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After more than a decade at the top of the video game heap, during which it sold more than 200 million consoles, Sony ( SNE) is set to be knocked off its firm position as King of the Hill because of its flawed PlayStation 3 strategy. This is only one of many reasons to avoid shares of the consumer-electronics conglomerate, but it's certainly the most important.

Zapped by Blu-Ray

Among the most glaring errors Sony has made with the PS3 has been the inclusion of a next-generation Blu-ray DVD drive in the console. Having seen Blu-ray in action up close, I can say it certainly is impressive.

But it has also had the effect of driving up the cost of the two versions of the PS3 to $500 (20 GB hard drive) and $600 (60 GB hard drive) respectively, much more expensive than the competing Microsoft ( MSFT) Xbox 360 and Nintendo Wii, with no discernible improvement in game quality. Shortages of certain Blu-ray components have resulted in extremely short supplies of the PS3, giving Microsoft and Nintendo some running room to build market share.

In addition, the competition between the two next-generation DVD technologies, Blu-ray and HD-DVD, is causing an enormous amount of confusion among consumers and hindering adoption of both. This is a critical issue; slow consumer adoption of Blu-ray will make it more difficult to build economies of scale, which normally result in lower manufacturing costs.

Look at the relatively unsuccessful audio formats DVD-Audio and Super Audio CD for a historical parallel. And in a world where digital distribution of media is becoming more prevalent by the day, it makes little sense for Sony to have made such a bold bet on a physical format.

Sure, we're years away from high-definition video downloads being both quick and economical, but download services such as Apple's ( AAPL) iTunes as well as numerous file-sharing programs clearly are shrinking the size of the market for physical media such as DVDs and CDs. Of course, the HD-DVD camp will suffer along with Blu-ray. But Sony is disproportionately tied to Blu-ray, given its strong dependence on its video-game division for profit.

Former Title Titan

Plus, Sony is losing exclusivity on many PS3 video-game titles. Software publishers such as Koei, publisher of the Dynasty Warriors series, are moving titles over to the Xbox 360 in increasing number. There are even rumors that Konami ( KNM) will put out a Metal Gear title on the Xbox 360, which would be a huge blow to Sony, given how popular that series is.

Then there's Take-Two Interactive's ( TTWO) blockbuster Grand Theft Auto series; a next-generation version of the game will appear simultaneously for Xbox 360 and PS3 consoles late in 2007. Sony previously had an exclusive deal with Take-Two for GTA games during the PS2 cycle, though those titles later appeared on the original Xbox. In addition, 2007 will see Xbox 360 players enjoying both monster PS2 hit Guitar Hero 2 and Sega's Virtual Fighter 5, formerly a PS3 exclusive.

This bet-hedging by all these software companies is making the lower-priced Xbox 360 much more attractive to consumers by drastically improving the breadth of software available for it. I also expect Microsoft to cut prices on the Xbox 360 in the near future. The console has sold about 10 million units to date, though I have recently noticed retailers getting a bit aggressive in giving away freebies with the console. That implies that near-term demand may be a bit sluggish.

While brand loyalty is an issue with console gamers, the lower-priced Xbox 360 has captured plenty of ground in attracting former Sony exclusives. That's likely to cut into Sony's fan base.

Wah-Wah Wii

As for the Nintendo Wii, the most important thing to note is that its low manufacturing cost and relative technological simplicity are giving Nintendo a huge boost in the important Japan market. The Wii is making its way into gamers' hands a lot faster than the PS3, giving Nintendo a chance to gain a foothold with consumers ahead of mass production of the PS3.

Sony's video-game business is easily its crown jewel. At its best, it has provided more than 60% of Sony's operating profit despite hovering around 10% of overall Sony revenue. Given that Sony is almost certainly going to lose market share, the company's profitability will be dragged down dramatically.

This state of affairs means Sony's historically lucrative video-game unit is very likely to lose its luster over the next few years as Microsoft and Nintendo gain market share in this segment. Plus, one must consider the generally tough state of the consumer electronics business, given how competitive businesses such as high-definition televisions have become. With that in mind, it is nearly impossible for me to come up with a bullish case for Sony.
In keeping with TSC's editorial policy, Michael Comeau doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Comeau is a research analyst at TheStreet.com. In this role he performs stock analysis for TheStreet.com Breakout Stocks, and is also a regular contributor to RealMoney.com. Prior to his arrival at TSC in June 2004, Comeau worked as a Consultant to Toyota Motor North America, performing in-depth research on automotive industry issues, primarily in the areas of alternative engine technologies, competitive analysis and macroeconomics. His primary market interests include consumer technology, specialty retail, and small-caps. Comeau received a bachelor's degree in Finance from Brooklyn College, and has completed Level 1 of the CFA program.. He appreciates your feedback; click here to send him an email.