36 AM  

  • I've owned the XBOX and hardly made time to play it (Halo). After experiencing LIVE, I had to get a 360 and am back gaming regularly (I try to get a couple of hours in a week if I can with a family, home, bills, job, etc.) for the first time in years. I am probably considered an old-school gamer. I had the Odyssey, the Vic20 and C64, Atari 2600, etc. and many others between them and the 360.

    Basically, I think the competition is giving us great products, and I like the way the market is heading with HD players and the entire LIVE experience.

    By Anonymous Anonymous, at 2:37 PM  

  • I think XBOX is just a defensive move by MS to prevent SONY from putting a non-MS OS in every family's living room. "Proof-of-concept" of a MS-based console was already thanks Dreamcast at Sega's expense.

    By Anonymous Dev, at 5:51 PM  

  • hmm, having been a computer user since the glorious speccy i drifted out of games for many years after the SNES. I did buy a PS and a PS2 but apart from PES and GTA never really had much use for thrm other than post pub fun. The games didnt appeal. 6 months ago i got given an old xbox. Have played it more in 6 months thanthan my 5 year old ps2 . Just splashed out on an xbox 360 simply because the games suit my pallete more. The fact that it streams stuff direct from my PC is the killer application.

    i think microsoft may actually win this war..

    By Anonymous Anonymous, at 12:50 PM  

  • You think that msft may win this war, based on the anecdotal opinion of your sample size of 1 (yourself)?

    By Anonymous Anonymous, at 2:12 AM  

  • This comment has been removed by a blog administrator.

    By Anonymous Anonymous, at 6:30 PM  

  • It would be a grievous mistake to look to Henry Blodget for any kind of insight into the prospects of any business. He is a Wall Street echo-chamber blowhard, who has never worked in a REAL business in his entire worthless life. He put the "anal" in "analyst". His recommendations are routinely outperformed by the Wall Street Journal Dartboard.

    This is the man who was touting all the way from $16 down to $1.43, at which time he downgraded it from "buy" to "accumulate".

    By Anonymous Anonymous, at 9:52 PM  

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