Why Sony? Why Now?
We had done a deep-dive on Sony back in March 2019. It was a direct follow-up to our view on Virtual Reality. Gaming seemed to be the obvious VR use-case in the near future. But that future has yet to arrive. If it does, Sony is likely to be in the driver’s seat.
At that time, we had found Sony to be fairly valued at around $40 per share. Since then, the stock price appreciated meaningfully. But we didn’t feel so bad because we had allocated our funds to Electronic Arts instead, which also resulted in fantastic returns for us. But were we wrong on Sony? In one particular aspect, yes – the cyclicality of the business.
We had concluded our Detailed Thesis on Sony with this:
“In Investing in VR: Real Numbers, Sony looked amazingly attractive from a valuation standpoint. But if we dig into the business, it’s clear that cash flows are extremely sensitive to modest drops in revenue. And that’s why they have been volatile. It’s a high fixed-cost business. And that explains why the market values it like it does. The high level of cash flow over the last 12 months is probably not representative of what’s to come. If it is, then Sony is a good buy. But for all the reasons discussed above, I’d bet that cash flow in 2019 will be lower. “
Well, we were approximately right, but maybe we were too pessimistic.
For the last decade, Sony’s been taking punches on its legacy businesses – Electronics, Movies and Music. But its crown jewel has been the PlayStation. Sony’s cash flows have moved up and down with PlayStation sales. Every time they launch a new game console, cash flows shoot up. And then they remain high for a while because of new game sales. But eventually they taper off, until a new console is launched. Here’s a chart from one of their presentations – it tracks Operating Profit of the Gaming segment:
We had expected this roller-coaster to continue. But, recently, it hasn’t been so violent. PS4 was the latest iteration, which was launched in 2013. Since then, Sony’s Revenue and Operating Income have been growing and stable, as you can see in the chart above. More recently, Operating Profit has kept improving. Here’s how the story has looked:
Now we’re back to a “console year”. Earlier this year, Management confirmed that Sony will launch the PS5 in 2020. We can expect a sizable bump in cash flows from this point on from console (hardware). And a supplementary bump after that from game sales (software). But the “console year” factor is already priced into the stock, more or less.
While most businesses have taken a hit in this strange year, Gaming has seen a bump. Last week, Sony reported it’s “Covid Quarter” numbers. Numbers were better than expected, especially due to its gaming business, even without a new console release yet. Sony sold a lot more games in the “Covid Quarter” than it did in 2019 Q2.
This chart represents in a nutshell what we’ve noticed about Sony over the last 1.5 years since our last deep-dive:
- Surprising resiliency in their cash flows during the last leg of PS4’s life.
- Better-than-expected cash flows from subscription models.
Sony’s Gaming success is in line with what we’ve seen in the rest of the gaming world. EA is one our holdings, so we keep track of its competitors too. They’ve had a good “Covid Quarter”:
While the impending release of the PS5 may be priced into Sony’s stock, there are two other factors that may not be:
- The continuing cash flow resiliency in non-console years going forward.
- A “dark horse” business segment that has massive upside potential.
It’s about positive optionality. In the next few sections, we’ll dig into both these topics to estimate the value of this optionality, and end with a “buy” or “watch” decision.
The PlayStation has been Sony’s crown jewel since the mid-90s. That’s about the time when Korean companies like Samsung started cutting into Sony’s core electronics business. Thankfully, the PlayStation was a massive hit. Sony could absorb the decline in its core business because of the stupendous success of PlayStation. Even with Microsoft following with the Xbox, PS still dominated.
But Sony’s cash flows have been volatile because most of its business – including gaming – are lumpy. And, as we mentioned before, revenues roughly followed PlayStation (and games) sales. But check out this chart of Revenue vs. Free Cash Flow over the last 10 years:
Something changed in the business. Sony is clearly a more financially productive company now. Let’s check out their revenue mix shift over the last 3 years.
