Microsoft Crushed Sony at E3

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sony's (NYSE: SNE) Entertainment division is great about creating awesome products, but under-performs at generating profitability. This is not an exaggeration either--Sony reported $72 billion in revenue in its fiscal year ending in March of 2013, but the company's net income of that $72 billion is $945.7 million in normalized net income. The company currently operates at a 1.53% profit margin.

The company did a whole round of fan-service during the E3 presentation with absolutely no regards for keeping up with their fiduciary duty to shareholders. Not all is lost, though. In a previous article I noted that the company's smart phone and tablet segment present compelling growth opportunities, but I remain a skeptic on the company's gaming segment performance going forward.

What went wrong

The company’s entertainment segment performs poorly. Let’s take a closer examination of Sony’s various business segments below.

Source: Sony

The game segment reported a 1.4% year-over-year decline in revenue in its fourth quarter for fiscal year 2012. In addition, the company reported a 1.6 billion yen loss in the video game segment. The company’s decline in game sales, when compared to Microsoft’s (NASDAQ: MSFT) 56% growth rate in its entertainment segment, indicates that Sony's business strategy in video games needs to improve.

The PlayStation 4 will be retailing at $399, versus the XBox One at $499. In classical economic theory, the general assumption is that the lower the price, the greater the quantity demanded. Sony may not be able to sell enough in terms of PlayStation 4 to make up for the $100 opportunity cost per unit sold. In the 2012 fiscal year, Sony sold a total of 16.5 million PlayStation 3 and PlayStation 2 consoles. So assuming Sony were to sell 15 million to 20 million PlayStation 4 units in its first year, the $100 in potential revenue per consoles could translate to a $1.5 billion to $2 billion opportunity cost.

Sony still supports used games

This got me scratching my head too. The company has developed software that allows gamers to download the game while the video game is being played. Think of it like YouTube streaming for videos--the video is never fully downloaded, but downloaded at a fast enough of a rate to allow you to watch from beginning to end without the need of waiting for a full-download.

GameStop (NYSE: GME) reported gross margins on new video games software at 21.9%. This percentage is the difference between the price at which GameStop buys a game at wholesale, and the price it sells at full retail. So by Sony supporting used video games and standard retail chains, the company has effectively crippled the amount of revenue that could be kept by video game development studios. This is because the studios could use that extra 21.9% to sell their games at a 21.9% discount through online distribution in the PlayStation Network, or by using the added incremental profit to increase the amount of games in development.

Microsoft and GameStop

Source: Statista

Consumer support for physical video games has declined by 35% since 2009. With Microsoft providing limited support for used games, the probability of an even more significant decline in GameStop's revenue is high. The company is also facing industry headwinds where total spending on video games has declined by 9% over the past 5 years. Part of this decline is because digital downloads are sold at a lower average unit price. This has had a weakening effect on total sales. It also gave consumers added incentive to buy digital content as game developers do a great job of passing on savings to consumers through discounts.

Microsoft is responding to this industry-wide decline in video game sales by offering an alternative distribution model.

Microsoft's strategy going forward

Subscription business models offer greater predictability, and it allows developers to focus on games, rather than randomly guessing the number of units it will sell.

What may happen is that Microsoft will take on the role of determining profit and distribution through the collective buying power of its 56 million XBox Live subscribers. Microsoft also stated that internet access will be needed in order to use the console, which supports the notion that XBox live will be the glue that keeps developers above water, and allow for more creativity in game development.

If the number of XBox Live subscriptions reaches over a hundred million (which it most likely will), the scale of content creation could vastly surpass that of Sony's PlayStation. The collective buying power of a hundred million XBox live subscriptions will give publishing studios added incentive to create "exclusive content" for the XBox franchise.

Conclusion

I believe that GameStop is still a lousy investment and that the business model for video game distribution is ripe for change. GameStop will end up losing a substantial number of its stores, as there aren’t that many stores that can operate at break-even in an environment of declining physical disk sales.

Sony and Microsoft are here to stay, but it’s time to unload GameStop.

It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In a new premium report on Microsoft, a Motley Fool analyst explains that while the opportunity is huge, so are the challenges. The report includes regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.


Alexander Cho has no position in any stocks mentioned. The Motley Fool owns shares of GameStop and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure