2680

Sony: Betting It All on Blu-Ray

The year was 1976. Sony was entering into a format war with other consumer electronics manufacturers. The victor would capture the prize of owning the consumer home video market. Wait a minute ... is this 1976, or is it 2006? Actually, it could be either.

In 1976, Sony introduced the first VCR for home use. Called the Betamax, it was as big as a microwave oven and cost a whopping $1,295 (more than $6,000 in today's money). A year later, RCA was the first of many manufacturers to introduce a VCR using a different technology: VHS. In terms of image quality, Beta was considered superior to VHS. Sony also had the advantage of being first to market. But VHS machines were cheaper and allowed longer recording times (initially, four hours versus Beta's two hours). In addition, there were far more movies available for purchase or rent in VHS than in Beta. Ultimately, consumers decided that those features were more important. VHS quickly surpassed Beta in market share, eventually wiping out Beta entirely. In 1988, after an eight-year battle, Sony surrendered by making the switch from Beta to VHS.

TWO MODERN TECHNOLOGIES: BLU-RAY VERSUS HD DVD

Today, once again, Sony finds itself gearing up for a format war in the consumer home video market. This time, Sony will go to battle with Blu-ray technology, pitted against the competing HD DVD format. As in 1976, the two technologies will compete for dominance of the home video market, now worth more than $24 billion. Since the first DVD players appeared in 1997, many companies have been working on a format capable of delivering high-definition video to the home market. Of the many technologies under development, Blu-ray and HD DVD have emerged as the frontrunners.

Blu-ray was developed by the Blu-ray Disc Association, a coalition of companies that includes Sony, Hitachi, Pioneer, philips, Panasonic, Samsung, LG, Sharp, Apple, HP, and a host of other companies. HD DVD was developed by a similar coalition and is being backed commercially by Toshiba, Sanyo, Kenwood, Intel, and NEC, among others. Although each of the technologies was developed by a coalition of companies, Sony and Toshiba appear to be the dominant players in their respective camps. And whereas Sony stood pretty much alone in pitting Beta against VHS, its Blu-ray forum has more corporate firepower in this battle.

In a situation where the differences between the two technologies seem critical, the formats axe surprisingly similar. Both use physical discs that are identical in diameter and thickness to current DVD discs. This allows the developers of the new-generation players to make them backward compatible (able to play previous-generation DVDs). Additionally, each technology employs a blue laser of the same wave length, as well as similar video encoding and basic copyright protection features.

3

WILL THE DIFFERENCES MATTER?

Despite the similarities, the Blu-ray and HD DVD formats have notable differences. Interestingly, some of the key differences likely to affect the success of the two new DVD formats are the same features that differentiated Beta and VHS 30 years ago. Specifically, both sides are vying for image quality, disc capacity, price, and availability of content advantages. At least initially, Blu-ray captures the quality advantage in this race. However, both Blu-ray and HD DVD produce high-definition video far superior to current DVD images, and the quality difference between the two may be indistinguishable by the average human eye.

Although Blu-ray and HD DVD discs look identical, there are fundamental differences in the way the discs are put together. Each technology utilizes multiple layers of data encoding, but Blu-ray uses more layers and can store more data on each layer. Thus, Blu-ray discs can store far more information—up to 200 GB versus HD DVD's 90 GB. For home video, this means that a single Blu-ray disc can hold longer movies. "Capacity is always going to be your number-one concern," says Andy Parsons, spokesman for the Blu-ray Disc Association and senior vice president of advanced product development for Pioneer.

However, whereas capacity was critical in Beta versus VHS, many observers believe that it will be less of an issue today. Both Blu-ray and HD DVD discs will have more than enough capacity to hold a feature-length high-definition film. But Parsons is quick to point out that the consumers really like the bonus features on DVDs, so much so that many titles now come in two-disc sets—one disc for the movie and the other for bonus features. "We . . . have learned ... not to try to squeeze the most we can out of mid- '90s technology, which is what the HD DVD guys have done." Even so, given the compact size of modern discs, capacity may be less of an issue than it was when video tapes were the size of paperback books. Additionally, it has yet to be determined how many layers could be added to either technology, ultimately affecting data capacity.

