Microsoft And The Gaming Console Battle

| About: Microsoft Corporation (MSFT)

The two major gaming players, Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE), are releasing their new consoles, Xbox One and PS4 respectively, in time for the start of the 2013 holiday shopping season. Demand is already high and Amazon (NASDAQ:AMZN) is sold out on pre-orders of the launch edition. The early pre-order data shows that the PS4 is outselling the Xbox One by approximately 2:1. A Wedbush Securities analyst expects Sony will sell 12-15 million PS4s in its first year, while Microsoft will sell 9-10 million Xbox Ones, approximately 25% less.

Also of note, the PS4 is priced at $399, $100 cheaper than its rival which is selling for $499. The price differential is slightly misleading because the Xbox One is already equipped with the Kinect sensor, whereas the PS4 motion sensor called the PS4 Eye Camera has to be bought separately for $59.99. The PS4 will allow users to use disks from the older consoles and also does not need an online connection for it to work. Microsoft is being far more restrictive in its policies for lending and reselling games and this could turn off some customers. The Xbox One also requires an Internet connection at least once every day.

The market for gaming consoles

According to NPD Group Inc, retail sales of videogame hardware, accessories and software dropped by 25% to $386.3 million in May 2013. Both hardware and software sales dropped by over 30% to $96 million and $175.1 million respectively. The market has been in decline for the last two years as users are increasingly turning to smartphones and tablets to access online games and ardent gamers are waiting for the first new consoles from Microsoft and Sony in the past seven years. Total spending on all videogame-related items was estimated at just under $800 million with physical sales accounting for half. Microsoft Corp has said that retailers in the United States sold 114,000 Xbox 360 game consoles in May, which helped it to remain the top seller for the 29th consecutive month.

Xbox One pricing strategy

In businesses such as these, it is important to get your consoles into the hands of your customers and then profit subsequently from the high volume of software and accessory sales. The importance of this is underlined by the success of companies like Gillette with razors and shaving accessories and Hewlett-Packard (NYSE:HPQ) with printers. Under the circumstances, it is difficult to understand the 25% higher pricing of Xbox One compared to the Sony PS4 in a price sensitive market. Moreover, one of the important factors in decision-making in the videogame business is the size of your online game playing networks. Because both Xbox and PlayStation are closed communities, a player using Xbox cannot play against another using PlayStation and vice versa. The value of the network is directly related to the number of people buying your consoles and it is difficult to see how the Microsoft premium gives it any particular advantage. In fact, I strongly believe that Microsoft is starting off at a disadvantage.

The investment thesis for Microsoft

Because of the sharp decline in the sales of desktops and laptops, there is an understandable tendency to write off Microsoft as a growth stock, but this could well be premature. Microsoft shares are up about 30 % this year after providing investors with little appreciation over the past few years. One catalyst could well be the impending launch of the Xbox One though, as I have said, optimism about this particular business is not particularly well founded. The fortunes of the gaming console business, which comes under the Entertainment and Devices Division, are simply not that significant. Revenues contributed only 13% of total revenue last year. If you are considering buying the stock, you should be doing so on the basis of Windows and its applications as well as its server business.

In a bid to boost sales of the Windows 8 operating system, Microsoft has established a partnership with electronics retailer Best Buy (NYSE:BBY) with its 600 outlets in the U.S. and Canada to launch "Windows Store" as a store in store concept. It remains to be seen how this is going to work out. In addition, the company has a rock solid balance sheet and holds more than $70 billion in cash and cash equivalents.

The bottom line

I think that Microsoft needs to establish its credentials for revenue growth over the next couple of quarters before an investment decision can be seriously considered. Meanwhile, I think that the stock is fully priced at its current level of around $35 and, despite the dividend yield of 2.7%, I would recommend investors hold their current position and new investors take a wait and see approach.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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