Description

Introduction

The concept of margin of safety is being shunned amidst an exuberant market fueled in part by artificially low interest rates, leverage, and retail investors day-trading with a disdain for fundamentals, the interplay between growth, cash flows, and returns on tangible equity. This is the type of environment it pays to seek investments that offer significant downside protection, while still earning high teens CAGR over 5-10 years. 

There are different ways to earn high returns. The approach that makes most sense to me is to be a business owner of a handful of great businesses that one understands and are likely to last decades, and size them at highly attractive prices and evaluating alternative opportunity costs. 

The company in discussion today is one that even the iconic Steve Jobs was significantly influenced by which in part influenced significant decisions at Apple.

Second, there have been significant changes under the new CEO, including recurring revenue as high as 50%, new incentives with cash-flow KPI, significantly improved disclosure and first-time large repurchases (without employing debt). 

Third, the company's free cash exceeds or at similar levels to many of the world's revered brands, Nike, Coke, Disney, McDonalds, L'Oreal, Starbucks, Adobe and 25 other cognitive referent brands I researched. Yet, the enterprise valuation of the business in discussion is 1/2-1/3rd or a fraction of theirs. 

Fourth, the net cash balance sheet is full of long-term, hard to replace assets multiplying in intrinsic value accounting for ~18-20% of market cap. 

I do not have "12 month" return forecasts for a variety of reasons. Given the interplay between growth of various business segments, returns on unlevered equity and free cash flow, and management track record, I anticipate the company to earn high teens CAGR consistently over the next 10 years. 

A long-term business owner has optionality to exponential growth like EV, AI, robotics, online medical for free. 

The idea is Sony. 

Sony's Historical Influence on Steve Jobs 

The iconic Steve Jobs, founder of the world's most valuable company was deeply influenced by Sony. In a must-watch speech on "Marketing is about values"  Jobs draws inspiration from the "greats of the greats". The 4 companies Jobs refers to are Nike, Disney, Coke and Sony. This is a Youtube video worth watching where Jobs mentions Sony: https://www.youtube.com/watch?v=wK_hxXAYVzA&t=117s

Studying history reveals Jobs was especially fascinated by Sony. Jobs was obsessed with Sony: Jobs at one time wanted to call the iPod MacMan after Sony's Walkman. His turtleneck was inspired by Sony. See: https://www.ocregister.com/2011/10/12/heres-why-steve-jobs-wore-turtlenecks-2/ 

Macintosh factories were influenced by Sony . Apple's name was in part due to Sony's "charming, kind of fun" name. The concept of Apple stores drew from Sony. Indeed, Jobs was a special friend of Akio Morita , Sony's founder who was his hero, much like Mr. Buffett is to generations of value investors. See: https://www.kornferry.com/insights/articles/the-greatest-marketer-you-may-not-know 

Apple is a sticky, long-term client of Sony: It should not surprise anyone that Apple is a recurring long-term client of Sony given the huge significance of the camera  to Apple. Apple is estimated to account for ~50% of sales or over $4.5bn in sales of Sony's image sensor division and this will grow . The segment has strong competitive advantages as #1 player globally, grown sales at 17% CAGR, generates positive free cash while earning 20% ROIC over the last few years.

Business Changes: Recurring Revenue, Capital Allocation Improvements, New Incentives and Greater Disclosure

Since Yoshida-san took over as CEO in 2019, there has been significant changes in Sony. 

i. Recurring Revenue: I estimate that Sony's recurring revenue is roughly over 50% ex financials. I differ, almost 2-2.5x from consensus as few sell-side and buy-side analysts appreciate the magnitude of the shift over the last decade.

While Sony does not explicitly disclose the figure, under new CEO, Yoshida-san, there has been a huge focus on recurring revenue, cash flow and ROIC.

The company guides the following segments  have high recurring-like characteristics. First, game & network services: a) network services with recurring subscription related to game, video, music content and b) software and add-on revenue distinguished by a virtuous cycle of recurring streams as if players have hardware, the odds of purchasing several software titles is high. In Q3 2020, CFO said "profitability structure of game business has changed dramatically due to expansion of network services. Second, music: a) recorded music streaming (content business) is recurring as if one purchases an artist’s album, the odds of repeat behavior is high and b) publishing includes management and licencing (content business). Third, pictures: TV productions (content business), media network (subscription revenue) is recurring as if customers watch a program, they tend to be repeat customers. Fourth, EP&S segment: interchangeable lens for cameras is recurring and b) So-Net, i.e., internet provider services have subscription revenue. Even in the IS&S segment, Sony is focused on developing a recurring business through subscription . In sum, I estimate nearly 50% is recurring ex financials and will manifest in greater growth visibility and predictable free cash flow which is not understood by the market. 

ii. "Outsider" Capital Allocator: Since Yoshida-san become CEO, for the first time ever, he has conducted large repurchases of over US$2.7bn (¥300.6bn). Dividends increased. I expect capital returns to multiply under him given ~19% of market cap is net cash/LT investments and significant FCF. 

