Can Sony Regain the Magic?

Sure, it still makes great gizmos. But great profits it isn't making

Early last summer, a thousand of Sony Corp.'s (SNE ) best and brightest from around the globe converged on Tokyo for a closed-door powwow. Sony's top execs had used such rallies in the past to kick off new corporate strategies, which is what President Kunitake Ando had in mind when he took the stage. The world was about to change, he declared. The personal computer was quickly losing its status as the heart of the Information Revolution. Soon, the real action in info tech would migrate to the living room, the family room, the automobile, the beach, the holiday retreat. Wherever people gather, or strike out on their own, Net-capable audio and video gadgets, cell phones, and games would keep them entertained and in touch.

Using graphs and diagrams to drive home his point, Ando insisted that Sony, the world's premier gizmo maker, was better positioned to triumph in this broadband world than any of its rivals. He went on to argue that nobody--not Samsung (SSNLF ), not Microsoft (MSFT )--had a sharper vision of how consumers would navigate superfast networks in which a single fat wire, or a sliver of radio frequency, would handle multiple layers of voice, data, and video. Already, he noted, Sony's violet-gray Vaio laptops were hits with the digerati, who liked to edit their own photos and music files and exchange them over the Web. Once broadband networks were ubiquitous, all of Sony's cameras and audio devices would meld into a seamless distribution network for Sony's movies, music, and games, supported by the company's own online shopping and financial services. "Ando's message was clear and aggressive," says Hiro Uchida, Sony's general manager for strategic ventures. "Sony faces big challenges, but Ando showed us that we're getting activated."

Trouble is, Sony managers have been preaching about this glorious networked future for half a decade with little to show for it. The company, in short, is caught between a past that no longer works and a future that hasn't arrived. Its core electronics division, which will account for 63% of Sony's estimated $56.4 billion in sales for the fiscal year ending this month, was in the red for the first half of the year. Thanks to a rapidly depreciating yen, better-than-expected U.S. holiday sales, and hot-selling PlayStation games, Sony will stay in the black this business year. Even so, most analysts are forecasting a 40% decline in the company's operating profits, to about $1 billion, on flat sales. And games aside, there is little likelihood of an overall recovery in the coming year. Says Masahiro Ono, senior analyst at UBS Warburg (Japan): "It's only going to get tougher to sell electronic gadgets, regardless of the Sony brand."

For all his fiery speeches, Ando understands just how tough it has become. Even in gadget-crazed Japan, it's a rare electronics shop that actually displays Ando's favorite new toy: a year-old wireless tablet computer called the Airboard that resembles a shimmering, disembodied flat-panel display. The tablet allows you to watch TV or DVDs or check e-mail. And if you aren't comfortable in one room, you just pick it up and carry it into another. Airboard's clean look and Jetsons-like promise for home entertainment are quintessentially Sony, and Ando wants to position it as a new gateway to the Net. But even Ando, who uses the tablet at home and in the office, admits that retailers haven't figured out how to sell it.

The Airboard is just one of many disappointments. Indeed, Sony's whole conception of the networked future has been slow to materialize. And while the global tech recession deserves some of the blame, it's hardly the sole cause of Sony's woes. Lately, critics of the company have begun to question the management skills of Chairman and Chief Executive Nobuyuki Idei. Although Idei was early to announce a restructuring program, back in March, 1999, his efforts have been slow and short of their mark. That's particularly worrisome because the consumer-electronics industry has been on a long and miserable slide into a low-margin, commodity business dominated by Asian upstarts. Sony's operating profit margins on electronics products, according to Ando and other executives, have fallen to 1% in 2001, down from 10% in 1991. And while group sales have risen an estimated 11% since 1997, operating profits have sagged 75%. "Sony needs a new business model," contends Takatoshi Yamamoto, vice-chairman and managing director of Morgan Stanley Dean Witter Japan Ltd. "Revenue can fall, but they've got to find a way to raise profits."

All of this raises a question: Can Sony regain the magic that made it one of the 20th century's greatest brands? Sony's many defenders won't easily accept this notion. First of all, to be fair, all the consumer divisions of Sony's rivals in Japan, Europe, and America--from Matsushita (Panasonic) to Philips to Thomson--are just as troubled, if not more so. Even with its latest problems, Sony stands out from the pack. Its brand is still golden, its marketing is ingenious, and its reach across music, movies, and the Net far exceeds that of any other maker of consumer products. Last business year, the company sold 5.5 million camcorders, 2.6 million digital cameras, and 2.5 million Vaios, while its movie studio grossed more than $1 billion in box-office receipts. With only about $5 billion in net debt, Sony's revenue from these richly diverse streams will surely keep the company at the top of the heap. And when the broadband future finally arrives, Sony may have a leg up on competitors in both PCs and consumer gadgets, not least because it makes them all, along with the digital "content" that drives their sales. When it comes to linking all these worlds, with a PC like the Vaio as a hub, the rest of the computer world is "catching up" to what Sony is doing, says Will Poole, Microsoft Corp.'s vice-president for digital media. "They've gotten this concept ahead of the others," he adds.

