Xbox: Microsoft’s white knight

August 6, 2012, 11:55 PM UTC

This is a big year for Microsoft. The company plans to launch Windows 8, a complete overhaul of its signature operating system, later this year as well as its own, home-grown tablet competitor to the iPad. A new version of Office is also in the works.

Lately, things have been pretty good in Redmond. During Microsoft’s (MSFT) last fiscal year, ended June 30, its Business Division accounted for over half of its operating income, generating $15.7 billion. Windows and Windows Live, meanwhile, came in at $11.5 billion. The company generated a $17 billion profit during its last fiscal year. Microsoft’s long-languishing stock price is up 13% since the beginning of the year.

Still, Microsoft has plenty of issues. It has a small presence in the massive online advertising industry, and the cloud, which is vastly important to its future, is up for grabs. One in three companies is adopting Google (GOOG) Apps for Business, the search giant’s cloud-based office-productivity suite, rather than Microsoft’s alternative, Office 365. And as Global Equities Research analyst Trip Chowdhry told The Wall Street Journal recently, Microsoft’s presence in the crucial mobile space is practically non-existent. “Less than 2% of smartphones are Windows devices and no tablets are Windows devices yet, which is troubling from a customer adoption perspective,” he said.

MORE: New battle-lines in the war for mobile

There is a white knight inside Microsoft: the Xbox 360. Microsoft’s Entertainment and Devices Division generates about 40% of the revenue of the Business Division. Considering the Xbox 360 is such a small part of Microsoft’s operation today, you might think it can’t possibly be so important. However, the Xbox 360 has quietly become a dominant force in the console business, making it awfully important.

Microsoft announced last month that it sold 257,000 Xbox 360 units in the U.S. in June, earning it 47% share of the U.S. console market. The console led the way in total sales for the 18th month in a row, and held over 40% share for the 16th-consecutive month. Microsoft said that total consumer spending on the Xbox 360 in June hit $272 million. Not bad for a device that launched nearly seven years ago.

“The company’s Xbox business continues to show solid unit volume, attach rate, and revenue growth performance, though the financial impact to Microsoft remains inconsequential,” J.P. Morgan analyst John DiFucci wrote in a note to investors last month. “However, the high-profile of this business in investors’ minds may create catalysts from news events from this business line.”

MORE: Best Buy has become a soap opera

But the Xbox 360’s importance to Microsoft goes beyond console sales. The Xbox 360 is coming to the end of its life cycle, and year-over-year unit sales were down 35% during the period. Software and services, however, drove the entire entertainment division to a 12% revenue gain in the fourth quarter.

Luckily for Microsoft, it appears poised to continue to derive its growth from those software and services. The console’s game library is extremely deep and Microsoft has doubled down on Xbox Live, turning its popular console into a viable living room media hub for those looking to stream video and download video games.

Market researcher DFC Intelligence revealed in a study recently that by 2017, 39% of all console game revenue will come byway of Internet-delivered distribution platforms and other Web-based sources. DFC believes that the gaming business will see revenue soar from $67 billion this year to $82 billion in 2017. In other words, nearly $32 billion will go to the console space’s Web-based services that year.

MORE: Google’s playbook won’t work at Yahoo

That’s a major opportunity for Microsoft. Back in 2010, it was estimated that Xbox Live generated about $1 billion in revenue. Since then, Microsoft has sold boatloads more consoles and according to Kantar Worldpanel, 11% of the company’s console owners, or about 7 million, have made purchases through Xbox Live. Xbox Live membership was up 15% in the last fiscal year, according to Microsoft. That growth is more than likely to continue in the coming years.

And Microsoft is getting ready to cash in.

Speaking during his company’s earnings call in April, Microsoft CFO Peter Klein said that “Xbox Live and all the entertainment content that comes with that” is viewed by Redmond “as a persistent long-term revenue stream, both from a subscriber perspective as well as a transactional perspective. “If you look at the engagement that our subscribers have, the amount of time they spend doing entertainment as opposed to gaming is increasing all the time,” Klein continued. “And so I think the strategy and the value proposition there plays out very well over the next several years.”

MORE: The unspoken truth about Apple

The Xbox and its associated services have a long way to go to match Windows or Office in overall revenue, but the world is moving towards an all-digital entertainment model. Turns out Microsoft knows it — and it’s quietly capitalizing.