Whether or not capacity emerges as an important feature, price is a critical issue. Toshiba introduced the first HD DVD players in April of 2006 at price points of $499 and $799. Pioneer introduced the first Blu-ray machine in June of 2006 with a much higher price tag of $1,800. This price difference parallels that of Beta versus VHS in the 1970s. However, Andy Parsons shares some insights on the implications of Toshiba's introductory strategy:

As part of a marketing strategy, certain companies such as Toshiba say, "Even though it costs us this much money to make this product, we're going to price it lower, even if it's below our factory cost, because taking that kind of loss up front might help to get the market populated with our product and help accelerate adoption." That kind of thinking is generally not very successful, because it ignores one very important element: You have to build awareness for the new technology before you can assume that price is an important or overriding factor.

4

This is why we have a natural curve with an earlyadopter group of people who are very focused on technology and performance. Right now in this space, the big buzzword is 1080P progressive scan, 24 frames per second, full-resolution HD TV—this is the Holy Grail, because it's the closest you can get to a theater experience in terms of frame rates, and [it's] a hot button for people who are following this story at the consumer level.

Consumers interested in buying technology that gives them the best display or audio quality won't balk at the price. This is why our player is $1,800. We focused on getting 1080P, because that is something we knew would resonate with the initial target market, whereas the $499 strategy is probably going off in the wrong direction, because the folks who are really paying attention to this right now want the highest resolution.

Taking another cue from Beta versus VHS, the Blu-ray and HD DVD camps have fought to get the support of major movie studios. The idea is that the format offering more movies will have the advantage. As both technologies come to market, Blu-ray has signed seven studios; HD DVD has signed only three. And yet, although most studios are backing only one technology at this point, Warner Bros, indicates that it will ultimately release movies in both formats. Other studios may well pursue this same strategy.

In the Beta versus VHS competition, image quality, capacity, price, and content availability were the deciding factors. In the current format war, only time will tell if these points of differentiation will have the same impact. But the HD DVD forum claims that new issues this time around will give its technology the advantage. For starters, manufacturing costs for Blu-ray will be significantly higher. (The Blu-ray camp counters that the cost difference is minimal and will likely disappear as volumes increase.) HD DVD software will also allow consumers to make copies of their discs to computer hard drives and portable devices. And with its iHD technology, HD DVD discs promise greater interactivity by allowing for enhanced content and navigation, as well as fancy features such as pic- ture-in-picture capability.

However, additional new issues could tilt the scales in favor of Blu-ray. Although Toshiba and HD DVD enjoy a brief first-to-market advantage, Blu-ray will likely experience a huge bump in market share when Sony introduces its long-awaited PlayStation 3 gaming platform In late 2006. The PlayStation 3 not only uses Blu-ray technology for its game discs, it will be able to play all Blu-ray movies as well. This could put millions of Blu-ray players into homes very quickly via the video consoles.

WILL THE POINT BE MOOT?

Drawing comparisons to the Beta/VHS format war assumes that one of the two current competing formats will ultimately win and the other will die out. However, two other possibilities exist. First, both formats could succeed and do well. Most of the issues mentioned previously may become nonissues as the Blu-ray and HD DVD technologies

5

evolve. Either of the two technologies could adopt features of the other. Additionally, at some point, hardware manufacturers may well release dual-format players, capable of playing both Blu-ray and HD DVD discs. Such a development could reduce the relevance of format labels.

Stephen Nickerson, senior vice president at Warner Home Video, believes that both formats could easily succeed. Although most analysts compare the DVD format war to the VCR format war, he suggests another analogy. "The [video] games industry since the early '90s has had two or three incompatible formats and it hasn't slowed the adoption of game platforms."

