Earnings Outlook: Microsoft earnings: 3 ways videogames can bring in more cash

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As investors approach Microsoft Corp. and its fiscal third-quarter earnings, they should begin to expect to see predictable videogame revenue instead of the cycles of sales they have become accustomed to.

Microsoft has three major ways it can drive millions of dollars more in videogame sales: Look beyond Xbox to other devices — especially mobile; capitalize on micro transactions and subscription revenue; and lure developers to the company’s nascent Azure unit, according to UBS analyst Jennifer Lowe.

The Xbox franchise has enjoyed undeniable success as Microsoft heads into its earnings announcement, scheduled for Wednesday after the bell. Launched in 2005, the Xbox division banked $9 billion in revenue in fiscal 2017. While the console market continues to grow, other categories of gaming are growing much faster, spurred by the popularity of digital downloads and the ubiquity of powerful mobile devices, such as the new line of iPhones from Apple Inc. AAPL, -1.39%  .

“The console market remains an important part of the gaming ecosystem, but the biggest influx of gamers has come through other channels,” Lowe wrote in a note to clients last week.

Microsoft breaks out a growth percentage for its gaming revenue but does not disclose exact revenue figures.

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The advent of digital downloads, for example, presents Microsoft MSFT, -2.34%  with a high-margin opportunity. Instead of taking royalty fees for third-party titles in the 10% to 20% range, Microsoft would be able to charge about a 30% revenue share on games downloaded from its digital store, according to Lowe. Margins are also significantly better because there are no manufacturing royalties or costs of physical distribution and production.

Azure is one of the most compelling cases. Gaming on demand — similar to the so-called over-the-top streaming video content services offered by Netflix Inc. NFLX, -3.66%  — as well as games hosted on Microsoft’s servers have higher margins than the console-based games running off physical media.

After seven years of declines in gross margins, gaming will help it grow the 50 basis points a year Lowe currently models in Commercial Cloud.

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Much like how Office 365 helped Microsoft lure corporate customers to its Azure services, Lowe said Azure has the same potential with game developers. Once developers use Azure for one task, it’s likely they will have more appetite for premium services such as the company’s artificial-intelligence offerings.

“We think the evolution of the gaming market represents a much richer set of opportunities for Microsoft today, with a larger revenue base and better unit economics, as well as an opportunity to pull through demand for Microsoft Azure services,” Lowe wrote.

Lowe has a buy rating on Microsoft with a $110 price target.

What to expect

Earnings: On average, analysts model fiscal third-quarter earnings of 85 cents a share, according to FactSet. Contributors to Estimize, which crowdsources estimates from analysts, fund managers and academics, predict earnings of 89 cents a share on average.

Revenue: Analysts polled by FactSet estimate Microsoft will bank $25.77 billion in sales for the fiscal third quarter, and contributors to Estimize predict sales of $25.88 billion. Of the total, analysts expect the LinkedIn unit to contribute $1.22 billion, intelligent cloud — a division that includes its Azure product line — to bring in $7.68 billion and its commercial office software business to earn $6.01 billion.

Stock movement: Microsoft stock has gained 3.3% in the past three months, as the benchmark S&P 500 index SPX, -1.34%  fell 6%. Microsoft stock is up 43% in the past year while the S&P 500 gained 14%.

Of the 35 analysts who cover Microsoft, 27 have the equivalent of a buy rating on the stock, seven rate it a hold and one has a sell. The average price target is $105.49, which represents a 13% upside from its Tuesday close.

What to watch for

Microsoft’s cloud endeavors remain of consistent interest to analysts and investors, as the company moves more of its products and services in that direction.

“We remain positive on Microsoft’s earnings as Azure and Office 365 continue to grow within the mix and as commercial cloud gross margins expand,” RBC Capital Markets analyst Ross MacMillan wrote in a note to clients Sunday.

MacMillan has a buy on the company with a $105 price target.

In his note, MacMillan wrote that he expects a 93% jump in Azure growth, compared with the year-earlier period. He also expects Azure margins to grow.

He noted that the restructuring of the engineering teams at Microsoft in late March will have a minimal impact on operations. MacMillan wrote that the company has discussed investing $5 billion in internet-of-things research, products and services over the next four years — for a total of $14.5 billion of research and development expenses in fiscal 2018.