How Sony Lost Its Moat

Nostalgia surrounding  Sony's (SNE) electronics, especially the dominant Walkman and PlayStation franchises, may create a sense of Sony as a powerful brand, but we believe the firm has lost a step on the competition in terms of design and no longer commands the premium pricing it once enjoyed. Sony holds considerable market share, but size does not necessarily translate into profits in these competitive markets.

Sony's largest segment, the electronics business, has been in decline for some time, but the strength of the gaming division in combination with the movie and music franchises had warranted a narrow economic moat. However, over the last decade we have witnessed further deterioration of the electronics brand, a reversal in console leadership, and disruptive trends in the music and movie segments that materially weaken Sony's prospects. Therefore, we are removing the firm's narrow economic moat rating.

Hardware Is No Longer the Key to Success
In the age of digital consumer electronics, it is becoming increasingly difficult to differentiate a product based on hardware design. Sony's failure to embrace software as a differentiating factor for its hardware has led to poor designs across many segments and opened the door for competitors such as  Apple (AAPL) and Nintendo. For example, we now associate portable music players with the iPod, not the once-dominant Sony Walkman. Why did Sony fall apart in a market it once controlled? Because success with the Walkman was based on hardware and brand, but digital music players have different key drivers. Sony launched digital music players with similar hardware capabilities as the iPod, but the interface did not appeal to users and Sony failed to deliver an ecosystem of tools and applications that made it easy for the average consumer to load their music collections. Meanwhile, Apple rolled out iTunes.

Creative Design Trumps Horsepower in Gaming
Similarly, misguided design efforts have diminished Sony's power in the gaming industry. In 2006, Sony rolled out the most advanced console, the PlayStation 3, sacrificing affordability and time-to-market to deliver the most bells and whistles. Unfortunately, although Sony won the technology battle, they lost the design war. Nintendo demonstrated that creative design trumps pure horsepower by claiming the market share lead with the Wii, a cheaper, less sophisticated device that appealed to a wide audience, while the PS3 and Xbox 360 battled over the smaller "super-geek" segment.

Whereas Sony was the unquestioned leader of the last (6th) generation of consoles, the firm continues to lag Nintendo and  Microsoft (MSFT) during the current (7th) generation, demonstrating the fragility of industry leadership from generation to generation and supporting our thesis that hardware is not always the key driver of success. Sony launched the most powerful machine, but it did so at an uncompetitive price point that severely limited the console's appeal. Game producers will release titles on all the major systems unless incentivized to do otherwise, leading to only a limited amount of exclusive games. With most games available on each major platform, switching costs are diminished, and the price point differential became difficult to overlook for many consumers. Four years into the current cycle, Sony remains far behind in installed base with 67 million, 39 million, and 31 million units sold for the Wii, Xbox 360, and PlayStation 3, respectively. In contrast, Sony's dominance of 6th-generation consoles is apparent, with 138 million PlayStation 2 consoles sold compared to sales of 24 million and 22 million for the Xbox and GameCube consoles, respectively.

Brands Erode as Customers Choose Value
Sony's consumer electronics business continues to hold significant market share, but sales have eroded relative to other manufacturers and the firm has lacked an ability to consistently drive profits from this segment during the last decade. We believe this unit's struggles are largely due to a convergence in the quality of the hardware across brands that make it difficult to differentiate Sony from the competition. We'll examine TVs as a proxy for Sony's electronics division because it is the largest product group and many of the trends apply across devices.

When flat panel televisions were new to consumers, many opted for the safety of known brands. But this tendency quickly changed as the perceived value of recognizable brands has eroded. As a result, when a consumer walks into Costco or surfs Amazon's site for a 50" LCD television, the first thing most do is look for the lowest price. Sony is still a recognizable brand, but one that doesn't resonate to the point that consumers will pay extra money to take it home. Instead, chunks of television market share are going to relative newcomers, such as Vizio and stores launching private-label brands, such as Best Buy's Insignia. Sony has been ill-equipped to compete on price due to an inefficient supply chain, and through its attempts to hold the line on pricing, the firm has ceded market share, falling from nearly 15% two years ago to under 10% in the most recent quarter.

