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Microsoft's Dangerous Video Game Assumptions

Enormous hardware subsidies and fierce competition are hardly two of the most appealing aspects of the video game console industry, yet Microsoft is still determined to forge its presence. Billions of dollars, however, hinge on one crucial assumption; that multi-player online games will earn large subscription revenues and be a catalyst for broadband services.

There's no doubting that video game consoles hold a great deal of commercial opportunity. In the twelve months to March 2001, gaming behemoth Nintendo reported earnings of $1.36 billion on revenue of $7.35 billion - not bad, especially considering the general market conditions.

With Sony having released the Playstation 2 earlier this year and Microsoft and Nintendo recently launching their next generation consoles in the US and Japan, the industry sits on the cusp of expectation.

A seat at the table is not for the financially shy. The economics require console makers to bear a financial risk by recouping hardware subsidies via the sale of games. Done right and the equation can produce lucrative rewards, a few misguided assumptions though and it can financially cripple an organisation.

The cost to produce an XBox is estimated to be around $US425 and Microsoft is selling the stand-alone console in the US for $US299. With Microsoft expecting to sell around 5 million consoles by mid-way through next year, it certainly raises the stakes for XBox-related products and services like online gaming subscriptions.

The risk in recouping these losses is heightened by Microsoft's decision to include standard PC components in the Xbox rather than custom made chips. Sony was able to lower its cost of production for the original Playstation from $US480 to $US80 over 7 years, largely due to manufacturing efficiencies. For Microsoft lowering production costs may prove a little more elusive, with many of the economies of scale already squeezed out of the price of Xbox's PC components.

By betting bigger on the cost of subsidising hardware units, Microsoft will need to produce greater revenues. The company believes this will be possible via multi-player online games and the increasing functions that video game consoles now carry out.

It's no secret that Sony holds great ambitions for the Playstation 2 as a conduit for its music subscription services and other digital entertainment plans. Yet the delay in launching its 'broadband adapter' (it pushed the release date back till late 2002) effectively puts such aspirations on ice.

Thus for Microsoft's foray into video game consoles to work it must pioneer the market for networked console games on its own - at least in the short term. Online games are no stranger to the PC, however their success on consoles is yet to be tested. For instance, several online role-playing titles currently earn significant subscription revenues. Sony's Everquest has around 350,000 players who pay approximately $US10 per month and likewise Ultima Online, which has around 235,000 players paying $US10 per month.

The transition to consoles is not as simple as it might seem. Of most concern is the fact that gamers must connect their console to a broadband Internet service.

Although curiously, consoles may end up being a primary driver of broadband adoption in Australia. Certainly in South Korea, where 50% of users have a broadband connection (source: eMarketer), online games have played a leading role in the uptake.

The simple fact is that without this revenue stream Microsoft is living dangerously. It's estimated that to break even on games alone Microsoft must sell eight or nine per console - clearly a risk. There is no reason to suggest it can't, however the margin for error is small.

Several industry pundits are quite bullish on the market for multi-player networked games and charging a subscription for access. Gartner|G2 estimates that the market for online console gaming revenue will grow from scratch this year to over $US2.3 billion in 2005 - with each household spending $US157 per year on subscription fees. Furthermore, analyst Paul-Jon McNealy believes that 13.1% of US households will be connected to the Internet via console - not an insignificant comment considering that America's current broadband penetration rate is 12%.

The economics associated with the subsidising of hardware in the video game console market coupled with the nature of Microsoft's hardware components, means the Redmond giant has made a multi-billion bet on being able to build a new revenue stream in the form of online console gaming revenue. Failure to execute in this regard will ultimately spell financial disappointment for the Xbox and its ambitious strategy.