Sony Vs. Microsoft In The Console Wars

Jan. 8.14 | About: Microsoft Corporation (MSFT)

Earlier this week we received word from Microsoft (NASDAQ:MSFT) that its Xbox One console shipped over 3 million units in 2013. Though double the notoriously undersupplied launch of the Xbox 360, the numbers suggest a significant slowdown from the early pace, as Xbox One had shipped 2.1 million units as of December 11.

As for Sony (NYSE:SNE), the PlayStation 4 sold 2.1 million units as of December 1. Although we don't have a read on sales yet, but the console remains largely sold out online and in stores. Xbox One, on the other hand, can be easily ordered online or in stores. At $399.99 versus $499.99, it appears that Sony is on its way to an early lead in the console war.

This news is sure to be jarring to both Microsoft shareholders, as well as Xbox One derivative plays like GameStop (NYSE:GME), Best Buy (NYSE:BBY), Electronic Arts (NASDAQ:EA), and Activision (NASDAQ:ATVI). Many developers were betting on strong sales from both next generation consoles, and the likes of Best Buy and GameStop are hoping that new consoles will recharge the demand for console video games.

Why is Xbox One losing?

Unless Sony's supply chain is lacking drastically, PlayStation 4 is winning the current console war. A lot of it is not because of what a great job Sony has done but rather Microsoft's mistakes.

Xbox 360 kicked off a huge lead in the previous console generation, but it was a device fraught with complication. Personally, as a fairly hardcore gamer, I went through not one, not two, not three, but four consoles. Only one was completely covered by warranty, and I was able to acquire additional units in the resale market at attractive prices, but the fact remains that the Xbox 360 was very poor quality hardware. In fact, for the past year, my console hasn't read disks. Even inside sources claim that Microsoft knew it had faulty hardware. Microsoft's reputation as a hardware company suffered a significant hit.

With many users burning through their first Xbox 360, many gamers opted to try out PlayStation 3. Although it offers an inferior online gaming atmosphere, several of the hardware issues that dogged the Xbox 360 were nowhere to be found on the PS3. Plus, the PS3 included better graphics and a Blu-Ray player-it made a mockery out of Xbox 360's "HD-DVD."

On top of poor hardware quality, the prevailing issue for Xbox One is price. Gamers tend to tilt towards younger ages due mostly to free time constraints, and $499.99 is a lot to stomach for parents and children alike. Considering the similar hardware specs and capabilities, I think Microsoft made a large blunder bundling the Kinect, which is responsible for the price differential. Assuming Microsoft has narrowed the gap in terms of hardware quality, it still costs $100 more than the PlayStation 4. Going forward, Microsoft is going to have to drop the price to compete, which may mean unbundling the Kinect.

What can Microsoft do to Catch Sony?

If we've learned anything from cable TV, it is that companies will pay a premium for exclusive content. I think the same will hold true for video game consoles, so Sony and Microsoft will battle for exclusive content. Xbox One has a strong lineup, including Forza, Halo 5, Ryse, and Dead Rising 3. PS4 has some similar strong titles like infamous: Second Son, The Order: 1886, and Killzone: Shadow Fall.

With its deep pockets, Microsoft could easily bribe developers with exclusive contracts. This is interesting in the sense that it shifts some of the risk onto Microsoft in hope that it spurs console adoption. Studios may not be interested in doing so because it increases the likelihood that Sony would freeze them out of the PlayStation world going forward. Either way, look for Microsoft to purchase another game development studio or perhaps engage in a partnership with another company.

Microsoft could also bundle things like a free year of Xbox Live or another controller, but either of those options would be expensive. In all likelihood, I think we can expect a Kinect unbundling and subsequent price reduction.

What if console sales weakness is systemic?

Before shares of GameStop surged higher in 2013, many investors were questioning whether or not Microsoft and Sony could reinvigorate console gaming. Several critics believe mobile gaming will come to dominate like never before. I tend to think this bear case is a bit overstated but worth exploring.

A real slowdown in console gaming is terrible for many companies. Take-Two Interactive (NASDAQ:TTWO), Activision, and Electronic Arts are all heavily leveraged to console gaming. Any large decline in user adoption will meaningfully damage all of these companies. We will likely then see consolidation and even fewer releases as studios concentrate on just a few blockbusters every year.

Best Buy will also suffer, but I think GameStop is in a great deal of trouble in the event of a console gaming decline. GameStop's derives profits largely through used game sales. With digital downloads already taking a bite out of revenue, fewer game launches means fewer sales for GameStop. Additionally, because so many younger gamers roll used games credit into new games, GameStop may have to offer lower credits to deal with the possibility of lower game sales, aggravating customers who may then turn to Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY) to get better prices for games.

How this Impacts Investment Decisions

Sony and Microsoft are large companies that value their respective console businesses. However, the game studios and GameStop are at the mercy of the video game industry. Xbox One and PlayStation 4 can be huge flops, but neither company's investment thesis is ruined.

Going forward, I would be hesitant to invest any fresh capital in video game studios. I currently own some Take-Two Interactive, but the slowdown in Xbox One sales does have me a bit spooked.

As for GameStop, I may consider shorting this name depending on how the sales velocity of Xbox One and PlayStation 4 progress. The market seems far too optimistic about the company's future as it faces the prospect of declining console gaming as well as huge competition from digital downloads, eBay, Amazon, and Craigslist. The long-term future for GameStop looks mediocre at best.

Disclosure: I am long TTWO. 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.