Microsoft Launches Larger Xbox One: Is MSFT Evolving Into A Hardware Company?

  • Microsoft has unveiled a larger 1TB Xbox One gaming console ahead of the E3 gaming conference.
  • The company's consoles have been selling very well which has led to its hardware segment becoming its second-fastest growing.
  • How is the low-margin segment impacting on Microsoft's margins?
Microsoft launches Larger xBox one analysis

Microsoft (NASDAQ:MSFT) has unveiled a bigger 1TB Xbox One gaming console a few days ahead of the E3 gaming industry conference scheduled to run from 16th-18th June. The new console, which will retail for $399 compared to $349 for the current 500GB Xbox One, comes just a couple of weeks after NPD revealed that Xbox One April sales topped those of its bitter competitor Sony’s (NYSE:SNE) PS4 after growing at a blistering 63% Y/Y. Meanwhile, Microsoft will permanently cut the price of the older 500GB console to $349, a promo price that the software giant introduced last Christmas and which has remained in force up to now.

But, this is just one of the latest additions to Microsoft’s gaming segment. The software giant recently forged an alliance with Facebook’s (NASDAQ:FB) Oculus Rift gaming platform that will allow Xbox One games to be played on the Oculus virtual reality headset by streaming to Windows 10 PCs. This appears to be a well-timed move to counter Sony’s Morpheus virtual reality gaming headset that the company plans to launch during the first half of 2016.

Is Microsoft’s hardware segment going to dominate the company before long? How is the rapid growth of the low-margin hardware segment affecting Microsoft’s top and bottom lines? Microsoft does not usually break down sales of its hardware division ever since it changed its reporting format a year ago. We can, however, estimate the contribution of Xbox to the segment and examine its effect on Microsoft’s profit margins.

Huge Growth in Xbox one sales

NPD unveiled April gaming hardware and software sales that showed that Xbox One sales had topped PS4 for the second time in five months. Overall, gaming hardware sales were up 12% on a volume basis but down 4% on a cash basis mainly due to huge price cuts on older consoles such as Xbox 360, PS3 and Wii. Microsoft’s Xbox marketing chief Mike Nichols told GamesBeat that Xbox One sales were up 63% Y/Y. Though NPD only tracks U.S. and Canada console sales, it appears as if Xbox consoles have been doing well elsewhere since the company revealed that the number of global active users for Xbox One and Xbox 360 grew 24% during the month. This is hardly surprising given that MSFT has repeatedly slashed the price of the new console taking it from $500 at the time of its launch to the current price of $349. Microsoft’s experiment of bundling free games with its new consoles also seems to be working well and is probably another big reason the consoles have been flying off the shelves.

But, how has increased sales and aggressive price cuts on the consoles been reflecting on Microsoft’s top and bottom lines?

Microsoft’s Hardware Segment in Focus

For tech companies, the hardware business is generally a low-margin one, whether you are talking about servers and PCs or gaming consoles. A PC company such as Hewlett Packard (NYSE:HPQ) sports a much lower gross margin of 24% than a predominantly software company like Microsoft or Oracle (NYSE: ORCL) with 67% and 79.6% gross margins, respectively. There are a few notable exceptions, chief among them being Cisco (NASDAQ:CSCO), whose gross margin of 62% that the company derives from selling switches and routers ranks among the highest for a hardware company.

Microsoft adopted a new reporting format in 2015 and no longer breaks out the actual number of consoles sold. During its last annual 10-K report, the company indicated that it had managed to sell 11.4 million Xbox consoles. Though the company did not provide specifics regarding numbers of Xbox One and Xbox 360 units sold, we can try to piece together some information from its earlier reports that said that Xbox One revenue had risen 34%, equivalent to $1.7 billion while Xbox development costs had jumped 72%, equivalent to $2.1 billion mainly due to a $600 million increase in Xbox One R&D costs. Note that the company did not provide any totals but merely increases in revenue and cost allocations. Using these pieces of information and the prices of Xbox One and Xbox 360 at the time reveals that Microsoft’s Xbox platform realized revenue of roughly $6.8 billion and cost of revenue of $5 billion in 2014.

Microsoft currently reports Xbox results under the Computing & Gaming division. During the first nine months of the current fiscal year, the segment brought in revenue of $8.25 billion, good for 31.2% Y/Y growth and almost three times the 12.5% overall top line growth by Microsoft during the period. Microsoft financials indicate that the entire segment’s gross margin came in at 16.4%, much lower than the company’s 64.2% corporate gross margin. The good part, however, was that the segment’s gross margins were still an impressive 552-basis point improvement over the previous fiscal year reading of 11.26%.

In other words, Microsoft’s aggressive Xbox console price cuts have not impinged on the segment’s profit margin. This is probably due to how the company has been charging its development costs by allocating the bulk of the costs during the early sales cycles of the consoles. The improved margins can also be an indication that Xbox One, which is currently the most dominant console, sports much better margins than the older Xbox 360 even after the price cuts.

Significance of Microsoft Hardware Segment

While Microsoft’s hardware segment sports a much lower margin than the rest of its businesses, the company still needs it to maintain decent top line growth. Microsoft is currently transitioning to a cloud-centric model where most of its services will be offered via the cloud. Microsoft’s cloud revenue grew a blistering 106% during the last quarter to hit an annual run rate of $6.3 billion. Despite the impressive growth, Microsoft’s cloud still consists just 7% of its overall revenue. The company’s hardware segment is twice as big, and its strong growth is helping to offset weaknesses in Microsoft’s other segments.

But, given its blistering growth, the cloud segment, not the hardware segment, is what is going to eventually become Microsoft’s most dominant segment. The cloud business is generally a high-margin business, so there is little danger of Microsoft’s hardware business dragging down its margins.

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