PlayStation 2 Costs Slash Sony's Profits

What Happened?
Electronics and entertainment giant Sony (SNE) on Thursday reported that its net income for the September quarter fell 57% from a year ago, coming in well below analysts' estimates. Strong sales and profit growth in the company's electronics division were offset by losses in its game, music, and movie units. Costs associated with the rollout of the hotly anticipated PlayStation 2 game console contributed to the losses, and weak sales of Sony's software titles were also a factor. Sony said that the game division, once the company's cash cow, will continue to lose money over the next two quarters as the company presses an extra factory into service to meet demand for PlayStation 2 units.

What It Means for Investors
The troubles in Sony's game division are short-term and no cause for undue concern, but we still believe that there are too many uncertainties in Sony's long-term strategy to justify the stock's lofty valuation. PlayStation 2 is a key element of the company's ultimate plan to deliver Sony-produced entertainment content over high-speed Internet connections to a variety of Sony-made platforms, including game consoles, computers, and handheld devices. But that plan won't pay benefits until high-speed access becomes more widely available, and in the meantime such competitors as America Online /Time Warner  and Microsoft (MSFT) are busy with broadband strategies aimed squarely at Sony.

Even if its game division recovers next year--and that seems likely, given the huge demand for PlayStation 2--a big chunk of Sony's current market value depends on this long-range Internet-based strategy for integrating hardware and content. However, the future in this area is still very uncertain. Not only is the competition fierce, but new technologies such as Napster have cast doubt on Sony's ability to control its content in the digital age. We think these uncertainties make Sony's current P/E of 70 look excessive.