Sony battles back (Fortune, 1985)

May 19, 2013: 9:00 AM ET

Editor's note: Every Sunday we publish a favorite story from our magazine archives. This week, with news that hedge fund Third Point has suggested breaking up electronics giant Sony, we turn to a 1985 feature about the company's struggles with VCR technology in the wake of its Betamax machine losing out in the market to VHS.

Buoyed by record profits, the company that invented the VCR -- then lost out to rivals -- shows it can still crank out high-tech magic. But Sony has yet to solve basic problems that hammered earnings before and could again.

By Lee Smith with Research Associate Darienne L. Dennis

handmade-vcrsFORTUNE -- Sony chairman Akio Morita bounded from his Mercedes, tilted his head back, and looked up at the huge Sony television screen overhead, about half the size of an American football field and bubbling with color. ''My people are crazy,'' he screamed with delight. The piece of electronic showmanship Sony built for Expo '85, Japan's new technology show in Tsukuba, is a good match for Morita's ebullient mood these days. A year and a half ago Morita grumpily avoided the press whenever he could, once sending word through an aide that he was tired of reading about Sony's problems and wouldn't talk until there was something good to say.

Morita is voluble again. Many of Sony's deep-seated problems remain, but a lusty recovery in its consumer markets has bought the company time to grapple with them. Sony had a record profit of $291.6 million in 1984, on revenues of $5.2 billion, bouncing back from a 52% drop in earnings the year before. Net income for the quarter that ended January 31 was up 15% over the same period a year ago. Sony's stock, which trades on the Tokyo Stock Exchange and as American Depositary Receipts on the New York Stock Exchange, is up almost 40% since January 1. Sony seems to be hitting its stride technically too. ''The magic is still there,'' says Michael F.J. Connors, Tokyo research director of the securities firm of Jardine Fleming. Sony's new supersmall compact audio disk player ought to keep a technical and price edge for at least a little while. And its 8-mm video camera, though aimed at an uncertain market, employs some nifty technology, such as an extremely sensitive microchip that can take pictures in very low light or with the sun shining directly into the lens.

Yet the basic problems that hammered earnings haven't gone away; they've just been glossed over by the industry's soaring sales. Demand for videocassette recorders (VCRs) was so strong last year that Sony went along for the ride even though its pioneering Betamax has long been odd machine out in a market dominated by the rival VHS system. Losing market share for a product it invented was bad enough, but Sony's problems go deeper. The company remains stuck in the consumer electronics business--where growth for products other than VCRs has been modest in recent years--while rivals like Matsushita Electric Industrial Co. (Panasonic, Technics, Quasar, and National brands) have rapidly expanded nonconsumer businesses. In consumer electronics Sony's innovative prowess hasn't been paying off as it once did. Within months after Sony puts a new product on the market, rivals match it-- often at lower prices.

Sony's answer to its continued dependence on consumers is its so-called 50-50 strategy--its aim to be a half-consumer, half-nonconsumer company by 1990. The current balance is 80-20 in favor of consumer products. But even with heavy capital investment--about 40% of Sony's $400-million 1985 capital budget is being spent to expand semiconductor facilities--it's hard to see how the company can reach that goal in five years. When pressed, Sony explains that at this point 50-50 is more a rallying cry than a precise goal.

sony-battles-back-openerEven if the proportions turn out to be other than 50-50, the transition is likely to take more than five years, and Sony will have to keep squeezing profits out of consumer sales. The new compact disk player will help. Although sales of radios, stereos, tape recorders, and the like brought Sony about $1 billion in revenues last year, the business has been sleepy since the Walkman craze slowed from a sprint to a stroll in 1983. One hope for reviving it has been the audio disk, a piece of aluminum and plastic about the diameter of a coffee saucer, impregnated with millions of tiny pits. A laser beam reads the sequence of matter and pits as digital signals, which become sounds much purer than conventional records or tape can render. Because no stylus rubs it, the disk doesn't wear out.

