In DVD War, Body Blows for Toshiba

Blockbuster's backing is the latest victory for Sony's Blu-ray in the high-definition DVD format race, but don't count out Toshiba just yet

When Atsutoshi Nishida took over as chief executive of Toshiba two years ago, he had a simple plan: Avoid the commoditization trapping the consumer-electronics industry by creating key products like next-generation TVs and DVD players that break away from the herd and are clearly distinguishable from rivals' products.

Fate has not been kind to Nishida's plans. One of the centerpieces of that plan, Toshiba's HD DVD format, is desperately looking for a lifeline after a series of major disappointments that culminated June 18 with video rental chain Blockbuster (BBI) announcing it would expand next-generation DVD rentals to 1,700 company-owned stores from 250, but only in the rival Blu-ray format. "Blu-ray rentals are significantly outpacing HD DVD rentals," Blockbuster said in a statement.

The move clearly is a major blow to HD DVD. Video rentals typically account for a huge chunk of home movie viewing. They tend to be more important in the early days of a new format, before discs get cheap enough to become an impulse buy. "Blockbuster is still your corner DVD store," says Tim Bajarin, president of tech consultancy Creative Strategies. "They are a very strong presence and are a very strong influence on the market."

Is Blu-ray the winner of the DVD format wars? At first blush, the Blockbuster announcement appears to highlight the momentum Blu-ray has built up after the introduction late last year of Sony's (SNE) $600 PlayStation 3, which includes that optical disc format and has sold more than 3.5 million units. After getting off to a slow start in which Toshiba's HD DVD format sold only 100,000 units in its first year on the market, Toshiba on June 13 slashed its total North American sales forecast by 44%, to just 1 million units, by the end of the year.

Rental Market a Major Player

But even with the rival Blu-ray format now apparently looking at HD DVD in its rearview mirror, Toshiba is hardly down for the count. In the rental market alone, HD DVD titles still have a big presence. Blockbuster also said it will continue to rent that format from its fast-growing online site. And Netflix (NFLX) and other popular online rental sites also continue to rent both formats. HD DVD Promotion Group, a consortium of companies led by Toshiba that pushes the format, in a statement was quick to point out that fact: "Read Blockbuster's release. They say themselves that no winner can be declared yet, which makes sense, given that the high-definition rental market is still just a fraction of the high-definition sales to date."

The outcome is even more inconclusive in terms of retail sales. Giant retailers like Wal-Mart Stores (WMT), Best Buy (BBY), and Circuit City (CC) dislike devoting precious shelf space to both the older DVD format and the two competing high-definition formats. But while sales of Blu-ray titles have been outpacing HD DVD by a 2-to-1 margin since January, it's hard to call a clear winner because sales of both format are still relatively tepid.

Complicating matters further, sales of Toshiba's HD DVD player have jumped since May, when the company slashed the price on its entry-level machine to $399. Meanwhile, Blu-ray player sales—excluding the PS3—have been sluggish, at less than 100,000 units. The Toshiba move has forced Sony to cut the price of its second-generation standalone player to $499, from $599, before it even could begin selling it this month. "The consumer is very price-sensitive in this time and age, and we're outperforming [Sony] on that front," says Toshiba adviser Warren Lieberfarb, a former Warner Bros. executive who now is chairman of his own consultancy.

Looking for Allies in China

The resurgent Toshiba player sales make it more difficult for retailers to sit firmly in the Blu-ray camp since those surging HD DVD player sales could also spur purchases of HDTV and other big-ticket home theater equipment. While the PS3 has sold well on a relative basis, the bad news for retailers is that the competing Nintendo Wii game console, which does not require consumers to purchase additional high-definition equipment, has been the retail champ since its launch.

Toshiba also is lining up allies in other quarters outside retail. It could get some unlikely support in coming months from the Chinese. The Japanese conglomerate is encouraging the Chinese government to adopt its variation of the HD DVD technology for internal use. Two large Chinese DVD manufacturers have committed to doing just that, and aim to begin selling such products later this year.

The bet Toshiba is making with its tieup in China holds promise and peril. It could benefit if the Chinese entries help bring down the cost of components rapidly. Analysts consider a price tag below $199 attractive enough to grab mainstream consumers. But those same Chinese manufacturers could try to export competing players that undercut Toshiba on price. And Chinese makers have balked at paying licensing and royalty fees on key patents held by Japanese DVD makers; the same could happen to Toshiba with HD DVD.

Hollywood Backing Pivotal

Still, the backing of Hollywood studios will be most crucial to either format's success. Content providers hope to strike gold with high-definition DVDs, much like they saw from a $24 billion home video sales market created after DVD players made their first appearance in 1997.

With so much money at stake, anyone betting on the wrong camp might pay a heavy price. Universal Studios is the HD DVD side's only exclusive partner, though Warner Bros. (TWX) and Paramount Pictures (VIA) support both standards. Blu-ray has had more momentum, since Sony, Disney (DIS), Twentieth Century Fox (NWS), Lions Gate Entertainment (LGF), and Metro-Goldwyn-Mayer (MGM) are solely in that camp.

Recent events, however, are making even that Blu-ray advantage appear less formidable. After hackers announced in April that they had cracked next-generation DVD encryption schemes, Fox, which also distributes MGM titles, has not released any new titles. Sources say both camps are working feverishly on new encryption software that might entice Fox to its side.

Another significant problem for both camps is that the high-definition DVD is not as obvious a leap in overall picture quality as the switch to DVD from videocassette recorders. What's more, most of the benefits viewers do see come when watching the content only on a very large high-definition television—usually 50 inches or larger.

PC Market Not Yet a Swing Factor

Toshiba recently announced plans to add HD DVD players to all its PCs and notebooks, while other large manufacturers such as Dell (DELL), Sony, and Apple (AAPL) support only Blu-ray (though Apple has yet to release a Blu-ray computer). Analysts say the PC market may not become a swing factor until manufacturers add recording capability and blank discs come down in price.

On top of it all, time doesn't appear to be on either side. With hard-drive capacity growing exponentially and prices coming down even more sharply, experts predict most broadband-enabled homes within 10 years will download much of their content off the Internet, store it on terabyte home servers or cable boxes, and shuffle that content around the home or onto portable devices.

The solution, of course, is for each side to call a truce and revive talks that failed two years ago to marry the two formats, Bajarin says. But with the exceptions of LG Electronics and Samsung Electronics, who have announced combination players, the two camps appear firmly committed to following the race through to its conclusion. By the time that happens, the money-losing strategies each side has set will have even the winner limping to the finish line.

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