Xbox at a crossroads: 25 years later, Microsoft is done playing around

In 2007, Microsoft Xbox 360 consoles began to die – overheating until the three lights on the front blinked red, disabled players called “red ring of death.” Microsoft’s response was to extend the warranty on every device and charge more than $1 billion to fix the problem, making it one of the costliest product failures in the company’s history.

Microsoft couldn’t afford it financially, but the big thing was the strategy. Xbox was a gamble in the living room, and for a company making money on Windows and Office at the time, losing a billion or more was a tangible cost of staying in the game.

Almost twenty years later, that patience is over.

“Going forward, this will not continue,” said new Xbox CEO Asha Sharma in a memo to employees last month, offering a blunt assessment of a business that has spent more than $20 billion in five years, only to see its bottom line drop by nearly half a billion dollars, operating at a measly 3% profit, through Microsoft’s internal measures.

With thousands of layoffs expected to be announced across Microsoft as soon as next week, the Xbox division is likely to be among the hardest hit.

The cuts span the entire company — including sales and consulting — as part of a restructuring that has become routine late in Microsoft’s fiscal year. But for Xbox, they are the first step in a broader effort to reset the business, recoup costs, and put the division at a healthy profit.

Microsoft CEO Satya Nadella has been blunt about it: the company has spent years subsidizing Xbox rather than making a profit from it, and that time is over. The videos and live streams of people playing Xbox games that populate YouTube generate more money than Microsoft makes from the games themselves, he said in his view. Hard Fork a podcast.

“Nobody can blame Microsoft for not investing in the last 25 years,” Nadella said. “And now we have to turn this into a sustainable business.”

Long-term strategic betting

Turning it around means breaking a pattern that runs throughout Xbox history.

The Xbox was launched in 2001 and lost money for most of its first decade. Microsoft found a loss and stayed – in opposition to Sony’s PlayStation and Nintendo – because it saw the strategic prize of having part of the living room, and later the mobile phone. Online gaming also gave the company early experience using services at scale, which satisfied its cloud ambitions.

Over time, the goal changed from selling hardware to selling subscriptions.

Xbox Live, launched in 2002, turned online gaming into a steady stream of revenue. Game Pass, which arrived in 2017, allows players to pay a monthly fee — the highest tier is $23 — for a library of games, including Microsoft’s newest releases the day they come out. The idea was to get people to pay for Xbox everywhere: consoles, PCs, phones and the cloud.

And when growth slowed, Microsoft doubled down. It paid $7.5 billion in 2021 to Bethesda, the studio behind it It falls again Scrolls of the Eldersand 69 billion in 2023 for Activision Blizzard (including its games Call of Duty, Military World, Diablo and a mobile hit Candy crush) is the largest acquisition in Microsoft’s history.

A series of economic conditions

Microsoft can be patient with everything. Now it’s not that easy. In recent years, almost everything about the gaming economy has turned to the Xbox at the same time.

Hardware is losing money, and AI is making it worse. Microsoft sells consoles at or below cost, banking on games and subscriptions to make up the difference. But AI data centers use so much memory and storage that chip prices have skyrocketed. That has forced Microsoft to raise the price of its Xbox console, most recently a $100-to-$150 increase this summer that it blamed directly on component costs.

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Xbox has lost the console war. By most estimates, Sony’s PlayStation 5 outsold the Xbox Series X and S two to one. A smaller base means fewer game sales and subscriptions to make up for the losses of earlier hardware. That left the Xbox a distant second for the rest of the generation.

Income decreases. Even setting aside the games it acquired from Activision, Xbox’s annual revenue fell by nearly $500 million over five years — while operating income continued to rise. It was investing more money to get less money.

Microsoft’s latest quarterly filing shows gaming revenue of $16.8 billion in the nine months to March, down about $1.1 billion, or 6%, from a year ago.

Game Pass ends in sales. Giving subscribers a new game the day it launches lowers the roughly $70 they would have paid to buy it. The service brings in strong subscription revenue, but little economy in the games themselves.

The activation did not adjust the margins. Even with one of the most profitable gaming businesses folded, Xbox only earns about 3 cents in profit on every dollar — less than the industry’s typical 17 to 22 cents. If the biggest acquisition in company history can’t move margins, it won’t.

All the remaining billions are flowing into AI. Microsoft is pouring more than $100 billion a year into data centers and chips behind its AI push, trying to capitalize on the boom. Against such a high risk and profit margin, a game business that doesn’t even break even sounds like yesterday’s strategic bet.

What’s next for Xbox

The cuts have already begun. In recent weeks, Microsoft has signed plans to close or sell other studios, including Ninja Theory, maker of the popular “Hellblade” series.

Spending on staff, studios and advertising will increase Xbox’s profit margins in the near term. What it won’t do is fix the underlying problem: the business can narrow its path to a better number before it has to shell out more money.

Sharma’s plan, so far, is to focus on the big franchises of Xbox, to support blockbusters like Hello again It falls while retreating elsewhere. It relies on Game Pass and releases most of its games on PCs alongside its rivals from Sony and Nintendo, reaching players beyond the shrinking base of Xbox, as it holds back a few exclusives like this one. Gears of War to give owners a reason to stay.

Microsoft is also rethinking the console itself. In his memo, Sharma described a “hardware component problem” that left the company unable to make as many consoles as gamers wanted, and called for a “new business model and interoperability” for its hardware.

How far the reset goes is an open question. Information has reported that Microsoft is weighing making Xbox an independent company, joint venture, or spin-off, though nothing is imminent.

Whatever happens next, it’s clear that times have changed. In 2007, when the death problem appeared, Peter Moore, who was in charge of the Xbox business at the time, and his manager Robbie Bach approached then CEO Steve Ballmer to ask for money to repair and replace the failing consoles.

Ballmer didn’t budge. “How much will it cost?” he asked, as Moore later recalled.

Told it was $1.15 billion, Ballmer said, “Do it.”

Moore credits that decision with saving the Xbox. There wouldn’t have been an Xbox One, he said, without Ballmer’s willingness to spend more than a billion dollars to protect the brand.

But nearly two decades later, Microsoft is done writing that kind of check for Xbox.