Blu-ray vs. HD DVD the ongoing standards war for the next generation DVD format is now

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1 TO: Professor Shapiro & Professor Messerschmitt 10/26/2004 FROM: Group F (Mark Chang, Tomo Hasegawa) SUBJECT: DVD Standards War Introduction Blu-ray vs. HD DVD the ongoing standards war for the next generation DVD format is now reaching a critical stage, as content software for both formats are scheduled to be launched in the year In this paper, we will provide (1) comprehensive analysis of this standards war, (2) prediction of which standard may likely to win, and (3) recommendation for more robust strategy to win the war. The current DVD format The current Digital Versatile Disc standard (more precisely, DVD-Video format) was officially formalized in The standardization process took more than two years, mainly due to the fact that there were two competing formats, namely the SD format and the MMCD format. The former was supported by Toshiba, Matsushita, Hitachi and others, and the latter was supported by Sony and Philips. Ultimately, both parties agreed to merge the formats, using technologies (patents) from both sides. The important points to note here is, (1) the standardization process took long time to finalize due to the consensus both parties tried to achieve, and (2) launching two different standards in the market would not be in the best interest, due to the possible confusion and fragmentation in the market. Matsushita and Sony both knew this from a lesson in the past the VHS vs. Beta standardization war. What is at stake in the standards war To continue using the current DVD standard, during the developmental stages of the standard, DVD was targeted/considered to be the replacement of CD. Ever since 1984 the year CD

2 was commercialized, Sony and Philips the innovators of CD enjoyed not only the earnings from selling hardware/software of CD, but also attaining royalties from licensing the use of intellectual properties (patents) to competitors. Furthermore, these companies enhanced their brand image as consumers started to view them as the leader in high technology. As a result, the establishment of the standard created a synergy effect, working directly and indirectly to boost sales of their entire products. Post current DVD format Having left reeling from the defeat of the VHS vs. Beta war and subsequently its halfway involvement in the development of the current DVD format, Sony was eager to regain lost ground in the consumer electronics industry. To make things worse, Chinese hardware manufacturers were becoming a major force in the consumer electronics industry, undercutting the profits of traditional Japanese manufacturers. Determined to make a head start in the next standards war, Sony spearheaded the development of the next generation of DVD. In 1998, Sony enlisted the help of Matsushita to investigate the use of blue-violet laser technology on optical devices. While current red-laser technology pumps out light at a wavelength of 650 nanometers, the blue-violet laser operates at a shorter wavelength of 405 nanometers, enabling greater volumes of data to be stored on a single DVD disc. As a bid to further improve the capacity, the protective substrate layer on the surface of the disc was reduced from 0.6 millimeters to 0.1 millimeters to reduce unwanted optical effects. At the same time, Toshiba, serving as the chairman in the DVD Forum 1, was invited to join 1 A consortium made up of over 200 companies. Set up in 1995, the Forum s purpose is to promote and decide on technical standards for the DVD.

3 Sony and Matsushita in setting the standards for the next generation DVD. Toshiba declined and proceeded with its own development in blue-laser technology. After about 6 months of experimenting, Toshiba s engineers came to the conclusion that while the thinner substrate layer was advantageous in terms of capacity, it was too expensive to manufacture and there was no backward compatibility with the current manufacturing equipment. Thus, Toshiba introduced the HD (High Definition or High Density) DVD format. Sony and Matsushita soon attracted allies who preferred a close alliance. They felt that the DVD, being a large consortium, was too unwieldy due to its size. They also thought that the technology used by Toshiba was too similar to the current technology used in today s DVD and would enable cheap Chinese manufacturers to duplicate production. In 2002, Sony, Matsushita and seven other companies announced the formation of the Blu-ray group. Later that year, two other major computer manufacturers in Hewlett Packard and Dell would join them. Meanwhile, Toshiba along with another Japanese electronics manufacturer, NEC presented their rival format, the HD DVD to the DVD Forum for evaluation. The Next Generation DVD formats Blu-ray and HD DVD are the next generation optical disc format for recording and playback of high-definition content. Blu-ray format, supported by Sony, Matsushita, Hitachi and others was proposed in HD DVD format, supported by Toshiba, NEC, Sanyo and others was proposed 6 months after the proposal of Blu-ray in Both formats are basically open standard. However, in terms of openness, there is controlled element embedded in the standardization process, as both formats are managed under the consortium called Blu-ray Association and DVD Forum. Unlike the current DVD format, these next generation formats have significant technological differences. Thus, we believe it is highly unlikely that the two technologies can merge as we have seen in the prior standardization process. As a result, it is

