Sony Part 3: State of Play





This is the third and final part of our three part series on Sony Group. In this note we look at Sony’s Gaming and Network Services (G&NS) segment and the fundamental pillars supporting its profitability. By doing this we uncover that the business is dependent on the technical competitiveness and the catalogue of game titles available on PlayStation, Sony’s console platform. We look at the primary known threat to the business’s profitability, which is cloud gaming. Breaking down how cloud gaming is technically achieved we are able to compare the technical limitations and advantages of both console based and cloud based gaming. Through this we can determine whether cloud gaming posses a disruptive threat as a substitute to Sony’s entrenched console platform, or if instead cloud gaming can be viewed as a complimentary service supporting further growth. In regard to the PlayStation business, we also analyse the current heightened level of deal activity in the game development space. Consolidation amongst game developers and increased ownership by the platform operators is seen as being indicative of a maturing gaming industry. Given this we look at Sony’s level of investment in gaming software to ascertain whether the company’s consistently strong performance over the past 2 decades in the home console market has allowed the company to gain a critical mass of IP and third party titles on its platform to continue attracting gamers.


Final comments outline how the company’s subsidiaries are effectively collaborating to create value no other company can, and why this second layer of value creation is being missed. The research note then concludes the series by valuing Sony via a sum of the parts valuation and valuing the financial business at the implied valuation Sony paid in early 2020.

PlayStation


Gaming involves two key types of service providers who on a fundamental level do two very different things. These are the gaming platforms and the game developers. Traditionally the purest examples of the platform operators are PlayStation and Xbox. Both Sony and Microsoft have invested heavily to attract gamers and game developers to their platforms over the past 2 decades.


Game developers are naturally attracted to the leading platforms that have the most gamers, which in turn attracts more gamers, creating a powerful reinforcing effect. Sony’s PlayStation has benefited from this reinforcing effect for the past 2 decades, where it has been the leading platform for home console gaming.


Traditionally there was a high level of risk in the gaming platform business, as every 5 or so years a new generation of platform was released. This introduced the chance that any lead could easily be broken if the platform didn’t hit the mark. As games were held through physical discs and with gaming libraries largely exchanged as store credit towards the new generation gaming system upon its release. This effectively allowed gamers to wipe the slate clean from generation to generation and if they decided to switch platforms there were minimal switching costs faced.


The result was a volatile business. One mainstay, however, was the PlayStation, with 4 of the top 5 most sold gaming consoles of all time. The overall volatility of the gaming console market can be seen in the below chart, with each company’s share of console sales changing materially from generation to generation.



This dynamic has largely changed with the proliferation of digitally downloaded games largely replacing the sale of physical copies of games. This has also coincided with backwards-compatibility support from Sony and Microsoft in their latest generation of gaming systems, the PS5 and Xbox Series X/S. What this has created is a large, accumulated library of compatible games amongst each platform’s users. As a result, this has seen the creation of significant switching costs between platforms, anchoring users to the platforms that they have invested in over the previous generations.


The below chart depicting cumulative PS4 unit sales gives an idea of switching costs faced per console, with a game software to console ratio of 12x at the end of the generation’s lifecycle:



It is no secret that console makers generate their cash from game software sales rather than console hardware sales. This is no different for Sony’s PlayStation. The business is dependent on a strong lead in console gaming to realise large royalty payments from the sale of 3rd party titles developed for its PlayStation platform. As we can see in the below chart of PS4 unit sales, an expanding installed base of consoles precipitates an ever faster run-up in game software sales:


The question becomes what is it that Sony’s PlayStation division fundamentally does on a granular level, and how can it protect itself from competitive forces that threaten this lead?


Exclusive Gaming IP


Gaming platform companies have been competing on exclusive IP since the advent of console gaming in the 1970s, leading to the acquisition and internal development of numerous gaming studios.


Now as the industry grows and matures, this competition for exclusive IP is manifesting in the acquisition of game development studios amongst existing gaming platforms, as well as new entrants such as Amazon. In the past 18 months we have seen an increase in the cadence of investments made by gaming platforms in game development. All this capital looking for differentiating and exclusive IP has resulted in the cost of developing games soaring, with big games requiring ever bigger budgets.