Though sales of disk players were sluggish at first because of heady price tags--initially around $1,000 without amplifier or speakers--they began to take off in the last three months or so as list prices dropped to less than half that. Late last year Sony started selling a player not much bigger than the disk itself for $200 in Japan and about $300 in the U.S. It plans to make 700,000 of them this year. At that price Sonywill make little, if any, profit on the players until its volume picks up considerably. But the market is about to crowd up. Matsushita says it will introduce its own small player later this year.

Somebody has to make the disks, and Sony's in that game too. CBS-Sony Group, a 50-50 joint venture with CBS, is the largest manufacturer of disks in Japan and the U.S. It's pressing 1.2 million a month at plants in Japan and Terre Haute, Indiana, and expects to step up monthly production to 2.2 million before the end of the year. The 2,500 titles, from Springsteen to Vivaldi, retail from $11 to $15.

The 8-mm video camera is part of a complicated strategy designed not only to exploit a possible new market, but also to help Sony get a second shot at the profitable VCR business. Sony blew it the first time around, a failure Morita blames on shortsightedness. Critics say it was arrogance. In 1974, seven months before Sony was to introduce to the world the first VCR using half-inch tape, Morita showed the machine to executives from Matsushita and JVC, as well as to Anthony L. Conrad, then president of RCA, which was developing a video disk player. Many who took a look came away with the message that the world would be a better place to view in if everyone made his machines compatible with Sony's. Says a spokesman for one of the early lookers, ''Morita's attitude was, 'We completed this one, so why don't you follow.' There was no scope for advice or joint development.''

Two years later, after Sony had sold 100,000 Betamaxes, JVC appeared with an alternative, the Video Home System, or VHS. The machines were incompatible and Morita was stunned; he felt betrayed. Morita, 54 at the time, went so far as to ask Konosuke Matsushita, then 81 and revered as one of Japan's great industrialists, to have JVC recall the VHS and make it conform to the Sony standard. Matsushita owns 50.2% of JVC, but the grand old man declined. Morita has generally been more admired by Americans and Europeans than by his countrymen, many of whom consider his flashy style decidedly un-Japanese. But his competitors had more in mind than that. The VHS was clearly a better mousetrap in an important respect. It could record for two hours, twice as long as the Betamax.

Other manufacturers, such as Hitachi, adopted VHS. ''We didn't put enough effort into making a family,'' reflects Morita, his usually spirited voice becoming slow and pained. ''The other side, coming later, made a family.'' Sony did persuade a few others, such as Zenith Electronics Corp. and NEC, to build on the Betamax model, but in the past few years all but Sony have either abandoned the Betamax or hedged by adding a VHS model.

Betamax keeps falling further behind. Though sales rose last year, Sony's world VCR market share shrank from 13% in 1982 to less than 7% in 1984, and seems to be shrinking still, according to Television Digest, an industry newsletter. No. 1 Matsushita's share is 19%. The Betamax is at least as good as VHS in quality, but VHS still leads in playing time--a stupefying eight hours on one machine, compared with a top of five hours for Betamax. And as consumers perceive Betamax faltering, they flock in even greater numbers to VHS, worried that those who produce movie cassettes for VCRs might desert Betamax.

Despite the roaring success of the half-inch format, the major manufacturers and a lot of minor ones have been trying to develop a format using tape eight millimeters (about a third of an inch) wide. It can be packaged in a cassette not much bigger than an audio cassette; by comparison, the half-inch tape cassette is about the size of a woman's evening purse. The player can be made smaller as well. Sony believes that in a few years the 8-mm videocassette player can be made small enough to be incorporated routinely in TV sets.

For Sony, 8-mm has one other advantage. Last year 128 manufacturers, including Sony, signed a pact agreeing to conform to a single standard so that all 8-mm tapes can be played on any machine. Even triumphant Matsushita doesn't want a rerun of the Betamax/VHS war. In the furious battle to establish their standard as preeminent, both Sony and Matsushita cut prices more than they would have liked.

