By JAMES SPENCE
& MICHAEL FLITTON
SONY– a unique content machine
Sony Group (SONY), which has been invested in the Cerno Pacific portfolio since May this year, has been added to the Global Leaders portfolio. This Journal, in part, reprises the report published in the most recent Investment Report (2Q24) of the Cerno Pacific fund with additional observations supplied by James Spence.
SONY is one of only a handful of businesses from Japan with a broad footprint among consumers globally. It is a global entertainment company with unique positioning across the major verticals of music, video, and games.
We are investing in SONY at this time because we believe i) the group, whilst still broad, has effectively refocused around key growth areas where it possesses estimable assets and good runways to further growth ii) it has, in recent years, demonstrably achieved financial discipline across operating cash flow, margins, ROIC and balance sheet iii) it is the global entertainment business that is best place to weave together gaming, music, film, sports and animation and deploy multiple aspects of AI in and across these product sets iv) we anticipate that the planned divestment of its financial services subsidiary next year with both release capital and help address the conglomerate discount attached to the shares and, finally, v) we believe that the current valuation of 15x forward earnings in undemanding.
Founded in 1946 Akio Morita and Masura Ibuka, SONY, like Philips, which is also held in the portfolio, has been an innovator and an inventor whose global ambitions have always lain beyond their home markets of Japan and the Netherlands respectively. Akio Morita was the totemic Japanese businessmen who visited the US immediately after the war and founded his company in the year after Japan had to pick itself up after its defeat by the Allies. SONY is a version of the colloquial term “sonny” that Mr Morita heard in the streets and factories of 1940s America.
Like Philips, SONY, was for a time a victim of its own successes, it became too spread, to in thrall to its past successes and lost financial discipline. Also, like Philips, it has concentrated its efforts within related areas businesses where it has achieved scale.
Today, post the bulk of the efforts to restructure, it stands as a content-first entertainment business with direct links into the hardware that supports the production of creativity. We anticipate multiple years of pay-off from these restructuring efforts. We capture below the operating profit development over time.
Source: Goldman Sachs
SONY’s business philosophy references the Japanese concept of kando. This refers to the enjoyment of creativity as well as the feelings that come from using tools to create. To fulfil this purpose means both creating and supporting other creators. In turn this leads to a group conceptually split in two between content intellectual property (IP: 58% revenues) and electronic hardware (32% revenues). The final segment is Financial Services but this is now set to be spun out in 2025. SONY sees itself as a creative entertainment company with a solid foundation in technology, a relatively rare type of business.
Despite the breadth of group interests, Sony holds leading positions across a number of verticals. In games, Sony is the dominant player in the console market and the second largest gaming company overall, after Tencent. Its share within console has been rising over the years and looks poised to continue to do so. Microsoft’s recent acquisition of Activision Blizzard may point to an eventual exit of Microsoft (Xbox) from the market to pursue a software focused strategy.
Sony Games Portfolio
Source: Company Reports
SONY is the largest music publisher globally but second overall to Universal Music Group when including music recording. The industry operates as a steady oligopoly controlling c70% of the market. The big labels have negotiated the advent of streaming well given the differentiation for consumers is in the IP, not the platform. The labels capture 40-45% of every dollar spent on streaming.
Selection of Sony Artists
Source: Company Reports
The pictures business is split between box office and TV, where SONY is No 2 and 5 respectively. Its strategic positioning as the only independent studio has been particularly astute in TV. As other studios have burned cash to rush out their own direct to consumer (DTC) platforms, they all demand SONY product to fill their shelves.
Leading Independent Studio
Source: Company Reports
Outside of the entertainment divisions, SONY has strong technical expertise, particularly in CMOS (complementary metal oxide semiconductor) image sensors. SONY is the global leader in high end visual sensors retaining a share over 90% at the top specifications. These sensors are integral to the cameras in smartphones, autonomous driving systems, cameras in creative industries and sports photography. Nikon, for example, source their sensors from SONY for their models as does Leica, with perhaps the exception of its newest model, the M11, which may have a Belgian made sensor. Leica prefers to keep this detail a commercial secret. CMOS sensors contribute c16% of group operating profits. The most obvious source of new competition in this segment will emanate from China.
