To have a successful system, you must not only sell a lot of the system, but make money off it, too. You can sell all the systems you want, but if you don’t turn a profit, you’ll go down the drain as a company.

Nintendo understands this – nay, it lives by it. While many have been irked by Nintendo’s conservative business practices, if you look at the company’s bottom line, it’s not hard to see why it has gone down the path of fiscal responsibility.

Many have made a big deal over the race between Xbox and GameCube, with Xbox in the lead with slightly over a million (19.9 million vs. 18.8 million). However, I find this lead to be more or less irrelevant. One, you have a system in another corner, Sony’s PlayStation 2, murdering each system by almost 70 million. The lead by the Xbox suddenly becomes quite small, doesn’t it?

And two, the market share comparison ignores the profitability of the systems, something I see as intrinsic to success. If Nintendo had the Xbox right now rather than GameCube, it would be struggling as a company. Xbox is not a profitable system. Microsoft can afford to lose money on Xbox simply because it is Microsoft and makes billions of dollars off other divisions, but Nintendo can’t – it sells only video game hardware and software. It’s make money or die.

Nintendo not only makes the GameCube, but also the Game Boy Advance and Nintendo DS, off which it garners many, many sales. The stated purpose of these columns is to show that Nintendo is certainly not pulling another Sega anytime soon. We can’t forget the other two systems when discussing Nintendo’s health as a company.

The most important piece of the puzzle is – profitability. Once again, the numbers aren’t hard to find – Nintendo, Sony and Microsoft, all publicly traded, are required by law to release their fiscal results every quarter. But, for whatever reason, financial health has often been ignored by the press. This column will take a look at what truly keeps Nintendo going – profit.

In the current video game market, in which consumers are demanding more and more powerful video game consoles, but also at a reasonable price, companies like Microsoft have found it necessary to sell their systems at a much cheaper cost than is required to make them. In other words, for every system Microsoft sells, it loses money. The company then hopes that the price of manufacturing lowers over time, and the lost money will be made up through software sales.

Though Microsoft doesn’t announce how much it costs to make an Xbox, analysts have put the system at over $300 – some say $375, while more conservative analysts put it at about $325. While it is true that the price of manufacturing lowers over time, and it may have dipped below $300 by now, Microsoft is now selling the Xbox cheaper than it did at launch -- $150, compared to $300. Microsoft is losing at least $100 per system sold, and possibly more, and coupled with other expenses, as you’ll see below, they haven’t exactly been able to make up for it.

Sony is facing a similar situation with PlayStation Portable (and the PS2 before that, but the PS2 was able to overcome this obstacle very quickly because of strong sales). A recent Bloomberg report says it costs 30,000 yen to make a PSP, or roughly $275. Sony is selling the PSP for $250 in America, so a $25 loss is not bad at all. But the system goes for a low 19,800 yen, or roughly $185, in Japan, meaning a $90 loss per system. Sony does say the price of manufacturing should go down soon, though, once the outsourced companies making much of the system’s parts see the system is successful.

In the final corner, Nintendo has it much better. When the system wars began, Nintendo GameCube was actually making money for each system sold, as Nintendo didn’t bother with all the extra non-gaming functions of its competitors, like DVD movie playback. The system was still making Nintendo money at $150, and it wasn’t until its $99 price tag that it was estimated Nintendo was losing money – but only in the single digits.

The same goes with Nintendo DS; Nintendo has done everything possible to keep manufacturing costs down and to make a profit with each system sold. For instance, the Nintendo DS doesn’t play GB and GBC games primarily because this would cost more money. Nikkei Electronics Asia also has a very interesting article on the cost control features of the Nintendo DS.

Now, it may be hard to understand how this affects each of the companies, but it all makes sense when we look at each of the companies’ financial reports.

Before we dive in to the intimidating world of financial reports, though, let’s define a few terms first.

First, you have “sales,” or revenue. This is a pretty raw number which tells us how much money a company made in selling products. Secondly, and probably the most important term for this discussion, you have “operating earnings,” also known as operating profit (if you made money) or operating loss (if you lost money). Operating earnings is, essentially, “sales” minus the cost of goods sold (how much it cost to make the products), marketing expenses (which the Big 3 certainly have a lot of), administrative costs, etc. So, this is where big spending and taking a loss on system sales may come to haunt a company.

Finally, you have “net profit” (or “net loss”), also known as the bottom line. This would normally be the most important thing to look at in a company’s financial reports, as it tells us the final amount of revenue a company made after taxes. However, companies like Microsoft and Sony only report “net profit” for the entire company. If we were only to look at net profit, Microsoft would win because it also makes products like Windows. In this discussion, we will look at operating earnings because those numbers are available for each of the company’s game divisions.

There is one other word of caution I must make – Sony and Nintendo have a different fiscal year than Microsoft. Yes, companies are strange and don’t start their years with January and end with December. Instead, Sony and Nintendo start with April and go through the next March in reporting fiscal results, while Microsoft starts with July and goes through the next June. While Sony and Nintendo’s most recent fiscal year results are out, Microsoft’s are not, because they are not finished with the fiscal year. For this discussion only, I will include the fourth quarter of its last fiscal year along with the first three quarters of its current fiscal year in examining financial health. (Basically, the numbers below take a look at the four most recent quarters for each company).

