Sony 6758
April 17, 2019 - 1:59pm EST by
bdad
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 $M): -5,600 EBIT 0 0
TEV ($): 55,266 TEV/EBIT 0 0

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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
 
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