FOR KEIJI KIMURA, the problem is small enough to fit in his pocket and just heavy enough to weigh on his mind. Kimura is a senior VP at Sony headquarters in Tokyo, and the problem in question is Apple’s iPod, the snappy little music player that’s revolutionizing consumer electronics the way Sony’s Walkman did some 20 years ago. By rights, Sony should own the portable player business. The company’s first hit product, back in the ’50s, was the transistor radio, the tinny-sounding invention that took rock and roll out of the house and away from the parents and allowed the whole Elvis thing to happen. A quarter-century later, the Walkman enabled the kids of the ’70s to take their tapes and tune out the world. But the 21st-century Walkman doesn’t bother with tapes or CDs or minidiscs; it stores hundreds of hours of music on its own hard drive. And it sports an Apple logo.

“It’s a good product,” Kimura says of the iPod. “It’s exciting. I am positive the hard disk is a key device that will change our lifestyle.”

A broad‑shouldered man with a shock of thick black hair and a ready smile, Kimura is in charge of nearly every Sony device that’s portable, from laptops and handhelds to Handycams and Walk­mans. And he’s right: When the average consumer has a hard disk not just in the PC but in the set-top box and in half a dozen other gizmos—all con­nected by wireless networks that zap their contents painlessly from one to another—life will be richer. In fact, this is the vision his boss, Sony president Kunitake Ando, laid out more than a year ago as the company’s core strategy.

Ando wants nothing less than for Sony to reinvent itself. But that will never happen as long as the company is frozen by its fear of piracy. Sony’s digital Walkman device is a good example. Where the iPod simply lets you sync its contents with the music collection on your personal computer, Walkman users are hamstrung by laborious “check-in/check-out” pro­cedures designed to block illicit file-sharing. And a Walkman with a hard drive? Not likely, since Sony’s copy-protection mechanisms don’t allow music to be transferred from one hard drive to another—not an issue with the iPod. “We do not have any plans for such a product,” says Kimura, the smile fading. “But we are studying it.”

Really? No plans? When the world leader in consumer electronics takes a pass on the hottest portable music player out there, you have to wonder what gives. Sony became a global giant on the basis of innovative devices manufactured by the millions on nothing more than a hunch that people would buy them. Now Apple is delivering the innovation while Sony studies the matter.

What’s changed since the original Walkman debuted is that Sony became the only conglomerate to be in both consumer electronics and entertainment. As a result, it’s conflicted: Sony’s electronics side needs to let customers move files around effortlessly, but its entertainment side wants to build in restraints, because it sees every customer as a potential thief. The company’s internal divisions reflect those in the marketplace, where entertainment executives have declared war on consumers over file-sharing. But Sony’s position is unique. It can settle the fight and flourish, or do nothing and be hobbled.

Instead, it’s tried to play both sides. As a member of the Consumer Electronics Association, Sony joined the cho­rus of support for Napster against the legal onslaught from Sony and the other music giants seeking to shut it down. As a member of the RIAA, Sony railed against companies like Sony that manufacture CD burners. And it isn’t just through trade associations that Sony is acting out its schizophrenia. Sony shipped a Celine Dion CD with a copy-protection mechanism that kept it from being played on Sony PCs. Sony even joined the music industry’s suit against Launch Media, an Internet radio service that was part-owned by—you guessed it—Sony. Two other labels have since resolved their differences with Launch, but Sony Music continues the fight, even though Sony Electronics has been one of Launch’s biggest advertisers and Launch is now part of Yahoo!, with which Sony has formed a major online partnership. It’s as if hardware and entertainment have lashed two legs together and set off on a three-legged race, stumbling headlong into the future.

This is not how it’s supposed to work.

