Back in September, Sony (SNE) conducted a full-scale review of its business and came to the conclusion that a spin-off of its assets is not going to happen in the foreseeable future. The idea of splitting up was introduced last Summer by a notorious hedge fund manager Dan Loeb of Third Point, who has been slowly building up his 1.5 million share stake in the company. In its 100+ page presentation Third Point argues that by splitting up Sony into two separate entities, the company will be able to unlock value and greatly reward all of its shareholders. We believe that Third Point has a valid point here. By splitting up, Sony will finally be able to fully focus on its core businesses from the media and entertainment fields and no longer worry about the cyclicality of the semiconductor industry.
Currently, the complexity of the Sony business prevents the company’s stock from fully appreciating in value. In addition, Sony continues to be undervalued to its peers. We decided to open a long position in the hope that the management of the company will reevaluate its stance on the idea of splitting up. However, if the split will not occur in the foreseeable future, we won’t be worried too much about our position as there’s enough margin of safety for us to justify holding the position in the first place. It’s also unlikely that the stock will dramatically depreciate in value sometimes soon.
Why Spin-Off Makes Sense
Back in 2013, Dan Loeb made a mistake. He built his stake in Sony and then forced the company to sell its media and entertainment assets and concentrate on the semiconductors business. After Sony rejected such a proposal, Third Point sold its stake in the company a year later at a hefty profit of around 20%. We believe that Sony made a right move back then by rejecting such an idea, as since 2014 its stock was appreciating at an annual rate of around 20% mostly thanks to an impressive growth of its gaming and entertainment assets. As of last quarter, gaming, music and picture businesses combined accounted for 44% of the overall revenues, while the semiconductor business (I&SS division) accounted for 12% of the overall revenues.
However, today the situation is completely different. Not only because Third Point flipped on its initial idea and now wants the company to focus on its entertainment business, but also due to the fact that spinning off actually makes sense this time. There’s no arguing that Sony is a stable cash-flow generative business that has been rewarding its shareholders for the last five years. But maintaining the status quo could have dire consequences, especially when the competitive landscape changes at a rapid pace.
To understand why spin-off makes sense, let’s take a deeper look at Sony’s role in the gaming and semiconductors industries. In gaming, the company continues to enjoy its role as the leader of the industry, as its PlayStation 4 console is the best-selling console of the current generation. Since its launch in 2013, Sony was able to sell more than 106 million units of the console, while its closest competitors Nintendo (NTDOY) and Microsoft (MSFT) were able to sell only 49 million units of Switch and 45 million of Xbox One, respectively. Thanks to it, the company’s gaming business became one of the major drivers for growth for the whole company and had a CAGR of 12% in the last five years.
Source: Company filings and Third Point estimates
However, gaming is changing. While Sony was able to enjoy its leadership position in the market in the last five years, the competitive landscape becomes more ruthless. Going forward, the company will need to keep its focus on all the changes that are happening at a rapid pace inside the industry in order to continue being the dominant force in the gaming industry.
Currently, we see cloud gaming as a major threat to Sony’s business model that could shake the company’s leadership role in gaming. In the past, cloud gaming was not possible due to latency issues. However, with the release of Microsoft xCloud and Nvidia (NVDA) GeForce Now, cloud gaming slowly but surely becomes a reality and a number of companies, not only from the gaming industry, are already trying to enter the space.
While Sony was the pioneer of cloud gaming, as it had streaming companies like Gaikai and OnLive under its roof, the company failed to completely implement the new technology and was forced to shut down those services. Currently, with PlayStation Now, Sony is able to have a presence in the cloud gaming field, but the service itself is not as great as a lot of gamers want it to be and the company doesn’t have any real competitive advantages in streaming at the moment. At the same time, Sony is unable to figure out the pricing strategy for its upcoming console PlayStation 5. The inability to successfully launch the console later this year could lead to fatal consequences in the long-term, which will make it harder for the company to dominate gaming as it did before.
Nevertheless, Sony continues to be undervalued to its gaming peers. The company’s P/E ratio of 14.69x is below the industry’s median of 32.57x, but its margins are also lower in comparison to its rivals. The problem is that the complexity of its business makes it harder for the company to fully unlock the value of its major entertainment assets. That’s why we believe that spinning off is the best thing to do at this stage, as the management will be able to focus on gaming and other related fields, while at the same time the stock will become more attractive to investors.
Source: Capital IQ
When it comes to the semiconductors business, which is part of Sony’s Imaging & Sensing Solutions (I&SS) division, the situation is different in comparison to the entertainment business. Unlike the gaming market, Sony is not under a major threat from other companies and the industry itself is not going to change rapidly in the foreseeable future.
Currently, Sony is highly exposed to the smartphone market, which accounts for more than 85% of the overall semiconductors revenues. As a leader of an image sensor field with more than 70% of the market share, Sony continues to aggressively diversify and establish a stronger presence in the automotive field, which currently grows at a 20% to 30% annual rate. However, despite having a dominant position in the image sensors field, Sony is also deeply undervalued to its semiconductors competitors.
With the P/E ratio of 14.69x, Sony is undervalued to its peers that have a median P/E ratio of 25.28x. At the same time, Sony’s operating and net margins are deeply below the industry’s average and median simply due to the fact that its electronics business recently has not been performing as expected and as a result, the whole company suffers from it. That’s why we believe that by spinning off, the new semiconductors Sony will not encounter such a problem and will be able to dramatically improve its margins thanks to its leadership role in the image sensors business.
Source: Capital IQ
Considering all of this, we believe that maintaining the status quo is something that Sony cannot afford if it plans to grow at a higher rate than it is today. While it currently trades at a discount to its peers from various industries, the complexity of its business is something that prevents the stock from trading higher. Since the semiconductors business accounts for 12% of the overall revenues, spinning off this business will result in the massive creation of shareholder value. It will also attract a large group of institutional semiconductors investors, who are currently not interested in acquiring Sony’s shares due to the company’s exposure to other industries.
At the same time, the spin-off will help Sony to focus on its entertainment assets, which account for nearly the majority of the overall revenues. In addition, the management will be able to better prepare the company for the upcoming disruption of the gaming industry.
We do believe that spinning off is the best thing that the company can do at this stage, as it currently holds a leadership position in a number of attractive industries. And we also hope that the management will reevaluate its thinking and decides to conduct another full-scale review of its business in order to determine once again whether to split itself into two separate entities or not.
However, if the management decides not to do anything and maintain the status quo, then we’ll continue to hold our long position for a few months, as there’s enough margin of safety for us to justify the current long position in the first place. We’ll probably sell our shares after the release of PlayStation 5, which in our opinion will definitely drive the company’s stock and will yield us some great returns by the end of the current year.
Disclosure: I am/we are long SNE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.