Microsoft typically makes billions of dollars in profit per quarter. With its latest earnings release, this pattern continues. While the media, bloggers, and other technology pundits debate the long-term impact on the company's finances of open source software, the software as a service model, Google, and the potential stagnation in its core software markets, one trend is clear. Despite investing billions of dollars in the consumer electronics (CE) market, the company is not profiting from its high profile ventures. Profit comes from Windows, Office, and its server offerings, but critical consumer products, such as the Xbox 360 and the Zune ecosystems, continue to lose money.

The red ink still flows in EDD

For the pervious quarter, Microsoft reported sales of $12.5 billion and earnings of $2.6 billion. When broken down by segment, the company reported that its three core businesses -- Client, Server and Tools, and Microsoft Business Division -- were responsible for all of its operating income. The Entertainment and Devices Division (EDD), which produces the Xbox 360 and the Zune, had a $289 million dollar operating loss (a year ago, before the Zune launch, the quarterly loss was $286 million on $1.3 billion less revenue). See the chart below to see the contributions in terms of segments.

The challenge of making EDD profitable 

Where is the money in EDD? According to its most recent 10-Q (Word doc here), Microsoft reports that in the EDD:

• The Xbox is driving revenue growth. "Xbox and PC game revenue increased by approximately $1.0 billion or 76% during the three months ... We sold approximately 4.4 million Xbox 360 consoles during the second quarter and approximately 5.4 million Xbox 360 consoles during the first half of fiscal year 2007. Since the Xbox 360 console was launched in November 2005, we have sold approximately 10.4 million units."
  
  
• Zune, new to the product mix, offered little. The Zune was launched on November 14th of last year -- halfway through the quarter. "Revenue from Zune, consumer hardware and software, and TV platforms increased $260 million or 104% during the three months and $323 or 71% during the six months ended December 31, 2006, primarily reflecting the recent release of Zune, new consumer hardware products, and deployments of MSTV products."
  

But a 10-Q doesn't tell the whole story. There's more to learn, and some insight can be gained from recent  interviews of key Microsoft executives.

Robbie Bach's take: EDD will be profitable by 2008

According to a November of 2006 Mercury News interview with Robbie Bach, President of EDD, the division is on track to be profitable by next year. The interview touched on a variety of topics, including:

• Reducing Xbox costs. "If you looked at the investment in the Xbox over the last four or five years, a significant percentage of that was purely in hardware subsidization." Later he notes: "The engineering team is always thinking about the future. Right now we are thinking about how to cost reduce the Xbox 360. That seems to be the first order of business."
  
  
• EDD profits. "To be clear, we have said that in fiscal 08, Entertainment and Devices makes money. That’s not exactly Xbox. We don’t break profit down by business. And there are parts of Entertainment and Devices that make money. Xbox doesn’t. Xbox has to make significant progress to enable E&D to get there. We feel we are on track."
  
  
• Zune making money. "But, yes, [the investment horizon is] multi-years, just to get back to your original question. It's definitely multi-year."
  
  
• Counting Xbox's sold. "In our case, it’s reasonably close to sold through. To make sure we’re clear, Sony does shipped from factory. We don’t. Our shipped means it has left a distribution warehouse in Memphis to a retailer. There is a big lag of six week to eight-week lag between what we called shipped and what Sony calls shipped. That’s the way we do the accounting."
  

On January 8, Bach spoke at Microsoft's Investor Relations Financial Analyst Briefing at the Consumer Electronics Show (CES) in Las Vegas (get the Word doc transcript here). Highlights of relevant EDD issues include:

• Zune shipments. "In fact, we're on track to hit a million units of Zune by the end of the fiscal year ..." Note that Zune was launched on November 14 of 2006; Microsoft's fiscal year ends in June of 2007.
  
  
• Xbox numbers. "10.4 million consoles sold into retail ... Attach rates really are off the charts.  We're 5.3 games per console right now." As for other Xbox services, he noted that, "Xbox Live, 5 million members and continuing to grow. Our movie download service is doing very well."
  
  
• EDD profitability. "We absolutely expect E&D to be profitable next fiscal year. We're still on track to do that. Nothing has changed that. So that part still completely square, and most of that is driven by the shift in what we're doing on Xbox 360. Financially it's such a big part of the model that we can't get to that number without 360 improving dramatically, that profit profile."
  
  
• Profitable devices. According to Bach, each of Microsoft's key consumer devices requires a different strategy to make money.
  
  
• Xbox: "So the things that make the needle move in Xbox are cost reduction, Xbox Live, games, and peripheral sales. That's the way the business model works. You reduce the cost on the hardware, so you keep that roughly neutral on your P&L, and you drive attach around the rest of the things, that's how you make money."
  
  
• Zune: "In Zune, in a funny way it's almost exactly the opposite, you make the money on the hardware. On the content, the content providers make most of the money, we make a little bit, but most of that money ends up going to the music ecosystem. And peripherals is a positive, but probably not as big as it is on the Xbox side."
  
  
• Mobile phones: "And then in the mobile phone space, you have the royalty rate that we get for the operating system, which is, you know, a much lower number than it would be on Windows, but we have the opportunity for services on top, which is the discussion that was had earlier here about services that we can build on top of that."
  
  
• Media Center PCs: "Relative to Media Center, its predominant role from an economics perspective is it drives people to higher priced versions of Windows. That's great for the ecosystem. It's great of the ecosystem, it's good for us, and we make a little bit more money on that."
  

CEO Ballmer backs up Bach

In a New York Times article on Microsoft CEO Steve Ballmer, the reporter noted the problem Microsoft has in terms of making money on the Xbox:

Still, despite investing billions, Microsoft has yet to show any profit from its video game venture. “Look, the jury is still out,” Mr. Ballmer acknowledges. “But I feel very confident that we’ve built a good market position with Xbox. I feel very confident that we’re on track to make money.”

The company has said the Xbox business, including hardware and software, should move into the black this year, but when, and if, the business will pay back its multibillion-dollar investment is unclear. 

The elephant in the room: The lack of Zune device profits

Losing money on consoles in the first couple of years is now fairly typically, so the challenge of squeezing out a profit on the Xbox 360 hardware is similar to the problem Sony faces with the PS3. However, Microsoft was never profitable with its first-generation Xbox hardware (discontinued after the launch of the 360), while Sony continues to sell tens of thousands of its now profitable PS2 hardware every month (see this International Herald Tribune article). But while its acceptable to lose money in the console space, the issue of Zune red ink is another matter.

Apple generates enormous profits from its iPod players. While it does not breakdown revenue or profits by product, in its recent quarterly earnings report the company said it had a profit of $1 billion on $7.1 billion in revenue and shipped 21,066,000 iPods (versus 1,606,000 Macintosh computers). Previously, the company has said that the iTunes Music store had broken even, but was not a major profit center. Its purpose is largely to drive interest in the iPod, and to some extent, Macs.

In contrast, Microsoft is apparently not only selling its Zune device at a loss, but is also paying Universal Music Group $1 for every device it sells (see this New York Times article). For the vendor, the embarrassment of losing money on each Zune device while its rival Apple makes a good profit on each iPod shows just how far Microsoft has to go to succeed in the challenging CE space. Microsoft certainly has the cash to invest in the business, and with Xbox 360 and Xbox Live, it has shown it can create a compelling offering. But at some point, losing money to gain share won't be tolerated by investors, particularly if Microsoft's key products, such as Windows and Office, show slowing sales and lower profits.

If the EDD can't make money in 2008, Ballmer will have to once again revise his outlook or begin to abandon some of his prominent CE efforts.

By: Tom Rhinelander, NRG Analyst