Microsoft thought it had a key-advantage and went straight for profit-maximization hoping Sony would do the same. Instead, Sony announced a 20% haircut on the price that Microsoft quoted.
Following that, the crowds cheered. The average net profit margin in the consumer electronics sector is 6.17%. So if Sony took a 20% haircut, it means that Sony is near break-even or losing money.
Now Microsoft will have to compete with Sony in fiscal year 2014 with a 20% price cut of its own, and I don’t think either firm will push prices any lower. In an oligopoly, the firms will not compete in a market if it is not generating a profit. Because of this, I believe that the current profit margin that both Microsoft and Sony will experience on the next-generation consoles will be at around 5%, the industry-wide average.
Pricing over a life cycle
Microsoft will make more money than Sony Corporation (ADR) (NYSE:SNE) in year one. But in year two, both Sony and Microsoft will sell consoles at the same price point, leading to similar profit margins. The $400 price tag will remain for perhaps two to three more years.
Console-device demand will peak in the third or fourth year. Eventually, the profit margins for Microsoft and Sony will shrink in year three and four because prices will be dropped again in order to stimulate demand. To offset the decline in prices, component manufacturers like Advanced Micro Devices, Inc. (NYSE:AMD) will have to accept an even lower average selling price.
Advanced Micro Devices, Inc. (NYSE:AMD)’s premium pricing for processors and graphics will drop because it will become obsolete when compared to a desktop-computer component. Advanced Micro Devices, Inc. (NYSE:AMD) will have no choice but to cut the price. Eventually AMD will be hit with smaller gross margins (the Qualcomm Snapdragon sells at $20 per unit, just so you can get an idea of how low prices can go).
Conclusion
Microsoft will earn more than a 20% profit margin in its gaming segment in the first year, but it is likely that the profits will be at around 5% in the following fiscal year (basically 2014). Investors in Sony Corporation (ADR) (NYSE:SNE) shouldn’t anticipate a boost in profitability or in earnings from the game segment because of its pre-emptive 20% price cut at E3. AMD will experience diminishing returns from its involvement in both consoles.
The article Microsoft and Sony: What Happened Behind E3 originally appeared on Fool.com and is written by Alexander Cho.
Alexander Cho has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft. Alexander is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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