MS hopes for Halo 2 + NextGen Xbox

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Microsoft Hopes Halo Can Light Up Xbox



Microsoft (MSFT:Nasdaq - commentary - research) is trumpeting Tuesday's
release of its Halo 2 sci-fi video game as the "biggest 24 hours in
entertainment history." Even if it isn't, the event undoubtedly will be a
high point in the company's short history in the sector.

To be sure, it's difficult for a single video game, even as widely touted as
Halo 2 is, to have a meaningful effect on the world's largest software
maker's overall financials, especially given that more than half of its
nearly $40 billion in annual sales comes from its Windows and Office
franchises.


But Microsoft CFO John Connors did cite, among other things, the expected
success of Halo 2 and greater sales expectations for Xbox when he raised
fiscal 2005 guidance last month. Halo 2, one of two hot game titles
launching this holiday season, will share the spotlight with Take-Two
Interactive's (TTWO:Nasdaq - commentary - research) next installment of
Grand Theft Auto.

The most meaningful effect of Halo 2 sales will show up in Microsoft's
money-losing home and entertainment division. The division's operating loss
shrunk substantially in the September quarter, to $142 million from $273
million a year earlier, partly because of an increase in software sales.
Microsoft generates a profit from video-game software sales but loses money
on every sale of the Xbox console.

Halo 2 sales are likely to help continue that streak of narrower operating
losses in the division in the December quarter. The company already said it
has preshipped 1.5 million Halo 2 games in the U.S. With a retail price tag
of about $50, that amounts to $75 million in sales.

Assuming conservatively that Microsoft gets about half of that, the company
nets $37.5 million in revenue. Microsoft has said it spends $5 million to
$10 million to develop a game, meaning that the company will ultimately net
between $27.5 million and $32.5 million on preshipped games alone.


Running Rings Around the Competition
That may sound like small potatoes for a company like Microsoft, but that
profit from one title amounts to nearly one-quarter of the operating income
of top video-game software maker Electronic Arts (ERTS:Nasdaq - commentary -
research) last quarter.




"If [Microsoft] can sell a couple million [Halo 2 games] , they'll earn that
back right away and that will become a very nice, profitable business," said
Matt Rosoff, an analyst with Directions on Microsoft, a Kirkland,
Wash.-based independent research firm that follows the company. "I think
they should be able to post a solid [December] quarter."

However, whether Halo 2 will drive substantial sales of the company's Xbox
console, meanwhile, remains an unknown. "If anything will drive Xbox sales,
it will be Halo 2," Rosoff said. However, this late in the console game
cycle -- a year before Microsoft is expected to launch the next-generation
Xbox -- sales are already slowing down.


In the first nine months of this year, total U.S. video-game console sales
dropped 17%, while unit sales decreased by a little more than 1%, according
to researcher NPD Group.

Sony's (SNE:NYSE ADR - commentary - research) PlayStation 2, which debuted
in Japan in March 2000, came out before Xbox (November 2001), and still
commands a large lead of the console market with 58% of the installed base,
compared with 23% for Xbox and 19% for Nintendo's GameCube, according to
Wedbush Morgan analyst Michael Pachter, who covers the video-game industry.
(Pachter does not specifically cover Microsoft, Sony or Nintendo.)

Even if Halo 2 does drive some sales, however, it will be difficult to
determine by how much because console sales typically do well during the
holiday season, and Microsoft has recently cut their prices, Pachter noted.

And because Halo 2 is coming out one year later than many gamers initially
believed, some analysts believe that the consumers who will buy Halo 2
already own an Xbox. "People have wanted [Halo 2] and were ready to buy it
last year," said Dalek Capital portfolio manager Joe Spiegel, whose firm
does not hold shares of Microsoft, Sony or Nintendo.

What's more important to Microsoft's video-game business, however, will be
how the company does with the next iteration of its Xbox, widely expected to
be unveiled next year at the Electronic Entertainment Expo (E3) confab.
Connors has forecast that Microsoft's home and entertainment division,
largely comprising Xbox console and game sales, will be profitable by
2007 -- only one to two years after the launch of the new Xbox.






"I think they're just expecting to get hardware costs down and hopefully
sell more games and get more Xbox Live subscriptions," Rosoff said.


Third-Party Aura
Analysts agree that key to Microsoft's performance in the next console cycle
will be its ability to sign on third-party game developers, an area where
the company has been weak in the current cycle. Right now, about 400 game
titles are available on Xbox, according to Microsoft. But that's less than
half the number of titles PlayStation 2 offers, according to NPD. In
addition, PlayStation 2 also can play games from the first PlayStation
console, which brings the total game library to more than 1,000.




"Microsoft has to be to market early, has to get a lot of third-party
developers on board and has to have a killer application that Sony doesn't
have," Rosoff said. "It's going to be very difficult" to displace Sony.

Pachter echoed that thought, praising Xbox's hardware technology, which is
widely believed to be superior to Sony's. But ironically, he noted, he would
give the company a "D" in software development. Microsoft underestimated
Sony's support from game publishers in Japan, a crucial market in which
Xbox's performance has been characterized as a dismal failure. And both Sony
and Nintendo's internal game development is far superior to Microsoft's,
Pachter added.

In addition, Pachter fears that Microsoft may not be able to improve
third-party game support in the next console cycle, in part because he
expects development costs to soar to $10 million a game from $4 million in
the current cycle. Pachter believes that higher price will discourage
independent game developers to make titles for Xbox, especially because its
sales this time around have trailed Sony's.

"They've spent an awful lot of money to finish a distant second in a race
where the winner is the only one who made any money," he said of Microsoft.
"It was a very expensive lesson, and I'm not certain that they learned the
lesson."





Pachter suggests that Microsoft should increase over time its internal game
development, buy a sizable outside developer and be more willing to pay
those developers to create games exclusively for Xbox.

Whether Microsoft will take any of these actions is still unknown. The
company is already singing the praises of Halo 2, but remains tight-lipped
about its next-generation console plans.








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