I questioned what caused the last console generation to drag for so long. In the end, I concluded that it was the lack of standardization, and poor planning on the part of Sony (NYSE:SNE) and Microsoft (NASDAQ:MSFT). They depended on lower pricing to push demand, rather than push frequent enough hardware updates to keep their own separate gaming ecosystem relevant. Eventually, consumers bought into other consumer electronics and ignored the aging hardware of the PlayStation 3, and Xbox 360.
Xbox and PlayStation pigeonholed themselves into their own ecosystem, and focused purely on gaming. In the same time, smartphones grew exponentially, and offered a richer host of services outside of gaming, that eventually made a $600 hand-held device offer more value to the average consumer than a gaming system could. It soon became obvious that Microsoft and Sony had to change their consumer electronics strategy to closely resemble what consumers actually wanted.
Consoles will remain relevant but they need to work with bigger software ecosystems
Titan Fall will be launched exclusively for Xbox One, Windows, and Xbox 360. This is Microsoft's ecosystem of hardware, which indicates that video game developers understand the importance of inter-operable software that can work across an ecosystem of devices. This is the type of advantage Sony doesn't really have, and I have been pretty vocal about my concerns in the past. If anything, Sony needs to figure out a way to get Android onto its console, but unfortunately, Google (NASDAQ:GOOG) hasn't developed a version of Android for X86, and the Chrome OS is an OS designed for web browsing offering little functionality to Sony's pre-existing game console.
It's all about ecosystem, and right now I find that the Xbox One has the strongest chance at building a larger content library, as game developers can justify the cost of exclusive development, by selling games to Xbox One and PC. Exclusivity establishes differentiation; Sony has been leveraging this fulcrum point against Microsoft, since the launch of PlayStation 4.
Game consoles are the gateway to entry level mainstream gaming. Spending thousands of dollars on a powerful gaming computer is way out of the price bracket of many consumers. Furthermore, game consoles offer the best user experience per dollar for video gaming. Last time I checked, the highest end graphics card solutions from NVIDIA (NASDAQ:NVDA) and (NASDAQ:AMD) cost well over $400, which is the price I would pay for an all-in-one system from Sony and for a $100 more, Microsoft.
Since game consoles are relatively cheap, I see no reason for Microsoft and Sony to further lower ASPs, and should instead look for ways to add enough value to justify higher pricing. I'm saying this, because consoles have been a losing business, and video game development doesn't always generate profits. If Microsoft and Sony are able to price consoles at slightly higher than break-even by working with a shorter product lifecycle, it can negate the negative backlash investors have had towards the gaming segment at the two companies. While estimates vary on the amount the two companies have lost historically, I'm willing to speculate that $1 billion in lost profit could have a sizeable impact on Sony more so than Microsoft, because Sony operates at a 2.24% net profit margin. These low net profit margins come as a result of unprofitable segments that should have been divested a long time ago.
Why pricing is appropriate the way it is
The Xbox One utilizes the Windows ecosystem, and runs software with X86 architecture. This indicates that standard PC games can play on the Xbox One and vice versa. Semiconductor companies like Intel (NASDAQ:INTC), NVIDIA and AMD have much faster release cycles than consoles. My best guess and what went wrong in the last console generation (PS3 and Xbox 360) were the (NYSE:IBM) based cell processors that over-promised, but under-delivered on CPU performance. Microsoft and Sony over-exaggerated the benefits of working with an IBM processor that operated under a different instruction set. This cost the two companies a lot, as it became painfully obvious that backwards compatibility wasn't possible. This resulted in a substantially longer console refresh (It took gamers 8 years to get their hands on another console. The hardware on the PS3 and Xbox 360 became so irrelevant, I started to wonder if ARM based processors could run the same games).
X86 comes with the advantage of really rapid depreciation. Game developers don't need to figure out backward compatibility, as they can easily lower graphical settings so that older versions of a console can play the game. Because of the easiness on the part of developers to release video games onto older console versions, both Microsoft and Sony can move through the hardware life cycle of the console that much faster. And because the semiconductor components are being bought in mass quantities, they can negotiate volume discounts with AMD, thus lowering the overall barrier of entry into gaming. The key differentiating value between console gaming and PC gaming, is that console gaming takes advantage of massive economies of scale to lower the overall cost on hardware. However, companies like Sony and Microsoft are in this to make money too, and because of this fact, I expect more frequent hardware updates to graphics and CPU. This will keep ASPs higher, and it will allow console gamers to enjoy volume discounts on high-end silicon. Faster hardware cycles benefits semiconductors as latest generation chips are priced higher.
However, I'm not making this assessment of faster hardware cycles just because I want to. Inevitably, fabrication of silicon wafers has to move to lower and lower processing tech. This is because Taiwan Semiconductor Manufacturing (NYSE:TSM), and other fabs invest heavily into their PPO (plant, property, and equipment), so they can maintain their competitive advantage. In this transition, 90 nm and 65 nm wafers become more expensive to manufacture as it becomes harder to break-even on fixed costs on lower and lower unit volumes. To be specific, foundries can't cater to the needs of everyone, and has to justify the cost of newer facilities by forcing companies to buy chips on next generation processor nodes.
Throughout the previous console generation, the Xbox 360, and PlayStation 3 came with better processing tech, but with no observable benefits to hardware. They couldn't update the hardware because it would change the product. However, with the shift to X86, both Microsoft and Sony are likely to update the graphical performance and CPU performance, along with manufacturing tech. I expect pricing of consoles to stay in the $300-$500 range. I expect higher pricing, because the cost of lower nm tech is expected to increase significantly, according to McKinsey & Company.
In other words, ignore history. Sony and Microsoft won't be out to destroy investor capital this console generation. If they do, I'm going to wonder how employees at both companies made it past business school.
It will become increasingly difficult for price cuts to be justified on the basis of higher unit volumes and cheaper components. Instead, Sony and Microsoft may be forced to take on a different strategy in the current console generation. Instead of lower pricing in order to chase demand, my best guess is that Microsoft and Sony will stress backwards compatibility and more frequently update the console to avoid falling ASPs. This way, they can conform to the basic laws of economics, and earn reasonable profit margins.
I also expect the gaming market to expand, and demand for console systems to be more clearly justified as Microsoft's rich content ecosystem will offer a reasonable trade-off for those who don't want to upgrade their consoles as frequently. In a sense, the profit-seeking motives of both the game developers, and console manufacturers can peacefully co-exist with each other, as a result of further standardization, and better planning for future product releases.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.