The 8-mm format also may be able to exploit the VCR's largely ignored ability to play tapes the consumer makes with his own video camera. Only about one out of 15 VCR buyers gets a camera too. Even though the manufacturers have squeezed down the size over the years so that a camera now weighs only five pounds or so, it is still heavy for carrying around outdoors. And the price is an even weightier burden, $1,000 or more. The half-inch video camera seems to have been shrunk in size and price about as small as it will go. The 8-mm format gives manufacturers a fresh start.

Last fall Eastman Kodak began marketing an 8-mm video camera made by Matsushita. Although Kodak is a leading maker of home movie film, the company believes that electronic cameras will be increasingly important. Canon soon followed with an 8-mm of its own, which it is selling in the U.S. and Canada. In January, Sony introduced Video 8 in Japan, and it plans to start shipping the product to the U.S. shortly. Sony is not only turning out 20,000 cameras a month under its own name, but is also producing 10,000 a month for other Japanese manufacturers, including Fuji Film Co. and Kyocera.

investor-snapshot-sony-1985The camera contains its own small VCR. To play back the tape, the camera is plugged into a TV set like any other VCR. Still, the first generation of 8-mm cameras is not likely to sell much better than did the half-inch models. They're only a little lighter and no cheaper. The trick for Sony will be to do one more time what it has done so well in the past: wring the big components and cost out of the gadget. Ichizo Miyauchi of Nomura Research Institute, the research arm of Nomura Securities, guesses that at below $750 the cameras will start to roll off the shelves. Low prices don't guarantee success, of course. The U.S. home movie market peaked in 1972, when about a million cameras were sold, and dwindled to about 40,000 units last year, according to Peter J. Enderlin, a photography industry analyst at Smith Barney Harris Upham. The video camera will have to carve out a new market and nobody knows if that's possible.

The next leap for Sony probably will be marketing an 8-mm tape deck--that is, a recorder and player without camera. It takes courage to be first, since there are few prerecorded tapes in the 8-mm format. In the half-inch, some 7,000 movies are available, from Casablanca to Porky's. Sanyo, Japan's fourth- largest manufacturer of half-inch VCRs, shipped 5,000 8-mm tape decks to the U.S. in February. ''The software will become available when the 8-mm is there,'' a spokesman for Sanyo says bravely. Sony won't say when it will follow. The biggest boost for the 8-mm would come if Matsushita and Hitachi got into the game.

At the moment Matsushita is comfortable on the sidelines, but it could be lured in if the 8-mm camera were a big hit. Or it could be pushed in. Last year's phenomenal growth in the VCR business is slowing down a bit. Korean manufacturers, moreover, are getting ready to market inexpensive VCRs in the U.S., so price cutting could chew into profits. Even if Matsushita ultimately takes the bigger 8-mm market share, Sony can still prosper. With a single standard in 8-mm, at least Sony will not be outside the family.

In Sony's best of all worlds, the 8-mm will quickly replace the half-inch format in low- and medium-priced equipment, but the half-inch will remain the standard for a time at the top of the line, where the Betamax does well. The world probably will not be so tidy. Even if the 8-mm does eventually succeed the half-inch, the question is whether it will happen before the Betamax market collapses.

There's no consensus. One Japanese think tank sees a reasonable chance that as early as 1990 the smaller VCRs will be selling at the rate of 20 million a year and will have supplanted the half-inch machines. But that assumes that manufacturers and consumers will readily junk the investment they have in the half-inch format. For videotape makers, it's a chicken and egg situation. Says Eugene G. Glazer, a security analyst with Dean Witter Reynolds, ''How many 8- mm tape decks have to be out there before we see a lot of 8-mm tapes? I don't think anyone knows.''

