This article is from the January 30, 2001, issue of Red Herring magazine.

TiVo (Nasdaq: TIVO) personal video recorders, Handspring (Nasdaq: HAND) and Palm (Nasdaq: PALM) PDAs, DirecTV satellite boxes, Diamond Rio MP3 players, 3Com's (Nasdaq: COMS) Kerbango Internet radios, and Microsoft's (Nasdaq: MSFT) Xbox game console: what these Internet-age consumer electronic devices have in common is that they were all developed, or will be developed, by companies based in the United States, not in Japan.

It's products like these that are leading a U.S. resurgence in consumer electronics, two decades after Japan Inc. nearly wiped out U.S. capitalists in digital watches, TVs, stereos, semiconductor chips, and just about everything else electronic. For the second half of the 20th century, the Japanese appropriated consumer markets while impatient U.S. companies fled to businesses with better margins and with sales growth greater than the 2 to 3 percent per year that the industry offered. Now the injection of new technologies, the proliferation of entrepreneurial capitalism, and the prospects for faster growth have pumped up U.S. participation again.

'Broadband and wireless are completely changing the game in consumer electronics,' says John Seely Brown, chief scientist at Xerox (NYSE: XRX). 'When something like that happens, you get a new set of players. And the United States is better at creating new players.'

Although Japanese conglomerates still produce the lion's share of consumer electronics worldwide, they have lost ground not only to Asian tigers in Korea and Taiwan but also to fleet U.S. companies that have their pulse on the Internet. In the first major overhaul of consumer electronics since the '70s and '80s, when semiconductor chips infiltrated every device, U.S. companies could gain an edge as everyday consumer devices integrate the smarts of Internet computing and become 'information appliances.'

Consider some of the evidence: the entrenched Japanese titan Sharp (OTC: SHCAY) is a distant memory in the handheld organizer business, which Palm now dominates. At November's Consumer Electronics Show in Las Vegas, the majority of the 1,500 companies in attendance -- and all of the keynote speakers -- were American. Even U.S. manufacturing of consumer electronics is steadily rising.

One staggering fact: the market capitalization of just two well-known U.S. companies, relative newcomers Palm and Handspring, is a combined $37 billion, roughly half of Sony's (NYSE: SNE) $71 billion valuation. Given that Sony's annual sales are more than 40 times those of Palm and Handspring combined, the valuations of U.S. startups are certainly inflated. But they give leverage to American companies that are trying to make big investments in focused products, allowing them to stockpile resources and acquire new technologies.

ELECTRONIC COMEBACK Why is the United States making such a dramatic comeback? Partly it's luck. But more importantly, the boom has roots in the differences between big Japanese companies and small U.S. startups. 'U.S. companies are good at the design and integration of technologies,' says Bill Maggs, chief technology officer of Palm. 'A lot of Asian companies are good at manufacturing but poor at software.'

U.S. companies may be surprised at how quickly Japanese companies can move. Thanks to the success of NTT DoCoMo's i-Mode mobile Internet service, Japanese companies lead the world in the development of advanced cell phones. Most of Japan's electronics conglomerates have launched corporate VC units for investing in Silicon Valley startups. The stalled IPO market may slow down smaller U.S. companies. And most U.S. startups, of course, still have to prove that they can earn sustainable profits.

Those on both sides of the ocean acknowledge that U.S. startups have the advantage of speed and agility. A couple of years ago, Diamond Multimedia, now a division of Sonicblue (Nasdaq: SBLU) in Santa Clara, California, undermined Sony's Walkman business by creating the first portable MP3 audio player distributed in the United States. Ken Potashner, chairman, president, and CEO of Sonicblue, says his company has held on to more than half the market as dozens of rivals have entered the fray. The company has created four models in two years and is moving on to products like MP3-based boom boxes and stereo receivers to stay ahead of Sony.

'You can create a disruption through technology. That's really what has opened the door,' says Mr. Potashner. 'Then you amplify your advantage with speed and more innovation, and in our case, that means making products that are sold by big names like Nike (NYSE: NKE) [for which Sonicblue is making a wearable MP3 player], which has a brand to go up against the largest companies overseas.'

At a recent dinner in Las Vegas, Sony's president and chief operating officer, Kunitake Ando, admitted, 'The Internet has destroyed the business models of some of our traditional businesses like music.' He added, 'Anyone without a legacy has an advantage. Sony has existed for 50 years, and it is hard for us to neglect the past and only think of the future. But we can gain an advantage if we use our assets and operate on a global basis in ways the small companies can't.'

The question remains whether the U.S. companies can gain a lasting advantage through innovation. 'If all you have is hardware, it might be tough to hang on to a lead' as prices fall from $200 to $30 per device, says Julie Shimer, vice president and general manager of 3Com's residential connectivity group. 'In software, where someone can build an advantage by creating an ecosystem, the pioneer might be hard to dislodge.' And software is where Japan has been historically weak.

Sony, for instance, resorted to licensing the Palm operating system to build its CLIE handheld. That's in part because Palm has the momentum as a platform, with the support of thousands of third-party software developers of new Palm applications. And even with the Palm OS, the Sony device isn't selling as well as its U.S. rivals' machines. Perhaps Sony and other Japanese companies have another entry point as the devices shift from low-tech organizers to multimedia gadgets.