Certainly, that is the stance of Ando, who took over as president from Idei in June, 2000. He claims that Sony's transformation into a broadband-entertainment company is right on track. In coming years, the company will shift its focus from making low-margin "boxes" to selling movies, music, games, and Internet services. Toward that end, Ando hopes to acquire Japan's largest private Internet service provider, called Nifty, from Fujitsu Ltd. In one fell swoop, that would make Sony the AOL Time Warner of Japan. Once most households are able to download movies or music over fiber-optic connections, Sony's vast film archives will be just a click away from its subscribers. And Sony will coddle these consumers with a full range of well-designed, function-packed gadgets that are specifically crafted to work together.

All this, however, is the future, and its golden glow does not penetrate Sony's present gloom. Investors want proof that Sony can grapple with its current business challenges, which are among the most difficult in Sony's 56-year history. During that period, the company repeatedly reinvented itself through stand-alone hits such as the Trinitron TV and the Walkman. But Sony's famed engineers haven't turned out such a product since the compact disk in the 1980s. Its stylish Vaios, which command more than 30% of the consumer market for PCs in Japan, are "Wintel" to the core--hardly an innovative leap. In games, Sony followed in Nintendo's (NTDOY ) tracks. And while robot pets like Aibo are novel and cute, Sony has sold only 110,000 of the pups--priced from $740 to $1,365--since they went on the market in June, 1999.

So what is Sony's bright hope in the short-term? Video gamesand more video games. Since the launch of PlayStation 2 in March, 2000, Sony has sold 26 million units worldwide--5 million in the past holiday season alone. Sony only recently started making gross profits on the consoles, which pack the silicon smarts of a Pentium PC into a box that costs under $300 at retail. But the games themselves are a cash cow. Like all software on disks, they can be manufactured for pennies per disk and sold for $50 a pop. Sony's own programmers develop a lot of these games, which carry an operating profit margin of 20%, according to WestLB Securities Pacific Ltd. All told, games--which account for 13% of Sony's sales--are expected to kick in 57% of operating profits this fiscal year.

Unfortunately for Sony, the game market is almost as fractious as a PS2 fighting game. In a strong fall launch of its competing Xbox console, Microsoft sold 1.5 million units through Christmas. It expects to have sold 6 million units by the end of June and has just rolled the Xbox out on Sony's turf, Japan. Nintendo Co., for its part, aims to sell 4 million of its new GameCubes worldwide by the end of March.

The competition is bound to hurt all three companies. Historically, each new generation of game consoles has a life span of about five years, with operating profits peaking in the second half of the cycle, after hardware investments are amortized and before demand trails off. With the original PlayStation, Sony's operating profit margins for the game unit as a whole hit 17.4% in 1998, four years after the system was introduced. But in today's competitive climate, the best Sony can hope for is 10% profit margins on the PS2 by 2003, says Warburg's Ono.

So far, both Ando and Idei have stayed cool under fire. For one thing, they're encouraged by Sony's exceptionally strong U.S. sales of digital cameras, its top-ranked Vaio laptops, and the breakaway success of its new Vaio desktops. If Hewlett-Packard Co. (HWP ) succeeds in merging with Compaq Computer Corp. (CPQ ), Sony should get another lift: The merged company is likely to lose share at retail, and shops looking for a second brand are bound to consider the Vaio.

What's unclear is whether Sony can continue to support both the Vaio and the PlayStation as the key controllers, or hubs, for home entertainment. Both devices already double as DVD players, and Sony is enhancing the PlayStation so that gamers can battle one another over broadband links in homes with cable or digital subscriber line (DSL) connections. But Idei, for one, seems neutral in the PlayStation-vs.-Vaio showdown. In his view, a win for either one will fan sales of Sony's many other cameras, TVs, and audio products. "HP is selling PCs in order to sell its printers," he points out. "But in Sony's business model, if we sell one computer [or game machine], we want to sell 10 other peripheral products."

