Value Investors Club / Sony (6758)

Description

Investment Thesis: Sony is simply undervalued and apparently misunderstood and I think Third Point’s

potential involvement creates a material opportunity for value creation. The Company has tremendous

franchises in several structurally attractive industries with oligopolistic market dynamics. Their key

gaming and music businesses are also transitioning from somewhat cyclical, hardware/hit driven

businesses to more of a subscription type business which ought to command a higher multiple. Their

technology in image sensing should position them well for growth of machine imaging and autonomous

driving. Their studio business probably can’t get much worse (and at the very least has significant

scarcity value in a rapidly consolidating industry). Management is also very good (especially by Japanese

standards). The Company is being valued like a secular decliner which makes little sense and there is alot that a constructivist approach to activism could yield here (in descending order of likelihood; utilize unlevered balance sheet to increase capital return, exiting money-losing mobile business, exiting studio/music/SFH).

In Bn JPY (except per share) FY16 FY17 FY18 FY19E FY20E FY21E

Share Price ¥5,363 Revenue ¥7,603 ¥8,544 ¥8,612 ¥8,946 ¥9,264 ¥10,188

FDSO 1,271 EBIT 288.7 734.9 904.7 942.8 1,046.7 1,085.1

Market Cap ¥6,816,373 EPS ¥58 ¥388 ¥696 ¥504 ¥564 ¥586

Net Debt (615,000) FCF (23.5) 626.2 576.5 709.6 808.4 838.0

Enterprise Value ¥6,201,373

EV/EBIT 8.4x 6.9x 6.6x 5.9x 5.7x

P/E 13.8x 7.7x 10.7x 9.5x 9.2x

FCF Yield 9.2% 8.5% 10.4% 11.9% 12.3%

Company Overview:

Sony is a media and entertainment Company with franchise businesses across several distinct verticals.

• Gaming: (27% of FY19E revenue, 28% of FY19E EBIT). Sony makes the most popular gaming console

in the world-the Playstation. They generate revenue from both sale of hardware as well as

subscription and licensing fees (see below). They also develop their own games/content.

• Music: (10% of revenue, 16% of EBIT). Sony is the 2 nd largest music label in the world and they own

the largest music publishing business. This segment also includes a mobile gaming business which

developed/publishes a popular game called Fate Grand Order. ~55% of segment sales come from

recorded music, ~30% from visual media (which includes gaming) and the remainder from music

publishing.

• Semiconductor: (10% of revenue, ~15% of EBIT). They design and manufacture CMOS image sensors,

mostly for smartphones but also for security cameras and machine vision. About ~80% of this output

goes into smartphones where they dominate at high end.

• Movies: (11% of revenue, 8% of EBIT). They own Sony Studios which develops and makes films and

TV shows.

• Financial Services (14% of revenue, 19% of EBIT on consolidated basis). They own 63% of Sony

Financial (publicly traded) offers insurance products to consumers.

• Home Entertainment and Sound: (13% of revenue, 6% of EBIT). Makes and sells Sony TV’s as well as

some home audio equipment.

• Image Products & Solutions: (8% of revenue, 9% of EBIT). Sell consumer and professional cameras as

well as medical imagine devices.

• Mobile Communications: (8% of revenue, -1% of EBIT). Mostly smartphones and mobile

components.

Main Thesis Points:

• Gaming is moving from a cyclical/hardware driven business to a subscription/software based

business:

o Historically gaming was a somewhat cyclical business (see below). Going into PS2/3/4

launches in ’00, ’06 and ’13 respectively, game revenue plateaued and EBIT declined/turned

negative.

o The current cycle is proving different and that is because the composition of gaming

revenue has changed-the Company will generate +60% of their segment revenue from

software and network services. Sony has ~35MM customers paying them ~$60/year to

access PS Network to play multiplayer games w their friends.

▪ Also, despite the current console cycle being long in the tooth by historical

standards, PS4 unit growth has actually accelerated recently and is tracking above

previous iterations. At this point in previous cycles, the Company had lowered MSRP

~20+% to drive volume while they have yet to lower PS4 retail pricing so they have

another lever they can pull to grow hardware sales.

o ~1/3 of console games are digitally distributed/downloaded (remainder still physical discs).

Digital download of games is a secularly declining activity and eventually digital download

should take the vast majority of game purchases. Economics on download are more

attractive than physical for Sony so this trend will provide a tailwind as the Company earns

50-150% more on downloaded games/content.

▪ Illustrative math on $60 third party game.

• Physical sale: Sony gets ~15% (~$9) as a licensing fee and that’s it. Costs are

fairly low so incremental profit on this probably ~$7.25 (~80%ish margins).

• Digital sale: Sony gets ~30% (~$18) as platform fee. From that SNE will have

CDN/transaction costs and also some fixed costs associated with online

store operations but net result is mid/high teens margin so ~$10.75 in

contribution (so download of games ~50% more profitable than physical).

• Beyond the digital sale, customers who download games also have much

higher attach rates for in-game purchases. According to NPD, ~half of

gamers purchase downloadable content with average spend ~$53. Margins

on this would be similar to game download (~$10 in contribution margin

from DLC on top of the $10.75 from the initial game download)

▪ As the dominant console provider (installed base ~2X MSFT), Sony is also well

positioned to leverage that scale in future console iterations by providing backwards

compatibility with games already purchased

• Music business has finally inflected upwards after 15 years of declines.

o The advent of streaming has offset the headwind from piracy and declining physical music

consumption. Yet the streaming market is still fairly nascent (Sweden was first big streaming

market and they have ~24% penetration of adult population v ~12% in US, ~6% in Germany,

~9% in UK, ~3% in Japan and <1% in China).

