"Ironically, the more units sold in the early years, the greater the losses," Merrill Lynch analyst Henry Blodget said in the report.
The expected losses represent a standard practice in the video game industry of relying on income from software sales and licensing to subsidize hardware costs. The practice helped drive Sega out of the hardware business earlier this year because the company could no longer come up with money to cover losses associated with production of its Dreamcast console.
Subsidies for the Xbox, set to launch this fall, are expected to be unusually large because of the huge investment required to move into a market with established players Sony and Nintendo. Microsoft already has committed itself to spending $500 million on Xbox marketing. And production costs are expected to be an unusually high $375 per machine because of the console's advanced features, Blodget said in the report.
Blodget estimates Microsoft will "lose $125 on every Xbox console--and that's before taking into account" sales, marketing and other administrative costs.
IDC analyst Schelley Olhava said Blodget's estimate is roughly in line with Sony's per-unit loss on its PlayStation 2 game console and may even be a bit conservative, with much depending on the final consumer price tag Microsoft settles on for the Xbox.
Microsoft has not set a price for the Xbox, but the price it can charge "will be capped by competition from (PlayStation 2) and Nintendo," Blodget said. Sony's PlayStation 2 sells for $300, and Nintendo's next-generation GameCube is expected to sell for around $199 when it goes on sale late this year.
"They're definitely not going to go above $300," Olhava said of the Xbox's price. "The worst-case scenario is it's going to $299. The best case is that Microsoft drops the price down to $279, to undercut Sony a little."
A Microsoft representative said Microsoft had not briefed Blodget on the Xbox but otherwise declined to comment on his report.
Blodget estimates Microsoft will sell 5 million Xbox units in fiscal 2002, peaking at 10 million in fiscal 2004. Microsoft's fiscal year runs July 1 to June 30.
The more units Microsoft sells in the early years, the more money it will lose, Blodget said.
But that's a typical pattern for video games, Olhava said. "If you look at the historical pattern, it's a peak-and-valley situation," she said. "The cost of the hardware goes down as the life cycle of the platform wears down. By the end of the life cycle, you're not selling much hardware but getting a lot of money from software."
In a report released last year, research firm IDC predicted that U.S. unit sales of video game consoles will increase significantly over the next few years, while revenue will drop by one-third, from $3.3 billion in 2001 to $2.3 billion in 2003.
The Xbox is Microsoft's response to Sony's PS2 as the Redmond, Wash.-based software company looks to expand into the nearly $20 billion gaming market. Sony and Nintendo combined make up about $11 billion of the market, reaping operating income of around $2 billion annually, according to Merrill Lynch.
"The size of the market, along with its similarities to Microsoft's core PC software business, make video games a compelling growth opportunity for Microsoft," Blodget said.
But Microsoft's challenges in breaking into the market are multifaceted, particularly given Sony's resounding success with the PlayStation, Blodget said. With the popularity of the Game Boy portable and franchises such as Pokemon, Nintendo holds a firm grip on the 7- to 12-year-old market. Sony's success is greater with teenagers and adults, and the consumer giant relies heavily on third-party games to drive console sales. Microsoft's business model will more closely resemble Sony's.
Factors running in Microsoft's favor, Blodget said, include the advanced hardware going into the Xbox, which will include a 733MHz Intel processor, built-in support for broadband Internet content and other network connections, an 8GB hard drive, and high-end video and audio processors.
Microsoft's reliance on familiar PC elements such as its own DirectX video software and Intel processors are likely to make the console easier for software developers to exploit, Blodget added. "The Xbox has what may be a more 'friendly' development environment compared to Sony or Nintendo," Blodget wrote, "which should help attract third-party developers."
But punching through Sony's success will be tough, Blodget added. Sony has shipped more than 80 million units of the original PlayStation and 744 million games. Although tight supply is still hampering PS2 sales, Sony has sold 8 million consoles since its launch last year.
"By the time Xbox is launched, there will be over 250 PS2 game titles available and a likely PS2 installed base of nearly 20 million units," Blodget said. By contrast, Microsoft is expected to launch Xbox with about 20 games. "Since games drive console sales, this is critical," he said.
Blodget's ultimate prediction is that Xbox will emerge as a strong No. 2 or No. 3 player in the video game market, although No. 1 is not out of the question. "It is conceivable, of course, that Microsoft will topple Sony and Nintendo in the games market the same way it did Apple in PCs and Lotus and WordPerfect in office productivity suites," he said.
Olhava gave Microsoft a slightly better handicap, noting that the first-mover advantage historically has not been a crash-proof barrier to dominating the game industry.
"Nintendo and Sega both had a huge advantage over Sony at one point, and Sony came in and blew the market away," she said. "Based on what I know, I really think it's going to be Microsoft and Sony vying for No. 1, and it could go back and forth a number of times."