The decrease in Electronics Products and the increase in Content and Semiconductors is clear. Gaming as a percent of total revenue has held steady years after the last console release. Now let’s zoom in specifically into Gaming revenues:
The key point is that cash flow volatility has reduced because Sony’s business has changed in 2 significant ways:
- The business has become more about Entertainment rather than Electronics.
- The Entertainment business is changing towards a subscription-based model – software, content, streaming.
The indisputable fact is that Sony’s business is now higher-margin and more stable. Management has obviously worked toward this and wants to double-down on this strategy. So, they’ve spent time reorganizing the company and its “purpose”.
Sony’s new purpose, as stated by Management in the company’s May 2020 Corporate Strategy Meeting, is this: “Fill the world with emotion, through the power of creativity and technology”. It sounds vague and fluffy, but we think it’s a clear enough north star.
Sony also added a “Management Direction” to its Purpose, which reads: “getting closer to people”. Again, it’s vague and fluffy, but their presentation did go on to put some structure around these slogans.
Management went on to say that “getting closer to people” refers to 3 types of business lines:
- Hardware & Sensors
Sony doesn’t report numbers this way. If we map the Management Direction onto their current, officially reported business lines, it would look like this:
- Gaming Software
- Hardware & Sensors
- Gaming Hardware
- Electronics Products & Solutions (EP&S)
- Imaging & Sensing Solutions (I&SS)
- Network Services
- Financial Services
Direct-to-Consumer is a bit of an oddball. Network Services basically exists for Gaming – for online gameplay. Sony experimented with movie streaming (it has a movie business), but it didn’t find many takers. Sony’s movie library is not nearly as comprehensive or compelling as Disney’s or Netflix’s. But game-streaming is important, because it generates subscription revenue.
Financial Services has recently been absorbed fully into Sony Corp. Previously, Sony had a large stake in the company, but it wasn’t wholly owned. This business doesn’t really fit in with Sony’s core competency. In fact, in our April 2019 thesis, we had left it out of our sustainable revenue estimate. But we’ll include it this time around, with some conservative assumptions.
In Hardware & Sensors, we believe Management now has a definitive plan to make the unit profitable. The EP&S business line has been declining for the past few years. Sony’s TV, Audio and Mobile products are just not the bee’s knees anymore. Demand for their cameras, however, have held up relatively well. Sony’s Management has realized that they need to trim some fat here. While they do that, they’ve found a moneymaker in the Imaging & Sensing business line.
Sony is the global dominator in CMOS Image Sensors. These are semiconductor chips that read images and digitize them instantaneously. Sony mastered the technology because of their reasonably successful camera business. By some accounts, Sony has a cool 50% market share in these types of chips. But these chips are now in demand in things other than cameras. Obviously, smartphones are the new cameras nowadays for most people. While Sony’s smartphone business has been a flop, its CMOS sensor business has been a big hit with more successful smartphone makers.
Management has noticed this, and they’re doubling down on it. In the May 2020 Corporate Strategy meeting, Management laid out their Capital Allocation plans for the next 3 years. Here’s the picture:
So, Sony will be reinvesting almost half the cash it generates in the next 3 years into Image Sensors. This is a huge bet. They didn’t expand much on why they’ll be doing this, but they said that the use-cases for this technology are set to expand in a big way. They cited Autonomous Vehicles and 5G smartphones as near-term use-cases. What’s really interesting is that they recently signed a deal with their Gaming arch-rival Microsoft to build an “AI-ready” CMOS Image Sensor chip. Sony is all-in on this technology that they dominate.
At The Buylyst, we like decisive bets. And this bet is right in our wheelhouse. The way we look at Sony is this: cash flow is more stable than it’s historically been, and just considering that, the stock may still be attractively priced. But what’s really attractive is the way Sony’s Management is positioning the business for the next few years. We see positive optionality here.
Sony’s potential upside rests on 3 pillars:
- The direct-to-consumer streaming of entertainment.
- The proliferation of its CMOS images sensors beyond smartphones.