This resulted in Google recently bowing out of the game development business. The head of Google’s gaming business, Stadia, stated that the reason they were bowing out was because:


“Creating best-in-class games from the ground up takes many years and significant investment, and the cost is going up exponentially[1]. – Phil Harrison, Vice President and GM, Google Stadia


We have seen major investments in first-party studios by both Sony and Microsoft over the past 18 months. In September 2020 Microsoft made the largest acquisition in the gaming industry’s history, purchasing ZeniMax Media, parent of Bethesda Softworks for $7.5 billion. In the last 2 years Sony has acquired 6 gaming studios alone. Sony’s acquisitions were on nowhere near the scale of Microsoft’s, with the largest deal being for $230 million.


This has been great for IP owners, and with both Sony and Microsoft enjoying extensive catalogues of exclusive gaming IP we believe it should be viewed as a positive. With the value of both consoles exclusive IP catalogues surging, the competitiveness of their platforms has become further entrenched. As is evident in Google’s withdrawal there are few companies that can foot the bill to develop their own catalogue, with no guarantees their propriety games will hit the mark and attract players.


This also likely a sign of the modern gaming industry maturing, with increased consolidation of IP and game development. In an interview conducted on September 13th, 2021, Sony Pictures CEO Tony Vinciquerra hinted that this was the case when replying to a question on consolidation in the film industry with:


“forms of traditional media probably have peaked and the new growth area will be games ... and I think the next area of consolidation will be in the games business".[2] - Tony Vinciquerra, CEO Sony Pictures


Noticeably though we have not seen a major increase in R&D, which includes investments in the development of new gaming titles as well as in technologies underpinning the PlayStation platform. This is depicted in the below chart depicting the financial data for R&D and revenue in the G&NS segment:




What this demonstrates is that Sony’s 2 decades leading the home console platform market has seen it accumulate what is likely a critical mass of IP to keep attracting gamers to its PlayStation platform. This has alleviated the company’s need to aggressively invest in game developers like its competitors Microsoft, who have continually played catch-up in the console market for 2 decades, and new entrants such as Amazon who are looking to establish a cloud gaming platform.



Cloud Gaming


A large segment of the investment community currently sees cloud gaming as an existential disruptive threat to the console market. To understand if this is valid we first need to understand the technical underpinnings of both cloud gaming and console gaming to see if the former can eventually be an effective substitute for the latter.


Server Blade Design

Cloud gaming eliminates the need for a console by streaming the sound, visuals and gamer inputs between a user’s device, whether it be a smart TV or mobile phone, to a dedicated server. There is a common misconception that the dedicated server enjoys a higher level of computing power than the consumer console hardware that gamers can buy for their living rooms, however, this is incorrect.


The servers supporting both PlayStation and Xbox’s cloud gaming services are comprised of console units identical in componentry and design to consumer models. When an individual logs into their cloud gaming service they are allocated a dedicated machine amongst the many server racks at the data centre. The only difference between the server machine and the one in a gamer’s living room is that there is no dedicated power supply or network chip per machine, this is instead shared amongst the consoles sharing the same server blade.


In its mid-2020 update Microsoft showed off what their Xbox server blades look like. Each server blade housed 8 Xbox One S machines. This server blade is depicted below with each grated area being 2 Xbox’s stacked on top of each other:



https://fragwire.com/project-xcloud-server-blade-analysis/

The point of looking at the server blade's design is to determine whether there are any meaningful performance benefits from processing a game on the cloud. We do not foresee the machines used to run games on the cloud as ever changing materially from those used in a consumer’s home.


This is due to the fact that it would require significant updates and changes to be made to each console gaming title, as each game is specifically designed for the standardised hardware of the console gaming platform. The current method of using identical gaming machines within the cloud gaming server blades requires near-zero input from developers for the games to run on the cloud streaming service as opposed to a console in a living room.