Even in manufacturing, the Japanese no longer dominate. Japan has moved so much manufacturing offshore that it is now a net importer of TV sets on a unit basis. Indeed, as Japanese companies have moved production offshore, the manufacturing trends that characterized the heyday of Japan Inc. have flip-flopped: while Japan's consumer electronics production is still almost twice that of the United States, the value of its manufacturing output has decreased by more than half over the past decade while the United States' has steadily increased.

CROSSED COUNTRIES North American contract manufacturers like Solectron (NYSE: SLR) and Celestica (NYSE: CLS) enable countless startups and U.S. companies to outsource manufacturing and focus on design. One recent irony: in October Sony sold off two manufacturing plants to Solectron, based in Milpitas, California, to streamline its costs. 'If you can't produce a product, the ability to dominate the market long term is questionable,' says John Latta, an analyst at Fourth Wave, an IT consultancy. 'That argument would seem to both hurt and favor the U.S., given the trends in manufacturing. It isn't clear if a lot of these startups will have legs for the long term.'

Under the hood of the newest consumer devices, American-made products are plentiful. Transmeta (Nasdaq: TMTA) has already placed its low-power Crusoe chip into a variety of portable devices. Rambus (Nasdaq: RMBS) and (NYSE: MU) hold strong positions in the memory chip market. Lucent Technologies (NYSE: LU) has a stronghold in communications chips. Texas Instruments (NYSE: TXN) dominates digital signal processors. Seagate Technology rules disk drives. Japan's chip makers, meanwhile, no longer dominate memory chips, and many have moved their manufacturing to cheaper places in Asia.

Chastened in the '80s, U.S. chip makers emulated Japan's focus on quality and recovered worldwide market leadership, thanks largely to the Intel-led PC juggernaut. And as consumer electronics shifted from analog to digital, time and again it was the Americans who had the expertise. 'The resurgence of the U.S. really began with the turnaround in PCs,' says Wilfred Corrigan, CEO and chairman of the custom chip maker LSI Logic (NYSE: LSI) in Milpitas. 'The pendulum swung back, not to old U.S. companies like RCA, but to new companies with new technology.'

The new U.S. expertise became even more valuable as the smarts in consumer electronics shifted from the system maker to the chip maker, which integrated a variety of technologies into increasingly dense and system-oriented silicon. National Semiconductor (NYSE: NSM) in Santa Clara is a world leader in information appliances because it not only makes the chips for the machines but also designs their systems. Many of National's 130 customers simply reconfigure the company's reference system designs, says Michael Polacek, vice president of National's information appliance division. 'The chip makers define what is possible in these products,' he says.

That can be important in determining which company has the strategic position in the supply chain. Case in point: C-Cube Microsystems (Nasdaq: CUBE) of Milpitas used its digital video expertise to create the first digital video chips for karaoke machines in the mid-'90s. C-Cube sold its chips to Sony, Matsushita, and many other Japanese electronics makers to prime the market. Then C-Cube armed Chinese manufacturers, who proceeded to undercut the Japanese. 'We had the right intellectual property at the right time,' says Alex Balkanski, former CEO of C-Cube and now a venture capitalist at Benchmark Capital. 'With so much talent in Silicon Valley, we moved at speeds that were impossibly difficult for the Japanese.'

But C-Cube's story also shows how hard it is to keep an intellectual property advantage over the big consumer electronics companies. In the latest TiVo boxes, Sony uses its own video chips rather than C-Cube's. 'Ultimately, C-Cube didn't manage its customers right, and those customers vowed to escape,' says Richard Doherty, director of research of the Envisioneering Group, a consulting firm.

Other U.S. companies have learned the hard way that the big electronics conglomerates will do everything in their power to avoid being locked into somebody else's architecture, as the PC industry was with Wintel. Like C-Cube, U.S. firms like 3DO (Nasdaq: THDO) and VM Labs once had grand ambitions, and they have faltered in trying to usurp leadership of video games and DVD players, respectively.

But even if the Japanese manage to defeat most of the startups, they will have to contend with some huge U.S. players, particularly those coming into consumer electronics from the PC industry. Microsoft, for instance, is making a run at Sony's game empire with the Xbox console, due to be launched this fall. It has pledged to spend $500 million on advertising and has already recruited 150 game developers to make games for the machine. But Microsoft will rely on contract manufacturers to assemble the Xbox.

Microsoft, like other U.S. companies, has learned the lessons of globalization. Japan Inc. remains powerful. But even tiny companies can tap into the international virtual network. After all, a small U.S. startup can design its products using chips fabricated in Taiwan, get the product assembled by a contract manufacturer in Northern Ireland, and ship the products for sale in the United States just as quickly as a giant Japanese company can.

'There is a tremendous open space for radical creativity,' says Xerox's Mr. Brown. 'Companies can challenge the status quo, but they have to do it by picking the right battles. You find partners in the value chain and then decide where to fight.' What was once Japan's game is now everybody's game.

ADDITIONAL RESOURCES Site for the Consumer Electronics Association, which keeps statistics on sales and production of consumer electronics devices in the U.S.

Site for This Week in Consumer Electronics, another source of statistics for the consumer electronics industry.

Text of a story on Sony outsourcing some manufacturing.

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U.S. companies achieve a hardware renaissance

Japan's VCs engage in foreign exchange

Capital steps of opportunity