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Introduction

Over the last couple of months, a few analysts and influential people have argued that Microsoft (NASDAQ:MSFT) should spin off its Xbox-division. Amongst others, Microsoft co-founder Paul Allen and CEO-candidate Stephen Elop (former Nokia CEO) have argued that a spin-off is desirable.

So what are the arguments for selling it and why has Microsoft under Steve Ballmer's regime kept it?

Why Microsoft developed the Xbox

Let me begin this article by taking a step back to the late 90's. Back then, Bill Gates attempted to convince Sony to use Microsoft's software in the upcoming PS2. Sony, however, didn't accept the terms presented by Bill Gates, and Microsoft found it necessary to react as there was a general consensus in the tech-industry that consoles would threaten the PC-industry. The PC-industry is where Microsoft makes its money and if the Playstation platform became too large, it could threaten Microsoft's long-term software revenue.

Initially, Microsoft wanted to find a PC maker to create the Xbox hardware so Microsoft could focus on the software. However, no PC maker was willing to do that as there basically is no profit margin in the business, so Microsoft itself was forced to develop the hardware as well.

Why Steve Ballmer kept the Xbox division

Today, the growth prospects for consoles aren't as prosperous as they were 10 years ago. Instead it has become much more important for Microsoft to be present in the smartphone and tablet market. So one may question Steve Ballmer's decision to reposition Microsoft as a hardware company with the Xbox as the largest revenue driver.

However, Steve Ballmer sees the hardware business as a way to increase software-revenue. For instance, if Microsoft can get enough Xbox's out in the living room, we may see an increasing amount of consumers searching through Bing while sitting on their couches. Further, consumers can use a W8 tablet or computer as an extension of the Xbox, which means that a purchase of the Xbox gets the consumer into the whole Windows 8 ecosystem. Thus, Steve Ballmer believes that creating synergies between all of the devices and Microsoft's software will increase Microsoft's total earnings.

What are the problems with the Xbox-division?

Ultimately, the question of whether the Xbox-division should be sold or kept comes down to whether the synergies are high enough in order to justify the losses of the division. I've seen a lot of Xbox skeptics argue that the Xbox division may lose $1-2B on an annual basis. It is my guess that they use the below methodology in order to get to that result;

  1. They assume that the Xbox One has a negative gross margin of roughly -5% with the Xbox 360 having a positive gross margin of 5%.
  2. They calculate gross profit by multiplying expected unit sales with average selling price and the -5% gross margin.
  3. They subtract expected operating costs from expected Gross Profit to obtain Operating Profit.

However, the problem with that type of calculation is that it ignores other sources of higher-margin revenue directly related to the Xbox platform. For instance, Microsoft earns royalties from game publishers. They also have a subscription-based service with roughly 24M paying users and at last, it generates revenue through Xbox Live transactions.

In the table below, I have added estimates for the other sources. While my numbers for gross margins are estimates (and thus nowhere near exact), I studied historical financial reports in order to come up with numbers that roughly replicate Microsoft's historical earnings. Adding it all up, I estimate that the Xbox platform will post negative earnings of $-215M in the December-quarter.

(click to enlarge)

On an annual basis, I expect a slightly lower royalty income (relative to total Xbox revenue) as sales of games tops in the Christmas quarter. The average gross margin related to consoles should also decline a bit as I expect a higher ratio of Xbox One sales to Xbox 360 sales. On the other hand, operating costs will probably also decline due to lower advertising spending. Thus, I end up with a rough estimate of an annual loss of $700M for this division.

On a slightly longer time-period, I expect Xbox One margins to improve as component costs are very high in the launch phase of a new hardware product. This improvement should eventually get the division out of the red.

Final remarks

The Xbox One is losing a lot of money on a operational basis. However after taking into account other sources of revenue related to the Xbox, the total loss is less than numbers presented by the media. Further, on a longer term basis (one year-plus), the division could very well break even as component costs and operating costs go down. Given the value the Xbox adds to the ecosystem, I believe that the business is definitely a positive contributor to Microsoft's long-term earnings.

In the end, the question of whether Microsoft should sell the division or not comes down to whether the Xbox business is more valuable in the hands of another company. I question whether that's the case. The Xbox ties up the Windows ecosystem and transforming it so it fits into a different ecosystem will likely result in a lot of additional costs.

So while Microsoft should be willing to sell the division if it received a bit in the order of several billion dollars, I believe it is very unlikely that such a bid ever will occur, and thus I expect that Microsoft will keep the division under its belt, regardless of the name of the next CEO.

Source: Why Microsoft Won't Spin Off Xbox