Tough Love for Sony's Chip Biz

Chip czar Nakagawa plans to cut capital investmentand maybe outsource its crucial Cell gaming platformto revive Sony's money-losing unit

On a recent morning in southern Japan, Sony (SNE) officials led a busload of financial analysts on a 10-hour road trip and tour of the company's high-tech chip-making facilities. The event was billed as a meet-and-greet with the new head of the semiconductor and components unit, Yutaka Nakagawa, who had taken over just four months earlier.

But Nakagawa wasn't about to pass it off as a small-time event. A few days before the tour kicked off on Feb. 15, he summoned reporters and spoke about his plan to revamp the Japanese company's money-losing semiconductor business. One detail caught many by surprise: To cut costs, Nakagawa was considering outsourcing production of the Cell multimedia chip.

That's not an obvious choice, given the billions of dollars Sony, IBM (IBM), and Toshiba (TOSBF) have poured into developing the chip. It was also unusual because Sony has big hopes for the Cell. Though now limited to use as a PlayStation 3 gaming console chip, the Cell could power everything from TVs to cell phones as Sony goes head to head in consumer electronics with computer companies Apple (AAPL), Microsoft (MSFT), and others.

How Tough is Too Tough?

The decision was a quintessential Nakagawa move. Sony declined a request to interview Nakagawa for this story, but company insiders—ex-employees and analysts—describe the 61-year-old executive deputy-president as a by-the-numbers taskmaster. He cut his teeth on consumer electronics, where he frequently nixed longstanding projects to get results. "It's pointless if there is no profit" goes one typical Nakagawa-ism. That obsession with money matters even extends to his managerial style: When traveling on business, he often flies coach and shuns posh restaurants and hotels.

While he may not be a favorite among engineers, Nakagawa's high profile shows he has scored big with his boss, Chairman and Chief Executive Officer Howard Stringer. At the company's quarterly management meeting last October in Tokyo, Stringer admitted that Nakagawa could be "a little fierce." "Some of you have said to me you are worried that Nakagawa-san is too tough," Stringer told the gathering. "God, I hope so, because that's why he was appointed."

Sony's chip business has been in the red for the past two years. This fiscal year ending in March, Sony expects a third negative result, with semiconductors and components combining for a $450-million loss. Part of the blame rests with the delayed launch of the PS3. The gaming machine runs on the Cell, which Sony makes at its Nagasaki factory in southern Japan. Its slow start means the company will have to wait longer to recoup its investment in chip-making machinery and materials. The division's poor returns have led to calls for Stringer to cut his losses and exit the chip business.

Set to Rein in Spending

But those critics have gone quiet since Nakagawa took over. That's because many analysts think Nakagawa will succeed where others, including his predecessor Kenshi Manabe, failed. Nakagawa says he'll rein in spending over the next three years. Though he hasn't said how large the cuts will be, analysts expect annual capital investment to fall by over a third to $830 million, from an annual average of $1.27 billion over the past three years. The savings should be enough to help semiconductors eke out an $8-million operating profit by March, 2008, predicts Macquarie Securities' David Gibson. "I'm confident that he can deliver," says Credit Suisse (CS) analyst Koya Tabata.

The improving outlook is one reason Sony's stock has been on a tear. Since the beginning of this year, its shares have gained 24%, hovering at their highest levels since June, 2002.

And they're up 4% since Nakagawa made his announcements regarding chip spending.

Stringer is counting on Nakagawa. The chief executive needs semiconductors to be profitable if he is to make good on his own promises to whip the company into shape by next spring. He has already trimmed the workforce by tens of thousands, sold off non-core assets, shut older plants, reduced the number of product models, and put the flat-panel TV business on track for profits by this fiscal year. His next task is to raise profit margins.

