"Ironically, the more units sold in the early years, the greater thelosses," Merrill Lynch analyst Henry Blodget said in the report.
The expected losses represent a standard practice in the video game industryof relying on income from software sales and licensing to subsidizehardware costs. The practice helped drive Sega out of the hardware businessearlier this year because the company could no longer come up with money tocover losses associated with production of its Dreamcast console.
Subsidies for the Xbox, set to launch this fall, are expected to be unusuallylarge because of the huge investment required to move into a market withestablished 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--andthat's before taking into account" sales, marketing and other administrativecosts.
IDC analyst Schelley Olhava said Blodget's estimate is roughly in line withSony's per-unit loss on its PlayStation 2 game console and may even be a bitconservative, with much depending on the final consumer price tag Microsoftsettles on for the Xbox.
Microsoft has not set a price for the Xbox, but the price it can charge "will becapped by competition from (PlayStation 2) and Nintendo," Blodget said.Sony's PlayStation 2 sells for $300, and Nintendo's next-generation GameCubeis 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'sprice. "The worst-case scenario is it's going to $299. The best case is thatMicrosoft drops the price down to $279, to undercut Sony a little."
Expected sales
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 fiscal2002, peaking at 10 million in fiscal 2004. Microsoft's fiscal year runsJuly 1 to June 30.
The more units Microsoft sells in the early years, the more money itwill lose, Blodget said.
But that's a typical pattern for video games, Olhava said. "If you look atthe historical pattern, it's a peak-and-valley situation," she said. "Thecost 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 alot of money from software."
In a report released last year,research firm IDC predicted that U.S. unit sales of video game consoles willincrease significantly over the next few years, while revenue will drop byone-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.-basedsoftware company looks to expand into the nearly $20 billion gaming market.Sony and Nintendo combined make up about $11 billion of the market, reapingoperating income of around $2 billion annually, according to Merrill Lynch.
"The size of the market, along with its similarities to Microsoft's core PCsoftware business, make video games a compelling growth opportunity forMicrosoft," Blodget said.
Advanced hardware
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 successis greater with teenagers and adults, and the consumer giant relies heavilyon third-party games to drive console sales. Microsoft's business model willmore closely resemble Sony's.
Factors running in Microsoft's favor, Blodget said, include the advancedhardware going into the Xbox, which will include a 733MHz Intel processor,built-in support for broadband Internet content and other networkconnections, an 8GB hard drive, and high-end video and audio processors.
Microsoft's reliance on familiar PC elements such as its own DirectX videosoftware and Intel processors are likely to make the console easier for software developers toexploit, Blodget added. "The Xbox has what may be a more 'friendly'development environment compared to Sony or Nintendo," Blodget wrote, "whichshould help attract third-party developers."
But punching through Sony's success will be tough, Blodget added. Sony hasshipped more than 80 million units of the original PlayStation and 744million games. Although tight supply is still hampering PS2 sales, Sony hassold 8 million consoles since its launch last year.
"By the time Xbox is launched, there will be over 250 PS2 game titlesavailable and a likely PS2 installed base of nearly 20 million units,"Blodget said. By contrast, Microsoft is expected to launch Xbox with about20 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 orNo. 3 player in the video game market, although No. 1 is not out of thequestion. "It is conceivable, of course, that Microsoft will topple Sony andNintendo in the games market the same way it did Apple in PCs and Lotus andWordPerfect in office productivity suites," he said.
Olhava gave Microsoft a slightly better handicap, noting that thefirst-mover advantage historically has not been a crash-proof barrier todominating the game industry.
"Nintendo and Sega both had a huge advantage over Sony at one point, andSony came in and blew the market away," she said. "Based on what I know, Ireally think it's going to be Microsoft and Sony vying for No. 1, and itcould go back and forth a number of times."