Microsoft (NASDAQ:MSFT) has been on good run this year, up nearly 20% in 2013, better than the broader market.
Part of the enthusiasm likely stems from the new Xbox video game console, which the company revealed earlier this year. While the Xbox One console will likely be a hit with gamers, are investors right to place their hopes on a new video game system?
Putting Microsoft and video games into proper context
Microsoft is one of the world's largest and most profitable companies. It operates in five core segments: Windows & Windows Live, servers and tools, online services, Microsoft business division, and entertainment and devices.
In all, Microsoft generated $77.8 billion in fiscal 2013 revenue, up 5.5% from the previous year.
However, some business lines are more important to Microsoft than others. Microsoft has three core segments that comprised 83% of the company's fiscal 2012 revenue: Microsoft Business, servers and tools, and Windows & Windows Live.
Meanwhile, the entertainment and devices division -- the segment responsible for developing and producing the Xbox -- made up just 13% of the company's revenue last year.
Even looking at the years immediately after the release of the Xbox 360, the division was still just a drop in the bucket.
By using history as a guide, we can see clearly that the last wave of consoles didn't produce the home run that investors may be expecting this time around.
The last console Microsoft released was the Xbox 360, which hit store shelves in 2006. Not surprisingly, the company's entertainment and devices division saw impressive sales growth over the following years. This division racked up 35% revenue growth in 2006 and 28% revenue growth in 2007, thanks to the newly released Xbox 360.
However, it's worth noting that Microsoft's entertainment and devices division actually reported operating losses in both 2006 and 2007. The Xbox was not a profitable venture for Microsoft when the last console was released.
This is why it seems that a rally in Microsoft's stock based on excitement over the new Xbox One console may be misplaced. Microsoft is a huge company, and the Xbox simply doesn't move the needle.
This all stands in contrast to fellow console maker Sony (NYSE:SNE), whose own PlayStation 4 console will compete directly with the Xbox One, and is set for release in November. While Sony has other operations outside the PlayStation, it's an electronics company through and through.
Sony's consumer products and services division, which includes its PlayStation console, accounted for nearly half the company's 2012 revenue. Consequently, Sony's new video game system is much more important than the Xbox is for Microsoft, relatively speaking.
Console enthusiasm is a likely reason for Sony's own impressive rally to begin 2013. After ending last year at $10 per share, Sony has doubled since then, to its current level near $20 per share.
Investors may be right to be optimistic about Sony's PlayStation prospects. According to Forbes, preorders for the PlayStation 4 are actually higher than the number of PlayStation 3 consoles sold in the entire fourth quarter of 2006.
There are plenty of reasons to buy Microsoft
Microsoft has a clean balance sheet with billions in cash on the books, a modest valuation (trading at 12 times earnings vs. a high-teens multiple on the S&P 500), and pays a solid 2.8% dividend. It's a highly profitable company and the case for buying Microsoft is a strong one -- just not because of the Xbox.
While the new Xbox system will likely sell tens of millions of units worldwide, the benefit to Microsoft is negligible. Microsoft is a strong cash-flow generator, but its biggest sources of all that cash do not involve gaming. Put simply, if you're buying Microsoft, your future returns are much more dependent on the company's Office software and Windows operating system than on the new Xbox.
As a result, investors hoping the new Xbox console will serve as a new growth engine for Microsoft are likely to be disappointed.