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By Carl Howe

Gaming analysts such as Roger Ehrenberg are looking at the Sony (NYSE:SNE) $100 price cut on its Playstation 3 gaming console announced at the E3 conference this week and assume that Sony marketing made the move to attack Microsoft's lower-priced XBox 360 console. Roger takes Sony to task for this strategy as follows:

So now you're forcing Microsoft to lower its prices and trying to re-define the console wars at the high-end of the market. Sure, higher volume, lower margins, pressing for share. Makes sense. But it doesn't address the larger issue - you are now fighting Microsoft for a smaller piece of the pie.

Sure, the pie has been expanded because the Nintendo Wii is drawing in new buyers - specifically casual gamers - into the console market. But even more than that, the Wii is taking sales away from both Microsoft and Sony due to its fun user experience and low price point (less than half that of the 60GB PS3, even after the price cut).

This analysis would be true if Sony's goals were the same as Microsoft's (NASDAQ:MSFT) and Nintendo's (OTCPK:NTDOY). The trouble is that they aren't. Sony's short-term Playstation 3 battle plan (and by short-term I mean two to three years) isn't that much about gaming. It's about who can get the lowest manufacturing costs for two key entertainment technologies that Sony hopes to lead in the next five years. More on that in a minute.

A little quiz might shed some light on the overall Sony puzzle. Think about the answers to the following questions:

1. Which next-generation optical disk technology currently has sold more drives to date? HD-DVD or Blu-ray?
2. What movie studio releases movies exclusively on Blu-ray technology?
3. What company currently has the largest market share of the LCD HDTV market by revenue?

The answers to these questions are:

1. According to a recent article in the Wall Street Journal (subscription required), approximately 103,000 Blu-ray players have been sold to date, but 3.6 million Playstation 3s (according to VGChartz.com) containing Blu-ray disc players have been sold as well worldwide. Only 310,000 or 0.3 million HD-DVD players have been sold, even including XBox 360 add-ons. Blu-ray movies are also outselling HD-DVD movies by a ratio of about 2 to 1.
2. Sony Pictures releases the high-definition versions of its movies exclusively on Blu-ray disks. That means that its future DVD revenue stream is tied to the success of Blu-ray for the time being.
3. Sony's Bravia line recently became the best selling LCD brand on a revenue basis, despite being third on a unit basis.

So now the picture should be getting clearer. By bundling Blu-ray drives into the Playstation 3, Sony has been able to ship almost 4 million Blu-ray players, more than 10 times the number of HD-DVD drives sold to date. That means that Sony is driving down the manufacturing cost of Blu-ray players because it is making them in higher volumes. That was the crux of the blue laser shortage last year -- Sony was making a boatload of Playstation 3s and suppliers couldn't keep up. Now they can. Playstation 3 sales are subsidizing lower cost Blu-ray high-definition movie players while ensuring that consumers have more of those players than any competing high-definition format. And conveniently, Sony gets a royalty payment for every Blu-ray player and disc, regardless of whether it makes it or not. So if Playstation 3 can establish Blu-ray as the dominant high-definition movie playing platform in the market, Sony Electronics wins big.

The second factor here is that Sony Pictures sells movies exclusively on Blu-ray disks. Blu-ray high-definition player deployments expand the market for Sony Pictures' high-definition movies on disc, making Sony Pictures' more valuable. And since DVD sales now are a bigger money-making business than box office sales for movies today, that has a huge effect on Sony Pictures' future. If Toshiba's HD-DVD were to become the standard, on the other hand, Sony Pictures would be just another studio.

Third, while Playstation 3s work just fine on ordinary TVs, PS3 games and Blu-ray movies look best on high-definition TVs. Playstation sales naturally generate some pull-through of high-definition TVs, and because consumers tend to stay in-brand with most bundled purchases, that drives some number of Sony HDTV sales. And since Sony HDTVs sell for some of the highest average prices of any of the flat panel makers (and therefore generate significant profit), those sales contribute significantly to Sony's revitalization of its traditional consumer electronics business. Don't think HDTV is that big a deal compared to next generation gaming? Think again: current projections by Parks Associates estimates that the HDTV market is worth $36 billion this year and growing 71% a year. The gaming business including all games, on the other hand, is only worth $13 billion currently.

Now Sony sells its Playstation 3 hardware at a loss currently, just as Microsoft does with its XBox 360 system. Both companies need a subsidy from some other part of the business to do that over any long period of time. For Microsoft, that subsidy comes from 1) the sales and licensing of games (which aren't enough to keep XBox from losing more than six billion dollars over the last five years) and 2) Windows and Office profits, which are also being tapped for other initiatives like Microsoft Live and Zune development. For Sony, the subsidy comes from 1) ongoing profits from Playstation 2 and PSP sales, 2) the sales and licensing of multiple platforms of games, 3) the royalties from Blu-ray movies and disks as noted above, and 4) some incremental sales of HDTVs as noted above. With DVD movie revenues projected to exceed $50 billion in 2009 and those being just one of four factors, Blu-ray success will solidify those subsidy streams for the foreseeable future. And since Blu-ray player and disk manufacturing will be 10 times larger in volume than HD-DVD, there's little question that Blu-ray will gain huge manufacturing cost advantages and higher profits over time. The result: Sony's Blu-ray strategy means that costs to manufacture the Playstation 3 itself will eventually come down substantially, despite it today having much higher parts costs than its competitors. And that positions Sony's PS3 to be significantly ahead of its competitors in the gaming business two to three years hence, when Microsoft and Nintendo will have to retool and relaunch their platforms to gain high-definition storage for games.

The bottom line: Sony's PS3 serves multiple Sony goals, only one of which is being the big platform in the the gaming console market. It doesn't have to outsell the Nintendo Wii or the XBox 360 for it to be successful; it only has to establish itself as a viable high-definition platform for next-generation developers, gamers, and movie watchers. With the DVD movie business several times larger in value than the gaming business today, setting a standard in next generation DVDs will reap bigger rewards than next-generation gaming for years to come -- and will give Sony a subsidy war chest for gaming that even Microsoft will struggle to match.

Full disclosure: The author holds no positions in the companies mentioned in this article at the time of writing.

Source: Sony's Playstation 3 Battle Plan Isn't About Gaming - It's About Costs