The video game industry is evolving. The old days when the video game companies based their financial strength and potential almost solely on the brick and mortar sales of their games and hardware are long gone. The introduction of various new business models throughout the years such as games as a service, downloadable content, microtransactions, and others have seen the industry landscape terraformed.
Not all companies were successful in adapting to the ever-evolving industry, while some spearheaded the innovation front, others were forced to play catch up. In this article, we will analyze why gaming has the opportunity to become one of the major growth catalysts and most reliable revenue sources for Microsoft (NASDAQ:MSFT), but also why Sony's (NYSE:SONY) (OTCPK:SNEJF) attempt to compete in the space might spell huge trouble for the Japanese tech giant.
There are two major growth catalysts that Microsoft is exploring with their venture into the gaming industry. First, they are spearheading industry innovation by utilizing their game subscription service called "Game Pass". Secondly, they are tapping into the potential of the highly controversial "metaverse" project that is being pushed by Meta (FB). While the company has been involved with the gaming industry for decades, this gambit does well to highlight Microsoft's "cloner spawner" approach that has been pushed by the acclaimed author and investor Monish Pabrai. Sony on the other end is being forced to play catch up finding itself in an increasingly less attractive position.
The story of how Microsoft first played into the idea of creating the first Netflix-esque subscription service for video games began years ago when the tallies of the last generation console war were being counted. Sony has left Microsoft bruised up and beaten badly as their heavy focus on "exclusive content" yielded extraordinary results with their PlayStation 4 outselling its Xbox One rival by almost 3:1. Sony managed to ship close to 120 million console units, while Microsoft on the other end was forced to stop releasing console sales as early as 2015, with the estimate being that the company managed to ship around 40 million console units.
Only months after the disastrous launch of the console, Don Mattrick, the previous head of Xbox has been forced to leave with industry veteran Phil Spencer taking his place. Spencer's vision has seen a huge shift in focus from a two-decade-long pursuit of brick and mortar games and hardware sales to assembling a roster of studios whose games can be played across a range of devices. His most important contribution to this day was doubling down on the "subscription service" model gamble that started its life under his predecessor as a small project codenamed Arches.
Following the enormous success that Netflix (NFLX) had as an early adopter of the video subscription model, or the success Spotify (SPOT) achieved as an early adopter music subscription model, Spencer realized the true potential that games as a subscription model would have. Microsoft's pitch to conquer the gaming world was simply titled "Game Pass". The platform proved a huge success since its inception back in 2017, attracting more than 25 million subscribers. For a flat monthly fee of $10 or $15, the subscribers have access to a huge cross-platform library of more than 300 titles, including features such as day one releases and backward compatibility.
The studio acquisitions create value for Microsoft in two different ways. First, they enable the company to push out games directly to its subscription service. This is a huge incentive for the average gamer. Instead of paying for tens of different games per year, it is much easier to simply maintain a subscription. The logic is simple here, the more studios and IPs they own, the lower is the incentive for the average gamer to look at anyone else other than Game Pass and Microsoft.
The second value generator is the contribution to the console wars, that is by significantly boosting console sales through the use of "exclusive titles". In a similar manner in which movies and TV shows could be made exclusively available on certain streaming platforms, games are often made "Xbox" or "PlayStation" exclusives, meaning the developer enters a deal with a hardware company for the product to be available to purchase only on their platforms.
Microsoft made a huge statement in terms of where they believe the industry is headed with the decision to ship the affordable version of their new gaming console without a disk drive, marking the first time in history since the emergence of the "Compact Disk" that a major console manufacturer designed and shipped a console without one. This means that the console has gone full digital, being unable to use physical media for games, movies, or music. Sony soon followed with the "lower-end" digital console version, abandoning the disk drive as well.
This generation's lineup of the latest Microsoft gaming consoles came in two versions, the higher-end $499 "Xbox Series X" and the more affordable "Xbox Series S". On the other end, Sony's lineup this generation consisted of "PlayStation 5" and "PlayStation 5 Digital". On launch, the standard edition MSRP was $499, while the digital version MSRP was somewhat lower at $399.
The "Xbox Series S" can easily be considered the most interesting product, at least when looking at things from a strictly financial standpoint. First, it is well known that both companies take a hit on the hardware, but Microsoft has decided to ship the console for $299, making it an extraordinary value proposition, with the company obviously taking a huge hit upfront. What is even more extraordinary is that the company is offering the console through a subscription service, offering customers to opt-in for the 24 month $24.99 bundle.