However, there is another potential outcome. Both formats might fail. Ted Schadler, analyst with Forrester Research, believes that most people are missing an important point. "The irony of this format war is that it comes at the tail end of the century-long era of physical media. While a high-definition video format does bring benefits over today's standard-definition discs, in movies as in music, consumers are moving beyond shiny discs." Schadler's statement refers to the fact that the consumption of all kinds of entertainment products, even television programming, has evolved dramatically since the mid1990s. Consumers have far more options than they used to, and the dust has yet to settle on which options will dominate for any given type of product.

For home video, more customers are choosing ondemand, nonphysical media, including online video and video-on-demand television. One in six cable subscribers has demonstrated significant interest in watching video-on- demand. As cable providers increase their video libraries and technologies improve, that number will only grow. Internet video is also spreading rapidly, with 46 percent of online consumers now watching movies via the Web. Additionally, with the success of the video iPod, major Hollywood studios aren't just considering which DVD formats to support. They're assessing how they can make money by selling movies directly to consumers in a file format that can be played on portable devices. According to Ted Schadler, the device more consumers age 12 to 21 now say they can't live without isn't their TV, it's their PC. Even Bill Gates has his doubts about the current DVD format war. "Understand that this is the last physical format there will ever be. Everything's going to be streamed directly or on a hard disk."

Although these predictions may very well be true, there is likely still plenty of steam left in the DVD market. Physical discs still hold many advantages over the nonphysical media. Even with the significant threat of VHS, Beta survived for eight years. And no format will last forever. Only nine years passed between the introductions of the first home DVD and HD DVD players. So although there's clearly a home video war looming, the big questions concern who will be fighting and on what fronts.

Questions for Discussion

1. Classify the high-definition DVD market using the product life-cycle framework. Based on this analysis, what objectives and strategies should Sony and the other competitiors pursue? Are any of the competitiors deviating from this formula?

6

2.As sales of the new DVD players increase, what will happen to the characteristics of the home video market and the strategies employed by Sony and other competitors?

3.Analyze the development of Blu-ray and HD DVD according to the stages of the new-product development process.

4.Who are the current combatants in the battle for the home video market? Who will they be in five years?

Sources: Beth Snyder Bulik, "Marketing War Looms for Dueling DVD Formats," Advertising Age, April 10, 2006, p. 20; Gary Gentile, "Beta/VHS-Like Battle Shaping Up for New High-Def ' DVDs," Associated Press Worldstream, January 6, 2006; Ann Steffora Mutschler, "The Convergence War," Electronic Business, May 1, 2006, p. 44; Sue Zeidler, "Hold On Tight; Going to the '1 Store to Rent a DVD May Soon Be a Thing of the Past," Calgary § Sun, p. 40; information on Beta and VHS accessed online at www.totalrewind.org.

Southwest Airlines: Waging War in Philly

BATTLE STATIONS!

In March 2004, US Airways CEO David Siegel addressed his employees via a Webcast. "They're coming for one reason: They're coming to kill us. They beat us on the West Coast, they beat us in Baltimore, but if they beat us in Philadelphia, they are going to kill us." Siegel exhorted his employees on, emphasizing that US Airways had to repel Southwest Airlines when the no-frills carrier began operations at the Philadelphia International Airport in May—or die.

On Sunday, May 9, 2004, at 5:05 A.M. (yes, A.M.), leisure passengers and some thriftminded business people lined up to secure seats on Southwest's 7 A.M. flight from Philadelphia to Chicago—its inaugural flight from the new market. Other passengers scurried to get in line for a flight to Orlando. And why not? One family of six indicated it bought tickets for $49 each way, or $98 round trip. An equivalent round-trip ticket on US Air would have cost $200.

Southwest employees, dressed in golf shirts and khaki pants or shorts, had decorated the ticket counters with lavender, red, and gold balloons and hustled to assist the throng of passengers. As the crowd blew noisemakers and hurled confetti, Herb Kelleher, Southwest's quirky CEO, shouted, "I hereby declare Philadelphia free from the tyranny of high fares!"

At 6:59 a.m., Southwest Flight 741 departed for Chicago.

WAR ON!