- The role of VR in Gaming.
No. 1 doesn’t need much explanation. The “Netflix-ization” of Gaming is fairly obvious at this point. Sony has already tasted how the growth of subscription revenues can increase margins and decrease cash flow volatility. They will no doubt do everything they can to keep the momentum going.
But it is an interesting technological question – will game-streaming work as well as movie-streaming? Gaming is obviously a lot more interactive, and even a half-a-second lag can kill the experience. The bottleneck is connection speeds. It’s unclear whether 5G will be the final solution, but it will make life a lot easier for Sony and Microsoft. The solution, for now, may depend upon some sort of optimization of workload between the Cloud and the Console. Needless to say, PS5 (releasing later this year) will be as optimized for game-streaming as possible.
The Netflixi-zation of Gaming is a no-brainer, regardless of whether it involves an expensive console or not. The growth in subscriptions is likely to continue and add a welcome layer. Of stability in Sony’s cash flows. That stability, as we’ve mentioned, is probably still underpriced. Consider this:
Sony’s PS4 sold about 100 million units worldwide. Let’s assume a scenario in which all games are available via download or streaming for a monthly subscription. PlayStation Now – Sony’s game-streaming service – charges about $60 per year. Let’s assume Sony’s PS5 market size is similar to PS4’s – about 100 million. At $60 per year, that’s about $6 billion in revenue – just from software sales. This amount doesn’t even count the $400 or $500 price tag that the PS5 will command. Just to put the $60 in context, a new game like EA’s NBA 2K20 costs about $60. A PlayStation Now subscriber may not be able to access a new game like that immediately as part of the subscription. But for that money, they’re getting access to a prolific library of reasonably new games and some popular old ones. It’s a great deal for customers and for Sony. We expect Sony’s Gaming revenue to be even more resilient than it has been in the last few years. The market be still be underpricing this resiliency.
But the real underpriced asset, we believe, is the Imaging Sensor business. In our view, the CMOS business has huge upside. The biggest use-case now are cameras on smartphones. Sony’s Management also mentioned Autonomous Vehicles as a potentially massive market. Well, to prove that CMOS is an effective technology in AVs, Sony went ahead and built an entire car! Check out the Sony Vision-S. CMOS in cars makes sense. AVs should view the road in front of them with as much clarity as possible. With the tie-up with Microsoft for AI, it can be tailor-made for AVs. Vision-S, in our view, is just a proof-of-product to show off their CMOS and in-cabin Audio/Video capabilities.
The big, under-appreciated use-case, in our view, is in Industry 4.0. Machine vision will be a key factor towards digitizing factories around the world. The most obvious use-case is Defect Detection. But the technology can be used for 3D Modelling or Inventory Management. Now, we’re quite bullish on Industry 4.0 because we see a business case for it. We’ve already invested in FLIR Systems, a company that makes heat and infrared detection machines. Sony could be our second Industry 4.0 name.
The reason we’re bullish on CMOS is because:
- It’s a superior alternative to its main technological rival, CCD.
- Sony has a dominant market share in CMOS chips.
For a good explanation on the advantage of PMOS for most image detection applications, check out this easily understandable blog from CERN. The article mentions an important point: While the path to CMOS supremacy has not been smooth, advances in semiconductor fabrication technology (like Advanced Lithography) and Process Control have put CMOS at a distinct advantage compared to CCD.
We were happy to see that conclusion because The Buylyst is also heavily invested in advanced Lithography (ASML) and Process Control (KLA Corp.). We’ve been “in the know” with advances in semiconductor fabrication, also in no small part due to our early investment in TSMC – the world’s largest semiconductor manufacturer.
The problem is that it’s hard to quantify the potential free cash flow generated by the Image Sensing business. For reference, here’s how the numbers have looked so far.
We could make rudimentary assumptions about IS&S growth; that would be pure guesswork. But as is customary at The Buylyst, we’ll take an alternative approach – Expectations Investing. This is a method we use for high growth companies. In essence, we answer the question: what do we need to believe about revenue growth in order to buy this company’s stock at current prices?