Looking to Explore Alliances

But Sony's core electronics division is still hurting and semiconductors are a big reason for that. Nearly half of the company's spending on electronics goes toward chip development and production, yet chips are likely to account for just 7% of the division's sales this year—and zero profits, according to Goldman Sachs (GS). "If you're making your own chips, you're pretty insular," says IDC semiconductor analyst IdaRose Sylvester. "You don't have to face the market." That's what has happened with Sony, which makes roughly 70% of chip revenues by selling to its own divisions.

It's one of the first things that Nakagawa plans to change. He'll offer in-house, image-sensor chips for digital cameras and cell phones—of which Sony has 55% market share—to other tech makers. That should boost external sales by nearly 40% over the next three years. Rather than spending lavishly on next-generation chip-making facilities for state-of-the-art processors such as the Cell, Nakagawa will focus resources on chip design, farm out production, and explore alliances to lighten the burden for Sony.

The idea is to avoid directly competing against chip specialists such as Intel (INTC). When it comes to cramming more processing power into each chip, Intel beats Sony hands-down. Intel is shifting from circuits measuring 65 nanometers wide to 45-nanometer designs (finer than a strand of human hair); Sony just started using 65-nanometer technology for the Cell in December.

Story of a Trouble-Shooter

Of course Sony won't outsource its most prized technologies. During the Feb. 15 tour, engineers at the Kumamoto plant showed analysts a chip they had developed for a camera that simultaneously captured high-resolution videos and photos of a girl bouncing a ball. No more flipping between video and still-photo modes.

Nakagawa is at the peak of his powers. Since last year he has jumped from one division to the next, solving crises. Last January, he set about improving the Connect online music service, which pales in comparison to Apple's user-friendly iTunes store. In July, he unveiled the company's first single-lens reflex camera made with technology acquired from Konica-Minolta. Three months later he was back in the spotlight apologizing for Sony's massive recall of laptop batteries after several incidents of laptops bursting into flame.

Despite his record of cutting costs, Nakagawa is no bean-counter. One Sony insider who worked for him years ago in digital imaging says he trained engineers to think more like businessmen. Nakagawa traveled on the cheap so he could take engineers on visits to retailers overseas to see which products were selling and which weren't. "Nakagawa was incredibly stingy: He would buy his plane tickets from discount agencies, fly coach, and stay at budget hotels," says the official, who spoke on condition of anonymity. "But he constantly reminded everyone that profits were a priority."

At Issue: The Cell as Platform

Nakagawa's methods aren't always good for morale, though. He has annoyed plenty of engineers by canceling their pet projects to save money. He's also been known to give two teams the same project to let them compete for the job, says Credit Suisse's Tabata. "What's good about Nakagawa is he's decisive," says Takahiro Miura, a former Sony attorney who quit a year ago and now works at a law firm in Virginia. "But some people think he puts too much of a focus on profits." Striking a balance between profits and technology is even harder in semiconductors because each chip can affect dozens of products.

Nakagawa's post puts him in charge of the Cell chip. So far, he has sidestepped questions about its fate. The Cell has loads of potential: As a video game processor, it already delivers several times the power of a PC chip, thanks to its nine "cores" and its 3.2 gigahertz-per-core speed. But all that computing power doesn't come cheap. According to an iSuppli estimate, Sony is spending $89 to make each chip. (Goldman Sachs estimates that chips comprise nearly half of the cost of the gaming machine.) That's part of the reason Sony is losing a bundle on every PS3 console it sells, though Sony says higher volumes are helping to bring down costs.

Sony's challenge will be to convert the chip into a semiconductor platform for every gizmo imaginable. If it succeeds, it could roll out products faster than ever and do so at a fraction of the cost, and engineers in different divisions could share technologies. Matsushita Electric Industrial's (MC) development of a chip platform in 2005 for TVs, video recorders, DVD recorders, and cell phones shows how well that can work. Matsushita, known for its Panasonic brand, has trimmed product cycles to six months; product-compatibility isn't a problem because the software handling digital files is standardized, whether on TVs, DVD players, or cameras. Nakagawa should keep in mind that his reforms will have a huge impact on Sony's consumer electronics.

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