If 8-mm doesn't become the dominant VCR, it's hard to see what other consumer product Sony could come up with to compensate for the loss. The market for TV sets, which accounted for $1.2 billion of Sony's sales last year, is mature, even though it picked up a bit recently. The next boom in color TV isn't due until well into the Nineties, when the customers are expected to line up for high-definition TV--a screen flashing with over 1,000 scanning lines instead of the 525 lines on U.S. sets.

So the long-term answer for Sony is to follow the lead of Matsushita and other competitors in strengthening its nonconsumer business. Though Matsushita was never as consumer-oriented as Sony, the company began to sense in the mid- Seventies that it was too dependent on consumer electronics; the enormous growth brought about by television and new audio equipment was going to start petering out. Now nearly a third of Matsushita's business is industrial, compared with 17% in 1970. Matsushita is one of Japan's largest manufacturers of robots, for example, and sells perhaps the broadest array of office equipment.

norio-ohgaAt Sony's low point in 1983 some critics said it was time for Morita to quit. He had run the company with single-minded passion and often vision--he persuaded the doubters that the Walkman would sell--but he missed important opportunities. Sony was the first Japanese company to make semiconductors, but for years it never made them for anyone but itself. At 64, Morita remains in command as chief executive officer. He and his family own 10% of the stock. His brother Masaaki, 57, is one of two deputy presidents. But he has turned day-to-day operations over to President Norio Ohga, 55.

Ohga caught the boss's attention nearly three decades ago. To promote his tape recorders, Morita sent samples to Tokyo University of Arts, where budding opera singers tried them out. Alone among the students, Ohga insisted the recorders could be better. Morita saw to it that Sony helped pay for the nervy baritone's training. ''Ohga was our spy,'' Morita says with a laugh. While studying in Berlin in the 1950s, Ohga would drop in on European electronics firms, and his hosts never caught on that he was warbling to Morita about what they were up to. Ohga joined Sony as head of the tape recorder division in 1959, and later ran CBS-Sony. When President Kazuo Iwama, Morita's brother-in- law, died in 1982, Ohga succeeded him.

Morita keeps in close touch. ''I have a telephone in my car,'' he says. ''I use it so much I may become the first Japanese executive to have two phones in his car.'' Still, he often defers to Ohga. ''A new leader should have different ideas of how we get into a real technological age,'' says Morita. ''The world is turning digital, and maybe I'm still living analog.'' Among other things, Ohga pushed Sony into selling semiconductors to outsiders. Competitors got the benefits of Sony's technology, and Sony got $50 million in revenues last year. It will probably get twice that much from semiconductors this year. Jumping into such a competitive market also forced Sony to bring down its manufacturing costs, which will help increase profit margins. ''We had the problem of living in a sheltered market,'' says Ohga.

Unfortunately for Sony, the static RAM chips that will start coming off a $70-million addition to its plant at Kokubu this summer will reach the market at a time of glut and price cutting. It's likely to be a long time before Sony's sales approach those of Japan's biggest chipmaker, NEC, which sold $2 billion last year.

Breaking into the office equipment business is one way companies like Matsushita and Canon have expanded out of consumer products. Sony would like to do the same. It has designed the 3.5-inch micro floppy disk drive that is used in personal computers made by Apple Computer, Hewlett-Packard, and Data General. KDD, Japan's international phone company, is using an erasable optical memory disk system fashioned by itself and Sony to store such data as the duration of phone calls for billing. That makes Sony the first Japanese company to devise a working erasable disk system and puts it in the running to be an international leader, along with companies like 3M. Otherwise, Sony's plans for outfitting offices are vague. ''It's a new field for us, and we . can't yet talk about the kinds of product we have in mind,'' says Masaaki Morita. Sony makes no copiers or facsimile machines, and its personal computer is designed for home rather than office use. It seems late for a newcomer to try to squeeze into lines that world-class companies already dominate.

The next few years are going to be perilous for Sony. It still has a long way to go before it can establish itself in its new businesses. Until then it will continue to be perhaps the world's most exciting consumer electronics company, but living dangerously from magic show to magic show.

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