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There are times in a company’s history where a financial cannot be an accurate metric for its performance or future profitability. This is usually the case with companies that are starting out or have yet to breakeven. This particular iteration of Sony’s (TYO:6758 and NYSE:SNE) earnings saw a massive decrease in revenue, and consequently profitability, and not only are we going to be reporting on the earnings itself but digging a bit deeper to figure out what the numbers mean.

Before we begin, it’s important to begin with a little context. To the casual observer, Sony has had a wildly successful year. It launched a new console under the PS4 brand, with another on the way. The Sony PS4 Slim and the upcoming PS4 Neo (now officially called the PS4 Pro) are both examples of this. This is one of the reasons why it would, initially, appear surprising that Sony has actually bled money this quarter.

Financial highlights for Sony (TYO:6758) Q2 FY16 Quarterly results

For the second quarter of the year ended 2016, the company managed to rake in 4.8 Billion Yen in net income compared to 33.6 Billion Yen last quarter. This is an almost 86% decrease in profitability year over year and is something that is usually enough to send alarm bells ringing for investors. The stated reasons for the stark contrast is the appreciation of the Yen against the Dollar (something which also adversely impacted Nintendo's Earnings here), the impact of the 2016 Kumamoto Earthquakes and the smartphone business unit losing money.

Operating income for the quarter fell 48% to 45.7 Billion yen (from 88 Billion yen) indicating an in operating expenses for this quarter. This figure also includes an impairment charge of 32.8 Billion yen related to the sale of its battery business.The semiconductor segment has also swung to a loss of 4.2 Billion yen from an operating profit of 34.1 Billion yen last year.Sony (TYO:6758) took a 1.2 Billion yen hit due to the Kunamoto earthquake due to which one factory closed down.The operating profit of the gaming business was also down 20% year on year.Mobile sales were down by around 39.6% but the company managed to bring in an operating profit of 3.7 Billion yen from a loss of 20.6 Billion yen in the year before thanks to a couple of things such as an increased focus on the high end as well as the appreciation of the yen.

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The key to understanding Sony (NYSE:SNE)’s second quarterearnings – our take!

Most of the analysts are currently talking about the following reasons for the startlingly poor performance of Sony this quarter. The Yen has appreciatedin double digits against the dollar and while this certainly has affected Sony’s revenue stream we want to include a few qualifying statements. Here’s the thing, while the strongerYen does impact the company’s financial reserves and petty cash transactions, more important and material contracts are protected by FRAs (Forward Rate Agreements) so the exchange rate risk can be managed. This means that companies are usually not hit by the maximum point of the volatility in Yen, if risk is managed correctly.

Secondly, even though the Yen has strengthened, the cost of its products is usually set on a purchasing power parity basis (for major markets). For example, the PS4 targets the $299, $399 marks respectively in the American market, also known as price points. A depreciation of 20% in the Yen will have no effect on this particular sale price and could actually help negate some of the increased cost of goods sold when the profits are converted back to Yen. All that said, the cost of goods sold has increased and we can use an adjustment of 10.8% to 20% depending on the particular case.

The revenue of the company (TYO:6758) decreased 10.8% from the same quarter last year and even if we were to assume a completely direct and complete impact from the currency exchange rate difference, a depreciation of 20% in the Yen does not account for an income drop of 86%. This is one of the reasons why we believe that the yen is not the main line item to blame for the income drop.

Moving on, Sony’s smartphone business has lost considerable business and we expect this to continue to decline. The company’s smartphone products are neither here nor there. They are not the highest end product out there, nor the best bang for the buck mobile. In an age where android markets are saturated with the same basic chipsets with thousands of variations – you must have a differentiation factor. Sony’s smartphones arguably have little to noneof this. The company’s low to mid end lineup accounted for the majority of the sales decline. It does currently hold a niche but significant fan base with some of its higher end products – and it would do well to focus on those as this quarter has shown.

Lastly, so what exactly changed? Well. The thing is, investors might see that the company has released 3 different consoles under the same brand name of the PS4. This might seem a similar case to the PS3 and PS3 Slim versions but we are looking at a very different scenario here. The thing is, while the PS4 and PS4 Slim are practically the same thing – the PS4 Neo is a completely different class of console. Ignoring what Sony says, and judging form a completely technical basis – it is a brand new console. It has much more powerful hardware (twice as powerful in fact) and a completely different processor.

Since the APU in question is a very large one, the economies of scale applicable to PS4 Slim thanks to the use of the 14nm process node, no longer apply. This also means that speaking on a purely technical basis, Sony (TYO:6758)is funding the cost of not just one console class but two. And the story doesn’t end there, the company also launched the PS VR platform, which can be construed as a completely different (and brand new!) class of cost that Sony has incurred this quarter. The headset is not cheap to produce and since there aren’t many titles out there – has not yet gained the sweet spot in terms of economies of scale.

The console is all set to launch next fiscal quarter, the matching principle dictates that most of the cost should also be incurred in the next fiscal quarter. However, and this is a big one, since the console falls under the ambit of the PS4 name, they would be allowed to include costs of the PS4 Neo in this fiscal quarter as well under US GAAP. Accounting wizardry principles (this is not a real standard) would dictate that the brunt cost of these new platforms (PSVR and PS4 Neo) be spread as much as possible to emphasize the return next quarter.

To sum it all up, we have seen no warning signs in the fundamentals of Sony Corporation(TYO:6758 and NYSE:SNE); (apart from the obvious question mark that is the smartphone business) regardless of any any sharp decline in net income which may be accounted for by the global slowdown in the silicon industry, earthquake, depreciation in yen and two new tiers of cost (PS4 Neo and PS VR).