4 likely that there is going to be two different standards, causing market confusion and fragmentation in early stages of the launch. This is undesirable situation for not only themselves, but also for consumers. To avoid or minimize this situation is ultimately to win the war. To win the war, both parties are aggressively building alliances. Alliances Unlike the Blu-ray group, the HD DVD group has the support of the DVD Forum. Many Taiwanese hardware manufacturers were part of the DVD Forum and they thrived on economies of scale to manufacture DVDs as a mass market, low cost item. They were reluctant to accept Blu-ray s idea of changing their entire line of production equipment to cater to this new format. By working through the DVD Forum, Taiwanese companies figured that they could inject some of their own technologies into the HD DVD format, potentially lowering future royalties. On the other hand, even though Sony-led Blu-ray members to form their own alliance Blu-ray Disc Association many also played a key role in the DVD Forum by occupying 10 out of 17 positions in the steering committee. This conflict of interest was a constant source of debate and sparked controversy on more than one occasion. When the near-final versions of Toshiba s technology were considered, it was voted against an endorsement on 2 separate occasions. This escalating struggle even brought about an inquiry by the Justice Department to investigate whether Blu-ray s group members acted collaboratively to inhibit the forum s technical progress. The approval for the HD DVD format eventually came after Intel proposed a change in rules to prevent abstentions from being counted as no votes. To the surprise of many, votes from Thomson and Samsung Electronics, both members of the Blu-ray alliance was enough to get one version of the Toshiba-backed format approved. Since then, the forum steering committee

5 approved a second, rewritable version of the HD DVD format and Microsoft s proprietary compression technology along with two others, MPEG-2 and MPEG-4. Threat of substitute Apart from the 2 competing formats in this standards war, we evaluated two substitute formats that might influence the outcome of this war. They are the dual-layer DVD format and the Enhanced Versatile Disc (EVD) format. Sony was the first company to introduce the double layer DVD recorder in April 2004, with Dell, Lite-On Technology and Iomega later joining the bandwagon. The current generation of recordable DVDs only holds up to 4.7 gigabytes (GB) and is unable to store a full length DVD quality movie on one disc. By increasing the total capacity to nearly 10 GB, mainstream users are able to use these newly developed DVD recorders to store an entire movie on one disc. With issues regarding the format s compatibility with conventional DVD players fully resolved, end-user consumers might see this as a convenient alternative to purchasing the next generation of DVDs. However, this particular format has several shortcomings. The 10 GB capacity is inadequate for storing high definition movies, which might put off several consumers especially since we are in the midst of transiting from an analog to digital domain, albeit for the last decade or so. As an additional constraint, each layer of the disc must contain the same amount of data. This means that the consumer cannot specify or control the timing of the layer break. While this might not matter for normal viewing of movie, it might be hardly enjoyable to see a layer break just before your baby gets up and takes the first steps during a family video clip. A possible solution to this problem would be to add redundant elements to the video but it is a time-consuming and somewhat meaningless fix. Lastly, the maximum speed at which these disc can be recorded is 2.4X. With current single layer DVDs being able to record

6 up to 16X, this is a huge step backward in terms of recording time further magnified by the increased capacity. Currently, the greatest market penetrations for these dual-layer DVDs seem to be in the DVD producer industry. Though it provides us with a short-term solution to the ongoing war, we think that this format has too many flaws to be considered a viable alternative for mainstream consumers. The other alternative is the EVD, developed specifically for the Chinese market. In 1999, a 13-member consortium led by Shinco, China's leading DVD maker was given the responsibility to conduct research and development of the EVD format. On2 Technologies Inc., an American company, eventually developed a new compression technology to store high-density data using red laser pickup. For Chinese electronics makers, developing proprietary technology is becoming a priority to further reducing manufacturing costs of consumer electronics. By holding patents to this technology, they are shedding off intellectual property value and royalties traditionally given to Japanese companies. Unfortunately, Shinco still imports two key components for its EVO players. The red pick-up lasers that read DVD discs are mostly made by Japanese firms, while the silicon chips that decode EVD's digital data are based off an American technology. Just like the Blu-ray group, EVD is a voluntary standard that can only succeed if it is accepted by the mass market. Due to national security reasons, China forces all foreign companies who intend on selling certain kinds of wireless devices to be installed with a Chinese-made encryption software, a requirement met with strong disapproval. Coupled with the fact that EVD players are twice the price of a typical DVD player, we do not see this format as a threat outside the Chinese market. Analysis We will begin our analysis by comparing the different advantages and disadvantages offered

