Sony's Trojan Horse
It's small, it's cheap, and it's loaded with advanced features. But the new PlayStation Portable is about much more than fun and games.
By Geoff Keighley

(Business 2.0) – It was big news when the father of the PlayStation confessed that Sony's consumer electronics strategy had been a disaster. Speaking to a group of Tokyo journalists in January, Sony Computer Entertainment president Ken Kutaragi admitted that Sony's historic emphasis on innovation had been "diluted" by the conflicting interests of the company's hardware and content divisions. That explained why many of Sony's recent devices have been hobbled by proprietary technologies that Kutaragi called "frustrating for everyone--even for those in the Sony family." Going forward, he promised, Sony would create better products by cooperating with the rest of the industry on technology standards. "We are growing up," he said.

So what, then, is one to make of Sony's new PlayStation Portable gaming device, which goes on sale in the United States on March 24? The sleek, handheld PSP is designed to play videogames, movies, and music. Kutaragi calls it a "Walkman for the 21st century." Skeptics, however, point out that Sony has loaded the PSP with not one but two proprietary data storage systems: a new Sony-designed optical disc called the Universal Media Disc, or UMD, and a slot for Memory Stick Pro Duo cards, a Sony flash-memory format with a current U.S. market share of less than 3 percent.

But take a closer look at the PSP and you'll see that Kutaragi has taught Sony a thing or two about marketing new technology standards--and building successful Trojan horses. Strictly as a gaming device, the PSP is already shaping up as a winner--1 million units have been sold in Japan, and worldwide shipments are projected to reach 3 million by the end of March. But that's just the beginning. To push PSP past the 15 million unit-sales threshold that would make it a mainstream success in the United States and Europe, Kutaragi is importing the tactics he used to launch the PlayStation, a Sony franchise that has contributed 50 percent of Sony's total operating income since 2002. By building a strong game library for the PSP and bundling it with a 32-megabyte Memory Stick Duo card, a pair of headphones, and a copy of the Spider-Man 2 film on UMD--all for $250--he hopes American consumers will snap up the new handheld in record numbers. If his plan succeeds, Sony's proprietary standards will establish a firm foothold in the marketplace, much like Apple's popular iPod.

Indeed, some analysts, like Richard Doherty of New York-based Envisioneering, are bullish about Sony's prospects. "The PSP will be the most in-demand consumer electronics device of the year," he predicts, "even more than the iPod."

A Unique Balance

Sony certainly needs a hit. In the fourth quarter of 2003, its consumer electronics business lost almost $1 billion, prompting investors to knock 25 percent off the company's share price in two days. This year, citing falling prices for DVD recorders and videocameras, Sony has scaled back its operating profit forecast by 31 percent, to $1.06 billion. The company's CFO, Katsumi Ihara, sees the writing on the wall: "The important thing for us is to develop products that consumers will recognize as unique that others can't copy," he says.

Still, there's a right way and a wrong way to be "unique." When the PSP was first announced, in 2003, copyright-obsessed execs at Sony Music made sure that all Sony gadgets played only music encoded with Sony's proprietary Atrac algorithms--and would not play the huge MP3 libraries already on many PC owners' hard drives. (Apple, in comparison, made its iPod compatible with MP3s while also pushing its own AAC format.) The result? Sony now holds less than 1 percent of the U.S. market for digital-music players, according to NPD Group.

Kutaragi understands that if you want to kick others out of the sandbox, you first have to play nice. So he spent two years lobbying to revise Sony's digital-music strategy. Helped by consumers' rejection of Sony's Atrac-only music players, he won the battle in mid-2004, and as a result, PSP buyers can effortlessly move their MP3 files onto the device.

Kutaragi's next coup was getting the execs who control Sony's other content properties in line. When the PSP debuted at the Consumer Electronics Show in January, Sony America CEO Howard Stringer, CTO Phil Wiser, and Sony Pictures vice chairman Yair Landau were on hand as Sony Computer Entertainment America CEO Kaz Hirai demonstrated the PSP's video capabilities by showing a trailer for Hitch, a new Will Smith movie about a New York City matchmaker. But Kutaragi--whose talent for getting different camps to collaborate helps to explain why Sony Corp. CEO Nobuyuki Idei named him executive deputy president of the entire company in 2003--was the real matchmaker. He was the one who persuaded the company's disparate divisions to work together to nurture UMD as a common format.

