Why the Emperor (Japan) still has no clothes: Sony Short Thesis

Why the Emperor (Japan) still has no clothes even as the weavers (Thirdpoint and Abe) furiously try to

convince the market the Emperors clothes are real

Authored by: Daniel Russell5/30/2013

Global Deficits, GDP Growth and Labor Force in the past decade

• Global deficits (in red) seem to be in a permanent “new normal” trend, global GDP growth is in a severe downtrend

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US GDP + Germany GDP + Japan GDP + France GDP Dollarized YOY % ChangeWorld Deficit as % of GDPUS YOY GDP GrowthChina YOY GDP Growth (not dollarized)

5 Largest Economies Dollarized GDP Growth YOY versus World Deficits as a percent of GDP

5 Largest Economies Employment to Population Ratio (ex China)

Over the past decade global deficits have increased global growth proxied by

the 5 largest economies has downshifted

Eventually the demographics will compound on the already bad decisions

being made to create a debt crisis.

• The population to employment ratio in the US (blue) peaked after the dot com bubble burst,

• Japan’s Population to Employment Ratio peaked in the early 90’s

• France looks like it peaked in the 80’s.

• A lower number of employed funding a larger number of unemployed workers creates social, political, and financial consequences

Japan – The Emperor

Japan – A Developed Country with huge debt load…

• The nominal debt dipped during 2008 because the debt was refinanced at a lower rate. Since 2008, the debt has again accumulated at a rather quick pace.

• Nominal Gross Debt shown in blue and estimated Gross Debt shown in Red.

….and whose answer to low GDP growth seems to be just expand the balance sheet

of the BOJ

• Nominal GDP in ¥ (shown in blue), the only answer for a massive drop in GDP seems to be the BOJ’s Balance Sheet (shown in red)

• Notice the exponential nature of the increase in the BOJ’s balance sheet since Abe has entered office

Possible ways to clothe the Emperor

Traditionally there are three ways to solve debt problems:

I. GrowII. InflateIII. Default

Which one will Japan choose?

58%

20%

20%2%

Japan GDP by Expenditure FY 2012

Consumption Investment Government X-M

Growing consumption?Growing Investment?

• New orders are picking up of a much lower base post 2008.• The flow of fixed capital being utilized is in a massive downtrend, less capital means the expectation s for using capital for creating

new businesses is very low

• Industrial production has dropped off a cliff• Inventories look to be in a downward spiral (reduction in inventory due to lack of demand)

Possible ways to clothe the Emperor

• Current account should go full negative 3Q – 4Q 2013• The massive move in the JPY could help trade bounce back but global growth doesn’t seem to be picking up

Without increases in investment or consumption, growth seems out of reach, to further compound the dilemma, Japan will hit a full negative current account for the first time in years

Structural Changes in Energy will compound the weakness in the Balance of Payments

Suspended/Shut-down/Cold Shutdown

Under Construction Operating

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02468101214161820

Japan Abandon’s Nuclear post 2011

Energy

Number of Plants December 2012 Poll - ASAHI SHIMBUN

Trade is deteriorating and with no natural resources and no nuclear production, Japan must import almost all of it’s energy. To add fuel to the fire, Japan’s politics have shifted post Fukushima to not favor any nuclear power.

Adding debt to the most indebted nation on earth

• The debt non-linearity is shown by the exponential growth in the interest cost even though the cost of borrowing is at an all time low

• Adding more debt will just add more interest expense to the budget

• When you spend 25% of your budget on your debt, adding debt is not really a solution

Current Accounts and Fiscal Deficits are highly correlated. A current account deficit will mean a increase in the fiscal deficit for

Japan.

Japan can’t grow, and Abe wants to inflate, but when you try and inflate with your debt spring-loaded like Japans you have a debt

crisis.

I believe Japan will try and inflate and then default on its sovereign debt in the next 5

years.

So how would you trade on Japan’s coming fiscal crises?

Characteristics I want in a company to play the eroding of Japan’s Fiscal situation:

• Highly levered to debt –• Credit risk includes the Sovereign risk of the home

country• High rate of production in Japan

• Inputs with a higher yen will be more expensive• Poor positioning within the industry • Poor product mix• Revenue mostly from Japan

• Higher inflation should mean lower purchasing power and combined with poor market position should spell real trouble with the firm

• High pension costs

•

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Sony Pension Underfunded Status

Underfunded

Funded as % of PBO

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Scale inverted

• Product mix – Bubble size is the amount of segment Revenue• Largest business lines have low or negative margins, major warning sign• Revenue growth is low for the most profitable Segments• Goal is to be in the top Right (Large operating margin large revenue growth)

• 30% underfunded pension as a percent of PBO• As of 2012, the asset class breakdown is 23% Equity and 45% Fixed income,

of which ~65% is invested within Japan

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Sony Segment MixImaging Products & Solutions