Sony President Kunitake Ando at Comdex in Las Vegas. Photograph: Reuters

OUTSIDE SONY’S surprisingly modest Tokyo headquarters, traffic is backed up as usual on the gently curving street people call Sony Avenue. Here, in the tree-shaded neighborhood of Gotenyama Heights, the company’s home since 1947, its presence looms so large the whole area is known as Sony Village. Gracious houses with blue-tile roofs are folded into the hills alongside humble storefronts and Sony’s utilitarian white tile-and-stucco office buildings. This is an outfit with 168,000 employees and annual sales of $57 billion. As president, Kunitake Ando hopes to transform Sony into a company that doesn’t just sell entertainment as well as hardware but delivers it in digital form to products that are part of in-home networks. “If we can combine the strength of hardware and the strength of entertainment, we could build a unique business model,” Ando says excitedly, his wide grin and even wider glasses making him seem more like an overeager kid than the second in command to CEO Nobuyuki Idei. It’s a bold strategy built on a big if.

As an electronics company, Sony makes some of the coolest gadgets on the planet, even without an iPod. In its last fiscal year, it sold a staggering 56 million of them: 19 million Walkmans, 6 million stereos, 10 million television sets, 5 million video players, 4 million PCs, 4 million computer screens, 5 million camcorders, 3 million digital cameras — some $36 billion worth in all. Year after year, it beats out the likes of Ford and Coca-Cola to top the Harris Poll of brands Americans consider the best. “Wow-type products— that’s Sony,” Ando exclaims, waving his arms as he sits perched on the edge of his chair in a mammoth conference room. “I call it the power of hardware.”

The Walkman changed everything. Now Apple is doing the innovating.

The problem of hardware is more like it, because for all this, Sony lost money on the stuff. Japan’s consumer electronics giants are being squeezed by upstarts in China, Taiwan, and Korea, where manufacturing costs are far cheaper. Without entertainment, which provided 30 percent of the company’s revenue and nearly all its profits, Sony would be as bad off as Matsushita, NEC, and Toshiba, its traditional Japanese rivals. “The big dinosaurs are struggling to survive,” Ando admits. “And Sony is one of them, of course.”

On the entertainment side, Sony is one of seven global media conglomerates that dominate the industry. The weakest link is its New York-based music arm, where sales are dropping despite hits from Jennifer Lopez, Shakira, Bruce Springsteen, and the Dixie Chicks. (A separate Japanese label is doing slightly better.) Sony Pictures is Hollywood’s hottest studio, producing blockbusters like Spider-Man and Men in Black II along with some of America’s top soap operas, popular sitcoms in Germany, and hit movies in China. And Sony’s PlayStation unit, located in Tokyo, is the undisputed king of videogames, leading the industry in sales of game consoles and software despite a determined onslaught from Microsoft.

The theory behind Ando’s “ubiquitous value network,” as his strategy has awkwardly been dubbed, is that the whole company will get a lift by enabling content to move freely through its hardware. Gadgets increase in value to consumers as they’re linked to other gadgets; digital delivery of entertainment creates the tantalizing possibility of luring those same consumers into a direct sales relationship. But the different entertainment units have a hard time talking with one another, much less with the sprawling electronics operations in Tokyo, San Diego, New Jersey, and Berlin. “Sony is not one company, it’s about 50 companies, and there’s nothing other than the CEO’s office to bring them together,” says Frank Sanda, CEO of Japan Communications, which provides mobile phone services to Japanese corporations. “I’m a student of Sony—I like and admire it. But it’s a bunch of vertical poles that don’t even hit one another in the breeze because they’re too far apart.”

Ando knows that things are awry. “Our intent is to provide rich content and services to users without any frustration, without any stress,” he says. “Initially, because of our content group, we tried to protect the rights of labels and artists too much, so this made it very difficult for consumers to use the machine. Now we know that for the industry to grow, we have to find an optimum balance point. We have to consider ease of use for consumers but at the same time protect content holders’ rights. We think it’s almost an advantage for Sony that we have both—we can understand the content side and we have hardware, so we can start thinking about this way ahead.”

