Sony's Blu-Ray Breakthrough

Warner Bros.' decision to back the format makes buying a PS3 less of a gamble for gamersand promises licensing fees in the future

For months, Sony's (SNE) PlayStation 3 video game console has seemed like a high-profile boondoggle for the Japanese giant. While Microsoft's (MSFT) Xbox 360 took an early lead that it later forfeited to Nintendo's Wii machine, the PS3 always lagged behind. Worse, the machine's next-generation Blu-ray DVD player and other pricey high-tech parts, which pinched Sony's profits last fiscal year, look likely to weigh on earnings again this year and next. And analysts are skeptical as to whether Sony can meet its sales forecasts for the console this year.

But you won't hear Chairman and Chief Executive Sir Howard Stringer badmouthing the gaming machine. That's because the millions of PS3s the company has sold since late in 2006 likely clinched Warner Bros. Entertainment's (TWX) exclusive support for the Blu-ray format.

Warner announced on Jan. 4 that it would release only high-definition Blu-ray movies starting July, ending its support for the rival HD DVD format. Winning Warner's backing was a coup for the Blu-ray camp, which counts Sony, Samsung Electronics, Matsushita Electric Industrial (MC), and dozens of other consumer-electronics makers among its members. Warner has the industry's most extensive offering of movies and consistently churns out blockbusters. With five out of seven major studios now on-board, Blu-ray has the upper hand—perhaps decisively—in the struggle over the next-generation DVD standard.

No Repeat of Betamax Fiasco

How will Blu-ray's momentum benefit Sony? For now, it's largely a morale boost, laying to rest any worries about a repeat of the Betamax defeat to VHS in the 1980s. "The exact impact is difficult to say," says Ovum analyst Carl Gressum. Eventually, though, tech manufacturers in the HD DVD camp may switch to Blu-ray technology and start paying licensing fees to Sony and others for the right to do so.

Investors are already cheering. In the two days since Warner's decision, shares of Sony have gained 4.1% in Tokyo. Still, investors want to see Stringer & Co. quickly recoup the enormous sums spent on developing the discs, lasers, and other key equipment and incentives to get consumers and studios on Blu-ray's side. (Sony officials declined to disclose figures.) "We spent a lot of money building up Blu-ray and we're now getting into the rhythm of innovation," Stringer told reporters on Jan. 7 in Las Vegas.

The news comes ahead of Sony's third-quarter earnings, which are widely expected to be strong. Goldman Sachs' (GS) Yuji Fujimori predicts the company's October-December operating profit jumped 17%, to $1.9 billion, from the same quarter last year, on a 6.3% uptick in sales, to $25.4 billion. Assuming Sony delivers, as expected, its operating margins for the quarter would exceed 7%.

Analysts Applaud Efforts to Shrink PS3 Chips

Stringer's promise to raise Sony's overall margins to 5% by the Mar. 31 fiscal yearend appears easily within reach. And margins should continue to improve as Sony's video-game division, Sony Computer Entertainment, trims the console's manufacturing costs and revs up output.

Nikko Citigroup's Kota Ezawa estimates the games division will lose $1.4 billion this fiscal year, following last year's $2.1 billion loss. And while he doesn't expect the business to be prosperous until late 2009, Ezawa applauds Sony's efforts to shrink the PS3's chips and tweak its design. Already such changes have cut the cost per machine to around $400 now, from above $800 just before it went on sale in November, 2006, he says. (The PS3 with an 80-gigabyte hard-disk drive retails in the U.S.

for about $499.) "We think the biggest factor here is that simplification has become possible through a reduction in the parts count, leading to a reduction in costs," Ezawa wrote in a Dec. 27 report.

Warner's shift to Blu-ray is a gift for Sony's videogame business. The console's sales have picked up in recent months after Sony cut the price in October, introduced a $399 model in November, and lowered the fees it charges game developers in a bid to broaden its games offering. But it still trails Nintendo's Wii, which also launched in November, 2006. Last year in Japan, for instance, Nintendo's Wii console outsold Sony's PS3 3-to-1, according to Tokyo market researcher Enterbrain. Macquarie Securities predicts Sony will ship just 9.2 million consoles this fiscal year, not the 11 million the company has forecast.

Stringer Likely to Stay CEO for Three More Years

Until now, gaming enthusiasts have been the console's main buyers. It didn't take much to convince them that the Blu-ray discs were ideal for cramming in more of the richly detailed pictures and realistic sound that the PS3 had been designed for. But for anyone else, splurging on a PS3 would have meant gambling on one of the DVD formats. There's less risk in that now, which gives Sony a chance to bill the PS3 as an affordable Blu-ray player that's also a gaming machine, connects to the Internet, and comes with a hard-disk drive for downloading games, videos, and music.

Stringer will be glad to have one less distraction to deal with. Last month, at a roundtable discussion with reporters in Tokyo, he suggested that he would be at the helm for another three years. He'll want to devote himself to rolling out an online channel, like Apple's (APPL) iTunes store, that can deliver Sony's huge library of movies, music, and games to all kinds of gizmos—and not have to spend time explaining why Sony still has problems.

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