Judgment Day Has Come for the Console Titans

Well, it's finally almost here.

After all the hype, promotions, unforced errors, and mind chess played by the warring companies, the eighth generation of consoles is upon us. Microsoft's (NASDAQ: MSFT  ) Xbox One and Sony's (NYSE: SNE  ) PlayStation 4 will hit the shelves this month. As fans line up at the stroke of midnight to sink their teeth into the next-generation consoles, investors will be hanging back to see which way the money winds will blow in probably the most watched fourth quarter for video games in a decade. Yet, if the seventh generation is any clue to initial success of the eighth generation, investors may want to hold their wallets longer than gamers will hold on to theirs.

In a generation far, far away
Seven years ago, the Xbox 360 and the PS3 stumbled out of the gate, if not totally face-planted. Reports circulated about melting consoles and fried hard-drives from the start, as well as a slate of games that were more sixth gen in quality than a harbinger for a video game revolution. One of my lasting memories of that era was seeing a review for launch title Mobile Suit Gundam Crossfire on the PS3, a game that according to video game expert Adam Sessler had ground graphics like Armor Core on the PS1 and was considered "shovel-ware of the highest order." Even though games like Call of Duty 3 and Halo 3 soon followed, initial hardware problems left a bad taste in gamers' mouths, requiring quick updates by both Microsoft and Sony to win back consumer confidence.

Microsoft also ran into a supply problem on its launch. After starting production three months before showtime, only 10% of orders were filled in the first few weeks of launch due to high demand. Microsoft would recover to sell 1.5 million systems in the first three months, but it was an embarrassing lack of foresight that kept Microsoft from truly capitalizing on tech-happy investors.

Still, there was nothing worse than the PS3's mistake of making a console for more than what they were selling for. Initially, the 20GB and 60GB systems cost over $800/machine to make, yet at most were sold for $600, depending on the size, putting the company $240-$300 in the red for each machine made. It would take until 2009, nearly three years after it was released, for the costs to come down to a point where the machine was profitable. By that time, Sony had lost ground to Microsoft in terms of quality of cross-platform games as well as exclusive content. Sony would regain the edge, thanks to the success of franchises like Killzone and Metal Gear Solid, but it was a costly unforced error that sent the company into an investment malaise that they are just now remedying.

Sony going for it all
Sony made a bold announcement with plans to sell over 3 million systems by year's end, a tall order given its two million threshold last generation, and the Xbox 360's 1.5 million unit total. This may actually be in reach for Sony given its dominating performance at this summer's E3 convention, and Microsoft ticking off the video game community with its initial ban on backwards compatibility and sporadic launch schedule. Microsoft was dealt further bad news when it was announced that due to a hardware problem, users will not be able to play the Xbox One until they install an update upon plugging in their systems. These setbacks may hurt Microsoft in the short term as more video game enthusiasts run toward Sony's arms.

Microsoft's winter of discontent?
The 3 million sales target is ambitious on its own, but making sure costs can stay down to churn a profit will be Sony's biggest measurement stick for investors. Sony has been trying to become a solely electronics company after trying to jettison its movie and TV arms, and this will be a big test to see if that strategy pays off. Microsoft meanwhile will rely on its ecosystem of Xbox diehards, who enjoy the sophisticated Xbox Live Marketplace from the Xbox 360, and the casual gamer base that likes the ability to use Microsoft features like Skype and Internet Explorer. These are the fans that will stick with Microsoft even after its summer (and early fall) from hell.

The bottom line
Investors should pay close attention to reports on initial sales from the first few weeks, and any hardware issues these consoles may encounter before hitting the buy or sell buttons. It won't be fireworks for your bottom line, but whoever comes out of the fourth quarter with the lead in sales and is the least dinged up by the demanding armada of critics will be the one who gets Wall Street's applause. Consistent performance is the key for gamers and investors alike, nowhere is that more important than the first few months of the next generation of games and consoles. Stay plugged in. 

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