But the entertainment and electronics industries were at odds long before Sony tried to marry the two. Sony and the Dutch electronics firm Philips pioneered digital music two decades ago with the development of the CD, only to have music-industry execs attack it as an incitement to piracy and a threat to vinyl. Meanwhile, Universal and Disney were suing Sony over its new Betamax videocassette recorder, which they claimed promoted illegal copying as well. The overheated rhetoric was a dress rehearsal for today’s music piracy debate: The president of Universal called Sony’s top US executive a highwayman on national television, while Jack Valenti, Hollywood’s lobbyist in Washington, compared the VCR to the Boston strangler.

In the end, of course, these technologies created a bo­nanza for show business. CDs triggered years of double-digit sales increases as people rushed out to replace their rec­ords; home video now accounts for 40 percent of Holly­wood’s world­wide film revenue, more than double its box office take. But while Sony scored big with its CD players, it lost out on the VCR when Betamax was eclipsed by VHS. So in the late ’80s, with the minidisc in development and cofounder Akio Morita convinced that Betamax would have won if he’d controlled a film library, the company spent billions to buy CBS Records and Columbia Pictures.

Later, when profligacy and mismanagement resulted in a $3 billion write-off, Sony’s enthusiasm for the American media business faded: Reached on the golf course in January 2000 with the shocking news that AOL and Time Warner would merge, Idei told Sony’s North American chief it was “a re­gional problem.” As things turned out, it was.

NOW, WITH THE AOL TIME WARNER DEAL an acknowledged fiasco, Sony is on the front lines of digital convergence. The job of making a business out of entertainment and hardware combined falls to Sony’s chief strategist, Yuki Nozoe. Having spent several years at the company’s Hollywood studio, Nozoe is one of the few in the inner circle who know both sides of the business. Sony has more than 100 online offerings up or in development in various spots on the globe — sites for videogames, video-on-demand, soap operas, even insurance. (Sony is one of Japan’s biggest insurers.) Most are designed for broadband, which means they might just about be ready by the time the world switches over from dialup.

What works now is music, so chief among the prototypes for Sony’s vision of the future are sites like bitmusic in Japan and pressplay, a joint venture with Universal Music in the US. But pressplay has delivered a hapless performance to date. Subscribers face a complicated set of limits on what they can do with the music they buy, and until recently they weren’t able to get anything at all from Warner, EMI, or BMG, which have a competing joint venture called MusicNet with even tougher restrictions. So pressplay subscribers haven’t even topped the 50,000 mark, while Kazaa, the leading file-sharing service, has 60 million users.

Copy protection kept Sony CDs from being played on Sony PCs.

Nozoe appears unfazed. He considers everything an experiment, and he isn’t counting on any one service to succeed on its own. Sitting in his nondescript office overlooking the flat, harborside district of Shinagawa, where gleaming new Sony towers rise above rail yards and worker quarters, he points to a small vase of flowers on the windowsill and says, “A single service may not attract many customers. But when it becomes a bouquet . . . “

Moments later, a woman’s voice emerges from his office walls. It’s 3:00 PM, break time at Sony factories throughout Japan, and the voice implores us to stand up, stretch, relax. It’s been saying this for decades, ever since Akio Morita decreed it. Set to ethereal Japanese music, the message exudes an eerie calm, but it’s a ghost from the industrial past, a reminder of how far Sony still has to go.

Idei has been focused on making Sony able to compete in an age of digitally networked products almost from the moment he was named president in 1995. “He had a vision that AV and IT would merge someday,” says Ando, who was a Sony insurance executive before Idei put him in charge of a project to break into the personal computer market. “We knew that everything must be connected.” The product that resulted, an entertainment-oriented PC that was named Vaio, for video-audio integrated operation, was a big success in Japan, and eventually it made inroads in the US. After Idei was named CEO in 1999, he made Ando president and put veterans of the Vaio team, like Keiji Kimura, in charge of key divisions. The message was clear: IT rules.

