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Microsoft's $500 million Xbox gamble

Like other console makers, the company is subsidizing the cost of the console and hoping to recover its expenses through sales of game software. But the strategy isn't without risk. video
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 Game wars: Consumers to decide the winner
Hari Sreenivasan, correspondent
November 14, 2001

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A $500 million gamble

By Richard Shim
Staff Writer, CNET
November 15, 2001 4:00 am PT

For Microsoft, the video game market is a pay-to-play affair.

Consumers who plunk down $299 for Microsoft's new Xbox game console, a system that will compete against Sony's PlayStation 2 and Nintendo's GameCube, will get their hardware at a discount. Like other console makers, Microsoft is subsidizing the cost of the console and hoping to recover its expenses through sales of game software and the decreasing cost of components over time.

While other game makers also subsidize console purchases, the strategy isn't without risk. Former Dreamcast maker Sega scrapped its console business because it was no longer willing to cover losses associated with hardware production.

Industry analysts have been estimating that Microsoft will have to absorb losses of $1 billion to $2 billion related to its effort to subsidize for the manufacturing of Xbox.

The company used similar subsidies to develop a market for WebTV, with the idea being that revenue would come from service subscriptions. But that market didn't grow as fast as Microsoft had expected, hovering around 1 million subscribers the past few years.

Gartner analyst Martin Reynolds said the difference between WebTV and Xbox is that WebTV was for an unproven market, while Xbox taps into a video game market that is not only proven but also highly profitable.

Microsoft is set to launch the Xbox on Nov. 15 at a retail price of $299. Estimates of Microsoft's cost to build each unit have ranged from $320 to $400. Microsoft representatives would not comment on manufacturing costs.

Microsoft also is investing heavily in marketing and has set aside $500 million to promote Xbox. Sources familiar with Microsoft's plans say that the $500 million marketing budget is actually smaller than it seems. Microsoft is using some of the $500 million to subsidize the costs of hardware and is teaming with software publishers to share in the marketing of software titles.

The prize is a chunk of the lucrative video game industry, which IDC analyst Shelley Olhava projected will generate $11.4 billion in North American revenue for 2001.

Though Microsoft has seen some success in hardware, such as with PC mice and keyboards, the company is not likely to see money from the Xbox for a few years.

James Lin, an analyst with investment banking firm Jefferies & Co., said it usually takes about three years before a gaming system manufacturer sees any profit from hardware.

"Historically, companies break even in year three, but they don't normally spend a half-billion dollars in marketing," Lin said.

One exception, Lin said, may be Sony and its PlayStation 2 gaming system, which he said was close to breakeven after initially costing about $450 per unit to build. Sony launched the PlayStation 2 in late October last year.

Analysts expect that in five years, Microsoft will be making as much as $20 million to $30 million annually from hardware sales.

IDC's Olhava also doesn't expect Microsoft to break even early on, but over time and with higher volumes of shipments, the manufacturing cost for Microsoft is expected to come down, she said.

"They won't want to upgrade Xbox too frequently, because if they do, they're only going to make it harder for developers, who would then have to change their software," she said. "It would also take longer for them to get high volumes, which generally relates to lower...material costs over the long run...They would be foolish to do it any other way."

Falling component pricing should help Microsoft cut manufacturing costs, but not much. Those components include a 733MHz Intel Pentium III processor, an Nvidia graphics processor, a multifunction sound processor, 64MB of double data rate (DDR) memory, a hard drive, a DVD drive and a motherboard.

"The Pentium III processor used in the Xbox has been around for a while and is really passé at 733MHz," IDC analyst Shane Rau said. "It's relatively close to end of life, so I would already expect it to be pretty cheap. But the Nvidia parts are probably relatively expensive, since they are developed just for the Xbox."

Rau said that over time the Nvidia chips are likely to come down in cost.

He added that many of the Xbox's components were the same as those used in PCs, which may help the price of manufacturing the Xbox fall faster than in other gaming consoles.

Sony's PlayStation 2 won't benefit from commodity component pricing as much because it uses a specially designed graphics chip, the Emotion Engine, and pricey Rambus memory.

Regardless of losses from hardware for Microsoft, licensing fees and other revenue from software are likely to far outweigh any deficit over time. Analysts place the profit per game for Microsoft in the range of $10 for titles from third-party publishers and as high as $40 for titles published by Microsoft.

Software revenue will add up much faster with some breakthrough Xbox games.

"The key is a hit game," Gartner analyst Martin Reynolds said. "Games are extremely profitable--more so than movies or music--so a hit game could open a big opportunity. They can still be successful with lower-level titles, but it would just take longer."