It’s the same with VR/AR – the original reason we started digging into Sony more than a year ago. Not much has happened in VR and Gaming since then. And if something does happen, it’s hard for us to quantify the revenue and cash flow impact. But the subjective case for optimism is that Sony’s expertise in hardware electronics (audio and video) and in content (music, movies and games) should lend itself well to VR headsets. They’ve already created the best VR headset for the PlayStation. This can only get better with time.
Sony’s positive optionality in subscriptions (for games, music and movies), it’s Sensor business, and in VR for gaming are all hard to quantify in dollars and cents because we would need specific price and volume data and projections. We could dig around for days just to make precise by questionable projections. It’s not worth our time or yours. But there’s a simple workaround.
The assumptions that Sony’s content subscription and sensor businesses will grow in the next few years is a subjective one. But the main question is: how much do we pay for that positive optionality?
We’ll do this in layers:
- Back into the valuation of Sony that would present enough margin of safety at current price for us to pounce.
- Estimate how much revenue growth is required to justify buying SNE at the current stock price.
- Ask ourselves: Is this growth believable?
There are few underlying principles in this type of “Expectations Investing”:
- We follow Charlie Munger’s advice of “Invert, always invert”.
- We assume that 20X Free Cash Flow is a fair valuation for a company with a sustainable economic Moat.
Let’s do step 1: back into the valuation of Sony that would make it attractive for us. Now, normally, we like having a margin of safety of more than 30%.
- Sony’s current market capitalization (as of writing this) is about $100 billion.
- Adding a 30% premium to $99 billion would be roughly $130 billion.
So, that’s our rough marker: $130 billion – it’s at least how much our estimate of Sony’s intrinsic value should amount to.
Now, let’s go the other way. Let’s estimate Sony’s Intrinsic value from the bottom-up. We’ll start by slapping on our customary 20X multiple to Sony’s current Free Cash Flow before factoring in any revenue growth.
Sony’s current Free Cash Flow: $8.5 billion
20X Free Cash Flow: $170 billion
Sony’s Current Market Cap: $100 billion
This is great. Without making growth assumptions, Sony already appears to be a safe buy. It seems like we don’t even need to factor in any “what do we need to believe” type of assumptions. We don’t need to really do much beyond this point. What we need to believe is this: that, overall, Sony’s business won’t decline.
There will be business segments that will probably face pressure. In fact, Sony’s Management has already made their own projections about the Fiscal Year 2020, which actually ends in March 2021 (Japanese firms have an odd reporting schedule). Here’s how their projections compare to past revenue trends by segment:
We don’t have any major arguments with this Management forecast. But, at The Buylyst, we never forecast by year. We estimate what we call a “Sustainable” level of revenue, within which we usually factor in some growth assumptions. We don’t focus on year-by-year projections because we consider ebbs and flows in the business as part of the game, which is why we think precise forecasts of revenues and free cash flow in 2021 or 2022 are futile. By estimating Sustainable Revenue, we free ourselves from forced near-termism.
Now, company managements have better information than us. So, for them to forecast one year out is easier, and maybe more credible. Of course, some Managements may play foul and project numbers with too much optimism or pessimism. We’d rather not play that guessing game.
In Sony’s case, we do believe they’re trustworthy because of their track-record. Sony’s Management has generally erred on the side of conservatism. While they’ve forecasted FY 2020 numbers, itis too “short-term” for us. However, we’ll assume that these numbers are conservative, and that they are “sustainable” over the next few years. We won’t attach any growth projections to either 2019 numbers or their 2020 forecast.
If we could reliably estimate specific price and volume data for each of their products, we would make our own sustainable revenue estimates. We don’t have that level of data, but we can make some subjective assumptions:
- Gaming sales and cash flow will likely see a big bump from the PS5 release.