Now Sony offers PCs with a variety of standard networking options—USB, Bluetooth, 802.11b (known in the US as Wi-Fi) and its heftier cousin 802.11a, which has the bandwidth to handle high-quality video—as well as portable gadgets, like Handycams and the NetMD Walkman, that connect to them. Yet many products don’t link well. Take the NetMD Walkman: Not only does it rely on a painfully slow USB 1.0 connection to transfer music to and from a PC, but it’s bound by the rules set by Sony’s copy-protection software, OpenMG. Introduced in 1999, OpenMG is responsible for the cumbersome check-in/check-out process and for other, even more annoying restrictions, like no copying of MP3 files without a time-consuming conversion to Sony’s proprietary Atrac3 format.

Other products don’t connect at all, among them Sony’s new high-end car audio system, which combines a standard CD player with an in-dash hard drive. A hit in Japan and just introduced in the US, it lets you rip CDs to your car stereo and leave the originals at home—a big deal to anybody who’s ever tried to dig under the seat for a lost disc while driving. Strangely, though, you can’t connect it to a Walkman or to anything else. Kimura, the man in charge of these gadgets, certainly sees Wi-Fi in Sony’s car-audio future: He’s excited about the idea that you could go online when you pull into a gas-station hot spot, or download a customized mix of songs from your PC before you leave the garage. But since OpenMG doesn’t yet permit file transfers from one hard drive to another, that’s out for now. “We have many things to resolve,” Kimura acknowledges. “Protection is one side of it—of course we have to protect our copyrights. But the challenge is how to excite the user.”

TWELVE TIME ZONES FROM TOKYO, at Sony Music headquarters in the upper reaches of a postmodern skyscraper in midtown Manhattan, you’d need a nanometer to detect much urgency about developing online services that give fans what they want. “There is a desire for the industry to live in a world of digital delivery as well as packaged goods,” maintains Fred Ehrlich, the label’s head of new technology. “But you have a lot of forces that need to be aligned.” By “a lot of forces,” Ehrlich means everything: How much can the labels charge? Should they charge by the month or by the song? Should they offer streams or burns or downloads? How long should a download last? How many devices should you be able to play it on? And so on, until you’ve reinvented the entire business.

Within the music industry, Sony is regarded as the technology leader, the one the other labels look to on issues like peer-to-peer distribution—if anyone can figure out how to adapt Napster-like technology for authorized downloads, the thinking goes, it’s Sony. And Ehrlich, a nonpracticing attorney whose job is to evaluate the business potential of things like P2P, is considered one of the more forward-thinking people within Sony Music. “Tommy Mottola doesn’t understand any of this stuff,” says an insider, referring to the label’s CEO. “He wants it all to go away. Fred sees where it’s headed.” But Sony also has a reputation as the most aggressive label legally, as exemplified by the massive breach-of-contract suit it filed last year against the Dixie Chicks when they claimed accounting irregularities. (The dispute was settled out of court after the group countersued, alleging “systematic thievery” by the label.) Put these two impulses together and you have a company that understands the future just well enough to go after every nickel it can get.

The key issue is online services—who’ll own them, what they’ll offer, and how much they’ll cost. The Big Five labels staked their claims early on but divided into two rival camps; only now are all five agreeing to offer their output through both. Major acts like Radiohead have flatly refused to make their music available online, though file-swapping sites are of course beyond their control. And independent providers like Listen.com have trouble getting releases while they’re hot: Months after the latest Springsteen album was on pressplay, for example, Listen still hadn’t gotten clearance to offer it. The site’s founder, Rob Reid, downplays the idea that the delay could be deliberate. But the Justice Department has been investigating both pressplay and MusicNet, and the judge who shut down Napster agreed to look into charges of collusion, declaring that the two ventures “look bad, sound bad, and smell bad.”

Someday Sony will let you keep online music forever and play it anywhere. Just not today.

