Tuesday, May 10, 2005

Microsoft “Xboxing” With Sony for What Exactly?

This Thursday, Microsoft will launch their next punch at Sony in an attempt to unseat the latter as the videogame market champion when Microsoft announces its next-generation game console just a few days before Sony makes its announcement. While some analysts believe this to be a straightforward fight for the multi-billion dollar videogame market, others believe this is a war with scope extending well beyond the video game market. As growth of Microsoft’s core personal-computer software slows, are they simply attempting to find new high-growth markets to enter or is there something much greater at stake? Is this a simple case of boldly entering a new market or is this a stalwart defense against a soon to be disruptive technology? While it is quite obvious that Microsoft would love to continue growing, we believe that this move is equally defensive of their competitive advantage as it is an offensive maneuver for growth opportunities. As the line between videogame consoles and home computer technology continues to grow thin – e.g., internet connectedness, computer music play, online transactions – the risk of Microsoft losing relevance increases dramatically (re: lower sales, margin pressure, lower profits).

What is the opportunity?

The overall videogame market has been estimated at over $30 billion per year As of Q3’05, Microsoft’s annualized revenue from its gaming division (Xbox) is close to $2 billion per year with about 17 percent market share in the console space. Assuming they can double or even triple their market share over the next few years, Microsoft may be able to increase revenue to $4-$6 billion. While this is obviously a sizable chunk of revenue, even for Microsoft (>14 percent of current year), there is no guarantee that this market will be that profitable for them. In fact, over the last four years Microsoft has lost and average of $1.2 billion per year.

So why do it? What’s the threat?

If the videogame console replaces the computer as the new centerpiece to the digital home, Microsoft stands to lose relevance in the home computing space. While it is not certain if or when this will happen, and it IS certain that Microsoft is not going to disappear any time soon, the videogame console still represents a huge risk to Microsoft’s titanic cash machine. How big is this cash machine? Microsoft’s fiscal year 2004 net income was over $8B on revenue of close to $37 billion, a 31.6 percent profit margin, and a measly $64 billion in cash on the books. The question is whether there is willingness to lose $1.2 billion a year in the short-term in order to protect over $8 billion per year in the long-term. This is very expensive insurance no doubt, but worth every penny in our opinion.

Hats off to Microsoft:

In the face of analysts and critics who are focusing on the individual battles – namely the gaming division’s drag on profitability, Sony’s product superiority, Xbox360’s launch date – Microsoft’s corporate strategy team is fighting a war to protect their cash machine for the long haul from a potentially disruptive technology. While many analysts are quick to point out Microsoft’s round one misses (their lateness to market, lack of profitability and Sony’s continued dominance in market share), we share Bill Gates’ opinion that they have bought themselves a seat at the table (albeit an expensive one). There were obviously some less than desirable outcomes from the original Xbox launch, but there was also something very important accomplished, namely – a successful entry into an entirely new market (as evidenced by being number two in market share) that not only has the potential to be a big money generator, but also maybe even more importantly, a big money protector.

Microsoft’s entry into the videogame market is textbook corporate strategy for dealing with disruptive technologies. Anticipate/understand a threat and manage the transition by leveraging existing capabilities and market position. Their overall strategy is to have ultimate “control of the digital home” from the computer screen to the television screen and we believe they are in fantastic position to do just that. They got it right with Windows and Office and we know from their launch of Xbox360 that they learned a lot from round one in the videogame console market. Will they pull it off? We think the answer is a resounding yes. Are you willing to bet against them?

Baruah, McGrath, Shelly

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