With growing legions of users watching TV programming on their own schedules, and ultra-high bandwidth soon being pumped to every home, the dawn of digital media convergence will soon arrive, and Yahoo! and Microsoft are well positioned (and priced) to give investors a real bang for their buck.

What’s this convergence thing?
So imagine this: you’re at work and you just realized that you missed your favorite show last night. But you’re not worried. You log onto the web and download last night’s episode in digital quality for under a couple bucks. Within minutes it’s on your media player, and after you get home, you plug your media player into your home TV, and are watching it without the need to sit through all those darn commercials.

Well imagine no more, because within a few years this will all become a reality, but not just with your favorite TV shows. In fact if Yahoo! has its way, millions of the 31 million hours of programming produced annually will be available through their network (1). And Microsoft wants their upcoming Xbox 360 to be the hub of your digital media experience. It plays nice with many digital consumer devices like Apple’s iPod, and you’ll be able to watch DVDs, digital video, listen to music, record TV and play video games all on one network-aware device (2).

With digital cable, on-demand, PVRs, and webcasts, most of the content we watch is digitized and telcos will soon be releasing their next generation fiber-optic networks. That means we’ll be able to download high-quality full length video in real-time from the Web in only a couple years time. According to CNET, Verizon continues to roll out its new Fios fiber system in test communities around the country (3) at speeds of 5x to 10x faster than DSL, and nearly 4x faster than current cable speeds.

Aside from being in the center of digital media in the coming years, Yahoo! and Microsoft have strong core businesses and reasonable price tags that will allow profits to grow and lead to great returns for investors.

Yahoo! (YHOO)
Yahoo! may in fact become the fifth network. Its Yahoo! Media Group is clearly setting up for the long-term and implementing a plan that will allow them to distribute and sell programming to consumers over the Internet. They started building strong connections in Hollywood by hiring media execs from Warner Bros., NBC and CBS. Plus, they set up headquarters in Santa Monica, CA, next to industry titans such as HBO, MTV and Universal. Unlike the less media-savvy Google team, who are also trying to make a media play in video archive searching, Yahoo!’s people are already comfortable on the playing field because they have home team advantage.

Their new IPTV initiative, dubbed Project Lightspeed, will allow Yahoo! to distribute content, but without a way to search all their content, much of it will get lost in the shuffle. That’s why Yahoo! is also building a search engine that will capture rich data about each show and allow that content to be searched, including spoken dialogue. These two core businesses — providing both content and the means for users to access it easily — place Yahoo! in a strong position as a leader in this new industry (1).

Yahoo! is also strong in its core business of Internet services. Because of threats from Google, Yahoo! has recently strengthened services such as mail, photos, and search. By building a network of services that they can bundle together for users, they’re able to drive traffic internally and generate substantial ad revenue while also adding value for their customers. Their ability to drive traffic internally is especially useful when launching new services, such as their re-entry into the media market.

Financially, Yahoo! has generated over US$1 billion in net income over the last two quarters (income statement) and has grown assets while keeping liabilities relatively flat (balance sheet). From an investment perspective their P/E Ratio of 35.36 is about 30% lower than their industry and about 18% higher than the tech sector, making it an attractive buy. Analysts also like Yahoo! Reuters rates Yahoo a low risk investment, and the consensus recommendation is at outperform. I’m looking for this stock to do very well in the next 2-4 years.

Microsoft (MSFT)
Microsoft’s new Xbox 360 is going to be a major improvement in the way computers and digital media are used in the home. Now a consumer device will not only be able to play games, DVDs, and CDs, but also record TV, play radio, store media, and connect to other computers on the home network and stream music and video through an entertainment system. And the Xbox supports plug and play for most media storage devices like Apple’s iPod allowing you to easily play all the movies, music and pictures on the device. Although the price tag is a bit steep (as high as US$400), for those of us who are a little cash or space strapped, this device brings together a lot of bang for the buck. (2)

In their core business, Microsoft continues their relentless growth in existing markets and expansion into new markets. SmartMoney reports that in the next 18 months, four of their seven business divisions will have significant new products and upgrades (4). Additionally, they’re doing some very exciting things in the area of software development which will undoubtedly stem the tide of developers migrating to Java. For example, their .NET Framework continues to offer highly competitive and advanced features that will allow .NET developers (such as myself) to produce much more sophisticated software in much less time.

Financially, Microsoft has got boat loads of cash — over US$40 billion — yes, with a zero and a b (balance sheet). In addition, the company generates about US$3 billion in profits per quarter (income statement). Those are amazing numbers in any terms especially with a P/E ratio like theirs, which is over 20% lower than the industry and the tech sector. Reuters has no risk alerts for the company and overall it’s recommended as outperform. I believe this stock will do especially well in the next 1-3 years.

The Bottom Line
Digital media is coming to a living room near you, and with strong strategies in their core businesses and already attractive prices, Yahoo! and Microsoft’s digital media initiatives will mean big profits in the hands of insightful investors.

[1] McHugh, Josh. “The Super Network.” Wired Magazine. Sept 2005. Page 107-11. Go to Story
[2] Microsoft. “Xbox 360 Media”. Go to Page
[3] Reardon, Marguerite. “Verizon hits the gas on fiber campaign.” CNET News.com. May 9, 2005. Go to Story
[4] Rendon, Jim. “Microsoft Gets Back in the Saddle.” SmartMoney Magazine. Nov. 2005. Page 32.