Users of online services are offered only “tethered” down­loads, which come with limitations on how files can be copied or burned to a CD, or trans­ferred to a portable player. It’s as if Macy’s used anti-shoplifting tags to set limits on how many times your pants could be put in a suitcase or where you could go in them. “The idea of crippling legal music services is so completely misplaced I have a hard time getting inside the logic of it,” Reid says. Some day, Ehrlich concedes, online music will offer the same flexibility you get with a CD—you’ll be able to keep it forever and play it anywhere. “I just don’t think it’s right now,” he adds.

Comments like this explain why industry execs are considered emotionally incapable of facing the future. But there are other obstacles, and pricing is one of the biggest. When the labels offer downloads or burns, they effectively set the price at $1 per song—about the cost on a CD. User surveys show that something like 50 cents would be more realistic. But the labels don’t want to undercut the retail chains that sell CDs, even if that’s what it takes for Web-based services to thrive. “In theory, Sony Music would like all these services to become successful,” Erlich says. “But we look at the business based on the past, while the services compete against the online world, where music has been free. It’s a dance for both parties to understand each other.”

Yet another hot-button issue is Internet radio, which is supposed to be just like broadcast radio except you get it online. If only it were that simple. Radio stations can play any song they want, while interactive services like pressplay have to get clearance for the songs they offer. Hence Sony’s suit against Yahoo! Launch, which it argues is not a radio station but an interactive service, because it lets listeners specify which artists and genres they want to hear. Then there’s the question of whether online stations should have to pay royalties when US broadcast stations do not. With broadcast radio controlled by two conglomerates that keep extremely limited playlists coast to coast while sucking up hundreds of millions each year in promo fees, you’d think the labels would embrace Internet radio as a cheap way to break new talent. But they want to collect royalties, even if it means sending Net stations under.

“If you’re looking for logic in this situation—hey, it’s the music business,” says Launch founder Dave Goldberg. “There’s not a lot of logic in what they do.” But to Ehrlich, the logic is in not letting another company play music gratis when it could be paying. Precedents matter: If broadcast radio hadn’t been exempted from royalty payments decades ago, for reasons hardly anyone can remember, the music industry could be collecting an extra $2 billion or so a year. “It’s hard to change the old world,” Ehrlich declares. “But that doesn’t mean you can’t change the new world.”

ANDO EXPECTS 2003 TO BE A PIVOTAL YEAR in Sony’s transformation into a combined electronics and entertainment powerhouse. At this winter’s Consumer Electronics Show, he’s demonstrating some of the products he hopes will make it so. There’s CoCoon, a personal audio-video recorder that has a hard drive and can be programmed from a mobile phone. There’s RoomLink, a networking hub that lets you stream video from a Vaio to a Sony Wega TV (both are already available in Japan). More important, perhaps, Sony is developing a new version of OpenMG that’s supposed to make it easier to transfer files from one device to another.

The new OpenMG is one of the fruits of a program Ando and Idei started more than a year ago to get everybody at Sony working in harmony. Known internally as Symphony, the effort began with a content and technology committee that meets a few times a year—October in New York, May in Tokyo; Nozoe and Ehrlich and a couple dozen other top execs, Japanese and American, together in a room trying to hash out the company’s issues. “With the arrival of digital everything, you can’t get away from each other,” says Howard Stringer, CEO of Sony Corp. of America, which includes the music label and film studio. “We all have to invent the business plan for the future. And even though we have sides of Sony that will disagree, finding a consensus is Sony’s style.”

The grunt work on the copy-protection issue is done by a subcommittee that includes Takayuki Sasaki, who heads the division in charge of OpenMG. Sasaki reports to Nozoe, who’s told Sony hardware execs they can’t make their decisions in a vacuum. At a meeting last May, “the content guys beat the hell out of Sasaki” because they wanted additional capabilities built into the software, says one executive. What they covet is flexibility—the ability to set the rules any way they like. “You want to be able to control the distribution of music,” Ehrlich explains. “If you want to say it can go to two devices, you can do that. If you want it to time out after 30 days, you can do that.”