The deterioration of the brand's pricing power for TVs is certainly troubling, but perhaps even more concerning are Sony's bleak prospects for reclaiming lost market share. The challenges facing the humbled giant may be best illustrated by examining the industry dynamics in what we consider to be the most important markets for consumer electronics, the United States and China. Sony's vulnerability has been exploited by Vizio in the U.S. This scrappy startup began in 2002 and has risen to claim the top domestic market share position for the first three quarters of 2009 using a strategy of providing good (not the best) televisions at low prices. The strategy is clearly resonating with consumers as the firm aims to generate more than $2.8 billion in revenue in 2010 and is looking to expand into other markets. Vizio's success clearly signals that consumers are emphasizing value over features, a poor match for Sony's hardware strengths. Furthermore, Sony is not positioned to capitalize on the massive growth potential in the Chinese TV market. China is quickly becoming a major source of demand, experiencing triple-digit growth and accounting for 18% of the global LCD market in the second quarter of 2009, but the market is full of domestic brands with low labor costs and is extremely price competitive.

 

Desperation Could Lead to Poor Decision-Making
We believe Sony recognizes the challenges facing the electronics business but lacks a winning strategy to reestablish the price premiums it once commanded. As the company becomes more desperate to turn around the electronics division, we are concerned that it is making large bets on solutions such as 3D technology that, in our opinion, are unlikely to pay off.

Sony is investing heavily in 3D technology through partnerships with ESPN, IMAX, and Discovery to fast-track the generation of 3D content. Unfortunately, we believe there are many obstacles in the way of mainstream adoption, including a need for new televisions and supporting equipment. Furthermore, we believe it is simply wishful thinking by electronics executives to assume consumers will be willing to pay for and wear special 3D glasses at home. Given the uncertain timing of 3D and growing competition surrounding the hardware to enable this technology, we are surprised that Sony is leading the charge. Despite potential synergies for the PlayStation, blu-ray, and movie businesses, the electronics and television fields are crowded with Samsung, LG, Panasonic, and others all pushing similar television technologies and benefiting from Sony's efforts to establish content. Misguided efforts such as this lead us to believe that Sony does not have a viable plan for reestablishing its economic moat.

Moatworthy Movie and Music Divisions
The movie and music businesses have some moatworthy characteristics, including a library of award-winning content and franchises that Sony monetizes. However, these businesses combined account for approximately 16% of revenue and are not enough to offset the weakness in Sony's core electronics and gaming segments. Furthermore, new distribution models including DVD by mail and online delivery are disrupting the some of the most profitable portions of these businesses, raising questions about the sustainability of margins.

Short-Term Catalysts Unlikely to Reestablish a Moat
There are several short-term catalysts working in Sony's favor that should strengthen company fundamentals in the short term. First, the firm hit a low point in profitability during fiscal 2009 that has served to shake things up in an organization that is notoriously slow to change. A restructuring effort is underway that includes factory closures and head-count reductions that should help streamline operations and return Sony to profitability. Second, consumer spending on electronics looks poised to bounce in 2010 relative to a dismal 2009. Although we clearly expect unit growth to be up across most product segments, bear in mind that falling prices could dampen the rebound. Finally, the recent price cut in the PS3 (to $299 from $399), should be a key driver of sales over the next 12 months. While we expect the gap between the gaming leaders to narrow, it is difficult to envision a state where the PS3 comes out as a market share leader, let alone a dominant platform. While the short-term benefits will help take Sony back into the black from an accounting perspective, we see little evidence to suggest Sony will be able overcome the long-term headwinds that threaten to eliminate economic profits across the consumer electronics space.