With complaints mounting about hardware failures in the Xbox 360, Microsoft has extended the warranty for affected systems from one to three years and will reimburse customers who've already paid for repairs. Microsoft estimates the warranty extension will cost more than US$1 billion, suggesting that millions of consoles might be affected. The move could restore the goodwill of existing Xbox 360 customers so they continue buying games—a necessity for the Xbox business to become profitable—but could drive undecided consumers toward competitors. Even so, the company remains confident that the Xbox will begin turning a profit this year.

How Big Is the Problem?

Since the Xbox 360 was released in Nov. 2005, there have been fairly consistent reports of complete hardware failures rendering the console inoperable—a type of hardware failure nicknamed "the red ring of death" because it's characterized by three red blinking lights around the console's power switch. Microsoft had claimed that the problem was rare. In Sept. 2006, however, Microsoft offered to waive the cost of repairs for any unit manufactured before Jan. 1 of that year, and acknowledged that these early units were coming in for repair at a higher rate than acceptable.

On Dec. 22, 2006, Microsoft extended the Xbox 360 warranty from 90 days to one year. However, the company did not reveal the expected cost of this warranty extension, making it impossible to guess whether this was a response to a widespread problem or merely a competitive move, as Sony and Nintendo released their competing consoles with one-year warranties.

As recently as June 15, 2007, Xbox Hardware General Manager Todd Holmdahl claimed in an interview with the San Jose Mercury-News that the "vast majority" of Xbox 360 users were satisfied, stating, "We don't have a high defect rate." However, game enthusiasts, the gaming press, and bloggers continued to complain of unusually high failure rates, and in early July, United Kingdom—based console repair shop Micromart reportedly stopped taking Xbox 360s for repair, claiming it was unable to fix most of the approximately 30 consoles per week it was receiving.

On July 5, Microsoft acknowledged an "unacceptable" rate of failures and extended the warranty for affected Xbox 360 units to three years, regardless of when the consoles were purchased. Customers who have already paid for repairs will automatically receive refunds within 10 to 12 weeks, with no action necessary, according to the Xbox support line. The extended warranty will cover only hardware failures characterized by the three blinking red lights. Other types of problems, such as scratched discs—another fairly common source of complaints—will still be subject to the one-year warranty. To cover the cost of the warranty extension, Microsoft will take a charge against earnings of between US$1.05 billion and US$1.15 billion in the fiscal quarter ending June 30 (Q4'07).

Microsoft did not describe the cause of the failures (overheating is widely suspected), nor did the company estimate how many or what percentage of consoles are affected. However, US$1 billion is enough to buy 2.5 million standard-edition consoles at their full retail price of US$400, and repairs probably cost significantly less than that, meaning that even more consoles could be covered. Microsoft has sold less than 12 million consoles to date, but the charge is meant to cover future repairs as well, and Microsoft could reduce the charge if the actual cost of repairs is lower than anticipated.

Business Fallout

From a business perspective, the warranty extension was necessary to prevent existing customers from stopping game purchases. Over the expected four-to-five-year life cycle of the Xbox 360, Microsoft believes it will break even on sales of the console itself, so game sales are critical to making the overall Xbox business profitable. (Around the Nov. 2005 launch, market research firm iSuppli estimated that Microsoft was losing about US$125 per console sale. Component and manufacturing costs have probably come down since then, and the company may be close to break-even on each unit sold.)

At the same time, the acknowledgment of quality problems could stall sales. During a call discussing the warranty extension, Microsoft announced that it had shipped to retailers only 11.6 million units as of June 30, lower than its minimum expectation of 12 million, which had already been lowered from initial expectations of 13 to 15 million. This means the company has shipped only 1.2 million units since the end of 2006, an average of 200,000 per month—much lower than the approximately 700,000 per month it shipped in the first 14 months of release. The low sales figures may reflect unexpectedly strong competition from Nintendo's Wii, which retails for US$250 and has outsold both the 360 and Sony's PlayStation 3 (which starts at US$500) in every month since it was launched in Nov. 2006, but reports of low quality probably played a part in the 360's slow sales as well.

The charge also draws new attention to the poor fiscal record of the Xbox business. Before the warranty extension, the Entertainment and Devices unit (formerly Home and Entertainment) in which the Xbox is based had lost more than US$6.1 billion since FY'02, with most of this loss attributable to per-unit losses on consoles.

In a presentation to financial analysts at the July 2007 Electronic Entertainment Expo (E3), Entertainment and Devices President Robbie Bach and Interactive Entertainment Vice President Peter Moore defended the Xbox business and explained that the company still believes it will become profitable in FY'08. Bach and Moore cited several reasons for optimism:

• Console costs are coming down exactly as Microsoft forecasted
• Xbox 360 has a more appealing game line-up for holiday season 2007 than competitors, including an exclusive on Halo 3, the latest installment of Microsoft Game Studios' strongest franchise
• The Xbox Live online service is growing faster than expected, with 7 million users (Microsoft expected 6 million at this point); some of these users don't pay a monthly subscription fee, but they may purchase downloadable content (such as casual games and high-definition TV shows), which has contributed more than US$125 million in revenue since Microsoft began selling downloads in Nov. 2005
• Many new games will be able to leverage Microsoft's May 2006 acquisition of in-game advertising company Massive, making FY'08 the first year in which advertising will contribute significantly to the Xbox business
• On average, Xbox 360 purchasers spend significantly more per console, including games and peripherals, than purchasers of the original Xbox—US$823 versus approximately US$520—and are buying more games per console (5.9) than any other console in history at this stage in its life cycle.

Despite these optimistic predictions, the warranty extension means the Xbox business will now have to recover another US$1 billion-plus to end up in positive territory for the entire history of the business.

Moore Leaving

Shortly after speaking at E3, Peter Moore announced he would retire from Microsoft effective Sept. 1 and take a new job as president of Electronic Arts (EA) Sports. According to Bach, Moore made the decision solely for personal reasons, and it was not related to the warranty extension or any other business issue. Moore joined Microsoft in 2003 from Sega and oversaw retail sales for the Xbox and other consumer products in the Europe, Middle East, and Africa (EMEA) region and Japan. By mid-2006, he was overseeing most of Microsoft's game-related businesses, including Xbox sales, marketing, and business development; the Games for Windows branding initiative; and Microsoft Game Studios, the company's game development branch.

Don Mattrick will replace Moore as vice president of the Interactive Entertainment Business unit. A veteran of the gaming industry, Mattrick founded Vancouver, Canada—based Distinctive Software, known for its racing and sports games for the PC, in 1982. EA bought Distinctive in 1991, and its portfolio formed the basis of EA Sports. Mattrick retired from EA in Feb. 2006 and has been an advisor to Microsoft for the past six months or so, according to Bach.