Sony and Microsoft's New Consoles Will Be Big Loss Leaders

Sony (NYSE: SNE) and Microsoft (NASDAQ: MSFT) both recently pulled back the curtains on their next-gen video game consoles, set for release in late fall of 2020. They'll both sport solid-state drives (SSDs), use ray-tracing technology, and support 8K resolution graphics. However, both companies stayed mum about their launch prices.

In a recent interview at GamingBolt, Wedbush analyst Michael Pachter suggested that Sony's PS5 and Microsoft's "Xbox Scarlett" will both launch at $399. However, Pachter noted that their hardware specs suggested price tags of "$500 or so," indicating that both companies will likely take losses on each console sold.

Companies usually take losses on gaming consoles

That loss-leading strategy for gaming consoles isn't new. At its launch in 2013, Microsoft's Xbox One had a production bill of $471 for manufacturing and materials according to IHS, compared to its launch price of $499.

Sony's PS4, which launched at $399, cost $381 to make. After factoring in marketing, shipping, and other operating costs, Microsoft and Sony likely lost money on each console sold. Both companies also subsequently lowered the prices of their consoles several times.

Anchors for software and subscription sales

Sony and Microsoft don't mind selling their consoles at a loss since they recoup the costs through software and subscription sales. For every $60 game sold, Microsoft and Sony retain about $7 in platform royalties. They also retain about $27 in publishing fees for first-party games.

Sony and Microsoft are also launching more subscription services to squeeze out more revenue per gamer.

Microsoft offers Xbox Live Gold, which costs $60 per year; Game Pass, its unlimited gaming option for $10 per month; and the new Xbox Game Pass Ultimate, which combines Xbox Live Gold and Game Pass for $15 per month. It also plans to launch its new cloud gaming service, Project xCloud, with the new Xbox next year.

Sony's PlayStation Plus, its answer to Xbox Live, also costs $60 per year. Its cloud gaming platform, PS Now, costs $100 per year and lets gamers stream over 750 PS2, PS3, and PS4 games to PS4 consoles and Windows PCs. To set up the anchor for those subscription sales, it wouldn't be surprising if Sony and Microsoft launched their new consoles at $400 -- even if the devices cost $500 to make.

The prices could still be too high

Sony and Microsoft might be aiming at $400 as a "sweet spot" for console sales, but the arrival of new subscription-based services -- like Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) cloud gaming platform Google Stadia and Apple (NASDAQ: AAPL) Arcade -- could throttle demand for dedicated gaming consoles.

Google Stadia will run on a wide range of devices, including phones, PCs, and Chromecasts, while Apple Arcade will run on all current-gen iOS devices. These single subscription services could be more attractive alternatives to Sony and Microsoft's platforms, which rely on customers buying both dedicated consoles and subscriptions.

Microsoft is aware of that threat. That's why it might launch two versions of the Scarlett in 2020: a cheaper "Lockhart" version for streamed games, and a pricier "Anaconda" version for high-fidelity gaming on locally installed software.

Sony hasn't revealed any plans for a cheaper PS5 yet, but it plans to move some of its media and gaming assets to Microsoft's Azure cloud platform. That move, which was part of a broader cloud partnership between the two companies, could be aimed at countering Google's aggressive moves into the gaming market.

Meanwhile, sluggish sales of PCs could force computer makers to sell cheaper gaming PCs, which would narrow the gap between high-performance PCs and cheap gaming consoles.

The bottom line

Microsoft and Sony both reported slower gaming hardware sales in their most recent quarters. Those declines were partly offset by stronger software and subscription revenues, but demand for current-gen consoles has clearly peaked.

That's why the jump to next generation consoles next year is crucial. If Sony and Microsoft price their consoles poorly and gamers flock to other decentralized platforms like Stadia or Apple Arcade, both companies could see their thriving gaming units wither into money pits.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Microsoft. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.