Daggers Drawn Over DVDs

How Sony gained an edge in its fierce battle with Microsoft over video formats

Every July, 400 of the most powerful media and tech industry chieftains meet at investment banker Herb Allen's conference in Sun Valley, Idaho, for what are usually convivial discussions of megatrends and megamergers. But this year, Microsoft (MSFT ) Chairman William H. Gates III laid into Sony (SNE ) Chief Executive Howard Stringer, according to two sources, including one who witnessed the exchange in a private room. Gates argued that Sony's new high-definition DVD standard, called Blu-ray, needed to be changed so it would work smoothly with personal computers running on Microsoft's Windows operating system. Stringer and two lieutenants defended the technology, insisting Blu-ray would work fine in PCs. Yet Gates's ire only grew. "There must be something much deeper going on," Stringer said later, according to another person who heard the comment. A Microsoft spokesman acknowledges that Gates and Stringer talked at the conference, but says things did not become "heated."

Gates's efforts to derail Stringer's plans soon became public, though. On Sept. 27, Microsoft Corp. and Intel Corp. (INTC ) fired a broadside at Sony Corp., suggesting publicly the company's Blu-ray technology couldn't deliver what it promised, and they pledged their support for a rival technology from Toshiba Corp. (TOSBF ). The news touched off a torrent of recriminations and finger-pointing. Several movie studios quickly voiced their support for Sony. Two major Chinese DVD makers backed the Toshiba standard, which is called HD DVD. And Dell Inc. (DELL ) and Hewlett-Packard Co. (HPQ ) took the highly unusual step of issuing a joint statement denouncing the move by Microsoft and Intel, the PC makers' two most important suppliers. "Desperation" is the way Brian Zucker, a technology strategist at Dell, characterized Microsoft's move.


It may amount to little more than that. Despite the backing of the PC industry's two biggest titans, it looks as if HD DVD'S days are numbered. Sony is lining up strong support among Hollywood studios as well as other consumer-electronics companies. On Oct. 3, Paramount Pictures Corp. (VIA ) announced it would end exclusive support of HD DVD and support both standards. Warner Bros. Inc. (TWX ) is expected to follow suit in the next few days, sources say. That'll give Sony six of the seven major studios. Sony may negotiate a deal to give a slice of Blu-ray royalties to Toshiba, and perhaps even Microsoft, but that would largely be a face-saving compromise. Sony appears to have a critical mass of support for its standard.

A major factor swaying these companies is Blu-ray's massive capacity. Its disks will hold at least 50 gigabytes and perhaps 100 gigs or more. HD DVD will start at 15 gigs, and top out at 45. "We want a standard that's going to be around for 10 or 15 years," says one studio exec. Microsoft's criticism is that Blu-ray disks will be more expensive to manufacture and may be impossible to make in large volumes. Yet the technology's supporters are convinced costs will be similar over the long term. "We don't see any big cost difference, and we know a thing or two about volume manufacturing," says Michael S. Dell, chairman of PC giant Dell.

Why is so much vitriol spilling from behind closed doors over one tech standard? The shiny little disk that Gates and Stringer tangled over has the potential to alter the landscape of the entertainment and technology industries. Next-generation DVDs will feature high-definition movies, extras like movie-themed computer games, and the ability to download film trailers from the Internet. Tech players, media companies, consumer-electronics giants, and retailers are brawling to take advantage of the new financial and strategic opportunities. "It's like the old Irish saying: 'Is this a private fight, or can anyone jump in?"' says Paul Saffo, director of the Institute for the Future.

For each side, the stakes are huge. Movie studios, struggling with a sudden slowdown in the $18 billion-a-year U.S. DVD market, are salivating over the chance to entice consumers with movies on new high-definition disks. Consumer-electronics makers -- which increasingly include Dell and HP -- are banking on people thirsting for more high-definition gear, from DVD players to big-screen TVs. And Microsoft and Intel, hungry for new growth opportunities, want to expand their roles in people's lives, helping them manage digital photos or download the next Batman flick off of the Net.

Behind the brinkmanship lie two vastly different views of where entertainment in the home is heading. Microsoft and Intel paint a futuristic picture of the digital home, with sleek PCs powered by their software and chips in the central role. The PC would shuttle music, photos, and video from room to room -- and grab off the Web everything from the latest Tom Cruise blockbuster to a National Public Radio podcast.

Sony and its supporters are skittish about the latest movies being zipped around the house. Blu-ray disks can hold more content than today's DVDs, but they would be used in much the same way. The new disks would be plopped into a DVD player, and copyrighted material, like Hollywood movies, couldn't be ripped to a computer's hard drive without a studio's permission. Blu-ray equipped devices are even designed to recognize and refuse to play pirated movies. Such protections are another big reason Sony has won the support of studios, such as News Corp.'s (NWS ) Fox.

No company has more at stake than Sony. Long one of the most innovative companies in electronics, it stumbled badly in recent years. With Blu-ray, it has the opportunity for a triple play. It'll reap royalties from all the disks sold with its technology. Its movie business could see a resurgence in lucrative DVD sales. And it could see sales soar for its electronics gear, including HDTVs, movie cameras, Blu-ray optical drives, and especially its new PlayStation game consoles, which will include a Blu-ray drive for playing movies. Sony's people have "bet the entire future on this," says analyst Michael Pachter of Wedbush Morgan Securities. "It's too important for them to lose, so they will do everything they can to win."


The story of how Sony and Stringer maneuvered their way into what looks like a winning position in the DVD wars includes enough intrigue to fill more than a few disks. The backdrop is Sony's famous failure two decades ago to establish Betamax as the standard for videotape, despite its widely recognized technological edge. It lost out to Matsushita's VHS, in part because its onerous licensing terms alienated the Hollywood studios.

