MoneyWatch Tech

Trying to Decipher Microsoft's Entertainment Division

By Erik Sherman

Updated on: September 8, 2008 / 8:26 AM EDT / MoneyWatch

This weekend, a reader emailed and upbraided me for missing that Microsoft had signed new parts deals and moved to a smaller GPU die, all of which should theoretically saved money and reduced the costs of the Xbox 360. We went back and forth a bit, only agreeing that Microsoft seemed desperate. In the process, I dug out the most recent 10K available, went though some explanations -- and came away more perplexed than ever.

In its fiscal year 2008 (ending June 30), the revenue of the entertainment and devices division was $8.14 billion and there was actually a profit: $426 million. That amount still seems pathetic when compared to what Microsoft might ordinarily charge -- until you examine how the company breaks out revenue and expenses:

Due to our integrated business structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products and services included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses.

When I read through the detailed description of what the entertainment and device division was, my jaw fairly dropped. The products are easily listed:

Xbox 360 console and games
Xbox Live
Zune
Mediaroom
many consumer hardware and software products (including mice and keyboards)
Windows Mobile software and services platform
Windows Embedded
Windows Automotive
Surface

Much of this makes sense, though you could argue that the specialized versions of Windows might better be considered with -- Windows. However, where things get pretty strange is when you consider the division "is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems." Yup, everything is takes to sell Office and Windows to consumers gets ascribed to this division. That suggests two really big points:

Given that the division made a profit even with all the push for Vista, it might be making a heck of a lot more money.
The Office and Windows product lines are showing enormous profit partly because one of the biggest expenses, marketing/sales, gets ascribed to another division.

That has got to be one big inter-departmental transfer. Microsoft says that the division has typically generated 40 percent of its revenue in the second fiscal quarter, otherwise known as the last three months of the calendar year. When you realize that games consoles and titles and maybe consumer hardware (to accompany new PC systems) are probably the major generators of that revenue, maybe I've had it backwards. Could it be that games are actually underwriting billions of dollars of what would otherwise be Windows and Office costs, thus propping up the paper profits?

Why would Microsoft do that? Maybe because stock price is so important to the company and management, and anything decreasing the apparent fiscal strength would not be appreciated by the investment community. What better way of making Vista look stronger than to have a 12 percent operating income increase from 2006 to 2007 and a 14 percent increase from 2007 to 2008.