Netflix and Microsoft Partnership Defines Future of Movie Distribution

I have been watching E3 2008 for a couple of reasons this year. The first is because I am a casual gamer and E3 is the grand-daddy of all video gaming conventions and let’s face it, there is nothing great on TV these days anyway. The second reason is to get a glance at the upcoming title releases and get investment ideas. <o:p></o:p>

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Nintendo keeps on going with its consoles still not meeting demand. Economic factors has still kept a lid on demand so their consoles will be the one to own for some time yet, but I wanted to talk about Microsoft here.<o:p></o:p>

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Microsoft (MSFT) has, in a relatively short amount of time, established its Xbox brand and how. Currently Xbox 360 has a larger install base in the US with over 5 million units ahead of Sony’s PS3. Their software sales raked in $2.7 billion over the last 12 months and 3rd party gaming revenue for the Xbox was more than both PS3 and the Wii. More importantly, Xbox’s online entertainment business has generated over $1 billion in sales since launching over 2 years ago with revenue from movies and TV shows contributing over a third of the online revenue.  The company claims to be the world’s largest provider of hi-def on demand TV shows and movies. Most importantly, Microsoft announced an exclusive partnership with Netflix (NFLX) to deliver Netflix’s library of movies via downloads on the Xbox 360. And with the updated Xbox interface due for launch this fall, downloaded movies can be shared with your Xbox friends. While a far cry from Apple’s iTunes success, Microsoft has Amazon’s Unbox, and Apple’s AppleTV beat with their offering. <o:p></o:p>

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Finally, the titles releasing over the next 6 months will certainly increase Microsoft’s Xbox sales. Gears of War 2, Fallout 3, Far Cry 2 and Rock Band 2 as well as the addition of Karaoke software title Lips, and family games like Scene It and UNO Rush will keep gamers of all genre and intensity engaged. <o:p></o:p>

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The Microsoft stock (MSFT), although having recovered some 10% this week, and lost it all after hours today after an earnings miss, is a cheap stock to own. But cheap doesn’t necessarily mean good. The stock is at the same levels today as it were over 10 years ago, despite the company’s revenues increasing significantly over the same period. Having said that, it is the least riskiest stock to own at these prices. At some point, the company has to increase its dividend or make some structural changes to bring more value to their investors. <o:p></o:p>

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As far as Netflix (NFLX) goes, their partnership gives them access to a different type of customers and a significant base of 10 million strong Xbox 360 consoles to convert into long-term customers. This is a good move on their part although the terms of the deal would give us a better indication of how much this will add to their top line growth. I think though that the stock looks attractive here, trading at 18 times next year’s earnings with a small market cap of $1.71 billion. <o:p></o:p>

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Just to recap, I am recommending a buy on MSFT (at $25) for long term conservative, risk-averse investors and a buy on Netflix. <o:p></o:p>

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--Faisal Laljee<o:p></o:p>

Full Disclosure: I own MSFT but no NFLX. My position can change anytime without notice. <o:p></o:p>

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