Was Southwest's entry into the Philadelphia market worth all this fuss? After all, US Air was firmly entrenched in Philadelphia, the nation's eighth-largest market, offering more than 375 flights per day and controlling two-thirds of the airport's 120 gates. Further,

7

in 2004, little Southwest served a total of 58 cities and 59 airports in 30 states and was offering only 14 flights a day from Philly out of only two gates. And until its entry into Philadelphia, Southwest had a history of entering smaller, less-expensive, more out-of-the- way airports where it didn't pose a direct threat to the major airlines like US Air. Did Southwest really have a chance?

Southwest was used to that question. In 1971, when Kelleher and a partner concocted a business plan on a cocktail napkin, most people didn't give Southwest much of a chance. Its strategy completely countered the industry's conventional wisdom. Southwest's planes flew from "point to point" rather than using the "hub-and-spoke" pattern that is the backbone of the major airlines. This allowed more flexibility to move planes around based on demand. Southwest served no meals, only snacks. It did not charge passengers a fee to change same-fare tickets. It had no assigned seats. It had no electronic entertainment, relying on comic flight attendants to entertain passengers. The airline did not offer a retirement plan; rather, it offered its employees a profit-sharing plan. Because of all this, Southwest had much lower costs than its competitors and was able to crush the competition with low fares.

For 32 years, Southwest achieved unbelievable success by sticking to this basic nofrills, low-price strategy. Since it began operations in 1972, it was the only airline to post a profit every year. In 2003, just prior to taking the plunge in Philly, the company earned $442 million—more than all the other U.S. airlines combined. In the three prior years, Southwest had earned $1.2 billion, while its competitors lost a combined $22 billion. In May 2003, for the first time, Southwest boarded more domestic customers than any other airline. From 1972 through 2002, Southwest had the nation's best-performing stock— growing at a compound annual rate of 26 percent over the period. Moreover, while competing airlines laid off thousands of workers following де September 11 tragedy, Southwest didn't lay off a single employee. In 2004, its cost per average seat mile (CASM— the cost of flying one seat one mile) was 8.09 cents, as compared with between 9.42 to 11.18 for the big carriers.

THE MAJORS: LOW ON AMMUNITION

In the early 2000s, the major (or legacy) airlines, such as US Air, Delta, United, American, and Continental, faced three major problems. First, "little" Southwest was no longer little. Second, other airlines, such as JetBlue, AirTran, ATA, and Virgin Atlantic, had adopted Southwest-like strategies. In fact, JetBlue and America West had CASMs of 5.90 and 7.72 cents, respectively. In 1990, discount airlines flew on just 159 of the nation's top 1,000 routes. By 2004, that number had risen to 754. As a result, the majors, who had always believed they could earn a 30 percent price premium, were finding it hard to get a 10 percent premium, if that. Third, and most importantly, the major airlines had high cost structures that were difficult to change. They had more long-service employees who

8

earned higher pay and received expensive pension and health benefits. Many had unions, which worked hard to protect employee pay and benefits.

ATTACK AND COUNTERATTACK

US Air had experienced Southwest's attacks before. In the late 1980s, Southwest entered the California market, where US Air had a 58 percent market share on its routes. By the mid-'90s, Southwest had forced US Air to abandon those routes. On the Oakland to Burbank route, average one-way fares fell from $104 to just $42 and traffic tripled. In the early '90s, Southwest entered Baltimore Washington International Airport, where US Air had a significant hub and a 55 percent market share. By 2004, US Air had only 4.9 percent of BWI traffic, with Southwest ranking number one at 47 percent.

Knowing it was in for a fight in Philly, US Air reluctantly started to make changes. In preparation for Southwest's arrival, it began to reshape its image as a high-fare, uncooperative carrier. It spread out its scheduling to reduce congestion and the resulting delays and started using two seldomused runways to reduce bottlenecks. The company also lowered fares to match Southwest's and dropped its requirement for a Saturday-night stayover on discounted flights. US Air also began some new promotion tactics. It launched local TV spots on popular shows such as "Friends," "American Idol," and "Frasier" to promote free massages, movie tickets, pizza, and flowers.

