Shares of Sony (NYSE: SNE) tumbled on Feb. 4 after the Japanese conglomerate posted mixed third-quarter numbers. Its revenue fell 10% year over year to 2.4 trillion yen ($21.3 billion), missing estimates by 270 billion yen ($2.5 billion). Its net income surged 45% to 429 billion yen ($3.8 billion), or $2.93 per share, which beat expectations for $1.03.
The bottom-line beat was impressive, but it included a 154-billion-yen ($1.4 billion) reversal of tax-related valuation allowances in the U.S. and other one-time benefits. Excluding those benefits, Sony's net income declined 43% to 158 billion yen ($1.4 billion) on an adjusted basis.
Sony attributed those declines primarily to the softer growth of its gaming business, which had been its strongest division in previous quarters. Let's see why that growth engine lost its mojo, and whether it can recover.
Image source: Getty Images.
Understanding Sony's gaming business
Sony's game and network services (G&NS) division sells PlayStation consoles and accessories, games, and services through the PlayStation Network. It generated a third of Sony's sales and nearly a fifth of its operating income during the third quarter. Here's how the business fared in year-over-year growth over the past year.
Year-over-year growth in yen terms. Data source: Sony quarterly reports.
After two quarters of robust growth, some bulls expected Sony's G&NS unit to extend its winning streak into the third quarter's holiday shopping season. However, Sony noted that waning sales of PlayStation hardware throttled the unit's growth and partly offset its higher software sales.
That wasn't surprising, since Sony launched the PS4 more than five years ago. The PS4 is already the top-selling current-generation gaming console with 92 million units shipped worldwide, followed by Microsoft's (NASDAQ: MSFT) Xbox One (41 million units) and Nintendo's (NASDAQOTH: NTDOY) Switch (30 million units), according to VGChartz.
The launches of the PS4 Slim, PS4 Pro, and PS VR headset in late 2016 generated some fresh hardware sales over the past two years, but the hardware business is clearly running out of steam as the current gaming-console generation matures.
Image source: Sony.
Sony CFO Hiroki Totoki attributed the G&NS unit's operating income drop to "aggressive" promotional sales of PS4 hardware to "expand the user base." Totoki stated that Sony sold in 8.1 million PS4 units during the quarter, which marked a decline from the prior-year quarter but was "in line" with the company's expectations.
Sony wants to sell more PS4s to tether more gamers to PlayStation Plus, which grew its subscriber base by 4.8 million annually to 36.3 million. That expanding digital ecosystem helps Sony sell more games and digital content, widen its moat against rivals like Microsoft and Nintendo, and offset the impact of its peaking hardware sales.
But on the bright side...
The slowdown in Sony's G&NS business is disappointing, but management maintained the unit's prior forecast for 21% sales growth and 75% operating income growth for the full year. It believes that add-on content sales in games and PS Plus should offset softer hardware sales.
The growth of Sony Music, which nearly quadrupled its operating profit to 147.1 billion yen ($1.3 billion) and replaced G&NS as its most profitable division, also partly offset the weakness of its gaming business.
The G&NS division's 10% sales growth was also notably higher than Microsoft's 9% constant currency growth in gaming revenue last quarter. Meanwhile, Nintendo recently reduced its full-year sales forecasts for the Switch and handheld 3DS. This indicates that the hardware slowdown isn't unique to Sony, and that its growth should accelerate again once a new console cycle starts.
Long-term investors shouldn't fret over the slowdown in Sony's gaming business. Sony remains well-diversified across multiple industries, and other growth engines (like Sony Music) should carry the torch as it pivots the PlayStation business from lower-margin hardware to higher-margin software and services.
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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of Microsoft. The Motley Fool has a disclosure policy.