Event:

Microsoft presented its Keynote today at E3

Conclusion:

Modest Positive for ATVI, ERTS, THQI, TTWO, UBI. We believe Microsoft’s new technology code-named Natal (see details below) is a potential important addition to the 360 platform that will at least enhance it as a multimedia and casual game device. The further expansion of the casual games business is positive for the third-party publishers, especially because they should be better leveraged to the expansion because Microsoft isn’t as competitive with casual gamers. To the extent that Natal eventually enhances hard-core games it could offer another reason for consumers to choose video games over other forms of entertainment.

Details:

If Natal works, it is going to be great for Microsoft. Microsoft’s introduced its new Natal technology, a 3D motion-sensing camera thattracks movements and recognizes voices for a controller-free experience, which was by far its biggest announcement. Microsoft acquiredmost of the technology from 3DV Systems in early April, which helped it to get a working prototype faster than developing it internally.Because it came from outside of Microsoft, it is unclear whether or not Sony or Nintendo would be able to develop similar technology.However we believe they could, which would limit any long-term advantage for Microsoft IF either did. Regardless, the technology is enough of a game-changer that instead of Microsoft looking like a slow follower in developing an alternative controller mechanism (like a motion-sensing wand), it appears it will now take a more advanced position technologically than Nintendo or Sony.

3DV was a small acquisition. 3DV was founded by two Israeli defense industry scientists who developed and patented the cameratechnology in Natal. It can figure out depth relationships of objects in a digital camera’s field of view, in real time with high resolution. From 3DV’s website: “The technology is based on the Time-Of-Flight (TOF) principle. The Depth information is captured by emitting pulses of infra-red light to all objects in the scene and sensing the reflected light from the surface of each object. All objects in the scene are then arranged in layers according to the distance information sensed by the D pixels in the camera, providing the Depth information in real time as standard black and white video where the grey-level correlates to relative distance. Color data is provided using a normal color imaging sensor.” It provides depth information at 60 FPS and resolution is accurate to 1-2cm. Estimates for the price paid by MSFT vary from $16M to $34M.

We do not expect a fully Natal-enabled game any time soon. It is unlikely that we will see a full console game using Natal anytime soon.First, the technology was only acquired in April after speculation as early as February. Second, developer kits just shipped to third-party developers today. Third, Microsoft hasn’t even named the thing yet. The near term opportunity is probably Xbox Live Arcade, and even that is likely more for next year than this year. Recall the issues developers cited with the Wiimote early on, saying it was not nearly accurate enough to control games at the desired level of accuracy.

Third party publishers should be eager to support Natal. We would expect third parties to be eager to support Natal. It should be viewed as a way to continue to expand the videogame market for people who are afraid to pick up and play an Xbox 360 game due to thecontroller and all of its buttons. Because publishers are still largely more exposed on a percentage basis to 360 sales vs. Wii sales, they should jump at the opportunity to address the casual market on 360.

Natal flies in the face of peripheral-based games. The rise in peripheral-based gaming this cycle has significantly increased industry ASPs and been a source of revenue growth for several publishers. Natal flies in the face of peripheral-based games because it does what peripheral games do (change the control interface) but without the peripherals. A major proponent of peripheral-based games is Activision, which was publicly excited about its ability to raise ASPs by introducing its many peripheral-based SKUs this cycle. This had mostly applied to Guitar Hero but has now extended to Tony Hawk’s RIDE and will extend to other franchises in the future. However with something like Natal there is no need for peripherals since games can be controlled with body movements alone. Microsoft demo’d Ricochet and Paint Party, both of which were obviously well-practiced but showed-off the technology well. It also showed a video of a family interacting with the ability to drive a car with just hands. This could potentially work for drumming, skateboarding, etc.

Natal will not completely displace traditional controllers. This is not the type of control mechanism that will be able to accurately control games well enough to completely displace normal controllers. There will still be a significant piece of the market that will necessitatetraditional controllers like MMOs, shooters, etc. Natal could enhance these types of games, but a controller will be needed to make it possible.One feature that stood out was the ability to control the Xbox Live menu with only gestures. This opens the possibility of sitting on your couch, voice activating your Xbox, making a couple of motion gestures to get to the movie you want to watch, and watching the movie all without using a remote control or pushing a button on a device.

Other announcements are solid additions to NXE. Microsoft had several announcements today besides Natal, but none were on the same level. Among them included: (1) Metal Gear Solid is coming to the 360. It had previously been a PS3 exclusive, but will now bring a new storyline to the 360. (2) Xbox Live is getting music, social networking. Microsoft announced an exclusive partnership with Last.FM which will bring the service to existing Live Gold members free of charge later this year. It will also upgrade its Xbox Live interface to incorporateunique Facebook and Twitter applications. (3) Perhaps the biggest announcement besides Natal was that it will introduce “Instant On 1080P HD” video which allows full HD movies to be watched instantly with no discs, no downloads and no delays.