After years of declining sales, the much-maligned video-game industry is eying a turnaround of sorts coming into the holiday season.
Several noteworthy game launches from names such as Activision Blizzard and Take-Two Interactive have gone a long way toward capturing consumers' attention. However, more recently, both Sony and Microsoft (NASDAQ:MSFT) made their own waves by launching the latest versions of their leading consoles.
Launching a week apart, Sony and Microsoft each sold more than 1 million of their respective PlayStation 4 and Xbox One consoles in their first 24 hours of availability. Although possibly only a short-term driver, the renewed interest in this sector is certainly a net positive for those looking to invest in the gaming space.
However, for Microsoft, the payoff from a premier console launch is less obvious. As the dust settles surrounding the Xbox One launch, it's still unclear just how much a winner this next-gen device is for Microsoft's shareholders.
A moneymaker for Microsoft?
Investors need to understand the economics of a device like this. To that end, over the past several years, many teardown services and research analysts have estimated how much companies like Microsoft make on their flagship devices.
There have been plenty of estimates of how profitable Microsoft's newest Xbox is, but a recent note from Nomura Equity Research's Rick Sherlund paints an especially depressing picture for the device.
In a recent note to clients, as detailed by Barron's, Sherlund notes the differences in the margin profile between Microsoft's recently released Xbox One and the previous-generation Xbox 360. According to his research, Sherlund believes Microsoft is currently selling the Xbox One for a negative gross margin of 5%-10%. For context, Microsoft sold the Xbox 360 for a slightly positive gross margin.
That's not the end of the world for a company as cash rich as Microsoft, but in this case the margin profile does matter, because Microsoft will incur additional significant selling, general, and administrative expenses around the Xbox One, such as the massive market campaigns for the rollout.
In all, Sherlund estimates that Microsoft will lose a total of $1 billion this year alone on the Xbox. Not exactly encouraging.
The long game
There are a few factors at work that make a possible $1 billion loss worth taking from Microsoft's point of view, the first of which is the natural production cycle that companies such as Microsoft incur in rolling out these marquee video-game devices. As we've seen with other devices -- such as Apple's iPhones -- prices for components tend to fall fairly dramatically over time. Microsoft, too, should see the overall input cost for the Xbox One fall beyond breakeven further into the Xbox One's product life cycle. The company's losing money today to hopefully make money later.
However, even beyond specific margins, the Xbox One carries a special strategic importance to Microsoft, which could also make the short-term unprofitability more palatable. Although many debate whether Microsoft will even remain focused on the consumer market, the Xbox One represents perhaps Microsoft's best opportunity to gain an early ecosystem advantage in an area that many expect consumer-electronics companies to focus on next -- the "smart" living room.
Gaining an early lead in the smart living room makes sense. Especially as Microsoft's other mobile environments slowly gain traction in the smartphone and tablet market, the Xbox One can help extend Windows and Microsoft's other software to create a seamless experience between PCs, smart devices, and televisions that will (in theory) drive consumers toward Microsoft's software ecosystem.
However, it's still unclear how Microsoft could monetize this market opportunity. Most believe Apple would focus on selling an all-in-one television that would probably carry a margin profile similar to its other very profitable iDevices. If Google moves Android in that direction, Android on TV would funnel users back to Google's rain-making search business.
Microsoft has lots of services it could provide to round out the ecosystem, such as Skype and Bing. However, it's traditionally offered Skype for free, and Bing's still firmly in the red. Although the company doesn't break it out, it's likely that Microsoft isn't making much money from licensing Windows to mobile devices. So especially with the prospect of not making considerable money off the sales of the actual hardware with the Xbox One, it's just not clear where the significant moneymaking opportunity lies for Microsoft with the Xbox over the long term.
Foolish bottom line
For all the glowing press surrounding the Xbox One launch, or the tailwinds in the gaming sectors more broadly, it still isn't clear how Xbox One fits into Microsoft's long-term strategy.
This is a dynamic situation for Microsoft. None of this is happening in a vacuum. However, as Microsoft's Xbox One launch makes headlines in the coming weeks and months, investors should also be aware that this big-ticket product launch might not be all it's cracked up to be for Microsoft's bottom line today.