Second, Yoshida-san has made great long-term investments as a business owner. Sony's 4.9% stake in Bilibili  (China's Youtube) since Apr 2020 doubled, yielding over $750mm in unrealized gains with large growth in China. At its highs earlier this Feb, Bilibili had almost quadruplued since Apr 2020. Sony's Spotify  stake has been a winner. Sony's 33% stake in M3, Inc has quadrupled since Yoshida-san took over, yielding a massive $12.5 bn in unrealized gains. Sony's $250mm investment in Epic Games  in July 2020 has doubled in value. In May 2018, Sony became the world's largest music publisher with EMI, increasing recurring streams. More recently, Sony Pictures Networks India (SPNI) and Zee Entertainment Enterprises Ltd. (ZEEL) announced that they entered into an exclusive, non-binding term sheet Sheet to combine both companies’ linear networks, digital assets, production operations and program libraries. Such investments in the post-COVID world of digitalization with online medicine, video, gaming, digital streaming, etc will yield long-term benefits for shareholders. Third, due to the recurring revenue focus, Sony has generated a total of $21.7bn (¥2.4trn) in operating cash flow in the last 3 years (exceeding by 25% the ¥2trn mid range plan set by Yoshida-san). Finally, Yoshida-san has adopted a new organizational structure . This includes name changes, leaner HQ/business portfolio and the highly recurring financials  as a 100% subsidiary. As CFO, he led restructuring to exit the PC business, spinoff TV, reduce fixed costs, setting the foundation for today.

  iii. Incentives Drive Value Creation: Mr. Munger teaches us to pay close attention to incentives. The first significant change at Sony is that operating cash  has a 50% weight, as a major KPI under the 3rd mid-range strategy plan. This is the highest weighting for cash flow and reflective of quality of earnings, growth and high ROIC. In the past, operating cash flow was not included as a KPI. Historically, Sony had an absurd 50% weight on a low-bar ROE target of 10%  (gaming unlevered ROE alone is over 50%). Second, long-term stock performance is set as ~50% of total compensation for senior executive long-term compensation as per the 2020 corporate report. The third significant change in 2020 is to tie performance-linked remuneration systems with inter-business collaborations. This is important because Jobs and Walter Issacson  recognized Sony's past missteps were directly tied to poor incentives as divisions worked in "silos" rather than as one firm. 

iv. Greater Disclosure and Transparency Shines Light on Value: New disclosure since 2019 include: publishing corporate report  (this did not exist before 2019), detailed segment breakdowns in quarterly supplemental information , speech transcripts, Q&A summaries, new sustainability report, and more. 

To fully appreciate the rationale for greater disclosure, here is what the CFO says in page 29 of the 2019 corporate report "market capitalization is the product of operating cash flow and a multiple. Cash flow will grow as we carry out the strategy, but to obtain a higher multiple we must ensure that the attractiveness and growth of our businesses are being properly evaluated by the market. When multiples fall short, it is the responsibility of management to make greater efforts...Tech giants, represented by GAFA, are not single business companies. They operate a range of businesses, like Sony’s business portfolio, and yet their multiples are higher. The key point is that the markets have confidence in their growth. Sony has entered a new growth phase. To improve our corporate value, we must clearly set forth our approach for creating the value we have promised". 

Activism

In his 1997 letter, Mr. Bezos writes "Its All About the Long-Term". This letter has had a significant impact on my own thinking. As a 75-year iconic brand, Sony is a long-term business owner thinking in terms of decades and centuries. 

Yoshida-san became the new CEO on April 1, 2019. Just 2 months fresh into the job, the company was the target of well known activist, Dan Loeb in June 2019. Thanks to Mr. Loeb, Sony has garnered much attention.