7 by the 2 competing formats: HD DVD and Blu-ray Disc (BD). The effects of technology, alliances, first-mover advantage and backward compatibility would be the focus of this discussion. Based on this analysis, we would state who would most likely win the war and as a conclusion, discuss possible strategies that could be implemented to win this war. The BD format holds the clear advantage in terms of superior technology. This format enables the DVD to hold a maximum capacity of 50 GB compared to HD DVD s 20 GB. One of the reasons cited for the need for such capacity is the predicted use of DVDs to store video games, movie trailers, full-length movies as well as other interactive software on a single disc. Using the Spiderman franchise as an example, the BD group hopes that consumers would upload Spiderman video games as well as the 2 movie releases all on one disc, all organized using an easy to use and interactive interface. In addition to the increased space capacity, BD group believes that it holds a more rigorous copy protection technology than the HD DVD format. Even if Chinese manufacturers were able to copy some of the technologies, BD group would still be able to hold the advantage by supplying key components and holding proprietary chipsets. It is clear that the BD group intends on keeping their technology at least semi-closed to maintain their revenue stream. This makes winning this war even more important. Unlike previous standard wars, the proliferation of DVDs in the use of consumer electronics, be it video consoles, personal computing machines as well as stand-alone players and recorders make it a potentially huge market waiting to be tapped. The next question to be considered is whether such a large capacity is required for today s market. As demonstrated by Digital Equipment Corporation s Alpha chipset as well as Sony s Beta, we learnt that superior technology does not necessarily translate to victory especially if no one buys your product. There does not seem to be a strong value proposition for the consumer as BD is viewed as a product which is nice to have versus a must have. In terms of storing movie files, music files

8 and its like, the fact that most people prefer to have discs with different file formats stored in them does little to suggest that consumers might consider consolidating all these files onto a single disc. Nevertheless, it is clear that BD was designed to be a product that would last possibly a decade or more. Sony acknowledged that this might be the final evolution of packaged media and that its technology was intended to last longer than its predecessors. As much as storage capacity tends to increase exponentially over time, it would seem reasonable to say that BD technology is ahead of its time, at least when viewed in today s context. Next, we will examine the alliances in further detail. Despite the backing of a consortium, the HD DVD format has a weaker spread of allies compared to the BD format. This has several implications on the potential installed base of each format. While the HD DVD has support in the consumer electronics industry, the BD group has good mix of allies, not only in the consumer electronics, but also the computing as well as movie studio industries. By acquiring a larger installed base, BD has an easier task of convincing consumers that it is the format of the future. Using the Playstation (PS) console as an example, with sales of 94 million units for the first PS, and 50 million units for PS2 as of September 2004, Sony has large installed user base on its PS. With Sony recently announcing the use of Blu-ray technology in its next-generation PS3, consumers might be swayed towards the BD format. This is because loyal PS customers would buy PS3 enabling the diffusion of Blu-ray technology. At the same time, software and hardware vendors would encouraged to join the BD format enhancing economies of scale in manufacturing. Content providers also play an important role in determining the strength of the alliance. At the time of writing, Columbia, FOX, and MGM formally publicized their support of the Blu-ray format. In terms of released DVD-Video titles in the market, these three studios have a combined market share of 46.1%. On the other hand, only Time Warner has voiced its support of the HD DVD format.

9 As for the details of each alliance, little information regarding formal contract agreements is provided at this time of writing. We can only predict that patent holders, for example Sony and Matsushita in BD, conducts negotiations with each member individually and based on their technological contribution, size of the firm or even potential ability to hasten the diffusion of technology, decide whether royalties should be awarded. Essentially, members would expect to acquire the technology developed by their respective alliances at a lower cost compared to if they were not part of the alliance. Whether this lower cost takes in a form of royalties or a reduced purchasing price is dependent on the company s overall contribution. So what are the benefits of forming such alliances? As mentioned before, one of the main advantages to keeping an alliance is a large installed user base. By having a large number of consumer electronics and computer companies at the consumer s disposal, this benefits both the consumer as well as company. Consumers can pick and customize complementary products like purchasing a DVD recorder from Matsushita as well as a personal computer from Dell, knowing that Blu-ray DVDs have cross-capability on both machines. Developing new technologies is a large investment, both in terms of time and cost. By collaborating on similar technology, companies are not only able to spread the risk across the alliance, but also reduce the amount of time required to develop the technology. Lastly, the royalties obtained from patents is an attractive incentive for companies to join an alliance. Though the specific amount is largely dependent on powers of negotiation as well as extent of contribution, it provides an opportunity for companies to reduce future manufacturing costs. Earlier this year, the first Blu-ray DVD recorders and discs manufactured by Sony and Matsushita were displayed on store shelves in Japan with an incredulous price of