Game

Mobile Products & Communications

Home Entertainment & Sound

Devices

Pictures

Music

Financial ServicesOperating Margin

Revenue CAGR

FY09 - FY12

Japan; 32.41%

United States; 18.66%

Europe ; 19.53%

China; 7.62%

Asia-Pa-cific; 9.80%

Other Areas; 11.96%

Net Sales by Region as % of Total Sales

Sony’s Fundamental’s

• Sony has decreased it’s CCC by increasing it’s days payables• Sony was downgraded to Baa3(negative outlook) in 4Q2012

• Because of this downgrade I don’t believe the CCC can improve by dragging out payables much longer

• Sony’s Long Term Debt/Equity Ratio continues to rise, making the firm more levered

• Leverage can hurt the firm if conditions externally and internally continue to weaken

• Managements use of assets has become more and more inefficient as shown by the Asset Turnover Ratio

• Both of these metrics show that management hasn’t effectively controlled the Balance Sheet

2008

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2012

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Long Term Debt and Asset Efficency

Financial Leverage

Asset Turnover

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2011

2012

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Sony Cash Conversion Cycle

Days Paybles

Days Inventory

Days Receivables

CCC

2008

2009

2010

2011

2012

0.00%1.00%2.00%3.00%4.00%5.00%6.00%7.00%8.00%9.00%

67.00%

68.00%

69.00%

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71.00%

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74.00%

Age and Depreciation of Assets

CAPEX as % Rev

R&D Exp as % of Rev

Depreciation/Amoriza-tion over Capex as % of Rev

Avg Age in %

• Sony allowed its assets to age without any plan to replace aging assets

• For the past 5 years, Depreciation/Amortization has outpaced CAPEX spending, this mathematically cannot continue into perpetuity unless all assets are expensed

The Weavers (Thirdpoint) proposal and why Sony shouldn’t agree

*Third Point’s Steps taken directly from the letter to Sony posted on businessinsider.com

•Step 1: Take Public a 15--20% Stake in Sony Entertainment, Allowing It to Thrive Independently with the Support of the Sony Parent Company While Increasing Capital to Revitalize Sony Electronics 

•Sony entertainment is an industry leader in the entertainment industry

•Sony Electronics doesn’t just need more capital it needs better products•Sony laptops batteries exploded in 2006

•Sony didn’t introduce a tablet until 2011

•Sony needs to trim its failing Electronics segment to only include the most profitable and best units

Point Counter-Point

20002002

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20082010

2012

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Sony Entertainment Box Office and Music Sales and Market Share

Gross Film Revenue MM USD

Gross Music Revenue MM USD

Film Market Share

Music Market Share

•Step 2: Focus on Industry-Leading Businesses to Bring Growth to Sony Electronics

•Sony should center on narrowing their focus and eliminating any segments that are outside of their circle of competence

•Sony Entertainment and Gaming can be leveraged to the existing product portfolio to add value and cash flow to fund the trim electronics division•Why can’t you buy movies and music on your Sony phone?

•80% of smartphone users shop on their phone (1)

Point Counter-Point

1. http://techcrunch.com/2012/09/19/comscore-4-out-of-5-smartphone-owners-use-device-to-shop-amazon-most-popular-mobile-retailer/*Music data only goes back to 2008: *Music Market Share source – Nielsen Company & Billboard’s Yearly Music Industry Report*Film Market Share source – BoxofficeMojo.com

Chairman – Former CEO - Sir Howard Stringer•Former Head of Sony Entertainment Division

Current President & CEO - Kazuo Hirai•Started at Sony Music Entertainment (Japan)

Member of Sony Board – Roland A. Hernandez – Ex-CEO of Telemundo

Does Sony’s Board Composition make Thirdpoint’s proposal less likely to be adopted?

Sir Howard Stringer - Chairman

Ryoji Chubachi – Vice

Chairman

Masaru Kato

Takaaki Nimura

Tsun-Yan Hsieh

Kanemitsu Anraku

Kazuo Hirai

Yorihiko Kojima

Yukako Uchinaga

Ryuji Yasuda

Peter Bonfield

Roland A. Hernandez

Osamu Nagayama

Mitsuaki Yahagi

Current Sony Board

• Chairman, President & CEO both started in the Sony Entertainment Division

• Another member of the board ran a large entertainment division

• Does Thirdpoint think the board will admit it has mismanaged the entertainment division and agree to a spinoff?

• Does Thirdpoint also think the insiders that started in that division won’t think they know what is best for Sony Entertainment?

• I don’t think the spinoff is likely to happen

Key Board Insiders

• For Thirdpoint’s proposal to be successful the board must be convinced that it is in Sony’s best interest to spinoff the Entertainment division.