- Gaming, Pictures and Music Content will see stability (due to subscriptions), and possible growth in 2021 (after lockdowns are eased).
- The Sensors business should see growth from 2022 and beyond because of demand from digitized factories (Industry 4.0) and from Autonomous Vehicles.
Now, if we dig into to Management’s forecast Sony’s Management forecasted an 8% growth in the EP&S (Electronics Products & Services) segment for FY 2020. However, if we think long-term, it’s hard for us to imagine this being a growing business. Sony’s cameras are good, but that’s a declining market. Their sound systems are good, but that’s a declining market as well. And it’s hard for us to factor in any growth in their TVs business. Samsung, Vizio and LG have that cornered. So, we won’t be factoring in any growth for EP&S. We won’t factor in a decline either because we believe most of it has already taken place over the last few years.
Sony also factored in a decline in their Sensors business. But remember, their forecast is short-term – less than a year out. For the long-term, they’re investing heavily in the business. We believe, this business will grow. But it’s positive optionality for us. Therefore, we’re not going to make our projections. However, since we “disagree” with Management on EP&S and IS&S, we can say that, overall, we’re in agreement. Put together, we’ll assume those two businesses won’t grow over the next few years.
So, there we have it. On revenue, we’ll go with Management’s FY 2020 projections as a substitute for our “Sustainable Level” numbers. The rest of the assumptions are customary:
- Assume same EBITDA margins as last-12-monhts (LTM).
- Assume similar Capex levels.
- Assume similar tax rate.
Now, there is one big difference between LTM numbers and our sustainable numbers. We’ve assumed that Changes in Working Capital amount to $0, instead of the nearly $1.6 billion cash release Sony realized over the last 12 months. This puts a bit of a dampener on our Sustainable Free Cash Flow estimate. But it doesn’t change the conclusion.
The net result is that our estimate of Sony’s Sustainable Free Cash Flow reduces down to about $6.7 billion. That translates to a valuation of about $135 billion, or $106 per share. That’s still a 30%-ish upside from Sony’s current share price.
In short, we’ve assumed no growth in Sony’s overall business. All we’re really assuming is stability in its current cash flow profile – abetted by the continued role of subscriptions in its revenue stream. This assumption of cash flow stability is the big difference compared to our last deep-dive on the company. It’s good to be in the content business these days. And again, we believe the CMOS Sensors business can be a huge cash generator in a couple of years.
We see a lot of positive optionality in this Global Dominator. What’s great is that we don’t really need to pay up for partaking in the potential upside.
The main thesis buster for Sony is that Game-Streaming (is that already a word?) doesn’t catch on because:
- Connections are too slow even after 5G and Wifi-6.
- Microsoft somehow leverages its Cloud supremacy to build a console that optimizes workloads better between the Cloud and the Console.
The Microsoft “tech-synergy” point is theoretical. We’re not sure what specific synergy can make the new Xbox’s UI and UX better than PS5’s. And, frankly, we’re not too concerned. We think Sony will figure out a way to compete – just like Netflix, which uses Amazon Servers (one of its main competitors) instead of building its own Cloud Infrastructure.
The other thesis buster is Financials – a segment that Sony recently brought into their fold 100%. They only partially owned this business last year. Financials companies are always a bit of a black box. While Sony Financials has been a cash generator in the past few years, there is no guarantee they’ll keep contributing. Bad lending decisions or poor risk calibration can lead to a significant cash bleed.
It’s also possible that we’re wrong about Industry 4.0’s business case. We’re betting on the digitization of factories, for which Sony’s dominance in CMOS Image Sensors can play a critical role. Clearly, based on Sony Management’s Capex priorities, they think the same. But it’s hard to pin down a “payback period” for this investment.
While these thesis-busters are perennial, we think the risks of material cash flow impact are low. They’re more “short-term risks” than thesis-busters.
Overall, Sony is a play on subscription, streaming, gaming, VR and, possibly, Industry 4.0. There is enough margin of safety in the price for us to buy into the story over the next few years.