From a performance perspective, what we are left with is a service that is underpinned by an equivalent amount of computing power as a home console system. As this service doesn’t require consumers to pay for a console upfront but merely subscribe, then why would anyone buy a console? Well, the answer lies in the fact that the gamer and the server based console are separated by an internet connection that often introduces deal breaking levels of latency.


Latency

The easiest way to view latency is as the time it takes between a message being sent and its reply being received. In the context of game streaming this manifests as the time it takes between an input being made on a controller causing an observable action on an individual’s screen. For this to happen many processes have to occur in between, each one contributing to overall latency experienced by the gamer.


Latency can be broken into the following components:

  • Network latency

  • Propagation

  • Router

  • Transmission medium

  • Storage delays


  • System latency (in order from input to observable action)

  1. Peripheral latency

  2. Console latency

  3. Display latency

When playing online multilayer games all of these components of latency are inherent within both console and cloud gaming. When games are played locally on a console network latency is eliminated. Overall latency is dramatically increased in cloud gaming due to the fact that network latency is introduced between components A to B of system latency. In console gaming this network latency is absent between components A to B of system latency in all instanes.


For online gaming the impact is that game streaming faces 3 times the amount of network latency compared to console based gaming. With playable network latency seen as being anywhere under 100ms, this would require internet connections supporting game streaming to support latency levels under 33ms.


We also need to take into account the fact that game streaming will take place over a wireless connection in the majority of instances, whether this is via mobile, laptop or tablet. The sole instance where a faster wired connection is feasible is when game streaming services are accessed via an application or dongle installed within a smart TV. In simpler terms, it is near technically impossible for cloud gaming services to reach technical parity with console based gaming in terms of observable performance.


Compliment Rather than Substitute

Internet speeds will continue to become faster, making game streaming more and more of a compelling option to gamers who do not want to make an upfront payment for a console. Due to the core technical limitations game streaming faces, particularly in high resolution multiplayer gaming where console gaming already excels, the service will always be inferior to console gaming in regard to performance.


In our view this limits the threat of significant disruption to the console gaming market that game streaming poses. However, we still believe that game streaming will be an important complimentary offering to any console based platform. Sony will need to continue to develop their PlayStation Now game streaming service so as to take advantage of this opportunity.


As of May 2021, Sony had confirmed that its PlayStation Now service had reached 3.2 million subscribers. The service was launched in 2014 and is currently positioned poorly in our view given that Microsoft’s Game Pass offering that was launched in 2017 had amassed 23 million subscribers in May of 2021 and continues to close in fast on the 30 million subscriber mark.


Game Pass advertises cloud gaming as a complimentary service, allowing console users to play games without having to download the full title from the Game Pass library. In contrast, game streaming in Sony’s PlayStation Now service is currently the core feature advertised, with the much smaller game library positioned as the secondary offering. Going forward game streaming in our view will likely continue as a complimentary service, allowing console users to play full titles, albeit at a lower level of quality, whilst the digital copy is installed on the console’s solid state drive. Due to this we believe Sony should reposition its PlayStation Now service to advertise the streaming service as the secondary component with access to the limited game library as the primary value offering.


If Sony is able to position its cloud gaming service in this way and improve upon it we believe it will further support console based gaming platforms as a convenient complimentary service. Cloud gaming will also support game software sales through readily accessible demos that do not require long installation times. For example, recent hit titles, such as Read Dead Redemption 2 and Call of Duty: Modern Warfare, have install sizes well over 150gb each. The ability to first stream these titles or games similar to them via demos with saveable progress will open avenues for console platforms such as PlayStation and Xbox to increase sales via their higher margin digital stores.



Digital Tailwinds


The gaming industry is in a transitionary phase of game software distribution. Bricks and mortar gaming retailers are being squeezed out of the market by digital stores offered by PlayStation and Xbox. In 2015 the percentage of PlayStation games sold via digital download was 19%. In 2020 this had risen to 65%, a CAGR of 27.9% per annum. This is a profoundly profitable shift for console platforms, as they receive a much larger piece of the sales ticket when games are sold via their digital stores.