Do all these add-ons really add up? Under a magnifying glass, Sony starts to look a lot like one of Japan's giant integrated electronics makers--a Toshiba, Hitachi, or NEC--which are jacks of all trades and "Microsofts" of none. These sprawling manufacturers churn out thousands of products, from chips and computers to robots and power plants, many of them unprofitable. Sony doesn't make nuclear power stations. But it does crank out more than 100 million devices a year--and loses money on TVs and cathode-ray tube displays, hard-disk drives, and cell phones. "Sony has succumbed to the big-company disease," says Hirotaka Takeuchi, dean of

Hitotsubashi University's business school.

At its core, Sony remains a consumer-electronics company--and that sector continues to sink in economic quicksand. With each passing year, Sony's new models of MP3 players, handycams, CD players, and cell phones are reduced more quickly to rank commodities by the industry's overstocked supply chain for key components. The Sonys, Sanyos, and Samsungs of the world--not to mention Chinese upstarts--all have access to the same huge pool of chips, liquid-crystal displays, audio pickups, power supplies, and packaging. To see what impact that has on prices, look no further than the DVD market, where Sony once ruled the roost. Recently, some of the hottest models are Chinese DVD players selling for less than $100.

In such a world, it takes a leader like Louis V. Gerstner Jr., CEO of IBM, or John F. Welch, the retired CEO of General Electric Co., to raise a company above the clutter. Yet Sony still draws its managers from an in-house--and insular--talent pool. For its first 40 years of existence, it was run by the whims and dictates of the charismatic Akio Morita and engineer Masaru Ibuka, Sony's co-founders. Later, when the company had grown huge and unwieldy, the reins were turned over to a marketing man, Idei. But the brooding visionary stayed aloof from daily operations. In 1999, he began shuttering factories, but that barely dented Sony's excess capacity. He also pledged to reduce Sony's global workforce of 170,000 by 10% in three years. Yet in the first year of restructuring, Sony's headcount actually grew.

Enter Ando, 60. Since taking over from Idei as president in June, 2000, he has sold four factories to Solectron Corp. and others, outsourced production of low-end products such as the Walkman, and moved some Vaio PC production to China. In the process, he has eliminated 11,000 jobs, with more to come. In addition, last April, he centralized management of all Sony factories around the world under a new unit, which quickly drove fixed costs down by 10%. The unit, called EMCS, aims to reduce inventory companywide to 45 days by March, down from 60 days a year earlier.

While Sony has traditionally pioneered new businesses on its own, Ando is now pushing alliances. In November, he announced a deal with AOL Time Warner Inc. that could help Sony build its missing link: a distribution platform for media content in the U.S. "This is a very important deal for us because we need an ISP to connect our products to a broadband network," says Ando. What it won't do is close the gap with AOL Time Warner (AOL ), Walt Disney (DIS ), or Vivendi Universal (V ), which have significant holdings in media content, cable TV, and in Vivendi's case, mobile-phone service. Japan, however, moves in a different orbit. If Sony succeeds in acquiring the Nifty ISP, it will have a total of 6.4 million Internet subscribers. "By running the biggest ISP, Sony will be able to test broadband content, online security, and other services," says Kun Soo Lee, a senior analyst at WestLB Securities Pacific in Tokyo.

Even so, other Sony watchers are skeptical about Sony's moves, outside its hardware business. "Management talks about broadband, but you don't hear anyone saying that it will contribute $30 billion to $40 billion in revenue stream," says Partha Ghosh, a former Sony consultant at Boston's Adventis Corp. In North America alone, overall broadband Net access is poised to soar from 10 million subscribers now to 32 million in 2005, according to market researchers Cahners In-Stat Group. In that period, the value of broadband services will then increase more than sixfold, to $37 billion a year. But so far, Sony has failed to explain how it would profit from this growth, unless it actually becomes a major ISP.

Investors haven't waited for explanations. They abandoned Sony in droves after the collapse of the Nasdaq nearly two years ago. The company's market cap is down by two-thirds, to $42.4 billion, since its peak in March, 2000. The stock has had a pop since September, but it's down against the S&P 500. A comparison of the total returns of Sony's American depositary receipts and General Electric stock over the past decade shows that an investment in GE returned 3.4 times as much as one in Sony.

In addition, since the mid-1990s Sony has missed some big opportunities, including the exploding market for flat-panel displays. The company suffered its biggest setback last year when it tried to enter Japan's booming Internet cell-phone market. Ando had predicted that phones would be a pillar of Sony's hardware business. He even launched several distinctive-looking phones for two Japanese carriers. But Sony had to recall the handsets on four occasions because of glitches, costing the company $340 million and forcing it to merge cell-phone operations into a joint venture with Ericsson (ERICY ).

