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While it's expected that with the initial strong retail sales for Microsoft's (NASDAQ: MSFT ) Xbox One and Sony's (NYSE: SNE ) PlayStation 4 -- with both having sold a million consoles during their respective launches -- will also lead to software flying off the shelves, a major expected driver of growth for the next generation platforms won't be reflected on any of the early NPD statements that investors will be clawing for come December and beyond.
The anatomy of a video game
There's good reason as to why Microsoft attempted and failed to have the Xbox One become an all-digital console. Sony strategically waited to see how the gaming community would react after the Xbox One's initial unveiling before coming to a decision to offer both physical and digital media. Had the onslaught Microsoft faced at the hands of the gamers gone the other way, there is no doubt that Sony's strategy would've been different because of one key reason, the huge gap in margins between physical and digital media.
Source: Data, OnLive; Chart, Los Angeles Times
Let's take a look at the anatomy of a $60 dollar video game that sits on the shelves at your local GameStop (NYSE: GME ) for every disc that GameStop carries, a publisher would net around $45 dollars leaving GameStop with a $15 dollar cut. With the money the publishers received, they would then need to pay an average $7 platform royalty fee to the platform holders, let's say Sony, for every game that is produced. Then they'd have to subtract $4 for the manufacturing and distribution cost and to top it off, every unsold copy of the title is returned at the expense of the publisher which eats away an additional $7. This leaves publishers with an average of $27 for every game disc they produce.
Source: Author's calculations based on the industry standard 70/30 split
Digital media cuts out the middle man completely, as well as eliminating the fee for producing discs, distribution, and returns. With bandwidth costing nearly nothing these days, this leaves greater margins for both the publishers and the platform holders where the standard split among the industry sits at around a 70/30 split. Compared to the $27 average publishers received in the prior example, they'd now be making $42 and the platform holders shares more than doubled at $18 -- no wonder why both Sony and Microsoft want to incentivize digital sales.
So why will consumers make the switch to digital?
The PlayStation 3 already offers a pretty attractive storefront design, but with a sluggish performance which deters customers away, small storage space that comes standard with nearly every console purchase, and a front end that barely calls any attention to the existence of a store (which is already hidden as is), the potential was never fully realized.
In comparison, the PlayStation 4 comes standard with a 500 GB hard-drive, offers a snappier operating system with a smartly integrated store front that will naturally lead to better utilization by consumers. Not to mention, with the PlayStation Plus service becoming mandatory for being able to play all PS4 titles online, the weekly sales offered to members of the service will drive sales even further.
In comparison, Microsoft had been ahead of Sony for the majority of the PlayStation 3's lifetime when it comes to digital sales. The Xbox 360 has seen several revamps done to its operating system throughout the duration of its lifetime, with the final one being based off the Metro design, the same design principle that has been seen in Microsoft products within the last year including the Xbox One.
Every single one of these revisions introduced a storefront that would progressively become more evasive up to the point where you couldn't navigate to either your friends list or library without seeing an advertisement. Even if it was annoying, it did drive sales but the Xbox 360 shared a similar shortcoming because the average hard disk space was limited. However, like the PlayStation 4, the Xbox One comes with a standard 500 GB hard drive.
Should GameStop be more scared than they already are?
While GameStop has been saved for at least another generation, both consoles now offer preorders and day one releases for all future titles moving forward and given those margins, where do you think the majority of publishers will wants their sales to come from? With strong numbers expected from the upcoming NPD release, don't forget a large market that is growing 33% each year -- and possibly more with the launch of the new consoles -- won't be represented in those numbers.
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