Microsoft Proves It's a Software Company as Devices Take a Hit

If it were an independent company that produced the Xbox 360 game console and little or nothing else, the news for the quarter that just ended could be devastating: Fewer than one-third the number of consoles sold, by the company's estimates, than three quarters ago. You might be hearing the usual platitudes from a consumer electronics company: the market is saturating, the product's already a year-and-a-half old, the first calendar quarter is always a downer after the holidays, and maybe the economy's not all that good.

But this is Microsoft, a corporation which has so many other projects going on that it has back burners behind its back burners. The company that three quarters ago was praising Xbox 360 for stellar sales numbers that more than compensated for R&D expenses, easily dispensed with the bad news - truthfully, though quickly.

"Entertainment & Devices revenue decreased 21% [year-over-year]," announced senior director of investor relations Colleen Healy, "as a result of lower Xbox 360 sales. We sold over 500,000 Xbox 360 consoles during the quarter, bringing our life-to-date sell-in to approximately 11 million. Software and accessory attach rates remain at record levels in the US...and we have passed the 6 million member mark for Xbox Live."

That Microsoft is losing money on its next-generation gaming console is not unexpected. At the time of its launch, we knew from iSuppli's teardown analysis that the company would be losing substantially on every unit it sold. The point of selling 11 million or so consoles was to invest in a platform that could become a bountiful farm of software consumers, who could be harvested for high-margin sales throughout the estimated five-year term of the console's shelf life.

That harvesting period is marked on Microsoft's calendar with a little flag that reads, "Halo 3." As chief financial officer Chris Liddell explained, "Halo 3 [is] clearly going to have a positive impact in two senses: One, it gives us more confidence in the number of consoles that we're going to be able to sell next year. In terms of the direct impact, obviously, it's a first-party product so it's reasonably profitable from our point of view, and it will be several hundreds of millions of dollars of revenue next year."

But after six quarters of shelf life, Xbox 360 hasn't yet reached its own turnaround point, where the cost of production decreases and the revenue from software and accessories increases to where the division can begin breaking even. Instead, it's the focus of the division's declining revenue - down 21.5% annually to $929 million. With Zune being out for such a short time, it could perhaps be blamed for rising expenditures but not for declining revenues.

However, the truth of yesterday was that only one analyst inquired about Entertainment & Devices. One of the big positive bullet points to emerge from yesterday's conference was that the computer enthusiast is alive and well, as evidenced by an increasing shift toward OEM sales and media-oriented versions of Windows.

"Consistent with the results we saw last quarter and the relative strength in the consumer segment following the launch [of Windows Vista]," Healy read from her prepared remarks, "we continue to see a change within the mix of sales of our premium edition operating systems. OEM premium mix is 71%, an increase of 18 percentage points from the prior year, driven by sales of Windows Vista Home Premium, while our other business editions of Windows declined a few points in the overall mix."

Now, that's not to say sales of Windows to businesses declined; rather, when you divide the pie between high-end consumers and business customers, the former got a bigger share this time around. Microsoft is indeed selling to high-class consumers...just not console games.

As Healy explained, however, an 18% shift toward OEMs doesn't translate into that much more revenue for Microsoft, since it costs the company more to sell to that end of the market than to businesses. The relative potency of sales to a segment - what Healy calls the "pricing uplift" - is five times more for Windows Vista Business than for Vista Home Basic, which is five times more potent again over Vista Home Premium. As a result, that 18% shift only translates into net revenue growth of 1%.

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