Mr. Loeb whose writings are widely read and respected highlighted the need to reduce portfolio complexity. Mr. Loeb advised: i) spinning off Semiconductors division which Mr. Loeb called "Japanese crown jewel and tech champion", ii) divesting several listed equity stakes including M3, Spotify, Olympus etc., iii) NewSony with gaming, music, pictures, etc. and iv) modest increase in leverage to 1.0x net debt/EBITDA to increase ROE and asset efficiency. Although Sony has undertaken significant positive changes above, the company did not directly follow some of the suggestions offered by Mr. Loeb. The full response is here: www.sony.com/en/SonyInfo/IR/news/20190917_E.pdf

Below were a few of the points I understand raised by Mr. Loeb:

• Monetize listed stakes: As a long-term business owner of a few great businesses, Sony largely ignored this advice. While hindsight is easy, it is relevant to note that if Sony monetized its combined stake in M3 (2413 JP) and Spotify on June 2019, US$8-13bn would have been left on the table. Since June 2019, M3 Inc, which Sony owns 33% quadrupled at its highs and Sony's Spotify stake has more than doubled. Sony did sell Olympus, while achieving a 207% return 207% since inception and bought the Financials business, a recurring business on the cheap. Sony's shareholders including Mr. Loeb  were richly rewarded by Sony's long-term thinking. I fully expect these listed stakes to pay rich dividends in the decade to come, particularly in the post-COVID enabled world of digitalization. 

• Portfolio complexity is not the core issue: Under new CEO, Yoshida-san, Sony has made significant positive changes as highlighted above. I believe portfolio complexity is not the core issue. Several of the world's best businesses, including Berkshire Hathaway and Asia's Tencent, the latter which has multiplied over 500x has hundreds of investments and diverse businesses. This can also be a strength, particularly in crisis, where one segment may be disproportionately targeted. Mr. Loeb in the past has been a long-term owner of Asian businesses that I also like such as Alibaba .  Notwithstanding, Alibaba has hundreds of "equity investments", e-commerce, cloud (capital intensive), AI, Fintech, AntFinancial, entertainment, logistics, VIE structure and more.Therefore, I believe the issue is not one of portfolio complexity, but a separate issue of clearly articulating growth strategy and management incentives. As I note above, this has significantly changed under new CEO.

• Spinoff Imaging & Sensing Solutions (formerly Semiconductors):  Mr. Bezos stresses long-term thinking and incubating new ideas and not be afraid to fail. IS&S was born as one such great idea at Sony. Today, it is a critical growth driver with sales growth of 17% CAGR the last 10 years and 20.3%  ROIC in FY19. Sony highlights: "Our current business centers on applications for smartphone cameras, but behind our success is a long-standing and close collaboration with our camera business". Apple accounts for 50% of sales or roughly $4.5bn in the image sensors segment. Significant growth exists not just in imaging, but AI, Internet of Things, autonomous driving and more. The dis-synergy and costs caused by the spin-off were meaningful, per my understanding from Sony. It is important to note that IS&S is a free cash flow positive business. The cumulative FCF from the IS&S segment in FY18 and FY19 was greater than all divisions, except gaming and in FY18 and FY19, the cumulative operating cash of IS&S is larger than all divisions and similar levels to gaming. The company in its response states "in the mid to long term, it will be possible to fund the investment of I&SS with the cash generated by the image sensor business itself".  Given the points laid out and thinking long-term, I agree with Sony's board to retain this business renaming it Imaging & Sensing. I believe Sony's long-term decision will create significant value. 

• Modest Increase in Leverage: With respect to NewSony, as articulated above, I believe the core issue is not of complexity. Sony benefits from a portfolio of great businesses. On the topic of modest leverage, given Sony's net cash and long-term investments of roughly $26bn in value or 19% of market cap, additional modest leverage is unlikely to move the needle to create sustainable long-term value for Sony.

Financials Snapshot

The below charts from FY 2000 to FY 2020 highlights that Sony has evolved into a diverse business portfolio and today owns some great long-term investments. 

The below chart highlights the improvement in business profitability and margin structure.

The below chart highlights the significant improvement in operating cash flow and free cash over the last decade. 

The below charts from FY 2000 to FY 2020 highlights that Sony has evolved into a diverse business portfolio and today owns some great long-term investments. 

Margin of Safety in Euphoric Market While Earning High Teens Annual CAGR

 In a euphoric bull market, it is rare to find a great business at a great price that offers high teens CAGR with downside protection and where meaningful capital can be deployed. It is important to seek a large margin of safety to weather storms.

In the last 12 months, Sony generated $10bn (¥1.1trn) and $5bn (¥540bn) in operating and free cash ex financials, respectively. In the last 3 years, Sony generated $23bn in operating cash, exceeding its 3rd mid range plan (FY18-FY20) by over 25%. The company has ~$20bn in net cash ex financials & LT investments or roughly 15% of current market cap of US$137bn. At ¥12,785 a share, Sony's enterprise value (EV) is ~$117bn. 