10 approximately US$4,000. Looking beyond the hefty price tag, this is a clear market signal to consumers that BD was committed as well as confident of its technology. On the other hand, Toshiba had been reluctant to share its technical specifications with the public suggesting that the development of the HD DVD format might be more problematic than thought before. However, it has been announced that the first HD DVD recorders and discs are scheduled to be released at the end of By holding first-mover advantage over HD DVD, BD currently stands at a commanding position to attack the market. Consumers are constantly looking for market leaders and this presents an opportunity for BD to lock-in their consumers. Though the substantial price might deter most mainstream consumers, technology enthusiasts might be willing to bite the bullet and invest in these new machines. Gaining the support of this niche market might serve as a platform to explore other market segments. For example, blue laser technology has been used in the professional archiving industry especially for health care and financial services. Plasmon s Ultra-Density Optical (UDO) in drives and storage devices is the current leader in this industry as it is considered a more secure option to conventional DVDs. BD could use this market as a beach-head, to solidify its position and reduce costs over time. Lastly, we will compare backward compatibility involved with both formats as well as its implications on the industry. Due to the smaller substrate layer used in BD, the manufacturing equipment used to produce current DVDs would need to be redesigned to accommodate the BD format. Therefore, manufacturers of hardware (players/recorders/discs) are required to make new investments. Besides this initial capital investment, there is also an additional opportunity cost in that this current equipment cannot be utilized in any other way. Sony stated that over the long run, manufacturing hardware for the Blu-ray format would be lower than the HD DVD format due to economies of scale. To emphasize this point, they acquired the support of Nichia Corporation, holder of the largest number of patents related to blue-violet laser diode,

11 paving the way for mass production of BD products. Assuming that this next generation of DVDs would last for the next decade or so, we tend to agree that these initial costs are warranted given that the benefits; in terms of costs savings and value addedness seem achievable. Unlike hardware manufacturers, consumers and content providers do not affect the outcome of this war. High-density feature films can be recorded on both current and future DVD formats with the same visual and sound quality with the recent approval of various compression technologies. Consumers would inevitably have to change their DVD hardware regardless of whether the BD or HD DVD format gets chosen. While this might delay the outcome of this war due to slow consumer adoption, consumers would have no choice but to change all their current DVD hardware as content providers start supporting the final format, for example offering a greater variety of movies or sitcoms. Who is more likely to win the war? Based on the above analysis, we believe Blu-ray format is likely to win the war. Recapping our reasoning, Blu-ray has three strengths/advantages over HD DVD. (1) Tangible market signal and Preemption (2) Leverage on the installed base (3) Complementors Recommendation for Blu-ray Although technological superiority for Blu-ray over HD DVD is clear, the consumer value for adopting the technology is still unclear. With unsuccessful establishment of the high definition TV format, having more capacity (50GB) will not be intriguing factor for consumers to adopt. Blu-ray Disc Association should highlight consumer benefits such as simplicity. For example, besides the current DVD-Video format, there are multiple DVD formats, namely DVD-R,

12 DVD+R, DVD-RAM, DVD-RW, and DVD+RW. These formats are incompatible to each other, and average consumer would be confused about the differences. However, with Blu-ray, there will likely to be only one format. This is because unlike CD and current DVD that were developed initially from playback then to recordable, Blu-ray has been developed initially from recordable off the start. Ultimately, we believe this reduces user uncertainty. In addition, based on our observations, it seems companies are not putting emphasis on the benefits that consumers can gain in terms of application. For example, by using the new BD technology, consumers can store full-length feature films with a resolution 6 times as sharp as the current DVD, and the audio sound will be stored uncompressed. These value proposition are unachievable by using HD DVD format. Looking ahead, constituents in the Blu-ray Disc Association can work together to proliferate its format by bundling. For example, since Sony owns Columbia Pictures and MGM, it can bundle software movie in BD recorders in the early stage of the launch. Matsushita can do the same for Universal, as it has ownership in the company. Nevertheless, it is not only the hardware manufactures that must put effort to win the war. Hollywood studios also should send message to consumers about the impact of the new technology. After all, it is up to them to produce software/content that offer the needs of consumers, and fully capture the technological strengths. The current approach the Blu-ray Disc Association is taking is focused on the hardware side and not on the software/content. To promote user benefits and to reduce user uncertainty, we believe this approach should be altered.