And that, after all, is the point of all the corporate backslapping and MP3 support: getting consumers to embrace the PSP--and the UMD format--for playing music, movies, games, and everything else while they're out and about. Kutaragi proved the value of a platform built on a widely accepted storage medium a decade ago, when he equipped the first PlayStations with standard compact disc readers, dramatically lowering the cost of manufacturing games and (as an added bonus) allowing consumers to play audio CDs on their PlayStations. He performed a similar feat with the PlayStation 2, which uses the DVD format for both gaming and video playback--a convergence feature that made the PS2 one of the most popular DVD players in Japan.

This time around, Kutaragi argues, Sony had little choice but to develop the 1.8GB UMD, as no existing content format offers similar capacity in a form cheap enough and small enough to use in a handheld. (UMDs cost just a few dollars to manufacture, far less than options based on flash memory or hard drives.) Yet Kutaragi still might be able to make UMD ubiquitous. His PlayStation experience taught him the importance of garnering support from game developers, and he's already lined up 24 game titles for the U.S. launch of the PSP. If mobile gamers want to play MVP Baseball or the Wipeout racing game, for example, they'll have to buy a Sony handheld. Plus, $250 is a great price for a device that offers vivid graphics, a wide-format color LCD screen, Wi-Fi, and an optical drive. At that price, and with its growing game library, the PSP could capture a global installed base of 12 million early adopters--and UMD users--by the end of the year.

This Way to Payday

The next step, of course, is to release other stuff--such as more movie titles--on UMD. Here, too, Kutaragi has been making remarkable headway. In January, Sony hinted that 20th Century Fox and DreamWorks would release movies in the UMD format. Kutaragi has also said he intends to license UMD so other device manufacturers and software developers can exploit the opportunities the format may soon create. That could leave Sony as the gatekeeper to portable digital content: "It's a huge card we can play," says Sony Computer Entertainment America executive vice president Andrew House. "We can turn to other content providers and say, 'Look at the installed base. Are you really going to miss out on UMD?'"

What a payday, if he's right. UMD royalty revenues would be one obvious perk--potentially adding billions of dollars to Sony's bottom line over the life of the format. Controlling a standard also confers technical advantages: Sony will have the upper hand in developing products that exploit UMD technology. Given time, mass acceptance would generate sustained momentum as switching costs deter users from embracing rival formats.

Similar logic explains Sony's decision to stand by its standard for next-generation DVDs that will offer higher storage capacity and improved image quality. Although the DVD Forum, the industry consortium that developed the standards used in today's DVDs, selected a rival format called HD-DVD as its preferred technology in late 2003, Sony continues to promote its own standard, Blu-Ray. Facing the prospect of a format war, Sony is counting on Kutaragi to prevent a repeat of the Betamax VCR debacle of the 1980s. That's why, when Sony's next console, the PlayStation 3, is introduced in 2006, PS3 game software will be published only on Blu-Ray discs.

Of course, there are limits to how much proprietary technology consumers will tolerate, and with the PSP, things may not go quite according to plan. Kutaragi may have needed to create UMD to distribute content for the PSP, but the same can't be said for the decision to use Sony's Memory Stick Duo cards for storing users' music files and personal data. Memory Stick Duo is expensive--on a per-megabyte basis, it costs as much as three times more than comparable Secure Digital cards, a popular format created by Panasonic, SanDisk, and Toshiba that commands 50 percent of the U.S. market. Sony's format is also more limited--the maximum capacity of Memory Stick Duo is currently 1 gigabyte, compared with 2 gigabytes for SD. In short, it'll be cumbersome and costly for PSP owners to transport their favorite tunes and pics on their new handhelds--a limitation that could hinder Sony's bid to make the PSP a truly personal personal media device.

But as a game machine, the PSP has been engineered to be a formidable competitor. And on that basis alone, Kutaragi has handed Sony the Trojan horse the company needs to reach millions of new consumers. From here on out, it'll be up to the company's content divisions to help him storm the digital kingdom.

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Source: Wedbush Morgan Securities