In early August, with only 6 weeks to go to a major product launch, Steve Race, head of the Sony Playstation project team that includes hardware and software, left the compny. Race had come to the Sony Playstation project from Sega and Philips only a few months earlier. To all outside appearances, he had led the company in the direction of an orchestrated hardware/software rollout. His departure raises questions about the future of Sony's Playstation effort.

What's it Costing?

The launch costs for the Sony Playstation are the sum of losses on hardware sales, software acquisition costs, and advertising/sales/overhead expenses -- offset by license fees from sale of software disks. At the high end of our estimates, we believe that the Playstation could result in a charge to earnings at Sony of as much as $200 million in calendar year 1995.

Hardware Losses
The cost of a mass market player can be reasonably approximated from industry sources familiar with the block diagram of the system. Based on interviews with knowledgable industry executives, we conclude that the Sony Playstation has a manufacturing cost at the factory of $40 or more higher than its suggested retail price of $299. This assessment is based on the bill of materials for parts in the unit, plus factory assembly costs, plus factory profit.

• In terms of the bill of materials, OEM prices for the MIPS, ASIC, graphics controller and video turner chips, the CD-ROM drive included with the Playstation, and other components total (aacording to our estimates) about $230. The MIPS chip, the ASIC chip and the CD-ROM drive may account for nearly $200 of that amount, so the final estimate of $230 may be somewhat low.

• Assembly or "build out" costs according to manufacturing experts for this system in quantity might run about $30 per unit. This estimate is based on time to assemble, labor and a capital charge for the automated production facilities likely to be employed.

• Factory profit as a percentage of FOB costs can vary widely, but a factor profit target of 15 percent (which is a reasonable target with respect to absorbing factory overhead and contributing to profits) suggests a delivered price of $305 per unit.

These cost estimates do not include the impact of the yen/dollar relationship -- a matter which was covered by us in an earlier issue. (See Interactive Update, April 18, 1995.)

Sony is attempting to offset this loss by requiring retailers to buy a bundled package of one player and two games, permitting them to sell the games separately from the player, but requiring the player to be sold at $299. This strategem is intended to provide Sony will a somewhat higher total sale, deliver the retailer a profit opportunity, and still maintain a target hardware price of $299. Assuming a 40 retail percent margin (off SRP) on hardware and a 30 percent margin on software (for two software titles with an SRP of $50), Sony's revenue on the package would be $250. This would be $55 below estimated manufacturing costs on the hardware alone. If Sony insists on a package price of $300, then the manufacturing costs of the hardware plus the manufacturing costs of the software plus mandatory software royalties would still be "underwater" by at least $40.

Sony has said that it expects sales of 1 million units in the first 12 months following launch of the Playstation. This results in a $40 to $60 million loss on hardware sales in the first year of which as much as half may be absorbed between launch and December 31. Our estimate of losses on hardware are $50 million.

Software Acquisition Costs
Estimates of spending by Sony to acquire software for the Playstation vary widely but all the estimates are high. Contributing to the high range of estimates are reported advances for exclusive "new platform" distribution windows for the most popular software titles (eg, Mortal Kombat) in the multimillion dollar range. Key Japanese software developers (including Capcom, Konami and others) are reported to have signed exclusive "new platform" deals with Sony for multi-million dollar advances against products yet to be delivered. Advances to developers of new product for the Sony Playstation were reported to be running in the $1 million range.

Steve Race, prior to his departure from the company, had lined up a wide range of titles to be available at launch, possibly as many as 50. This is generally regarded as "insurance" for a successful launch, but such insurance comes at a price. We believe that total software acquisition costs may represent as much as a $100 million investment by Sony in the Playstation.

Advertising, Sales and Overhead
Sony has announced that they intend to spend as much as $100 million in advertising to launch the Playstation. For the launch period, September through December, that amount has to be committed already.

In addition, Sony has about 100 people in Redwood City (south of San Francisco) working on the Playstation launch. The staff is generally well regarded in the industry (selected by Steve Race from some of the better talent at Sega and other Valley based game companies). The annual cost of this team, fully allocated, including salaries, benefits, space and space related costs, may total $20 million. Over the two year pre-launch period, this cost may have accumulated to as much as $40 million.

Offsetting Software License Revenue
Various industry standard formulas are available for disk sales per first year hardware unit. These "tie in sales" will generate royalty revenues for the Sony Playstation of an estimated $8 per unit. The question is, how many disks will sell per unit of hardware. An assumption of 8 disks per unit is high; 10 disks per unit would be unparalleled (especially at the SRP of $50 likely for these software titles). We believe that software royalty revenues of $50 million (given an optimistic assessment of 1 mm player sales) is a reasonable royalty revenue forecast.

