PS3 and Backwards Compatibility: What the Analysts Are Missing

| About: Sony Corporation (SNE)

My friend Rob and I talk a lot about gaming in general, and gaming analysts in particular. Frequently, we can't quite understand how these analysts they approach problems or arrive at conclusions, probably because they are mired in cranking out reports and not spending enough time thinking about the big picture.

And this was never more clear than in an article that ran in yesterday's GameDailyBIZ concerning the issue of Sony's (NYSE:SNE) PS3s lack of backwards compatibility. The analysts' conclusion: since much has been made over the PS3s high price point, and since stripping out this functionality saves between $30-$50 per unit, a cost reduction is clearly more important than offering this feature. Voila! Instant Wall Street group-think.

In short, my pal and I believe this thinking is, well, quite stoned, and evidence of thinking deep, deep inside the box. It also fails to look at the facts or Sony's true economic motivation. But hey, this is only the view of a couple of stupid non-gaming analysts.

First, some excerpts from the article:

So the question must be asked: Considering the pure dominance of the PS2 and the millions of gamers who may want the ability to play PS2 games on the PS3 should they ever purchase the console when it comes down in price, is Sony shooting itself in the foot?

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"Cost is hard to gauge, probably $30 - $50 per unit," Wedbush Morgan Securities' Michael Pachter said. "I thought lack of backward compatibility would hurt the Xbox [360], but it really didn't. My guess is that Sony has addressed the concerns of those who care about backward compatibility with all of the boxes sold to date, and that they will continue to offer the 80GB model if anybody feels that they need backward compatibility. So it's not fatal."

It's not an ideal solution, but something had to be done. "It's about cost reduction, but also getting people to focus on PS3 games. End of the day, they need to do something, and this was probably a compromise between costs and price cuts," UBS analyst Ben Schachter said.

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For Cole, the bigger issue for Sony and its consumers remains the price barrier and the losses piling up in Sony's gaming division. "For me the big problem with the PS3 is high price. The problem is bringing the price down means bleeding a lot of money per unit. You lower the price $100 and you are losing $100 million for every million units sold. To me I just can't imagine many consumers stumbling over backwards compatibility. But I can imagine a whole bunch stumbling over price," he said.

Colin Sebastian, an analyst at Lazard Capital Markets, agrees wholeheartedly. "It appears that pricing is becoming more of a priority, which makes sense given where the PS3 is selling in terms of market share. I don't believe removing backwards compatibility is a huge deal, considering that most people who want to play PS2 games will continue to do so on their PS2s," he said.

So why Sony wouldn't make the PS3 backwards compatible? There has been tons of talk about the PS3 being priced too high. "Let's see, it costs money to make the PS3 backwards compatible, the price of the console is too high...I've got it, they're going to strip out the functionality and reduce the price. That's surely the answer." There is only one answer for such narrow-minded thinking: the recency effect.

The recency effect, in psychology, is a cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end on a list rather than items that were in the middle on a list. For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, he or she is likely to conclude that there were more red cars than blue cars throughout the drive.

Right. Since high price is the proximate problem, any action Sony takes will be perceived as trying to address this issue. My view: WRONG. Consider this explanation. PS2 is kicking PS3's ass, both in terms of hardware and software sales. And not by a narrow margin, mind you. Consider these figures from VGChartz:

So, if I'm Sony, am I worried about people focusing on the PS3, or not cannibalizing my far more profitable cash cow, the PS2? Come on, guys. The answer is right in front of you. Sony is actually being economically rational for a change. The last thing they want is for PS2 console sales to slow to a trickle, sales that attract a far greater margin than PS3.

Further, they are selling many more PS2 titles than PS3. And Sony is enjoying that nice license stream off of PS2 games. So bottom line, they are using PS2s profits to subsidize PS3s losses to offset a slower-then-expected adoption cycle. And they are making the bet that the PS3 has the technology and will have the game library to overtake Microsoft's (NASDAQ:MSFT) Xbox 360 and Nintendo's (OTCPK:NTDOY) Wii over the long haul, ergo their 10 year console life cycle positioning.

It all makes perfect sense, doesn't it? But again, my pal and I aren't Wall Street analysts. And maybe that's a good thing.

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Tagged: , Electronic Equipment, Japan
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