At this point, one might reasonably conclude that Sony doesn’t need a symphony, it needs some head­banging.

With OpenMG X, the version being developed, Sony will no longer set blanket rules for its own devices; it’s created a digital rights management system that works on any manufacturer’s hardware and allows the content owner to set the rules. Sony wants OpenMG X to be accepted across the entertainment industry—an ambition that puts it face-to-face with Microsoft. “The whole security/digital rights management/copyright arena is a critical battlefield,” Stringer declares. “We’re racing—racing—to get to a solution that has an open standard so that Microsoft doesn’t waltz in and develop the audio-video operating system.”

A digital rights management system isn’t just a traffic cop; it’s a powerful tool that gathers all kinds of information about consumers, from credit card numbers to listening habits, and dictates which devices can talk to the PC and how. Microsoft’s DRM software, a key feature of its Windows Media platform, promises total flexibility for entertainment companies, and it’s designed to work not just on PCs but with consumer gadgets like Sony’s. “If it is the de facto standard for all digital rights management,” says Stringer, “then at some point it migrates into all the networked devices, in­cluding the television set and everything else. Sony’s nightmare is that the TV set becomes a mon­itor.”

This puts Sony in a bind. Except for the Xbox, Microsoft doesn’t really sell hardware. All it has to do is keep entertainment executives happy and watch them adopt its DRM platform. If Sony fails to offer every bondage option the entertainment folks can imagine for their customers, it opens the door for Microsoft to take control of its hardware. But if Sony’s devices don’t break out of the DRM straitjacket, it could be overtaken by manufacturers with less to lose—like Apple. To save its electronics business and make its dream of digital services a reality, Sony needs a system that doesn’t punish consumers yet somehow satisfies the entertainment industry. It needs to square the circle on digital rights.

Sony thinks OpenMG X is a step in that direction. But there’s no indication that other entertainment companies would rather have Sony control DRM than Microsoft—which is why Sony recently partnered with Philips to buy InterTrust, a struggling Silicon Valley outfit that holds key DRM patents. Years ago, Sony and Philips jointly developed the CD and licensed it so widely that it became an industry standard. Now they hope to do something similar with DRM technology, so that all such systems, Sony’s included, can work interchangeably. A bonus twist is that InterTrust is suing Microsoft in its own intellectual property dispute. InterTrust maintains—and Redmond vigorously denies—that Microsoft illegally appropriated its DRM algorithms for the Windows Media platform. Should InterTrust win the suit, Sony and Philips could bring Microsoft into the fold as well. But Sony won’t win with consumers until its two halves, electronics and entertainment, join forces to offer online services with all the freedom consumers already enjoy offline.

The stakes are huge—and yet if Sony pulls it off, the company will be unrecognizable in a few years. The networked devices and services being developed now are just an interim step. “Nobody can create a clear picture of what is a winning business model for 2010,” says Idei. “The reality is transformation and constant change. We are on the sea of uncertainty, but sometimes there are small islands, and we have to navigate our company to the nearest. There are many, many Internet business trials at Sony, because we don’t know if we can find a small island we want to go to, and this is the way.”

Idei’s ultimate goal is more distant and more radical: the dematerialization of Sony and its products. Instead of boxes stuffed with electronics, Sony will sell screens. Instead of CDs, Sony will sell sound. Ken Kutaragi, the creator of Sony’s PlayStation, has made a deal with IBM and Toshiba to develop a “supercomputer on a chip” that can power network servers, pumping games with stunning 3-D graphics to Sony devices no bigger than a wristwatch. This is the future Idei envisions: invisible, interactive networks that bring sound and light to almost any nearby surface. Sony networks, Sony sound and light, Sony surfaces. If only it didn’t depend on a bunch of music men who’ve yet to wean themselves from shiny plastic discs. ◆