Physical Disk vs Digital Download Unit Economics

Traditionally console platforms received a royalty of around $12 from every physical copy of a game that is sold on their platform. With games typically retailing for $60 at release this equated to a 20% commission. On the other hand, digital game sales see both Sony and Microsoft taking a 30% cut from the games ticket price, a 50% increase in the commission for console platforms.


A secondary effect of digital game sales is the fact that the market for second-hand games has largely disappeared to the point that retailers such as GameStop no longer itemise the segment. The impact digital game sales and increased backward compatibility support have had on second-hand game sales is evident in the below chart depicting GameStop’s pre-owned game sales:



https://www.nasdaq.com/articles/gamestops-most-important-business-trouble-2018-09-11


Current State of Play


Since its release in November 2020 Sony’s current generation console the PlayStation 5 has sold just over 10 million units as of June 30th, 2021. In comparison, the combined sales of Xbox Series X & S, Microsoft’s latest generation of consoles, as of 30th June were estimated at 6.5 million units. In short PS5’s are outselling the new Xboxes by 55%. This is shown in the chart below:


Xbox has made up considerable ground considering it is being outsold by only 55%. The PS4 outsold the Xbox One generation by over 2 to 1. This, however, is more a product of an abnormally horrid launch for the Xbox One system in 2013 rather than any deterioration in Sony’s products.


The reception of the PlayStation 5 and its sales figure show that there is currently no sign of Sony’s G&NS segment slowing. The two pillars underpinning the segments profitability, a competitive gaming platform and an attractive content offering, have been explored on a granular level and appear reasonably insulated from competition.


Valuing G&NS

There are no quirks or tricks in our example valuation for the G&NS segment, just a simple DCF with a multiple based valuation as a sanity check.


Sony has averaged a 12% CAGR over the past 5 years in the growth of its G&NS segments revenue. This has coincided with a 38% CAGR for the growth of the segment’s operating profit. We have constructed our DCF assuming that the company can continue to grow sales at its long-term rate.


This decision was made based on our understanding of the growth opportunities available in complimentary cloud gaming services, the continued shift towards digital game sales and Sony’s existing catalogue of games allowing the company to attract gamers at a faster rate than the industry as a whole. In light of these attributes a 12% CAGR seems reasonable given consensus estimates for the gaming industry’s growth are in the vicinity of 10% per annum.


We further assume investment levels and operating costs remain similar to their prior state. The output is a valuation of 6.3 trillion JPY, or 57.4 billion USD, equivalent to a P/E ratio of 26.40.





Summing Up Sony


Sony’s businesses are complicated in nature, and adding to this is the fact that there are multiple of them to understand. What this creates is a situation requiring immense work to understand how each business functions on a granular level.


There is then additional work required to understand Sony, and it is related to how the company’s businesses interact with one another. It is this second level of work that the reports we have read so far stop at, though it is this additional layer of understanding that is most critical.


Through this research series we have explored this additional layer of understanding through multiple examples. More impressive is the fact that the collaborations are in areas that are experiencing significant tailwinds. Examples range from collaboration between Sony’s semiconductor manufacturer and digital camera unit, to the leveraging of PlayStation gaming IP in film by Sony Pictures. For the above explained reason it appears this second level of value creation and insulation from competition is being largely missed by the market.


Using our valuations for each business segment over the series, and implied valuation for Sony’s financial business based on the price the company paid for a 35% stake in 2020, we get a total group valuation of 23 trillion JPY. This implies a share price of 18,500 JPY compared to Sony’s current share price of 11,860 JPY. This valuation implies a P/E ratio of 35 using Sony's 5-year traling average net income.

Sony Financial


Sony Group




[1] https://blog.google/products/stadia/focusing-on-stadias-future-as-a-platform-and-winding-down-sge/

[2] https://bofa.veracast.com/webcasts/bofa/mediacommunicationsentertainment2021/idW907c3.cfm#/player/html5/speed/v150

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