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Deep-dive 2022-17: Sony
Japanese entertainment company with a PlayStation 5 kicker. Estimated reading time: 7 minutes.
Disclaimer: Asian Century Stocks uses information sources believed to be reliable, but their accuracy cannot be guaranteed. The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers, including whether any investment is suitable for your specific needs. From time to time, I may have positions in the securities covered in the articles on this website. Full disclosure: I hold a position in Sony Corporation at the time of publishing this article. Note that this is disclosure and not a recommendation to buy or sell.
Sony’s rise is the stuff of legends. In a war-torn Japan in 1946, a senior engineer called Masaru Ibuka and a brash young entrepreneur named Akio Morita started an electronics company called “Tokyo Telecommunications Engineering Corporation”. Their first product - a wooden rice cooker - was a failure.
The first breakthrough came with the Type G tap recorder - the first of its kind in Japan. It then moved on to transistor radios. In the late 1950s, the company changed its name to “Sony” because it sounded American, and Morita wanted the company’s products to be more marketable overseas. They then sold transistor radios in the United States.
Under the leadership of Morita in the late 1970s, Sony developed the Sony Walkman - a portable cassette player that ended up selling hundreds of millions of units. He then moved on to invent the Sony Discman, the Sony Handycam and later the Sony PlayStation.
Sony was so successful at the time that even Steve Jobs modelled his entire new company Apple Computer on Sony. Akio Morita was the hero that he tried to emulate:
“Steve’s point of reference was Sony at the time. He really wanted to be Sony. He didn’t want to be IBM. He didn’t want to be Microsoft. He wanted to be Sony” (John Sculley, 2010)
But in the early 1990s, Morita quit his job at Sony. And gradually, the old guard stepped down. Sony was left in a vacuum. It ceased to be an innovation powerhouse, and its product development became more incremental.
The years under CEO Howard Stringer between 2005 and 2012 were challenging. Sony’s TVs lost out to cheaper Samsungs and LGs, and the over-powered and over-priced PlayStation 3 failed to connect with consumers.
Sony’s latest phase of development began in 2012. New CEO Kazuo Hirai sold loss-making divisions such as the PC business, the camera module and the battery manufacturing segments. He moved Sony away from unprofitable mass-market products into premium ones. Kazuo Hirai wanted Sony’s businesses to focus on their unique competitive advantages. Or, if they didn’t have any competitive advantages - cut them off.
The current CEO, Kenichiro Yoshida, has continued the Kazuo Hirai legacy. He was the CFO under Kazuo Hirai and is a “numbers guy”. Since Yoshida became CEO in 2019, he has undertaken additional reforms. For example, he introduced new key performance indicators (KPIs) for staff remuneration. In these KPIs, operating cash now has a significant weight. And for senior management, long-term stock price performance also plays a part in compensation - as it should.
The jewel in Sony’s business is undoubtedly the PlayStation segment. It’s hard to underestimate how much Sony has dominated console gaming over the past 30 years. For example, three of the four best-selling consoles of all time are PlayStation consoles. And this leadership extends to the current generation of consoles. While the Xbox Series X/S has sold an almost equal number of consoles as the PlayStation 5, consumer purchase intent is stronger for the PlayStation 5. And the component shortages that have held back production of the PlayStation 5 finally seem to be easing.
The music business has grown nicely over the past decade as streaming services has kept bidding up the value of Sony’s library of recorded music and copyrights. Sony is one of three dominating companies in the music market, along with Warner Music and Universal Music. They are all growing together with the market with high-single-digit growth.
Sony’s film and TV production business began with the acquisition of Hollywood studio Columbia Pictures in 1988. But by the 2010s, the company had stagnated. In 2017, Sony hired long-time film executive Anthony Vinciquerra to turn it around. He has done an excellent job. For example, in 2021, Sony Pictures had a record year despite an incredibly challenging global box office. And now that streaming services are clamouring for content, Sony can sell its library of movies and TV shows to the highest bidder.
Sony also has a competitive advantage in smartphone image sensors. These semiconductor chips are used to capture images that your smartphone takes through the use of photodiodes and image processing chips. Sony is now the sole image sensor supplier to Apple’s iPhones, which are known to have some of the best cameras in the smartphone industry. Sony’s image sensor business was hit by US sanctions on Huawei in 2020, but with new customers and its recent capacity expansion, it’s well-placed to grow in the coming years.
The two segments that are perhaps the least interesting at this point are the consumer and financial segments.
Sony produces consumer electronics such as cameras, TVs and smartphones. But so do Samsung, Canon, Nikon and several Chinese competitors. Sony’s product offering is not differentiated, and these markets are not growing.
In the financial segment, Sony started the first-ever online-only bank. And it also owns a life insurance business. They seem well-run, but a target ROE of 8% is not exciting.
Taken together, you get the picture of a company growing nicely across video games, music, movies and image sensors. Growth may even accelerate with the launch of the newest PlayStation 5 video game console. While it’s already been out on the market for over 1.5 years, supply constraints have constrained Sony’s ability to meet customer demand. Now that component shortages are easing, management believes that PlayStation 5 console sales could almost double in the coming year. And given that each console buyer typically buys 8-10 games each, we should see a significant increase in high-margin digital game software sales.
Plugging in reasonable assumptions about PlayStation 5 sell-through rates and steady growth in most other segments, you will get to a P/E ratio in the low double-digits a few years out. Peer group multiples are higher, almost across the board.
The longer-term question about Sony is its capacity for innovation. Sony was innovative during its Sony Walkman, Discman and PlayStation years. Today, many believe that Sony is resting on its laurels.
CEO Yoshida wants Sony to return to its roots. New R&D projects such as an electric vehicle in a partnership with Honda, Sony’s PlayStation VR 2 virtual reality goggles, and robotic leg prostheses are being prioritised.
I’m sceptical. Sony did well when the consumer electronics game was about creating the highest-quality hardware at a reasonable price. But Sony’s software cannot match the quality of software from, say, Apple or Google.
Sony is a different type of company. It’s a collection of high-quality assets with dominating market positions across video games, music, pictures and image sensors.
And Sony’s capable management team are now in the process of monetising these assets. They may well end up rewarding shareholders more than Akio Morita, and his Sony contemporaries ever did.
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