Why Sony Deserves a Second Look
S&P thinks now's the time to buy. Why? A major restructuring is starting to kick in, and lots of promising new products are coming.
Over the last two years, a weak economy and tougher competition have taken its toll on Sony (SNE ). However, we at Standard & Poor's believe some of the Tokyo-based company's restructuring efforts have begun to take hold. On Thursday, Oct. 23, Sony reported net income of $299 million (down 25% from a year ago) and operating income of $297 million (down 34%) for the quarter ended September. Sales were up slightly to $16.19 billion. We're heartened that Sony reported operating income as opposed to a loss, a crucial hurdle cleared with room to spare.
Another point that deserves investors' attention: Sony's electronics division posted operating income of $325 million, an increase of 36% year-over-year, which is concrete proof of the restructuring measures' effects on earnings.
On the other hand, operating income and sales in Sony's gaming division decreased 91% and 36%, respectively, year-over-year. Operating income fell mainly because of higher research and development expenses, but we're not discouraged. This division has seasonal tendencies, and we believe Sony can hit our sales target of 8 million PlayStation 2 units worldwide in the important holiday season.
COUNTERATTACK. Overall, earnings have improved in the last few months. In late April, Sony surprised the market with a sharp loss of $1.06 billion in its fiscal fourth quarter that ended March. It also reduced its profit forecast for its current fiscal year (ending in March). Sony shares, which trade on the New York Stock Exchange as American depositary receipts (ADRs), skidded to $23.92, a nearly 24% drop over the two days in April after the earnings news.
Since then, Sony has assessed the problems and come up with some solutions. Chairman and CEO Nobuyuki Idei, who has frankly admitted that Sony is in trouble, disclosed four key plans to improve profitability: reducing fixed costs by restructuring, leveraging its games division for future growth, improving the electronics division, and strengthening the balance sheet by reorganizing the corporate structure. On Tuesday, Oct. 28, Sony plans to announce more details of Idei's plans to revive its struggling electronics division (see BW, 11/3/03, "This Time, Sony Better Finish The Job").
We at Standard & Poor's think the business plan on the table should sustain investor confidence. Sony shares recovered from the April lows, rising to nearly $38 in the days before its latest earnings release and then retreated to $34.50 on Oct. 23 after the report.
FIRST THINGS FIRST. In our view, Idei should be praised for his efforts, and we expect earnings to improve when the restructuring is completed. We believe that Sony's target of 10% operating margin (excluding financial business) by March, 2007 is attainable, given that phase two of the restructuring plan is modeled for growth.
Phase one of Sony's restructuring -- which started in April, 1999 and ended in March -- was aimed purely at reducing costs, with special focus on revamping the electronics division. Four goals were accomplished. Production costs were cut, and manufacturing sites were consolidated from 70 to 55, resulting in gross margin improvement of 3 percentage points from fiscal year 1998.
By implementing supply-chain management (SCM), inventory levels decreased by 37% in three years. Sony slashed its workforce by 19%. Lastly, it completed the merger and integration of Aiwa. In phase one, profitability didn't improve much, as fiscal year 2003 operating margin rose by only 70 basis points compared with 2002.
REVENUE STOKERS. In phase two, Sony plans to slash more costs and boost revenue growth. It expects annual fixed-costs savings of $1.55 billion by March, 2006. And it plans to spend $2.73 billion -- with most of that devoted to electronics -- on new products and other restructuring efforts in the next three years.
We believe that Sony's projected savings over three years is rather conservative. It could reach more than $1.82 billion, according to our calculation. One main reason is Sony's successful implementation of SCM and its outsourcing of partial or entire manufacturing processes. As a result, we expect gradual improvement in inventory level.
Along with reduced inventories, Sony has four products that should stoke revenue. In its gaming division, it's pinning its hopes on the PSX, a new version of the PlayStation 2 console with a DVD recorder and hard-disk drive (HDD). PSX's release late this year is coming at a time when Panasonic and Pioneer are racing each other to capture the lucrative DVD recorder market. Japan Electronics & Information Technology Industries Assn. estimates that DVD recorder shipments in 2003 may reach 1.3 million (twice 2002's level) in Japan alone. The suggested retail price for Sony's PSX is $725.
TRIPLE THREAT. In this lucrative market, we believe that Sony could score a coup with PSX. The only differentiating features among competing DVD recorders so far are price and storage capability. PSX separates itself with a bang: Not only is it a DVD recorder with a hard drive but it's also a game console. Sony hasn't disclosed how many units it will ship, but if marketed right during the Christmas season, PSX could be a considerable contender in the DVD recorder market.
And given that its competition can't play video games, PSX could be the market's top seller by summer of 2004. Since the gaming division accounts for half of Sony's operating income, a successful launch of PSX would continue to improve the group's bottom line.
Sony has another bit of exciting news: Its coming portable PlayStation 2, or PSP. A release date hasn't been set yet, but this little gadget's potential is enormous. In addition to playing PlayStation 2 games, PSP can play music and movies. Like PSX, PSP's could be another major earnings producer, in our view.