I’ll start with Microsoft. As I alluded to earlier, the Xbox isn’t exactly doing a lot for Microsoft financially. Every fiscal year, Microsoft has reported a sizeable loss in operating earning for its Home and Entertainment division. Now, the Home and Entertainment division does not only do Xbox – it also does PC games and Microsoft’s “TV platform” – but the Xbox makes up the largest part of the division.

The news isn’t all bad – in Microsoft’s second quarter of fiscal year 2005, the Home and Entertainment division made profit for the first time ever, thanks to $300 million in sales by Halo 2 alone and overall revenue of $1.4 billion. Microsoft ended the quarter with an operating profit of $84 million. However, the very next quarter, the Home and Entertainment division was back to where it began, with sales of $593 million but an operating loss of $154 million. That kinda cancels that one out, doesn’t it?

Backtracking, in the first quarter of fiscal year 2005, the Home and Entertainment division reported $632 million in revenue, but ended with an operational loss of $142 million. And in the fourth quarter of fiscal year 2004, the Home and Entertainment division reported $499 million in revenue, but a $339 million operational loss.

Put it all together, and for the last four quarters, Microsoft’s Home and Entertainment Division has reported revenue of over $3.1 billion but a $551 million operational loss. The Xbox’s selling at a loss, as well as very high marketing spending, were major contributors to the operational loss.

Next, we have Sony; unlike Microsoft, its games division was profitable during the most recent fiscal year. Overall, revenues were at 729.8 billion yen, or approximately $6.76 billion. Its operating profit was 43.2 billion yen, or $400 million. Still, that’s over a $6 billion drop going from revenue to operating profit, and a 36.1% drop from the previous fiscal year. One of the prime instigators, says GameSpot? The PlayStation Portable launch.

And finally, we have Nintendo. Even with three systems in its hands, including a recent launch of the Nintendo DS, Nintendo’s operating profit increased by 3.6% in the new fiscal year to 111.5 billion yen, or $1.03 billion. Its revenue was also 515.3 billion yen, or $4.77 billion, meaning a $3.74 billion drop from revenue to operating profit, compared to Sony’s $6.36 billion drop. Quite simply, Nintendo’s conservative business principles have allowed the company to turn respectable operating profits. No drop because of the DS launch or even less GCN sales here.

You may not hear a lot about Nintendo’s fiscal strength in the press, but investors understand it well. According to Reuters, in the most recent fiscal year, Nintendo was one of the few video game companies that gained in the stock market. The company's shares rose 11.3 percent in the last fiscal year, while Electronic Arts lost 3.6 percent, Microsoft dropped 3 percent and Sony lost 2.1 percent.

Just like last week, we can pretty much nail one thing right off the bat – Nintendo certainly isn’t going to pull another Sega any time soon. What we have here is a successful company that knows what it has to do to turn a profit.

We also see the fiscal consequences of managing a video game system like Microsoft, or even Sony. It should be abundantly clear that if Nintendo made the GameCube more powerful than Xbox, put DVD movie playback features into the GameCube, took the ‘Cube online like Microsoft, etc., it would only have negative consequences on the company.

Let’s be clear – Microsoft can afford to lose money on Xbox. In fact, spending as lavishly as Microsoft has done on the Xbox will only help the company in the long run, and Microsoft expects to start making profit by fiscal year 2007. But Nintendo isn’t Microsoft – they don’t have a Microsoft Windows to absorb any losses.

With Nintendo’s market share analyzed, we looked at how Nintendo’s decision to bring out a third pillar really did make sense.

Similarly, an analysis of Nintendo’s profitability helps us understand Nintendo’s path with Revolution. The PlayStation 3 and Xbox 360 will be many times faster than their predecessors, while the Revolution will only be 2-3 times faster (says USA Today, anyway). It seems clear that, if Nintendo desires to remain profitable, trying to win a video games arms race isn’t going to help much, and Nintendo has realized that.

I didn’t mention it in the article, but Nintendo ended its most recent fiscal year with its net profit skyrocketing 163% over the previous year. Next year, it expects to pull in another 75 billion yen in net profit; in comparison, Sony as an entire company (including the electronics division, games division, etc) expects to bring in 80 billion yen. And Nintendo only makes video games.

Are we really supposed to believe Nintendo is struggling?

Success is a funny thing. Most of the time, as video gamers, we have a tendency to look at how game companies are doing from our glasses only, meaning how many sales their consoles have made in North America and how much third-party support each system has - and that’s to be expected.

But when we take a step back and try to see the big picture, especially from Sony, Microsoft and Nintendo’s perspective, we see a different ball game. Suddenly, we see that Nintendo is actually pulling in a nice amount of cash, that Nintendo depends on more than just GameCube for market share, and that Microsoft isn’t doing as well in territories like Japan as it is in North America. When we determine the success of companies like Nintendo, we must not limit ourselves to simply North American console sales.

-Johnathan Coley