Huge Xbox losses hidden by patent royalties, says analyst

Microsoft is hiding billions in losses from its Xbox gaming business, according to Nomura analyst Rick Sherlund. In a note to investors yesterday, Sherlund laid out a plan suggesting what steps Microsoft should take to resolve its current CEO vacancy and address some key issues going forward. One of Sherlund's key points in the note is that the Xbox platform, despite being largely viewed as a success, is actually losing huge amounts of money for Microsoft, according to his own estimates.

"If we start with the overall traditional [Entertainment and Devices Division] business that actually loses money before corporate allocations and back out the nearly $2 billion 95 percent gross margin Android phone royalties, we conclude that Xbox platform plus Windows phone and Skype lose about $2.5 billion per year, and we estimate that the Xbox platform may account for roughly $2 billion of this," Sherlund said. "This is contrary to conventional wisdom, we think investors do not realize how extensive the operating costs are for this business and it is concealed by the hugely profitable Android royalties."

The Android royalties mentioned are the result of patents Microsoft holds on technology that Google infringed upon in developing the operating system. Microsoft has signed numerous licensing agreements with the manufacturers of Android and Chrome OS devices--Acer, LG, Samsung, and HTC among them--that bring in revenue while letting those companies continue using Android on their devices.

"Xbox is an orphan in our view," Sherlund said. "It is a 'cool' product line and a successful consumer franchise, but it also loses a lot of money and we think is a distraction to the more enterprise strengths of Microsoft."

As for the narrowing cast of potential CEOs for Microsoft, Sherlund said it is likely that Ford's Alan Mulally will be appointed to the position by December.

Sherlund first made headlines for advocating Microsoft spin-off its gaming business back in June.