Microsoft's Next $1B Xbox Mistake?

(MoneyWatch)  Being popular can be dangerous if the attention brings liabilities. Microsoft found that true when, back in 2005 and 2006, many of the new Xbox 360s developed the "red ring of death," eventually forcing the company in 2007 to extend the product warranty and take over a billion dollar charge to cover the necessary repairs and replacements. Now there's a new problem, called the E74 error, that is also causing a hardware failure and shaping to be not just another public black eye, but, given the volume of Xbox 360s that have sold, possibly the source of another massive charge to cover unit replacements.

In the E74 problem, the phrase "System Error: Contact Xbox Customer Support" appears in nine different languages, followed by a large "E74" at the bottom of the screen. The error is apparently not always complete disaster, and sometimes it is possible for a user to recover from it. But it is happening frequently enough that Microsoft released the following statement:

While the majority of Xbox 360 owners continue to have a great experience with their console, we are aware that a very small percentage of our customers have reported receiving an error that displays "E74" on their screen. After investigating the issue, we have determined that the E74 error message can indicate the general hardware failure that is associated with three flashing red lights error on the console. As a result, we have decided to cover repairs related to the E74 error message under our three-year warranty program for certain general hardware failures that was announced in July 2007. We have already made improvements to the console that will reduce the likelihood of an occurrence of this issue. Detailed information related to the Xbox 360 warranty and resources for those who require repair can be found at www.xbox.com/support (www.xbox.com/support) .

Microsoft will refund to customers the amount paid for an out of warranty repair due to a general hardware failure associated with the e74 error message. Those customers should automatically receive the refund within 4-12 weeks, and no additional action by customers should be necessary. However, if a customer has not received a refund by July 1, 2009, the customer should visit www.xbox.com/support before November 1, 2009 for information on how to place a claim. All refund claims must be received on or before November 1, 2009.

Depending on the number of units on which Microsoft must make good, this could be pretty expensive. I've been told in the past by Microsoft that the company plans on a three year loss on a game console, followed by two years of profitability. A single big problem like the red ring of death can turn those plans inside out. According to the 2008 10-K, the Entertainment and Device Division, of which the Xbox is part, actually saw an operating profit of $426 million for the year. But the loss for the previous two years, including the $1.1 billion charge that the company took, was $3.31 billion. That already badly affected the five year view that Microsoft takes. If the cost of this disaster is another billion, that could conceivably make the Xbox 360 a net loser. Of course, charges taken are for actual out-of-pocket expenses that the company will face, not the costs of:

• public relations
• customer confidence
• management and staff distractions

Microsoft has been in a solid unit sales position between Nintendo and Sony (actually third place of four, as Nintendo owns the first two spots). But having another major hardware error must be raising questions at Microsoft as to what it will take to make the units work, and possibly whether it's even worth being in this line of business, if five years could leave it with no financial advantage to show. Has the company been cutting the design costs too much to stay fiscally competitive? And will this setback necessitate a delay in future Xbox models? The current model will have been around for five years come 2010, and there's only so long Microsoft can expect to sell variations on the same unit. But clearly something has to happen in the division, because two billion dollar mistakes is two too many.