STILL HAS THE TOUCH. We also believe that Sony's games division -- which made up 12% of total revenue ($62.28 billion) in fiscal 2003 -- will continue to improve its operating margin throughout fiscal 2004. Ever since PlayStation 2 broke even in fiscal 2002 after selling 27 million units worldwide, Sony reduced its production costs, thanks to smaller chips and SCM. Management didn't disclose the actual margins on PlayStation 2, but we estimate that production costs improved by approximately 40% in the past year.
Another key source of Sony's revenue growth is electronics -- which contributed 60% of total revenue in fiscal 2003. We believe that Sony hasn't lost its magic as the premier producer of consumer electronics. It's struggling in commodity products such as cathode-ray tubes (CRT) TVs and portable audio players, but considering its broad portfolio, some key products could override margin squeezes in weak areas. To revamp its electronics division, Sony will pay special attention to products that command high market share and future growth, including camcorders, digital still cameras, notebook PCs, flat-panel displays, and mobile phones.
Take its Handycam camcorder. As of April, Sony sold 6.3 million units, up 10% from a year earlier, which is impressive growth considering sluggish consumer sales worldwide. Ever since the introduction of the PC105 line, Sony has been gaining back market share as the leader in camcorders. In Japan alone, it has shipped 1.8 million units this quarter, up 6% from a year ago. Sony's domestic market share rose to 44% from 41% in March. As of May, it held 48% of the U.S. market and roughly 40% of Europe's.
PICTURE OF GROWTH. We believe that Sony's target of controlling 43% of worldwide camcorder sales by yearend, from 40% now, is feasible given its leading-edge position in charge-coupled devices (CCD) -- the chips used for capturing images -- and its impressive ability to miniaturize the camcorder, a crucial differentiating feature when compared with others.
Moreover, since the barrier to entry in camcorders is high, thanks to the difficulties of CCD technology, Sony doesn't have to worry about Korean and Chinese gadget makers entering the market yet. Thus, Sony could keep the new Handycam out front until the middle of next year.
Or consider digital still camera (DSCs), where Sony is No. 2 worldwide, behind Canon. Sales of its DSCs have been strong recently in Asia (excluding Japan) and Europe. With such explosive growth in Asia (sales jumped 77% year-over-year) and Europe (up 108%), Sony should be able to maintain its double-digit operating margin in DSCs through this Christmas season.
FIRM DEMAND. Flat-panel displays (FPDs) are another important earnings driver. Two types, plasma display panels (PDPs) and liquid-crystal displays (LCDs), broke even for Sony in the quarter ended June, given the higher research and development and marketing costs for new products.
However, we believe that good things are coming. In its latest earnings release, management affirmed that demand was firm. As of March, Sony shipped about 80,000 units each for LCDs and PDPs. It expects PDP sales to grow three- to four-fold and LCD sales to increase seven- to eight-fold, by the end of March. We believe these targets are attainable given Sony's superb technology.
In fiscal 2004, Sony expects the industry to ship 970,000 PDPs worldwide, an increase of 70% from 2003, and believes it can ride this boom. It invested $45 million in NEC's PDP plant in Kumamoto prefecture last year -- a key move since Sony is dependent on other PDP makers.
BETTER BALANCE SHEET. Given these four major product catalysts, we believe Sony's revenue potential for fiscal 2004 (ending in March) is very upbeat. We see revenue rising to $65 billion, up about 4% from fiscal year 2003. In our opinion, the player with leading market share and competitive edge can outlive others in the tough electronics and gaming market. Sony has both.
Finally, Sony's plan to improve its balance sheet also deserves kudos. It's considering spinning off or selling certain assets, like its financial businesses, that aren't efficiently utilized. Thus, return on assets in fiscal 2003 was a dismal 1.4%. We expect fiscal 2004 ROA to increase tremendously once certain dead-weight businesses are spun off.
For fiscal 2004, we at S&P project earnings per share of 85 cents, compared with Sony's forecast of 49 cents, which we see as conservative given the new-product launches and aggressive restructuring efforts. For operating income, we expect $950 million, vs. Sony's projection of $909 million.
UNDERVALUED. We're pleasantly surprised by management's aggressive stance to preserve the Sony brand "premium" -- which could equate to strong earnings. Consequently, our fiscal 2004 projection for return on average equity is 5.5%, compared to 5% a year ago. Considering the improvement in ROAE and huge cost reductions expected within the next three years, we believe the stock should be trading higher.
Our 12-month target price for Sony shares is $45, based on our discounted cash-flow (DCF) model and price-to-book (p-b) analysis. Our DCF model assumes free cash-flow growth of 10% for the next five years, with a weighted average cost of capital of 6%. Our p-b analysis assumes that Sony will continue to trade at forward p-b of 2, compared with a peer group (includes Matsushita, Sharp, Sanyo, and Pioneer) average of 1.3, given its high market share in products such as camcorders and CCDs, and new catalysts such as PSP and PSX.
With Sony's restructuring efforts about to show results, coupled with promising new products, we think investors should buy the shares.
