Microsoft's Entertainment Segment Wins at E3

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Microsoft (NASDAQ: MSFT) came back to the E3 conference with a strong lineup of games. The company is hoping to build on its strong track-record of growth in consumer electronics by investing time and effort into studios across the world in order to build exclusive content.

Microsoft is building new in house gaming franchises like Ryse Son of Rome while at the same time, depending on bread and butter franchises for growth. The company plans to release another sequel to the Halo franchise, which should stimulate growth in the entertainment division in 2014. The company plans to launch the Xbox One in November 2013 with a $499 price tag for the United States.

Xbox One Impact on Growth

Currently, the entertainment segment is Microsoft’s fastest growing segment. The company plans to sustain the growth of Xbox Live subscriptions by offering two free games per month to subscribers. This may help to put a floor underneath the digital demand for video games and give developers added incentive to create unique video games without worrying about the risk of not meeting the break-even point for game development.

The Xbox One has been able to attract some of the best video game sequels such as Forza Motor Sports 5, Electronic Arts’ (NASDAQ: EA) Battle Field 4, and Dead Rising 3. Activision Blizzard (NASDAQ: ATVI) is also planning to release its next generation Call of Duty and Diablo 3 for the Xbox One.

The Xbox One also comes packed with recording capabilities. Xbox Upload Studio goes head to head with Sony’s recording and sharing software on the PlayStation network. Both Microsoft and Sony are integrating features that help the consumer share video gaming content. Video gaming is starting to become a sport, and because of this, more advanced recording features are necessary in order to encourage gaming into becoming its own spectator-driven sport.

Console refresh hitting Activision Blizzard’s guidance

In anticipation of the console refresh, Activision Blizzard anticipates EPS guidance of $0.73 for the full-year (in 2012 the company earned $1.18 per share). The significant decline in earnings is driven by the rapid increase in research and development expenditures.

In the last console refresh cycle, Activision Blizzard was overly dependent on the World of WarCraft franchise, which eventually reported declines in both subscriber figures and net income because of competition in the massive multiplier online role playing game space. World of Warcraft players are starting to become fatigued by the gaming experience and are investing time into other video games.

The company anticipates that the operating expense margin is expected to increase from 40% to 49%. Operating expenses are going up in order to address the constraint in video game development for the console refresh.

Both Xbox Live and PlayStation Plus subscriptions give games to the subscriber’s collection every month. The collective bargaining power of the 56 million Xbox subscribers allows for this content redistribution. The subscription model is giving added incentive to game developers to develop games as it is easier to predict future buying patterns with a subscription distribution rather than a retail distribution. As a result, game developers are putting up the research and development dollars today in order to increase year-over-year earnings growth in future accounting periods.

Electronic Arts expects gross margin improvements

The company reported weak earnings result for the first quarter of 2013 because demand for console games is likely to decline in anticipation of next-generation games. This is a seasonal trend and is likely to be temporary. The company trades at a 73.8 earnings multiple because analysts anticipate substantial earnings growth once the negative carry-over effect of a console transition are through.

For now, developments in the console space are allowing Electronic Arts to give off some strong guidance in terms of cash flow (which is expected to grow by 23.45%). This is mostly driven by declining gross margin (the improvement in gross margin is driven by digital downloads which will lower distribution costs i.e. Cost of goods sold).

Analysts anticipate the company’s release of next generation games paired with the declining cost of goods sold to lead to substantial growth rates in earnings. Analysts believe that the company will grow earnings by 40.5% for the current fiscal year and 19.50% growth in the 2015 fiscal year ending in March. The company’s growth may experience even greater upside if holiday sales of both the PlayStation 4 and Xbox One beat analyst expectations.

Conclusion

Microsoft’s entertainment division was able to grow earnings 56% year-over-year in its latest quarter. The growth in sales must be sustained in order for Microsoft to offset the decline in Windows license sales that is anticipated for the rest of the calendar year.

Microsoft has been able to grow Xbox's market share to 44%, and it is likely that Microsoft will try its best to fend off competition in the console space. The company’s line-up of Microsoft Windows 8 tablets may, at some point, become fully integrated as an alternative console controller leading to further upside in mobility sales.

What’s keeping Microsoft’s stock price grounded is the growth in entertainment and mobility, services, and servers. The company cannot afford a slip-up in any of these segments as the company is running on three cylinders out of four to generate growth.

It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In a new premium report on Microsoft, a Motley Fool analyst explains that while the opportunity is huge, so are the challenges. The report includes regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.


Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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