Then in the 1990s, Toshiba outmaneuvered Sony to establish the standard for today's DVDs. The Japanese company teamed up with Time Warner Inc. on the technology, using the media giant's clout to get other Hollywood studios on board. The result is that Toshiba and Time Warner rake in the lion's share of the royalties generated by DVDs. No one has disclosed precisely what those royalties are, but they run into the hundreds of millions of dollars.

Toshiba looked as if it could win the battle for high-definition DVDs too. After Sony and partners Philips and Matsushita began work on Blu-ray, Toshiba in 2003 hired former Warner Bros. video chief Warren Lieberfarb to lobby for studio support. It was a savvy move, since it was Lieberfarb who had won the studios backing for the first DVD standard. By November, 2004, the assault appeared to be working -- with Warner, Paramount, Universal, and New Line Cinema seemingly firmly in the Toshiba camp.

With so much at stake, Sony went on its own recruiting campaign. It quickly signed up some of the biggest names in consumer electronics, including Samsung and Sharp. By early 2005, Dell, HP, and Apple Computer (AAPL ) joined the industry standards group. The electronics makers think Blu-ray has the greatest chance to prompt consumers to start opening their checkbooks for new gear.

Microsoft at first stayed out of this tug-of-war. Instead, it focused on selling its software to both sides. The Toshiba camp first agreed to use a piece of Microsoft software, its VC-1 codec, that squeezes content onto the disk, then decodes it for viewing. Then, in September, 2004, the Blu-ray backers adopted this chunk of code as well -- in exchange for a public pledge of neutrality from Microsoft. "We wanted them to join us," says an insider who is close to the Blu-ray Disc Assn. "But we compromised on neutrality."

That neutrality has unraveled over the past year, as Microsoft increasingly came to see Blu-ray as a risk to its fortunes. In May, Sony confirmed that it would include Blu-ray in the new PlayStation game console beginning next year. Microsoft's Xbox wouldn't have such capability. Then on June 15, the Blu-ray camp decided against using Microsoft's iHD technology to add interactive features to Blu-ray disks, opting instead to stick with software based on Java technology.


In July, Sony decided to refine the Blu-ray standard in a way that would have far-reaching implications for Microsoft. Sony wanted to win the support of Twentieth Century Fox Film Studios, long Hollywood's leading advocate for tough anti-piracy measures. So Sony agreed to add safeguards developed for Fox by San Francisco's Cryptography Research Inc., which could prevent Blu-ray movies from being ripped to a computer's hard drive. Fox execs say their decision became a no-brainer, because of the extra protection and because as many as 30 million PlayStations might be sold in the next three years. "They have a Trojan Horse that will play a critical role in igniting the market for this product, and when they do, we intend to be in that market with them," says Michael Dunn, president of Fox Home Entertainment.

The move was a serious blow for Microsoft's Xbox. The company had decided to hold down costs by not including a next-generation DVD player in the game console. Instead, it planned to stream high-definition content from a PC sitting in one room to the console, which would be attached to a television. But Cryptography's safeguards meant studios could block their content from being taken off the DVD. That was the reason for Gates's exchange with Stringer at the conference. Gates wanted Sony to drop such technology, but Stringer wouldn't budge.

Andy Parsons, a Blu-ray spokesman, says the Cryptography technology does not block content from being moved around a network, but the association has yet to finalize details of whether it will allow for managed copying of the disk as Microsoft demands.

Meanwhile, Sony's camp received help winning over one influential studio from an unlikely source. Raider Carl C. Icahn, one of Time Warner's largest shareholders, began pressuring the studio to find ways to boost its stock price earlier this year. Despite Time Warner's long alliance with Toshiba, CEO Richard D. Parsons asked Jeff Bewkes, chairman of the company's entertainment unit, to reconsider the best way to recharge DVD sales. Bewkes decided that the studio should forget appearances and back Blu-ray if it was the format most likely to win consumers' hearts. "Blu-ray's potential for more capacity started looking better and better," said one Hollywood executive.


Once Warner started to waver, Paramount Pictures decided to move first in order to negotiate better terms, according to Hollywood insiders. On Sept. 23 one Blu-ray insider saw preliminary contracts written up by Warner Bros. and Paramount to join the Blu-ray board. "It was all going to happen in a day or two," says the source.

Leaked to Microsoft, the news put the company in crisis mode. Execs began working the phones, lobbying retailers about the potential for mass consumer confusion if competing standards came to market. Concerned, CEO H. Lee Scott of Wal-Mart Stores Inc. (WMT ) personally telephoned Stringer and Walt Disney Co. CEO Robert Iger, two Hollywood sources say. Finally, Microsoft issued its joint statement with Intel. Microsoft declined any additional comment for this article.

The public attack may have backfired. One day after Microsoft talked up the importance of Toshiba's ability to hit the market first with its standard, Toshiba announced it would delay rolling out its own HD DVD players until after the holidays. Sony's Blu-ray-equipped PlayStations are scheduled to go on sale early next year, too. The same day, Yoshihide Fujii, Toshiba's corporate senior vice-president for digital media products, said the company remained open to creating a single format.

Such a compromise would avoid the confusion of two technologies coming to market next year. A few components of Toshiba's technology, and possibly Microsoft's, could be incorporated into Blu-ray to make it easier for them to join Sony. While Sony may agree, it is taking steps to avoid any substantial delay in Blu-ray. Sources say the company is considering reducing its royalty take and may underwrite the production costs of Blu-ray disks.

It may not be the Sony of old. But a Blu-ray victory would help the company regain a starring role in living rooms everywhere.

By Cliff Edwards and Peter Burrows in San Mateo, Calif., and Ronald Grover in Los Angeles, with Tom Lowry in New York and Kenji Hall in Tokyo

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