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On May 21, Microsoft (NASDAQ:MSFT) will reveal the next generation Xbox, which is widely expected to take the same hardware approach of the already announced Sony PlayStation 4. Microsoft will join Sony (NYSE:SNE) in moving to an Intel compatible x64 accelerated processing unit (APU) made by AMD (NASDAQ:AMD). While we don't yet know the specs for the next gen Xbox, Sony has published specs for the PS4 which are very impressive. The impact of the two new consoles will be to reduce the size of the gaming enthusiast market for PCs and associated hardware, including high end CPUs and graphics cards.

A Case of Good Enough Being the Enemy of Better

The AMD processor in the PS4 will feature an 8 core "Jaguar" CPU and what is billed as a "next-generation Radeon" graphics processor integrated onto a single chip. Just as so many Intel (NASDAQ:INTC) processors have become systems on chip (SOCs) integrating CPU cores with a graphics processor, AMD has been integrating Radeon graphics processors into their own line of Intel compatible devices. According to a recent AnandTech review of AMD's current top-of-the-line desktop APU, the A10-5800K, the graphics performance of the APU is quite a bit higher than the built in graphics of Intel's Ivy Bridge Core i7 3770K, although only equivalent to a mid-grade discrete graphics processor unit (GPU).

Most likely, the performance of the next gen consoles will not be as good as what is achievable with a very high end PC gaming rig, but it won't matter very much. For most PC games that make heavy use of Microsoft's DirectX 11, frame rate performance is mostly determined by the graphics card, and high end graphics cards can often produce frame data output rates much higher than what is displayed. For instance, in a review of the EVGA GTX 580 graphics card hosted on an Intel Core i7 3930K system, I measured a non-overclocked frame rate for Call of Duty: Modern Warfare 3 of 193 frames/sec for full frame 1080p output with all quality settings to maximum.

Of course, frame rates vary by game and graphics processor, but it really has gotten to the point where the frame rate performance is often academic, or merely for bragging rights. This is why the selection of the AMD APU makes perfect sense from the standpoint of cost effective performance. Sony must have decided that the graphics performance of the APU was good enough, given that the console will probably support no more than a 60Hz frame rate.

There's still some question about the exact configuration of the next gen Xbox, however, and as of this writing, I've read some rumors that the Xbox will feature a separate Radeon graphics processor in addition to the APU. Regardless, I expect consumers won't notice a difference between a high end gaming PC and the new generation of consoles. Except that the new consoles will cost a few hundred dollars while a gaming PC can run into the thousands.

Console Business Opportunity

And this is the crux of the value proposition for the gaming console, and why I expect both Sony and Microsoft to do well with their consoles. Yes, I know console sales have been on the decline, but this is to be expected since the Xbox 360 was released in 2005 and PS3 was released in 2006. In the intervening years, the consoles have been becoming obsolete as increasingly higher performance PCs and graphics cards hit the market. Nevertheless, about 77 million each of the 360 and PS3 have been sold, for an average of about 10 million each per year.

I'm also aware that some are looking at the Nintendo Wii U as a sign of what to expect. Since its release in November, Wii U is estimated to have sold 3.5 million units worldwide, but I doubt that this is indicative of the performance to be expected for the next gen Xbox and PlayStation. The Wii U features an LCD based game pad, which, together with HD output capability, significantly raised the price of the Wii U compared with the previous generation. A basic Wii U now costs about $300.

Although pricier, the internal architecture is still PowerPC based with an accompanying Radeon GPU, in order to retain compatibility with existing Wii games. Given the architecture choice, Wii U will undoubtedly continue to be excluded from some of the most popular game franchises such as the Call of Duty series, the Crysis series, and the Elder Scrolls (Skyrim) series, all of which feature top notch graphics.

Mobile devices have also had an impact on gaming, but here I think the mobile gaming market is fundamentally different. Most mobile device games are not nearly as graphically sophisticated as those for PCs or even consoles, simply because the graphics processors included in mobile SOCs don't have the horsepower of a discrete GPU or even AMD's current generation of APUs. And I doubt that they will for the foreseeable future. Here, the limiting factor is power consumption: consoles can plug into the wall, and might consume upwards of 100 Watts, whereas a tablet or phone is limited to less than a tenth of that power.

