Sony's Blu-Ray Breakthrough

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

by Kenji Hall

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.