To summarize, Series S showcases several interesting things: orientation towards a fully digital future, readiness to utilize console sales to boost Game Pass subscriptions, willingness to significantly underprice Sony in the console wars for the first time.
Whilst the two companies have been trading blows with each other for years being viewed as equal competitors by the majority of the public, the reality is in fact quite different. Microsoft's enormous financial success over the past decade combined with a prolonged period of stagnation which Sony is going through has created a rivalry that is looking awfully similar to the biblical tale of David and Goliath, likely with a rather different outcome. In the following years, as industry consolidation is heating up, the differences are only going to become more obvious.
The revenue ratio between the two companies is set at 2:1 in favor of Microsoft, but the analyst consensus tells us that the ratio will likely only widen over the course of the next couple of years. Sony is expected to struggle with its mid to high single-digit growth, while Microsoft is expected to generate 14-19% growth in the same period. The ratio might rise to 3:1 as early as 2025 if the estimates are correct. In short, while it was possible to compare the two companies financially during the period of the last two console generations, that is no longer going to be the case with Sony almost definitely taking up the role of Goliath in this hypothetical.
The main takeaway and the most important reason why I firmly believe that Microsoft can easily afford to outspend Sony is the way gaming as a segment reflects onto the income sheet. For Sony, gaming has grown to become the bread and butter of the company significantly contributing to the bottom line. Microsoft on the other end can afford to view its gaming segment as almost completely growth-oriented.
Sony is reporting gaming numbers under their Gaming and Network Services segment which is making up almost 30% of the revenues generated today by the company. Microsoft on the other end reports gaming under its "Personal Computing" segment. Gaming as revenue for Microsoft made up only $15 billion of the $168 billion in revenues they have generated in 2021. It is making up less than 10% of the total revenues. The latter years have seen gaming become an almost integral part of Sony's identity, while it still remained a marginal and almost overlooked part of Microsoft's identity.
With the two companies building up their subscription services, IPs and franchises are becoming more important by the day. In a similar scenario to what is being played out in the streaming space, companies with access to popular and more valuable IP are determined to have an edge over their competitors. Knowing that Sony will be forced to make a decision, it can either attempt to match Microsoft in its ambition or accept the financial reality and attempt to create a niche product and offering that is going to stay relevant in a space dominated by Microsoft. Choosing the former will involve them in an attrition war their balance sheet simply cannot endure in the long run, ultimately hurting their investors.
Going back to the potential of Game Pass, the "Netflix for video games" has reportedly surpassed 25 million subscribers this year, meaning we are discussing a 40% rise in the number of subscribers since the last year's reported numbers. The service notably also had "only" 10 million subscribers in 2020, speaking volumes of how well it was actually accepted by the community. In comparison, Sony's PS Now is reported to have little more than 3 million subscribers.
The projection that I've made is solely based on the revenue generated by the subscriptions. If Microsoft would use a metric such as ARPU, the average user brought into the ecosystem would probably generate double or triple the amount. The growth is rapid and can only be driven further by the number of acquisitions that Microsoft is making. The Activision acquisition alone gives the company access to the Call of Duty franchise among others, which is most likely the best-known first-person shooter franchise in history, becoming almost synonymous with the genre over the decades. The franchise still manages to generate north of 100 million MAU even today. Not counting the 240 million MAU from King, the Activision and Blizzard ecosystem of games have close to 140 million MAU. If we are to assume that only a third of the user base decides to play using the subscription instead of purchasing the games individually, the projection would be broken. This entire section is highly subjective and we could have a prolonged debate on the projection numbers, but I only wanted to highlight the real potential of Game Pass and point out why I believe that Microsoft is on the path of something huge here.
If the venture into the gaming market proves anything close to a failure, not many will be willing to criticize and look down upon Microsoft and their management for their attempt to innovate and capitalize from an increasingly attractive market. One might argue that even if their entire venture collapsed and resulted in a failure, this would be exactly the sort of prowess and initiative that Microsoft shareholders have learned not only to expect but also to appreciate throughout the years. The approach plays well into what Monish Pabrai would define as a "failed seed" within his "spawner concept" approach.
The situation with Sony is completely different. The struggling Japanese tech giant has been relying more with each year on their gaming and console division in order to keep the dream going. The company will continue to struggle in finding a balance between playing catch up with Microsoft and keeping its finances in order. The video game industry is an industry marked by decades of mergers and acquisitions, with the recent developments surrounding Microsoft and Activision Blizzard proving once again that industry consolidation is not a question of if, but a question of when. The willingness of management to keep up with Microsoft's seemingly never-ending shopping spree of various game studios and developers will sooner or later be hindered by the depth of their checkbook.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.