Sony (NYSE:SNE) has been selling the PS5 gaming console at a loss since its launch last November. In its third-quarter report, Sony said its "strategic price points" for the PS5 were lower than its manufacturing costs.
Sony didn't disclose exactly how much money it loses on each sale, but Wedbush analyst Michael Pachter previously estimated Sony would barely break even on the full-featured PS5, which costs $500, and take a loss on each PS Digital Edition, which costs $400 and strips out the optical drive.
That news might seem troubling for Sony, since the PS5 is often cited as a major catalyst for its long-term growth. However, I'll explain why investors shouldn't fret over these short-term losses.
Gaming consoles are usually low-margin products
Companies usually sell their consoles at razor-thin margins to remain competitive, maintain their market share, and attract more developers.
Back in 2006, Sony launched the 20GB version of the PS3 for $500 and the 60GB version for $600. However, IHS estimated it lost over $300 on each 20GB console and $240 on each 60GB console. The firm also claimed Microsoft (NASDAQ:MSFT) lost about $130 on each Xbox 360 sold.
Sony launched the PS4 at $399 in 2013, and IHS estimated the console cost $381 to build. Microsoft initially sold the Xbox One, which reportedly cost $471 to manufacture, for $499. But after factoring in marketing costs and other expenses, both companies probably still lost money on each console.
Planting the seeds for future profits
Console makers usually offset their hardware losses with software sales. For each physical video game sold at $60, the publisher retains about $27, the retailer keeps $15, the platform operators (such as Sony and Microsoft) earn $7, and the remaining $10 is split between other parties.
Sony and Microsoft both publish first-party games and distribute them on their own digital download platforms, which allows them to retain the publisher, retailer, and platform operator revenue. They also retain nearly a third of the revenue from third-party games sold on their digital stores.
Therefore, Sony and Microsoft only need each gamer to buy a few games to offset their initial hardware losses. That's why Sony is willing to take a steeper loss on each PS5 Digital Edition -- which it can easily recoup by selling more digital games.
Meanwhile, manufacturing costs for consoles generally decline each year, which makes it easier to lower the price of the original console, launch cheaper versions, or sell more powerful versions at similar prices.
Sony's gaming profits are still rising
Sony's G&NS (game and network services) revenue surged 40% year over year during the third quarter -- which included a month and a half of PS5 sales -- and accounted for a third of its top line. It attributed that growth to higher software sales and robust demand for the PS5.
The segment's operating income rose 50% year over year and accounted for 22% of Sony's operating profits. It noted that robust software sales, higher service revenue from PS Plus, and higher profit margins from its PS4 hardware all offset the PS5's launch costs and initial losses.
Sony raised the G&NS segment's full-year revenue growth forecast from 31% to 33% on higher-than-expected sales of its software, PS Plus services, and peripheral devices like controllers.
It also raised the segment's operating profit growth forecast from 26% to 43%, thanks to ongoing cost-cutting measures, favorable foreign exchange rates, and the strength of its higher-margin PS Plus services. Those strengths should all easily offset Sony's initial hardware losses for the PS5.
The bottom line
Last November, I predicted Sony's PS5 launch, its strong music business, the growth of its financial services, and better cost controls at its weaker businesses would all propel its stock higher.
Sony's stock has risen 40% since I wrote that article, but I believe it still has room to run this year as its plentiful strengths offset its handful of weaknesses -- including its initial losses on each PS5 sold.