Valuation Output

FCFF 2013 ¥3,461,033.4

FCFE 2013 ¥1,452,062.4

FCFE/Sh ¥1,356.1

Share Price in $ $13.96

Valuation and Sensitivity

4.50% 3.50% 2.50% 1.50% 0.50%

Share Price in $

34.289456680225

22.2366898333908

14.5547166256032

9.23093513542185

5.32396885367005

$2.5

$12.5

$22.5

$32.5

Growth Sensitity on SNE Share Price

Share Price in $

Key Assumptions

Growth 2.5%

WACC 8.24%

Cost of Equity Adjusted with

CDS Premiums11.77%

• One stage FCFE model was used because Sony is a mature company with estimated guidance issued by the company

• My target price based on intrinsic value is $14.55 which is a 30% drop from its current price

• The twelve month target price also fits with the technical levels on the chart

1 2 3 4 5 6

Japan CDS

0.0078 0.0178 0.0278 0.0378 0.0478 0.0578

WACC

0.0823439598596098

0.0937677188812858

0.105191477902962

0.116615236924638

0.128038995946314

0.13946275496799

Share Price

13.9697681066838

8.44470738279202

4.49380301417392

1.5281971819097

0 0

1.00%

7.00%

13.00%

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Japan CDS Sensitivity Share Price

Japan CDS

WACC

Share Price

Why I could be wrong

Thirdpoint’s Reputation

Thirdpoint has an excellent track record

being an activist

Thirdpoint has brought a deal that is relatively

small and not very intrusive to the board

Sony is ready to turnaround its business

Shareholders might be ready for change

Institutional ownership is at a 5 year low, so

entrenched shareholders shouldn’t

be a problem

Overall Environment

With Abe doing “whatever it takes”

Sony could find renewed vigor for

change

Kazuo Hirai has placed an emphasis

on the turnaround and not status quo

• Sony has lagged the major indices over the past two years• The JPY weakening hasn’t helped Sony’s stock much

Sony – Details of the Trade

Long Term Target 14.06

Stop at 22.63

Entry after the gap is filled at

19.01

USDJPY Paired with SNE

Why pair Short Sony with USDJPY Long?• Sony could possibly benefit in

the very short term from a weaker yen if they decide to take off their hedges

• When CA goes negative the Yen will have to weaken or foreign investors will have to invest in Japan

• With the lowest yields in the world I don’t see foreign investors jumping to Japan

Levels• A small contract, long at the

current spot (101.000) with a stop at 98.475 and a target of 105.

• The 61.8 Fibonacci level was previously rejected this should be set as the stop level

Structure of Trade:• Short SNE at 19.01• Buy the spot USDJPY (utilizing

the standard leverage for spot currency contracts)

Long Term Target 105

Stop at the 61.8 Fib Level

(98.475)

Entry at the

confluence of 101.00

Scenario Analysis and Risk’s of Trade

$14.06 $15.56 $17.06 $19.01 $19.63 $21.13

98.475 11.36% 11.36% -2.92% -12.20% -15.16% -22.29%

99.475 16.26% 16.26% 1.98% -7.30% -10.25% -17.39%

100.475 21.07% 21.07% 6.79% -2.49% -5.44% -12.58%

101.475 25.79% 25.79% 11.51% 2.23% -0.72% -7.86%

102.475 30.41% 30.41% 16.13% 6.85% 3.90% -3.24%

103.475 34.94% 34.94% 20.67% 11.38% 8.43% 1.29%

105 41.69% 41.69% 27.41% 18.13% 15.18% 8.04%

Sony Stock Price

USD/JPYSpot

Scenario Analysis – Short SNE & Long USD/JPY

Risks to this trade:• Events in Europe cause a flight to safety in

USD/JPY• Sony takes off some currency hedges and

reports an upside EPS surprise due to FX Translation

• BOJ gets skittish when inflation occurs and talks down further easing

• Sony starts an early marketing campaign for the PS3 (expected Holiday of 2013) and the market bids up SNE

• Macro concerns ease as global central banks continue to ease Monetary Policy

• Sony’s 5 step turnaround plan succeeds • Namely, TV turnaround and

Realignment of business portfolio and optimizing resources

• Sony decides to spinoff Sony Entertainment, this would result in a price spike

Tailwinds to this trade:• Asian trade relations worsen• Global Macro data worsens • BOJ doubles down on asset purchases and

further weakening of the yen in an effort to boost the Current Account

• Japan 2QGDP misses expectations and causes the BOJ and Abe to institute further inflation expectations

• Sony hedges incorrectly causing the headline EPS to miss by more than expected due to FX translation

Risk Reward Ratios

USDJPY 1.58

SNE 1.37

Total Trade 1.87

**Gross of trading costs