Equity Position: Sony Corporation (SNE)
Third Point acquired a significant stake in Sony Corporation ("Sony") earlier this year, and in May, we unveiled a proposal to increase value by partially listing Sony's Entertainment ("Entertainment") business in the U.S. Our investment thesis is that Sony – composed of Electronics, Finance, and Entertainment – is not well understood by investors and is therefore significantly undervalued. Sony's Entertainment division has leading franchises in movie and television production and distribution via Columbia Pictures and Sony Pictures Television, and is one of the top recorded music and publishing companies in the world. Sony also has coveted global cable network assets, including a strong position in the fast-growing Indian market. Electronics is best known for its struggling televisions and VAIO computers but its true value lies in its strong semiconductor and video game console divisions, and its resurgent smartphone business. At the time we made our initial investment, we believed that at our purchase price we were acquiring Entertainment at an attractive value while receiving Electronics nearly for free, giving us a substantial margin of safety.
In addition to its appealing valuation, we believed Sony would benefit from the economic tailwinds created by the First and Second Arrows of Prime Minister Shinzo Abe's economic plan, i.e., a weaker currency and fiscal stimulus would immediately benefit Sony's margins and drive earnings per share. But it was not until we became familiar with Abe's Third Arrow that we became confident Sony was an ideal candidate to benefit from the type of structural reform recommended by his administration. Following recent victories in the Upper House, Premier Abe is now well-positioned to begin enacting his much-anticipated reforms to modernize Japan's economy and corporations. Like the rest of the world, we are eagerly awaiting these changes, which should benefit Japanese companies like Sony.
Finally, the Sony management team installed last April seems to have broken a long string of challenged leadership and has started to make some difficult decisions in the Electronics business by reducing overhead and cutting the number of products offered. Highlyregarded CEO Kazuo Hirai deserves plaudits for the green shoots increasingly visible in Electronics. Sony's Xperia Z smartphone is a hit, and new product momentum has built meaningfully over the last few months while competitors have been losing ground. Sony is introducing an array of new Xperia models, including a large screen "phablet" device, the Xperia Z Ultra, and new Xperia C and SP devices for China Unicom and China Mobile. The launch of Sony's refreshed Xperia line has been a success in Japan, where Sony has overtaken Apple as#1 in smartphone market share, and in Europe, where Sony has risen to #3 in smartphone share. The upcoming launch of the Honami smartphone and other products in China and the U.S. should offer further opportunities for Sony to gain share in smartphones.
Strong momentum in the smartphone business has been accompanied by a perfectly executed introduction of the PlayStation 4 ("PS4") platform. The PS4 is set to gain share versus its competitors – the Wii and Xbox – with better hardware performance, new title breadth, and attractive launch pricing. Sony's consumer-friendly approach also stands to benefit investors with better initial hardware margins than PlayStation 3, increased market share and the growth, revenue and profit contributions ofthe PlayStation Network. The visible improvement in Sony's new products has caused us to rethink our approach to valuing Electronics. The Game and Mobile Products divisions are now poised to join the Devices business as meaningful profit contributors, while the Television business is becoming only a marginal drag.
Putting these encouraging gains into perspective, they are modest in light of the longerterm challenges facing Sony and the Japanese electronics industry. Drastic – rather than incremental – action is required. Third Point's proposal to partially list Entertainment should not only increase overall profitability but also provide capital to accelerate restructuring at Electronics, against a backdrop of increasingly fierce global competition. Turning to another challenge: unlike Electronics, Entertainment remains poorly managed, with a famously bloated corporate structure, generous perk packages, high salaries for underperforming senior executives, and marketing budgets that do not seem to be in line with any sense of return on capital invested. We were surprised that after Entertainment's highly-touted big budget summer film releases – After Earth and White House Down – bombed spectacularly at the box office, CEO Hirai, speaking at the Allen & Co. Sun Valley conference a few weeks ago, brushed off these failures, saying:
"I don't worry about the Entertainment business, it's doing just fine"
We find it perplexing that Mr. Hirai does not worry about a division that has just released 2013's versions of Waterworld and Ishtar back-to-back, instead giving free passes to Sony Pictures Entertainment Co-CEO's Michael Lynton and Amy Pascal, the executives responsible for these debacles. Unfortunately, Mr. Hirai's remark is consistent with accounts we have heard repeatedly from key industry players and others: under Mr. Lynton and Ms. Pascal's leadership, Entertainment's culture is characterized by a complete lack of accountability and poor financial controls. To us, these latest blunders are prima facie evidence of our thesis that Entertainment's U.S.-based business is being ineffectively overseen and needs its own governance structure led by a board whose job it will be to worry about such troubling results.
