Gamers Should Be Very Concerned For The Xbox One’s Future

xbox one e3 copy

With the Xbox One set to launch in a few days, the attention of many gamers is set squarely on the next-generation video game console and all the promise that it holds. While that excitement is entirely justified, there are some very real factors in play that have the potential to bring an early end to their enjoyment of the $500 console.

For many consumers, the notion that there is any risk of Microsoft exiting the video game console business is inconceivable. The average Xbox 360 owner has likely spent at least $300 or $400 on hardware and accessories, purchased a sizable library of physical and digital software, and shelled out up to $60 a year for an Xbox Live Gold account. Multiply that (or a similar) experience times the impressive 80 million Xbox 360 consoles shipped worldwide since November 2005, and it must be nothing but sunshine and lollipops over at Microsoft’s Entertainment and Devices Division (EDD), right?

Well, not exactly.

Even though the Xbox 360 is widely regarded as a success, and the launch of the Xbox One this Friday (November 22nd) will fully realize Microsoft’s dream of sneaking the ultimate entertainment Trojan horse into our living rooms, the company has paid a heavy entry fee for the privilege of competing in the hardware side of the video game industry.

Looking through the company’s financial statements dating back to the launch of the original Xbox in 2001, reveals that the division responsible for the Xbox business — which has changed hands multiple times over the years — reported approximately $7.3 billion in operating losses over the life of the original console and the first two fiscal years of the Xbox 360. The following six fiscal years were a more positive experience for the EDD, but the total loss in the division still stands at just over $3.5 billion as of June 30, 2013.

As deep as that $3.5 billion hole is, the actual losses attributed specifically to the Xbox business are likely significantly worse. The Xbox has never operated on its own within the EDD, and at times those losses were combined with the profits gained by the sale of computer hardware (like keyboards), PC games, and various other products. Additionally, this is just a straight up calculation of operating losses and incomes in the division and does not take into account factors like the time value of money (the dollar spent to develop the original Xbox was worth more than the dollar the Xbox 360 earned 10 years later) or the opportunity cost that was lost with the Xbox investment (those funds could have been invested in more profitable divisions at Microsoft).

Xbox One 8 Playable Games at TGS

Okay, they are at least $3.5 billion in the hole. So what? The division is profitable now and it is a great brand, why would Microsoft even consider getting rid of it? For starters, the profits gained from the EDD are almost inconsequential in relation to the rest of the company.

Setting aside the Online Services Division (which is its own financial disaster), the EDD is the least profitable segment of Microsoft by a long shot. In the last fiscal year ending June 30, 2013 EDD pulled in $848 million in operating income (up from $380 in fiscal 2012), but that only accounted for 3.17% of the company’s total operating income. In comparison, Microsoft Business Division and Windows Division reported $16.2 billion and $9.5 billion in respective operating income for the same time period. As much as the Xbox brand is loved by gamers, the sad fact is that Microsoft could shut down the entire EDD, stuff the saved operating cost of the division in a mattress, and the financial loss to the bottom line would be barely noticeable.

The other thing to note about the EDD’s recent string of relatively small Xbox profits is that they may not even be real. According to a recent report from Nomura analyst Rick Sherlund, Microsoft has been lumping $2 billion in annual Android patent royalties (95% of which is estimated to be profit) into the Entertainment and Devices Division earnings reports for “the past few years.” If that operating profit were removed from the division, Sherlund estimates that Microsoft would be showing a yearly loss of approximately $2 billion from the Xbox platform alone.

If any part of that estimate is correct, it solves the mystery as to why prominent MSFT investors like Microsoft co-founder Paul Allen and ValueAct Capital (who recently successfully lobbied to have their outspoken president appointed to Microsoft’s board of directors) have publicly suggested that the company should get rid of the Xbox business. It also explains why one of the prospective candidates to replace Steve Ballmer as CEO is rumored to be open to the idea of selling segments of the business he views as not “critical to the company’s strategy,” specifically the Bing search engine and the Xbox.

At this point, there are four main possibilities for the Xbox business going forward; The board of directors and new CEO could push forward with the current strategy and hope for the best, the entire Xbox segment could be spun-off into its own company, Microsoft could attempt to sell the business, or they could simply stop throwing good money after bad and cut their losses.

The overwhelming number of competing (and cheaper) devices capable of streaming entertainment, combined with the fact that the Xbox business is at best turning a relatively small amount of profit (at worst it is still bleeding money), seem to indicate that staying the course is the least viable of those four options.

While the impending launch of the Xbox One is an exciting time for all gamers, the fact of the matter is that the Xbox brand, as we know it, is facing some very real threats from within. It is impossible to predict what the future holds — as we can only guess as to what direction the board and new CEO will take the company — but prospective Xbox One owners would be wise to at least consider the possibility that Microsoft might sell, spin-off, or shut down the Xbox business in the not too distant future.