3 Reasons Microsoft Should Spin Off Its Xbox Division

Analysts frequently debate whether or not Microsoft (MSFT 0.37%) should spin off its Xbox business. On the one hand, the Xbox One is a low-margin product facing tough opposition from the Sony(SONY 1.10%) PS4. On the other hand, the Xbox One gives Microsoft a strong brand presence among younger consumers and could help the company gain a foothold in living rooms.

Source: Microsoft

Despite those opportunities, I believe an Xbox spinoff will be a great long-term move for Microsoft. Let's take a look at the three top reasons.

1. A money-losing business
The Xbox business has likely lost money for Microsoft ever since the launch of the original console in 2001. In late 2013, Nomura analyst Rick Sherlund estimated that losses could be as high as $2 billion per year. The official figure is unclear as Xbox, Skype, Windows Phone, and patent royalties were previously grouped together under the entertainment and devices division.

Last August, Microsoft reported that its Xbox division revenue had risen 34% year-over-year to $1.7 billion, but cost of sales soared 72% to $2.1 billion due to marketing costs. Gaming consoles should become more profitable as component costs decline over time. When the Xbox One launched in November 2013, IHS revealed that the console, without the Kinect, cost $396 to manufacture. 

However, subsequent price cuts on the Xbox One were so steep that the consoles are now likely still sold at a loss. Microsoft recently slashed the price of the Xbox One (console only) from $399 to $349 across the U.S. To make matters worse, those discounts are barely helping Microsoft catch up to Sony. According to Vgchartz's latest numbers, Sony has sold 18.5 million PS4 units worldwide compared to just 11 million Xbox One consoles.

Spinning off the Xbox division can help Microsoft protect its bottom line. Last quarter, the company reported a 13% year-over-year decline in net income, due to restructuring costs and steep discounts on software and hardware.

2. It's not part of "One Windows"
The Xbox One confused some customers, because it tried to take over living rooms as a media supercomputer when most users simply wanted to play games.

That identity crisis caused Microsoft to bundle, then unbundle, the Kinect from the Xbox One. Microsoft launched an in-house studio for original video programming in 2012 but shut it down two years later. Early commercials focused on using the Xbox One for Skype and watching NFL programming, instead of playing video games.

Those problems could have been avoided if Microsoft stopped trying to turn the Xbox into an extension of the Windows ecosystem. It certainly makes sense to tether smartphones, tablets, and PCs to the Windows cloud and productivity ecosystem, but it makes less sense to do the same with Xbox.

Windows 10 -- which will unite Windows Phones, tablets, and PCs -- will not be installed on the Xbox One. Instead, Xbox One users will run "universal apps" that can also be installed on those other devices from the Windows Store. Microsoft also recently unveiled Office apps for the Xbox One, but I seriously doubt that customers buy gaming consoles to use Microsoft Word.

Therefore, a spinoff would allow the Xbox division to focus on improving the console gaming experience instead of aligning its interests with the broad Microsoft vision.

3. Microsoft could retain majority control
Microsoft could retain a majority stake in the new Xbox entity, which would also generate fresh cash for the company. This would also prevent the newly formed company from being taken over by a major rival like Sony.

A theoretical Xbox Corporation could use its own stock to buy out smaller studios. For example, Microsoft bought Minecraft maker Mojang for a whopping $2.5 billion last year. Before that, it acquired other shops like Ensemble Studios, Rare, and Lionhead Studios to expand its library of exclusive games.

If Xbox became an independent company, it could use a combination of cash and stock to acquire additional studios, secure exclusive games, then port them over to Windows phones, tablets, and PCs.

But don't hold your breath . . .
Microsoft clearly wants to keep the Xbox closely tethered to its Windows PC, tablet, and phone businesses for now. When asked about a possible spinoff of the Xbox business last May, CEO Satya Nadella stated that he had "no intent to do anything different" with the division.

But if we look further down the road, Microsoft might eventually realize that the Xbox division is not an integral part of its "One Windows" plan. When that day comes, I expect Microsoft to revisit the idea of spinning of the Xbox business, so it can grow on its own.