Xbox One Upgrade Means Significant Margin Improvement For Microsoft

  • There are rumors that Microsoft and Sony will unveil upgraded consoles instead of a completely new launch.
  • Microsoft's Xbox One appears to be selling poorly lately.
  • An upgraded console could mean significant margin improvement for Microsoft.

By the current look of things, it's looking like video game console leaders Microsoft (NSDQ:MSFT) and Sony Corp (NYSE:SNE) will abandon their tradition of launching a new console every 6-7 years and instead go for a mid-line refresh to their current consoles. People have already dubbed the upcoming consoles ''half consoles''--Xbox 1.5 and PS4.5. These rumors have lately gained even more credence after Microsoft announced that it will discontinue production of Xbox 360, probably in a bid to free up more resources for productive use. Reports emerged last year that sales of older consoles had plunged as much as 70% Y/Y.

Also read: Microsoft Stock Is Still A Good Long Term Buy Following Latest Earnings

Since current gaming consoles feature plenty of storage (Microsoft has a 1TB Xbox One that sells for $400), the upgrades will mainly involve introducing more powerful processors, maybe powerful enough to handle 4K gaming and virtual reality which are all the rage now.

But of course, ultimately Microsoft and Sony are looking to preserve higher price points and juice console margins. Microsoft has been forced to repeatedly slash Xbox One prices due to waning demand, with the current price of $230 ($350 sales price plus $120 worth of free games) a far cry from the introductory price of $500.

Microsoft no longer provides updates on its console sales. But recent comments by Electronics Art gave investors a glimpse into how Xbox One is doing... and it's not good. EA said that 55M Xbox One and PS4 consoles had been sold since their launch. Sony frequently provides updates on PS4 sales, and the most recent update put PS4 sales at 35M units. This means that Microsoft has sold ~20M Xbox One consoles units since its launch about two and a half years ago. Microsoft provided an update about sales figures for the console one year after its launch saying it had sold 10M units. This in effect means that Microsoft has taken 18 months to move the next 10M Xbox One consoles which works out to a 33% Y/Y decline. That's a pretty serious decline.

Now, Microsoft's hardware segment (More Personal Computing) is the company's largest revenue segment contributing 43% of the company's revenue during the last quarter. The segment is not doing well and is, in fact, the reason Microsoft provided soft guidance for the current quarter. Microsoft said that it expects FQ4 (calendar Q2) revenue to clock in the range of $8.7B-$9B, or about a 6% Q/Q decline compared to $9.4B revenue posted by the segment in FQ3. Console sales are probably the biggest revenue contributor for the segment since Surface sales were only $1.1 billion last quarter.

Before the dramatic price cuts and free games offer, there were two Xbox versions on the market: the 500GB base version selling for $350 and the 1TB model selling for $450. Assuming that the two consoles sold in 3:1 ratio in favor of the cheaper console, then the ASP of Xbox One is $363. Xbox One debuted at $499. Assuming the base model of the upgraded console sells for $399 and Microsoft is able to move 10M units during the first year, then the company will be looking at $4B in annual sales from the device.

Microsoft provides very scanty information about its console sales though it used to be more generous in the past. Before the hefty price cuts, Xbox One was estimated to sport a gross margin of about 10%. At the current price point of $230, Xbox One is almost certainly in the red zone, perhaps by as much as -10%. An upgrade of Xbox One can, therefore, potentially increase Xbox One margins by 20% more from where they currently stand.

But of course, investors are more interested in how Microsoft's corporate margins are likely to be affected by the upgrade. If the above assumptions are anywhere near accurate, then Microsoft's gross margin could increase by at least 100 bps, and possibly more if the company's losses on console sales are bigger than our assumption (which they likely are). The effect on Microsoft's top line would be as much as +3% growth.

But there are some major caveats here. There is no guarantee that consumers will readily accept Microsoft's and Sony's new modus operandi as far as consoles go. Gamers in the past did not need to buy new consoles with the release of new games because they were able to play newer games on their old hardware. But a processor upgrade would likely mean that gamers with older consoles will not be able to play new game releases. People might feel like Microsoft is trying to force them to buy new consoles and they are likely to resent it. The good part is that Sony is likely to do the same so people will not have much choice in the matter unless they decide to switch to less popular consoles like Nintendo's Wii. People might revolt for the first few months after the upgraded console hits the market or even for a full year, but eventually, they are likely to cave in and buy the new devices.

Investor Takeaway

It's not clear when the upgraded console will arrive though rumors put the date sometime later this year. If Microsoft updates Xbox One, the effect on the company's margins and top line growth could be very significant.

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