▪ Streaming revenue is estimated to grow at low DD CAGR across the industry for next

5 years

o As the 2 nd largest music Company, Sony is a prime beneficiary of this trend. Also, note that

music recording and publishing are both fairly consolidated industries and there are limited

ways to “play” the theme of growing streaming music consumption.

• Semiconductor business is best in class operator with industry leading technology

o ~80% of Semiconductor business is image sensors and ~80% of image sensors are used in

smartphones (remainder into machine imaging, security cameras, etc)

o Sony has been the leader in CMOS image sensing technology for the past 10+ years (they

leveraged their IP and institutional knowledge of imagery from their legacy camera

business). They pioneered development of backside illuminated, stacked sensors which

enable better light sensing in a smaller chipset.

o As a result of this, SNE has ~half the CMOS image sensing market (+2.5x their nearest

competitor) and a lock on high end smartphones (ie 100% of front camera sensors for new

IPhones)

• The mobile business is the most problematic segments and the one for which I believe Third Point is most likely to encounter success. Sony represents <1% of global smartphone volume and the strategic rationale for keeping this business is tenuous, at best. Exiting this business wouldinstantly increase EBIT ~10% and also signal that managementisn't oblivious to shareholders.

▪ Primary research with competitors suggests that there are legitimate design and

production barriers to matching Sony here. Also note that only Sony and Samsung

own their own fabs for image sensors which allows them to have production

advantages.

o This segment will be the recipient of up to half of total capex over the next three years as

the Company looks to be able to compete in A/R and autonomous driving which are

segments that their high end sensors are well suited for, but which historically they have not

sold in to.

▪ It’s also possible the large capex increase announcement is a signaling mechanism

to other potential entrants that Sony is committed to this business and they should

refrain from looking to enter it. I think this argument has some validity since

spending ~$5Bn over 3 years in CMOS as implied by their capex guidance would

build way more capacity than they could plausibly utilize.

• Other businesses are also attractive

o Studio: Margin opportunity to close the gap with peers (who have margins 3-4x higher). This

is also a consolidating industry and as one of six major studios, they benefit from scarcity

value.

o Home Entertainment: Had been a money losing business but after a major cost-cutting

initiative over past 3 years, they have gone from 150Bn JPY loss on ~1.3Tn JPY in revenue to

~30Bn JPY in profit on ~1Tn in revenue (on the TV portion in particular, they cut volume

almost in half and still swung from a loss to profit by focusing on higher end products

instead of just going for scale)

o Image Products and Solutions: Stable growth and double digit EBIT margins make this

business a great source of cash.

o Mobile is not a good business and should be shut down (an action I don’t expect

management to take any time soon).

• Management is high quality (especially for Japan)

• For context, Yoshida-san became CFO in May ’14. In Mar ’15, after posting FY14 OP of 69Bn

(5 year avg of 92Bn), they guided to 3 year target of 500+Bn and 10+% ROE (interestingly,

the plan didn’t even contemplate revenue, all the focus was on margin/returns). This was

viewed as very ambitious, but they ended up doing north of 700Bn.

o One of the first things Yoshida did was shut down underperforming PC segment.

o They have taken costs out of every business line, especially the ones that are facing

the most pronounced headwinds.

▪ Also haven’t been afraid to fire underfperformers. After some strategic

missteps around CMOS modules, they changed top Semiconductor segment

mgmt. to foster accountability.

o In Q118, Yoshida took over as CEO while his former lieutenant Totoki becomes CFO

• Senior mgmt. team total comp 50% salary 50% performance based (and that’s determined

by 40% ROE, 40% EBIT, 10% net income and 10% cash flow)

Risks/mitigants:

• Gaming business slows going into next PS launch.

o The increased importance of software/network services revenue means the pushback of

potential hardware sales won’t have the same negative impact it has had in previous cycles.

Also, a new console launch date isn’t expected for at least 18 months.

o A potential move towards streaming gaming (away from consoles) is worth monitoring

though.

• Semiconductor investments end up being squandered in a competitive industry. Sony’s CMOS

business seems sufficiently differentiated that it will be difficult for competition to encroach on the

high end smartphone market in the near term. But this is definitely a risk worth monitoring and

probably the risk I worry about most.

• Spotify (or some other streaming platform) disintermediates labels

o Unlike video where the transition to streaming platforms like NFLX enabled content

providers to be marginalized, the vast majority of music consumption is of back catalog

(~70+%). Consumers may watch a show/episode once and never again but listen to the

same song dozens of times. This makes it harder to displace labels who already own

valuable catalogs. At the margins these platforms may introduce new content to fragment

listening, but unless/until they can replace the catalogs, the labels should continue to be an

important part of the music business. But since the space/technology is still evolving, this is

worth keeping an eye on but I think early evidence is favorable for labels.

Valuation/scenario analysis:

Bull: 9,500 JPY (78% upside) as stock trades to 11x FY20 EBIT (~17x P/E)

Base: 7485 JPY (40% upside) as stock trades to 8.5x base case FY20 EBIT (~13.3x P/E).

Bear: 4500 JPY (16% downside) as business stagnates and trades at 6x bear case EBIT of 800Bn JPY

Misc interesting charts

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Exiting mobile business, selling studio/music/semiconductors/SFH, increasing shareholder returns.

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			2019	2020
Price:	5,363.00	EPS	504	564
Shares Out. (in M):	1,271	P/E	10.7	9.5
Market Cap (in $M):	60,866	P/FCF	9.6	8.4
Net Debt (in $M):	-5,600	EBIT	0	0
TEV (in $M):	55,266	TEV/EBIT	0	0