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A Software Titan Looks to Get Hip Once Again

|Includes: GS, Microsoft Corporation (MSFT), SNE

Those prescient words, uttered by Chauncey the Gardener in the film Being There, is an annual rite of passage for tech stocks, which tend to rally each spring. Not this time. Instead of growth, the group has fallen sharply, thanks to a high degree of exposure to Europe and the weaker euro. The pain has been especially notable for Microsoft (Nasdaq: MSFT), which has lost roughly $45 billion in market value this spring.

While the weakening euro will surely crimp profits in the current quarter, Microsoft has more than a few arrows in its quiver -- a point brought home at a technology conference this past weekend. Microsoft unveiled a new product, called Kinect, which may not have a huge impact on the bottom line, but should show investors that it can still create compelling software and generate impressive synergies in its various divisions.

The Next Wii
While Microsoft and Sony (NYSE: SNE) were busy one-upping each other for the title of most hardcore video game platform developer, Nintendo went the other way. Its Wii platform proved to hold great appeal for families that didn't tend to like shoot 'em up or racing games. The Wii's motion-sensing technology let users play an interactive game that got users up off the couch. Microsoft's new Kinect will match the Wii's functionality, with a host of other features to boot.

Rather than wave a wand as Wii users do, Kinect will come with a full set of body motion sensors. This will allow for full 3-D motion capture and facial recognition. Built in microphones will also allow for voice-based interactivity with the device. Most importantly, the (estimated) $150 device is simply an add-on to Microsoft's existing Xbox console, extending the expected usable life of that platform for many years. By adding features such as a massive hard drive and WiFi and incorporating access to social networking sites and the ESPN sports network, Microsoft views the platform as a potential all-in-one gaming and entertainment device.

Microsoft is unlikely to make money on the Kinect hardware, but high-margin software sales could get a solid lift while the company also signs up more subscribers to its $50 annual plan that provides a range of premium services like multi-player online gaming. Kinect is expected to be released later this year ahead of the key holiday selling season.

Most importantly, Kinect could give investors a sense that Microsoft is once again a cutting-edge entertainment company, justifying the untold billions it has poured into video games, MP3 players and online platforms. A smartphone or tablet device like the iPhone or the iPad that runs on Microsoft software could ultimately tie all of these offerings together. Unfortunately, Microsoft is behind schedule on this effort, and the company thinks it will be several more quarters before it can release a stripped-down version of its Windows 7 software to power such a device.

Waiting for the Cycle
When Microsoft released Windows 7 last year, it hoped many enterprises would notice the sterling reviews and decide to upgrade their computer systems. But IT spending has been cautious thus far. A turn may be at hand. Goldman Sachs (NYSE: GS) recently surveyed large firms and found that an increasing number expect to finally move to Windows 7 in the second half of this year and the first half of 2011. That migration is seen as the biggest potential catalyst for shares.

Analysts think Microsoft can boost sales close to +10% in the fiscal year that begins July 1 as the Windows 7 upgrade cycle begins in earnest. Profits should grow at a slightly faster pace thanks to an ongoing stock buyback plan that has already eliminated 1.5 billion shares from the market during the past three years. If the new Kinect is a hit with consumers, investors are likely to reward the entire consumer division with a higher valuation, pushing shares back up into the low to mid-$30s, implying +20% to +30% upside with very little downside.

Disclosure: No positions