These investments include fast growth good businesses, Japan's M3 33% stake (online medical), Bilibili 5% stake (China's Youtube), Spotify, etc. each growing over 25-50% and dominant niches. I model Sony's normalized operating cash and free cash to grow to $12-14bn and $8-10bn respectively within 3 years. This is due to a virtuous cycle of recurring revenue, predictable growth, lower capex and steady margin expansion. The financial target for the fourth mid-range plan is ¥4.3 trillion of adjusted EBITDA cumulatively over the next three fiscal years, this would mean atleast ¥3.2 trillion (US$28 billion) in operating cash over 3 years. The company's strategic investments, in order of priority, remain: IP and DTC, technology, and share repurchases. 

Great brands like Nike, Coke, Disney, McDonalds, L'Oreal, Adobe, Starbucks, Netflix, and 25 other cognitive referents I researched generate lower or similar free cash, yet Sony's enterprise value is 1/2-1/3rd or a fraction of theirs.

Most businesses have debt on the balance sheet unlike Sony which has ~15% of market cap in net cash and investments.

All of Sony's business segments generate positive free cash. Each earns high returns on capital between 15-40% except pictures.

The core business is yielding 8-9% unlevered free cash yield despite attractive business segment growth and excess value creation, given low cost of capital. Even without multiple expansion, I believe a high teens annual CAGR is reasonable to expect from Sony. If the business were to get a multiple re-rating, this would provide higher attractive returns, with downside protection.

I do not have "12 month" return forecasts for a variety of reasons. Given the interplay between growth of various business segments, returns on unlevered equity and free cash flow, and management track record, I anticipate the company to earn high teens CAGR consistently over the next 10 years. 

In sum, under the new CEO, Yoshida-san, Sony is a dramatically different company with recurring revenue, cash cow, reinvestment, high ROIC, predictability, aligned incentives and capital allocation. It is rare to find a great business at a great price with this combination, amidst a euphoric bull market.

Growth Optionality at Current Prices: Low Downside, High Upside 

At CES 2020, Sony announced the VISION-S car concept  which generated greater interest than Sony's new PS5 gaming cash cow business. In Jan 2021, Sony announced public road testing in Europe. According to Sony, a total of 33 sensors, including CMOS image and ToF sensors are embedded in the vehicle, leveraging Sony's strong competitive advantages. I recommend you see it for yourself here: www.sony.com/en/SonyInfo/vision-s/ 

In addition, Sony AI has been established to combine the company's R&D and AI, especially in the fields of imaging and sensing, robotics, and entertainment to “unleash human imagination and creativity with AI".

Visit Sony's robotic puppy: https://us.aibo.com/;

Sony also has significant growth options in online medical platform with its 33% stake in M3. 

Conclusion: In sum, Sony offers a mispriced situation and significant change with great portfolio of unique assets with world's leading cash cow gaming business and high recurring revenue, world's largest music publisher, world's leading image sensor business and top 5 TV production and motion pictures business. The balance sheet is strong with net cash and LT investments of $20bn, ~15% of the current market cap which include leading companies like M3, Bilibili, Spotify, etc growing 25-50%. Sony also owns a 100% owned life assurance recurring business where one can insure one's life, buy a house, etc and its M3 medical platform helps save lives. To top if off, investors get significant growth potential for free in EV, AI, robotics and for free Aibo, Sony's own robotic puppy (visit: https://us.aibo.com/). At current prices, I believe the upside greatly outweighs the risks in this euphoric bull market fueled by artificially low interest rates, leverage and retail frenzied trading. 

Disclaimer: The information contained in this VIC writeup is strictly for informational purposes only and should be considered neither an offer nor a solicitation to invest in any funds and or managed accounts, both now and in the future. The information has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to its accuracy, adequacy, or completeness.  Liability for errors or omissions is expressly disclaimed. The information is provided without obligation and on the understanding that any person or entity who acts upon it does so entirely at their own risk. This presentation does not purport to be replace any managed account agreements and or fund offering documents but is to be used for explanatory purposes only.  Potential investors in funds and or managed accounts should obtain independent legal, financial, tax, accounting, and other professional advice in respect to investing. No regulatory authority has reviewed this presentation. For detailed terms and conditions and subscription process please refer to a fund’s information memorandum, fund supplement and subscription documents and or managed account documentation. The views contained in this document are views expressed by the Analyst who reserves the right to change his view to accommodate current developments.  

Catalyst

Business Changes: Recurring Revenue, Capital Allocation Improvements, New Incentives and Greater Disclosure

Too cheap to ignore