It's no secret that Japan's Sony Corporation is in a tight spot these days, especially after its recent Q2 earnings report. Yesterday Sony revealed a 25% year-on year drop in profits to 32.9 billion yen (about $300 million) for the quarter ending September 30, compared to 44.1 billion for the same period last year. This is arguably a slight improvement over Q1, which saw a shocking 98% decline in profits from the previous year, but there's no denying the numbers show a continuation of a downward trend.

From Sony's viewpoint, one of the most worrisome aspect of its recent results is the weak performance of its game division. Typically, games are a high point in Sony's earnings report: the games division contributed just over 60% of the company's operating profits in both 2001 and 2002 - ironic considering the famously stiff resistance Kutaragi faced in getting approval for the original PlayStation project. The fact that the game department accounted for just 7% of operating profits in the past quarter is a serious problem for Sony.

The game division reported 2.2 billion yen in operating profits; a 91% drop compared to the same period last year, and Sony's reports on its three key markets didn't give fans much reason for optimism. Revenue from hardware sales decreased in the U.S., Japanese, and European markets. Sony pointed out that U.S. hardware sales for the period one year ago were inflated by the dockworker's strike on the West Coast last fall, which drove retailers to buy extra hardware as a safety stock, and the May price cut from $299 to $199, but that doesn't do much to make these results more palatable.

The only bright spot was the European market, where the number of PS2s sold increased, but at the cost of "strategic price reductions" that led to decreased revenue compared to the same period last year. Worldwide, although the number of PS2s shipped increased, total consoles shipped decreased, as the drop in PSone sales outweighed the growth in PS2 sales: Sony reports 8,780,000 PS2s shipped this period, 490,000 more than last year, but only 960,000 PSone consoles, 49% less than the same period in 2002.

Sony's software results were similarly disappointing: a small increase in unit sales of PS2 games was overshadowed by dropping sales of PSone games. Software sales of 54 million units (44 million PS2, 10 million PSone) were 4 million units less than this period last year.

Sony claims that heavy R&D investments in semiconductor research - presumably code for its CELL processor - are responsible for the game division's poor performance, but that explanation only goes so far. Though it could be the reason for the low operating profits, it doesn't do a thing to explain the declining sales of both hardware and software. To this reporter, it looks more like the PS2 market is maturing. If this is the case, Sony's lethargic console sales will continue to shrink until its next-generation console is launched, which most industry watchers feel won't happen until at least 2005.

Of course, slowing hardware sales are a secondary concern for Sony because hardware profits are just the icing on the cake: the real money is in game royalties. And because Sony's installed base is more than twice as big as Nintendo and Microsoft combined, the potential earnings from a hit game - especially an exclusive like GTAIII - are enormous. But despite this fact, in some ways Sony is at a disadvantage to its competitors. Nintendo has been consistently strong in portable devices and the youth market, while Xbox has Microsoft's deep pockets behind it. Playstation, on the other hand, has the burden of supporting Sony's electronics and music business - both of which have had one unprofitable year in the last two - as well as evening out the results from Sony's inconsistent film business, which lost $70 million over the first two quarters of this financial year after turning solid profits in the two previous years. If the PSone and PS2 falter in their role as Sony's cash cow, the company could find itself in real trouble. Electronics, music and film would all need to be consistently profitable: something that has eluded the company in the past.

As a result, Sony could hardly be in a worse position to engage in a price war. Microsoft couldn't ask for a better chance to carve itself a bigger slice of the console market. This earning report opens the door for Microsoft; it's just a question of when and how the Xbox team will make its move.