We are also surprised that Sony's CEO does not worry that Entertainment continues to generate profitability levels far below those of its competitors. Based on publicly-available peer data as of March 31, 2013, Entertainment has trailing twelve month EBITDA margins that are 700 basis points below peers in the Pictures division and 380 basis points below peers in the Music division, despite the fact that each is an industry leader in revenue terms. If Entertainment achieved peer margins, EBITDA could increase nearly $800 million to just over $2.0 billion.
Entertainment's poor relative performance has been a chronic phenomenon extending back to the famously profligate Guber-Peters regime, suggesting the current configuration of these businesses – far from offering synergies to shareholders – is in fact undermining Sony's value potential. Keeping Entertainment underexposed, undervalued and underperforming is not a strategy for success. Sony's investors today would be hardpressed to explain the composition of Entertainment or the key value drivers at work. While management goes to great lengths to explain the strategy for Electronics, it treats Entertainmentlike its "red-headed stepchild", addressing itin only three slides in a twentysix slide analyst day presentation made just a week after Third Point announced its proposal. At a moment when Entertainment was of paramount interest to investors, management barely addressed its significance, business strategy or profitability expectations. Given Entertainment's perpetual underperformance, perhaps Sony's reluctance to discuss it candidly stems from (understandable) embarrassment.
From a creative point of view, we are concerned about Entertainment's 2014 and 2015 slate, which lacks lucrative "tent pole" franchises. Anecdotally, we understand that its development pipeline is bleak, despite overspending on numerous projects. We are also disappointed to see that Sony's television business lacks new material and instead relies on old Merv Griffin Productions workhorses like Jeopardy and Wheel of Fortune. Entertainment has no hit network television shows, only one major syndicated network show– the Dr. Oz Show, and has missed the market for unscripted television.
Meanwhile, our research continues to reveal Entertainment's hidden value. We believe the Pictures unit profitability is anchored in higher margin (and higher multiple) international cable networks and television production, with the film business offering negligible profitability. This makes apples-to-apples comparisons with peer film studios (which lack the benefit of cable networks in those segments) even more unflattering. Nevertheless, we believe the film unit possesses considerable library cash flow value, currently masked by poor new production profitability, as well as significant asset value in its Culver City lot. Beyond the hidden value in the film business, we see meaningful value in the Music division, particularly in VEVO and GraceNote.
Absent a major improvement in transparency and accountability, Entertainment's fortunes are unlikely to change and Sony's full potential will remain unrealized. We are continuing to study Entertainment's businesses, uncovering opportunities for improvement in strategy, culture and operations that bolster our view that it would benefit significantly from our proposal. The suggestion that the status quo of opacity, underperformance and under-management is superior to transparency, management accountability and distinct leadership seems to be based on the misguided notion that the status quo strategy has worked over the last two decades. By contrast, our proposal for a public listing of Entertainment provides investors with a compelling opportunity – offering focused leadership, direct exposure to high-value international cable networks, significant margin improvement head-room, structural catalysts, hidden asset values and capital return. The status quo offers Sony and its shareholders only more of the same unfulfilled potential.
While CEO Hirai focuses on Electronics, Entertainment is in desperate need of proper supervision. We believe Sony's Board, which we understand continues to consider our suggestions, has plenty of reasons to worry about Entertainment and should enact our partial listing proposal quickly. A resurgent Electronics combined with a well-managed, publicly-listed Entertainment business would make for a stronger Sony and offer tremendous value for shareholders.
From Third Point's second quarter 2013 letter.
Equity Position: Sony Corporation (SNE)