Total Launch Costs
Total launch costs for this system, therefore, are likely to be in excess of $200 million. This estimate assumes sales of 1 million units in the first year, leading to total costs of $270 million against potential revenues of $50 million. In the event that sales are less, costs decline because the loss on hardware sales is less; but revenues also decline by a comparable amount because software royalties are reduced. Our estimate, therefore, of launch costs (independent of the engineering development costs involved in the system) is in excess of $200 million regardless of consumer "take up" at launch.

The Software Angle

A colleague of ours who focuses on game software points out that while all this "sturm und drang" at this time is unfortunate for the company, the launch at this point is on auto-pilot and software will win the day. The elements of this view are:

• Sony will have an in-depth line up of its own software at launch from which it will reap publisher's profits as well as hardware license fees. This software line will be much deeper and broader than the Sega line up was earlier this summer and will provide an integrated hardware/software profit analysis that will erase any launch related losses.

• Key to Sony's software line up is the exclusive window it has for the release of Mortal Kombat III on the Sony Playstation. This window will last six months and will help the sales of the hardware immeasurably.

• The flow of top product is likely to continue because Imagesoft and Psygnosis, the latter a UK company in which Sony has an interest and which recently established offices in Cambridge, Mass, have an outstanding line up of releases for the new platform.

• Indepedent software developers are excited about the new platform because of the ease which which new titles can be prepared. This means that developers working on a title for release on the Sega Saturn and the Sony Playstation will finish their work on the Playstation first, giving Sony another de facto window in the software market.

• Computer game developers are discovering that the "C" based development environment for the Sony Playstation is similar enough to their computer game environments that many of them are planning to port or develop for Sony.

• Sony's worldwide distribution capability -- in both hardware and software -- is world class and its brand, in the same league as Coca Cola, will propel consumer acceptance.

These are important points and highlight the fundamental logic of an integrated hardware-software launch for a new consumer electronics product. The question remains, however, whether Sony will be able to exploit this logic in its new organizational framework. Certainly, this will be as good a test case as there is of the theory Sony has been promoting since its acquisition of Columbia Pictures: that software drives hardware and that the failure of the Betamax was because Sony did not own a motion picture supplier.

Why Do It? Why Go Through This?

There are internal struggles at Sony over how the launch of the Playstation should be managed. Steve Race's effort was to create an integrated hardware/software launch that brought the product to market with the greatest momentum. In the wake of his departure, the Consumer Electronics Group within Sony has, we understand, gained control of the hardware launch. The software portion of the launch may be shifted to Kelly Flock at Sony ImageSoft in the Los Angeles area.

While internal struggles over who controls the product may have been part of the issue, we believe that the real question has to do with the struggle over business objectives and forecast losses. In order for Sony to recoup its investment in this launch, it would have to win nearly one-third of the total current games market (cartridge and CD-ROM based, 16 and 32 bit combined), which seems unlikely in the short term. The prospect of sustained losses in multimedia for a company that has just taken substantial write downs in music and movies cannot be appealing.

What does this mean for Sony, then, and what can it be expecting by going forward with the launch of this product? First, we suspect that there will be enormous pressure inside the company for more realistic hardware pricing -- possibly leading to a player SRP at least $100 higher than the announced launch price of $299. Second, we suspect that any manager assuming responsibility for the pieces of this situation would want to cut developer guarantees and discretionary advertising. There may be as much as $50 to $75 million available in these accounts. Third, there will be staff reductions in the Playstation division as the Redwood City operation is split between New Jersey and Los Angeles.

These changes in the Playstation project change the competitive environment for the launch of all the new hardware platforms.

• First, the Sony situation will weaken due to separate management of hardware and software; these divisions will have separate pressures and will not present as coordinated a front to the new market as they might otherwise have -- resulting in an overall less successful launch.

• Second, the Sony situation strengthens the hand of the established existing players in the new platform market, 3DO and Atari. Atari, however, has not shown the ability to develop a consistently focused marketing campaign, so it is unlikely to benefit much. Any benefits that are available may go more to 3DO.

• Finally, Ninentendo's decision to wait until Spring of '96 to introduce its player is beginning to look better and better. We examined this issue earlier in the White Paper on "Did Nintendo Blow It?"

Sony is unlikely to abandon its effort any time soon because the territory being challenged is "real estate" inside the consumer's home. The Playstation (as does 3DO) represents a potential interface to a future consumer broadband network, a playback system for advanced digitially compressed entertainment, and a game platform. The stakes in having a position in the consumer's playback environment (or CPE -- which in telco talk is "Customer Premises Equipment") are too great not to compete.

The only question is whether the company can stand the heat of these kinds of losses while it is competing for its future position in the home.

Meanwhile, all's well with Steve Race, who immediately took a position as Chief Executive at Gilman Louie's Spectrum Holobyte at the invitation of Louie and his venture backers. The revolving doors just work faster in Silicon Valley than they may do elsewhere.