Console manufacturers are also endowing their consoles with a wide array of non-gaming functions in order to make the consoles even more attractive. Both next gen consoles are expected to have Blu-ray disc capability for BD movies as well as game software. Both consoles will be able to download content and games from online stores, as well as provide built in web browsing and social media capabilities. For many consumers with smart phones and tablets, the console will be a more than adequate substitute for the desktop PC at a price comparable to the lowest cost desktops.

I believe that there's a lot of pent up demand for the next generation consoles, so I expect them to sell at least as well as their historical average. At their last Q1 conference call, AMD management claimed that the number could be as high as 40 million/year, which is plausible considering that consoles will probably sell at a higher rate than their historical average in the first year. IDC's recent forecast for consoles stated that alternative platforms such as mobile devices and smart TVs were not "positioned to materially disrupt the trajectory of the 'big 3' console OEMs in 2013 or 2014."

Game Console Winners

AMD: The console wins are huge for AMD, adding $200-400 million in revenue per quarter on unit sales of 5-10 million APUs. Despite this, AMD almost deserves its own category of Pyrrhic victory, since even with the console wins, a return to profitability is not assured.

In 2013 Q1 the company posted an operating loss of $98 million on total revenue of $1.09 billion, which was down 31% y/y. AMD is divided into a Graphics division (Radeon GPUs) and a Computing Solutions division (CPUs, APUs), and while graphics revenue only declined by 12% to $337 million, Computing Solutions revenue is in free fall, declining by 38% y/y to $751 million. AMD probably wouldn't have survived much longer without the console wins.

If CS non-console revenues hold steady from Q1, the low end of my console revenue range ($200 million) would add about 27% to CS total revenue. If gross margin holds steady from Q1 at 41%, this wouldn't quite be enough however to cancel the operating loss of $98 million.

To achieve profitability, AMD will either need to sell more console APUs or further reduce operating expenses. In a previous article, I estimated that AMD probably had no more than 12% of the PC CPU market as of the end of Q1, and that share could continue to decline.

Nevertheless, the market sees reason for optimism, as do I. AMD is up 20% over the past 5 days, as of 5/14/13. It's certainly reasonable to expect that Microsoft and Sony will sell more than 10 million consoles each in the coming year, in which case AMD's profitability is almost certain. Furthermore, consoles may create a halo effect for AMD's desktop and mobile APUs, which are very economically priced, and thereby arrest the loss of market share.

Sony: For the fiscal year ended March 31, Sony's game division saw revenue decline 12% to $7.522 billion, but operating income declined 94.1% to $18 million. If Sony sells roughly 10 million PS4s in the coming fiscal year, this could add about $1.5-2 billion in revenue or 20-25% to the previous fiscal year total.

Microsoft: In 2013 Q1 Entertainment and Devices Division (EDD) home of Xbox posted a 56% increase in revenue to $2.531 billion primarily due to higher Windows Phone licensing revenue and recognition of video game revenue deferral. As in the case of Sony, sales of 10 million next gen Xbox in the coming year could boost revenue by $1.5-2 billion or 15-20% of the previous fiscal year total.

Game Console Losers

Nvidia (NASDAQ:NVDA): The growth of Intel architecture SOCs having built in graphics simply means that the market for separate graphics cards and discrete GPUs gets smaller and smaller. A presentation by John P. Webb of Intel at the 2012 Intel Developer Forum spelled it out very clearly: Ivy Bridge had eliminated the market for entry-level graphics cards, and Haswell was being positioned to "move up the food chain" to mid-grade graphics processors.

AMD has already positioned their A-10 series APUs to take on the mid-range performance segment. Intel's presentation also indicated that the enthusiast market was relatively small, about 30 M, while the performance and mainstream segment numbered about 220 M. The next gen gaming consoles will probably siphon off many in the mainstream segment and even reduce the enthusiast segment as the console's "good enough" solution wins converts for convenience and low cost.

The trend is pretty clear that eventually Nvidia's discrete GPU market will be reduced to special purpose engineering and scientific applications that make use of the GPU's parallel processing capability, and a few high end gamers for whom consoles aren't good enough.

Ouya: The Ouya game console is essentially an Android tablet using an Nvidia Tegra 3 processor, stuffed into a box. As such, its capabilities are in line with mainstream Android tablets. Neither Android nor iOS devices will be able to compete with the next gen consoles, but they don't have to, since their mobile. Ouya, lacking the saving grace of mobility, will be crushed in the marketplace.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Next Gen Game Consoles: Winners And Losers