In a report titled “Will the PS2 Hold Up?” released today by the Susquehanna Financial Group, analysts Jason Kraft and Chris Kwak look at the holiday prospects for all the major consoles to be released through the end of the calendar year, and wonder whether the PS2 can survive in the new climate.
The report starts as follows (thanks to Kraft and Kwak for permission to reprint here):
"In upgrading the Big 4 (ERTS, ATVI, THQI, and TTWO) in June, we believed the stocks had been oversold. Recently, we’ve been concerned that sentiment has bounced too far too fast. There are many who believe it is cruise control now for the group. NPD data for June, July, and August were solid, and September is shaping up to be another good month on the back of Madden NFL 07, NCAA Football 07, and Saints Row. November is the industry’s most anticipated month of the year.
Not only does November bring the PS3 and Wii, it brings arguably the most anticipated next-gen titles, Gears of War (Microsoft) and Call of Duty 3 (Activision). Could Gears of War be the next blockbuster for Microsoft Game Studios and could it boost Xbox 360 (“360”) hardware sales? How will Call of Duty 3 realism look and feel on Xbox Live on 360? What about Resistance: Fall of Man on PS3? Will the Wii herald a new interactive gaming paradigm that resonates with the casual gamer and family?
If the video game market can make it through this holiday and spring without too many wounds (PS3 supply in particular), investors will have, not withstanding valuation concerns, much to look forward to over the next six or seven years. Getting to spring should be the goal. There’s a catch and a snag here, and it’s not completely with the next-gen consoles. The issue may have more to do with the PS2 market.
The big question: Will the PS2 hold up while the PS3 supply ramps? Or will the PS3 delay and limited volume cripple the PS2 installed base, as was the case with Xbox v1 (“XBX”) in the face of the 360 launch? We believe the answer to this question will determine if estimates and expectations have upside or downside, and whether stocks take a deep breath before at last casting the yoke of current-gen consoles.
PS2, XBX, GCN
When the Xbox 360 launched in November 2005, demand for Xbox v1 (XBX) fell markedly. While PS2 software revenue in October 2005 (leading up to the 360 launch) rose 23% month-over-month, XBX revenue fell 11%. November 2005 was worse: having grown 100%+ month-over-month in November the prior three years, XBX revenue grew a meager 57% in November 2005, down from an already weak October month. Microsoft gave up on XBX and so did the publishers. We project current-gen revenue for 4QCY06E by platform.
We expect the PS2 platform to receive greater support from the OEM and third-party publishers than XBX last year. Several high-profile titles could help PS2 demand stay strong. Among the titles this fall, Guitar Hero II could make the difference for PS2. Applying similar month-over-month growth rates for XBX in 2005 to PS2 and GCN in 2006, we arrive at the forecast for current-gen console revenue in 4QCY06E below. We note that we expect PS2 to be steadier in September, as Lego Star Wars should be material. GCN, on the other hand, had Mario Superstar Baseball in September 2005; we do not expect this kind of upside in September 2006.
PS3 and Wii
To arrive at our PS3 and Wii estimates for the Big-4, we look at hardware units, attach rates, and ASP. In 2005, the 360 attach rate was about 2.8. We believe the PS3 will have a lower attach rate (given the console’s price) and the Wii will have a higher attach rate (given the console’s price). In arriving at each publisher’s share on the PS3 and Wii, we look at each publisher’s historical average revenue share and assume a geographic mix per publisher.
Since the PS3 will launch only in the U.S. and Japan this year, and further because the Big-4 will not release a title in Japan this year, 100% of the Big-4 publisher revenue on the PS3 should be in the U.S. Nintendo will launch the Wii in all geographies. To evaluate each publisher’s revenue on the Wii, we assume a revenue mix percentage per publisher in the U.S. and gross up accordingly to get total revenue.
What does our analysis of the PS3 and Wii imply for each publisher, and how do we get confidence in our assumptions? In the figure below, we see that the resulting attach rate assumption for the PS3 and Wii are 1.8 and 3.1, respectively. This compares to attach rates of 1.7 (PS2) and 2.7 (GCN) when the PS2 and GCN launched in 2000 and 2001, respectively. We are comfortable with our assumptions.
All-In: Current-Gen + PS3 + Wii + 360
In our analysis, we project the Big-4 publisher revenue on current-gen, PS3 and Wii, and 360. While there is always room for error, we believe we’ve taken sufficient precautions and have outlined our assumptions thoroughly to give the reader a level of comfort. Because we have modeled just the global console revenue for each publisher, we apply our estimate of console revenue as a percentage of total revenue for each of the Big-4.
This leads us to Total Global Revenue for each publisher. According to our analysis, with the exception of Take-Two, all three publishers should beat our and consensus estimates in 4QCY06E. ERTS and THQI have the greatest upside to current estimates. And while Activision has less upside, the publisher should have the biggest opportunity for upside in two blockbuster titles this holiday in Call of Duty 3 and Guitar Hero II.
When we contemplated this analysis, we were concerned by the potential deterioration in the PS2 market. Given all the PS3 supply problems, we hypothesized a PS2 deer-in-headlights syndrome was possible. Having gone through each console platform, we feel comfortable with the revenue estimates for each publisher except Take-Two (which has yet to file its 10Q).
It may surprise some that the revenue implied by our analysis appears consistently to provide some breathing room relative to consensus estimates. We believe managements of each company go through similar forecasts before issuing guidance. We caution readers that our analysis is limited to revenue of the publishers and does not address margin implications and expectations.
Specifically, as PS3 consoles dribble out and the next-gen games with them, each publisher (with the exception of ERTS) will have to accelerate the depreciation of capitalized development costs. This is likely to depress margins materially. The longer it takes Sony to ship PS3 hardware, the greater the pain in publisher margins and the greater the risk to revenue in out quarters.
We believe Sony may have to reduce its PS3 shipment forecast for its FY06 ending March 2007. Currently, Sony expects 6 mln PS3 units worldwide by March 2007. We believe many investors see this number as a foregone fantasy. The biggest risk to the video game market is not the direct revenue impact from a longer rollout of PS3 hardware, in our view, but the resulting negative effect on the PS2 software market.
This is the analysis we did for holiday 2006, and we found comfort in 4QCY06E estimates. At this point, any further PS3 delays will more likely hurt publishers’ revenue on PS2 than on PS3."