To get Sony back on the growth track, Ando has set aside fresh reserves of $230 million to cover the cost of closing unprofitable businesses, in addition to the $150 million reserved for early-retirement packages. In all, he's planning to eliminate 48 money-losing product lines, including VCRs and computer peripherals. He has already farmed out to Solectron the assembly of some PS2 consoles and car-navigation systems and will likely announce more such moves in coming months. Many analysts would also like to see Sony sell its controlling stake in money-losing Aiwa Co. and ditch Trinitron TVs.

Even as it retrenches, Sony is pushing into wireless networks that will connect all of Sony's products in the home. This vision motivated Sony's $1.9 billion investment in new chip facilities over the past two years. While the first multimedia chips were developed for the PS2, Sony plans to use them in its next-generation network products.

In the U.S., Sony is behind the curve on wireless. Without waiting for Sony's networks, millions of U.S. homes have already gone wireless, using gear from Linksys Group Inc., D-link Systems Inc., and others. But none of these networks goes beyond connecting multiple PCs. None currently allows the user to transport, say, digital pictures or videos among PCs, TVs, and pocket computers. Sony's networks, and a technology it calls Feel, aim to make this a snap. And for all-Sony households, the company hopes to guarantee that the devices will work together without any software glitches or plug incompatibilities. That's important to loyal consumers like Hiroshi Mikitani. The founder of Rakuten, Japan's biggest online shopping site, he owns a Vaio laptop, a Clié personal digital assistant, and a Cybershot digital camera. Still, even Mikitani has doubts about Sony's long-term prospects. Wonders Mikitani: "They're going for everything, hardware and software, but is this a strategy that will work?"

When it comes to business creation, Ando has a good track record. A protege of Sony co-founder Morita, he helped the chairman kick off a life-insurance unit that is now the fastest-growing of its kind in Japan. Then he built the Vaio business from scratch. Powerful as Ando is, however, he isn't the only resident hero at Sony. Ken Kutaragi, 51, outspoken president of game subsidiary Sony Computer Entertainment Inc., believes the PlayStation business he created will remain Sony's cash cow and will morph into the centerpiece of Sony's network strategy. The fiercely independent Kutaragi appears intent on building a broadband service. In Japan, he has tied up with four ISPs to jointly run a high-speed online game service built around the PS2--and not the Vaio. He says this could become "the world's largest broadband platform." If his PlayStation strategy prevails, Kutaragi may succeed--or even replace--Ando.

Another big challenge Ando faces is inspiring ace engineers. Once highly respected at Sony, the engineers complain that they have been relegated to the backseat while marketing execs have taken over company and research budgets. Indeed, some say Sony has lost its technological edge. According to Clayton M. Christensen, a Harvard Business School professor and author of The Innovator's Dilemma, Sony developed a dozen disruptive technologies between its founding in 1946 and 1979. But other than CDs, Sony has contributed little since then. "Engineers are frustrated about the shift in emphasis from technology to marketing," says former Sony engineer Jun Nakai, chief technology officer at Japan Communications Inc., a mobile-phone service operator.

Meanwhile, ever-toughening competition is taking a toll on morale at Sony. Just the name "Samsung Electronics" triggers anxiety attacks in Ando's offices on the eighth floor of Sony's Tokyo headquarters. Japanese rivals such as Matsushita Electric Industrial Co. (MC ) and NEC Corp. (NIPNY ) are far ahead of Sony on Internet-ready cell phones. And then there's Microsoft, whose managers admire Sony but don't exactly fear it. For all Sony's consumer clout, says Craig J. Mundie, Microsoft senior vice-president for advanced strategies, the company "is confined to the audio-video cluster" of appliances. When it comes to linking devices through software, Microsoft's Windows franchise gives it a tremendous headstart. "I don't think anyone has a birthright in this space," says Mundie.

Sony execs probably won't quibble about birthrights. They make some of the world's sexiest products and hold one of the world's most powerful consumer brands. The living room is Sony's franchise to lose. Still, nobody disputes that the company's hardware-centric business model is a flimsy pillar to support this giant while it waits for the broadband era to dawn. Over the next six years or so, "Sony will go up and down as it struggles to bridge the gap between the present and the networked future," predicts Reiji Asakura, author of two books on Sony. If it doesn't cut costs, crank up innovation, and find more talented managers, its future is gloomy, he warns. The world's media and technology giants will be watching closely to see how Sony solves this dilemma.

By Irene M. Kunii in Tokyo, with Cliff Edwards in San Mateo, Calif., and Jay Greene in Seattle

    Before it's here, it's on the Bloomberg Terminal.