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MSFT's new Xbox One introduction tainted by negative reaction to DRM

Last month Microsoft (NASDAQ:MSFT) joined competitors Sony (NYSE:SNE) and Nintendo in announcing its new gaming console. There has been some excitement already; Nintendo offering a large touch screen, and Playstation a new controller. Microsoft's introduction of the Xbox One (thenew console) has taken video and voice interaction to previously unimaginable heights.

However, most of the buzz related to technology enhancements was offset by negative feedback from gamers regarding Digital Rights Management (DRM) issues. This week, Microsoft did an about face with respect to DRM, reversing its position on requiring games to be played only while online and permitting the trading-in, lending, reselling, gifting and renting of games.

The stock price showed almost no reaction to any of the announcements regarding Xbox One. In the last month MSFT has traded in a fairly narrow range from a closing low of 34.15 on May 23 to a closing high of 35.67 on June 7. This is not surprising, since MSFT's generates just 5% of consolidated operating income from the Entertainment and Devices business segment (which includes Xbox and video games).

Xbox One could change its business model to include significant advertising revenue

While the Xbox has not produced mountains of cash for Microsoft in the past, the Xbox One might just change everything. In the past, this was due to the fact that the console had to be sold at a loss initially, with the expectation that profit would be generated from the sale of games. This business model, which the video game industry has been built on, might change forever. Microsoft has truly made a game-changing move (no pun intended) with one essential hardware fixture.

For readers who own an Xbox 360 themselves, they might be familiar with the Kinect apparatus that is paired with recently sold 360s or bought separately for older ones. The Kinect is a USB device loaded with cameras and software to read the player's movements and recognize the user's voice for gaming gestures, commands and chatting online. This currently marketed Kinect device seems like it might have merely been a beta-version for the newest version, the Kinect 2.0, which comes in-box with the Xbox One.

Some might find Kinect 2.0 features creepy and some might find them cool. However, from a business perspective they provide Microsoft with an innovative mechanism for marketing ads to consumers. The Xbox One will not turn on without the Kinect 2.0 plugged into the Xbox. The Xbox One can be turned on by voice with the Kinect 2.0 even when the console is turned off (the Kinect 2.0 is always listening). The Kinect 2.0 is so sophisticated that it is able to read accurately both the user's pulse and emotions, and listen to ongoing conversations. In addition, Microsoft has patented the ability to advertise to the user based on this information. The Kinect 2.0 has infrared cameras and is difficult to trick.

Previous generations of consoles, including but not limited to the Xbox, have never been able to effectively advertise to gamers. In some games that take place in cities, there might be a billboard that updates every so often to advertise something new. There might be advertisements on home-screens of consoles before the game loads. While video games have surpassed the movie industry in terms of revenue, they have not been as effective in generating advertising revenue (like the product placements that are in movies).

The Kinect 2.0 for the new Xbox Onewill allow for unprecedented advertising opportunities

Kinect 2.0 will be able to see and hear what is going on in front of the camera. If two friends are talking about where to get some food, a Domino's Pizza advertisement might appear in their game in real-time. It will be able to see what type of soft drinks and snacks you like and what type of clothes you wear. It will likely be able to determine your race, your approximate height and weight. By listening, it will learn your consumer preferences.

Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) have built advertising-based business models that are highly successful because they have gathered significant information about their users. Google and Facebook know about users from the sites they visit and the information in their profiles, but also from various apps (such as Google Maps) that provide a wealth of information about a user's whereabouts and activities. Microsoft takes this information gathering one step further by essentially putting a camera and microphone in your home.

A recent survey conducted by the Interactive Advertising Bureau (IAB) and PwC estimated first quarter 2013 digital advertising revenues in the U.S. at $9.6 billion, up 15.6% over the prior year period. This number seems conservative considering that Google by itself reported $13.0 billion in the revenue line item: Google (advertising and other). However you measure it, advertising is a big opportunity for Microsoft considering the hours spent playing games and the ability Kinect 2.0 will have for gathering information and targeting users with relevant advertisements. And at this point, this powerful tool is exclusive to Microsoft.

The addition of advertising revenue for MSFT could produce a major boost to earnings. Assuming that MSFT can capture just 20% of the rapidly growing market for online advertising (generating $8 billion in annual sales) and earn 20% net margins, Xbox-related advertising could contribute an additional $0.24 in annual EPS. This is rather significant considering the consensus estimated EPS for 2013 is $2.75.

Advertising potential enhances investment thesis

After being considered dead money for most of the past decade, MSFT has produced 31.5% year-to-date returns versus 15.3% for the S&P 500 Index. These returns have come as MSFT has reported two consecutive quarters of handily beating estimates. In the most recent quarter, EPS were up 20% over the prior year, despite significant weakness in PC shipments. While the Entertainment and Devices business segment has historically been a small contributor to earnings, the introduction of Xbox One could provide a new growth engine for MSFT, especially if the potential for advertising revenue is fully exploited.

With MSFT selling at just 11.2 times forward EPS estimates, investors are obviously skeptical about its ability to generate future earnings growth. At its current P/E ratio, MSFT trades at about a 24% discount to the broad market. In addition to strong positions in its major business segments, advertising revenue could provide MSFT with a significant area of growth that is not currently anticipated by the market or incorporated into its current stock price valuation.

Source: New Xbox One Could Provide Major New Growth Engine For Microsoft: Online Advertising