Breaking Up

There has been much heat, and little light, in the media this week regarding comments made by Goldman Sachs analysts - who argued, in a note explaining their downgrading of the company's stock from "Buy" to "Neutral", that Microsoft would be best to spin the profit-challenged Xbox division off into a standalone company.

The reaction in some quarters has been nothing short of furious. It's seen by many consumers - whose attention has been drawn to it by unfairly negative coverage of Goldman Sachs' statements on various websites - as a slight on the success of the Xbox, an unwarranted criticism of the business by financial analysts who don't really "understand" the videogame market. Many calmer minds within the games business also find the proposition somewhere between simply unpalatable and outright bonkers.

Yet neither of those positions is entirely fair - and even if Goldman Sachs' statement is tough to agree with entirely, the sentiments expressed by the analysts at the firm are grounded in a pretty reasonable view of what's happening at Microsoft.

Firstly, let's dismiss the idea that this was some kind of dismissal of the success of Xbox. On the contrary, the report goes out of its way to note that very success and the rapid growth in the cachet carried by the Xbox brand. It's this very fact that leads Goldman to believe that the Xbox business has the fundamentals in place to be a successful standalone business unit.

Although the firm reckons the Entertainment and Devices division (which includes, and indeed is dominated by, the Xbox business) is Microsoft's least valuable division by quite a margin, it still estimates its worth at some $3.6 billion - hardly small change, and not an unreasonable figure for a business which despite its consumer success has unquestionably struggled with profitability over the years.

Moreover, let's do away with the widely circulated notion that this report in some way blamed the Xbox for the decision to downgrade Microsoft. On the contrary - the recommendation regarding the Entertainment and Devices division was practically a footnote (albeit a controversial one), with the clear rationale behind the downgrade being lengthening life cycles in the PC market, meaning less Windows licenses sold, along with strong evidence of tablet devices (in which Microsoft doesn't have much of a foothold) eating into sales of low-end laptops (which generally run Windows).

While we're at it, it's worth noting that the 2 per cent drop in Microsoft's stock following the release of Goldman's report was broadly in line with the movement of other similar stocks that day, suggesting that even if the report set gaming blogs the world over alight, it didn't actually nudge the stock market in any meaningful way. That's pretty much what you'd expect from a single firm shifting from Buy to Neutral based on evidence which is already out in the open and has been factored into Microsoft's share price for weeks if not months. Analyst reports rarely influence the mood of the markets in any meaningful way, and this one was far from explosive.

So Xbox is off the hook. It's not dragging Microsoft down - frankly, for all that the division wields enormous clout within the games business, it's little more than a pebble on the side of the sturdy mountain which is Microsoft's finances. Nor did Goldman's comments on the division have the slightest impact on Microsoft's share price. Calm down.

None of which is to say that Goldman Sachs' idea isn't outright fascinating. The argument they're making is straightforward. Up until this point, the Xbox division has been treated as something of an experiment by the wider company, which has - for the most part - been content to pump money into the division and its various projects, ranging from the successful (the Xbox itself) to the unproven (Windows Phone) and right through to the miserable failures (Zune).

More recently, there's been evidence of a struggle within Microsoft between two opposed camps - those who believe that the Xbox should still be treated as an experiment, or a land-grab, and thus heavily subsidised, and those who believe that the console's success means that it should now be paying its own way. The conflict between those in favour of further market growth and those in favour of monetisation has been most clearly seen in the mixed messages regarding Kinect, but it's a debate which goes to the very core of Microsoft's entire console strategy.

What Goldman Sachs proposes, in essence, is a dramatic end to that debate. By spinning off the Xbox business unit as a separate company, the division would be forced to think long and hard about profitability, to rein in its spending and start acting like a real business, rather than a costly, heavily funded experiment. It's reasonable to assume that such a move would collapse the factions within the division - while it would be a victory for the monetisation camp in principle, in reality it would force both sides to work together to find realistic ways to line up their thinking and keep the business afloat.

As a consumer or as a member of the wider games business, this is potentially very uncomfortable thinking. In theory, we'd all prefer for a platform holder like Microsoft to continue splashing cash around like there's no tomorrow. A business that's more focused on profitability is, one might argue, one which is less likely to take risks, less likely to pursue original approaches to development or new business models, less likely to subsidise new ideas in the hope of future breakthroughs.

Those fears are reasonable, and they're all solid reasons for the industry to dislike Goldman Sachs' proposal. However, there's another angle from which one can look at this suggestion - which is that there's a wealth of history to show that failing to show solid regard for profitability can result in worse products and less innovation, rather than the explosion of creativity and original thought one might expect.