On the other side, Southwest knew that Philadelphia posed a big challenge. Philadelphia International was one of the biggest airports it had ever attempted to enter. And with US Air's strong presence, it was also one of the most heavily guarded. Finally, the airport was known for its delays, congestion, bureaucracy, and baggage snafus, making Southwest's strategy of 20-minute turnarounds very difficult.

Therefore, Southwest unveiled a new promotion plan for Philly. Ditching its tried-and- true cookie-cutter approach, the airline held focus groups with local travelers to get their ideas on how it should promote its service—a first for Southwest. As a result, the airline developed a more intense ad campaign and assigned 50 percent more employees to the airport than it typically had for other launches. Southwest also recruited volunteers to stand, on local street corners handing out free inflatable airline hats, luggage tags, and antenna toppers. The airline used billboards, TV, and radio to trumpet the accessibility of its low fares as well as its generous frequent-flier program.

THE BATTLE RAGES ON

Two short years after Southwest began service to Philadelphia, the market took on a dramatically different look. Southwest had boosted daily nonstop flights from 14 to 53. It had added service to 11 new cities and quadrupled its number of gates from two to eight, with its eye on four more. The number of Southwest employees in Philly approached 200, a huge increase over its post-launch total of fewer than 30.

But the external impact of Southwest's first two years in Philadelphia was a classic example of what has come to be known as "the Southwest effect"—a phenomenon in which

9

all carriers' fares drop and more people fly. In Philadelphia, the intense competition brought on by Southwest's arrival caused airfares on some routes to drop by as much as 70 percent. In 2005, airline passenger traffic for Philadelphia International was up 15 percent over 2004. The airport attributed much of that increase to Southwest. In all, by the end of 2005, Southwest had captured 10 percent of total passenger traffic. In turn, US Airways' share fell about five percentage points.

Just as US Air was absorbing Southwest's blows in Philadelphia, the underdog airline struck again. In May of 2005, Southwest started service to Pittsburgh, another major US Air hub. Shortly thereafter, Southwest announced that it would also soon enter Charlotte, NC, US Air's last stronghold.

Still, although it appears that Southwest is on cloud nine, many factors are forcing the nation's most profitable air carrier to change flight plans. First, the best-known discount airline has more competition than ever before. Upstarts such as Frontier, AirTran, and JetBlue are doing very well with Southwest's model. And they are trumping Southwest's low fares by adding amenities such as free TV and XM satellite radio at each seat.

Even the legacy carriers are now in better positions to take on Southwest's lower fares. All of the major airlines have ruthlessly slashed costs, mostly in the areas of wages and pensions. Some, like US Air, have used bankruptcy to force steep union concessions. In fact, Southwest now has some of the highest paid employees in the industry. And although Southwest still enjoys a big advantage in total costs over the major carriers, these big airlines have narrowed their cost disadvantage from 42 percent to 31 percent. With the wind now at their backs, these competitors could soon decrease the cost gap to as little as 20 percent.

Being the low-cost leader has some disadvantages. Because Southwest already has such a lean cost structure, it has much less room for improvement. For example, travel agent commissions have been at zero for some time (Southwest doesn't work through agents). Sixty-five percent of Southwest customers already buy their tickets online, minimizing its expense for call centers. And Southwest is losing another of its traditional cost advantages. For years, though some smartly negotiated fuel-hedging contracts, Southwest has enjoyed fuel prices far below those paid by the rest of the industry. But the most lucrative of those contracts are expiring. At a time when fuel prices are surging for the entire industry, this means that Southwest's fuel expenses are rising faster than those of its competitors. In the first quarter of 2006, Southwest's paid 63 percent more for fuel that it did for the yearearlier period.

As these factors have quickly turned the tables on Southwest, some analysts are questioning the company's current strategic direction. "Slowly, Southwest is becoming what its competitors used to be," says industry consultant Steven Casley. Serving congested hub airports, linking with rivals through code sharing, and hunting the big boys on their own turf are all things that Southwest would previously have never considered.

10