The group has good growth opportunities across most of its portfolio, bar some mature technologies in the electronic components division. We highlight a few key themes below.
Music is a crown jewel within SONY. As an asset class music exhibits rare characteristics amongst different forms of content. While most people might watch a TV show once, they will listen to the same songs again and again through their lives. Labels are paid a recurring revenue stream as a result. The global market is on a secular growth path with headroom still on the shift to digital. SONY has strong positioning in local content in India and Latam.
Anime is one of the fastest growing segments in entertainment and Sony’s Crunchyroll platform is the leader in Western markets. With 13mn subscribers, it has the largest number of titles available in the US. Goldman Sachs forecast 126% per annum growth in the division to reach 42% of the Pictures division operating profits in 5 years.
While the future may not be the metaverse, there is an argument that a lot more of our experience of entertainment will become digital. IP is the core value proposition in this environment and it is where SONY has very consciously focused. Streaming offers a testing ground for this concept. The barriers to getting music to the wider public have been all but eliminated. The major labels contribute only 5% of daily streaming uploads and 98% of artists are DIY or AI. But not all music is equal, as that 98% collect only 5% of the royalties. This suggests SONY’s IP strategy puts it in a strong position for today’s world of digitalised entertainment. Over and above existing strengths, we are embarking on mixed stream offering whereby mobiles augment live experiences, sports feeds anime, the Hawkeye system generates instant anime of sports players.
The group’s moat can be summarised into IP and strategy, in our view. Content IP takes a long time to build and is a scarce resource. SONY not only has a lot of valuable IP but, unlike any other global entertainment company, its IP sits in leading position in all verticals. This makes revenues more resilient to switches in how consumers spend their time. Entertainment platforms all compete for attention and regardless of whether the expanding time is with TikTok or Netflix, SONY has a route to monetise its highly valuable IP. This may become increasingly relevant if we see a peaking out of leisure time spent on media devices as consumers’ attention becomes saturated and no more available hours can be deployed. The breadth of its IP offers the possibility of following Tencent’s ecosystem approach to cross-fertilising IP across the verticals. This strategy is only just beginning and has a long runway ahead.
The second aspect of the core moat is strategic positioning and vision. While there have been some missteps in recent years in executing on the group’s strategy, including overpaying for some acquisitions, management deserves credit, in our view. Since 2018, the re-orientation of the group around a purpose of kando, has created a strategic coherence that was severely lacking. This is a potentially powerful culture flywheel, which could help create more robust growth.
SONY is a franchise stock with latent potential, solid balance sheet, and low cyclicality. With the restructuring now largely delivered and an undemanding valuation of 15x earnings, there is space for investors to re-appraise the long-term potential of the group, which we believe is exciting.
Aptiv divestment
Aptiv has been sold from the Global Leaders portfolio. The position was initially invested in October 2020 and has been an unsuccessful investment over its period of ownership with a negative total return of 6.5% per annum over the period.
Aptiv is in the business of revolutionising vehicle architecture. It provides the brains (software) and nervous system (hardware) for cars. As vehicles electrify and become smarter, the demands on both aspects are likely rise rapidly. For the nervous system, electric vehicles require specialist high voltage cabling and interconnects. How the hardware is configured must also change. Existing automotive architectures will become increasingly challenged by the demands on networking capabilities as vast amounts of data need to move from the vehicle’s eyes and ears (sensors) to the brain (compute platform). Finally, software must integrate the data and allow real time analysis.
The company’s competitive position remains attractive. It is the market leader in hardware systems integration and top three within the software stack. It is the only company whose offering spans both domains. It is thus well positioned as an enabler of the evolution of personal mobility towards smarter, cleaner transport.
However, the company has struggled to navigate the shifting dynamics of supply chains. The rise of Chinese marques and the retaliatory tariffs from the West have embedded new risks for participants and stymied the momentum of new model planning at established OEMs. While Aptive has been successful in gaining business with local Chinese EV manufacturers, its greater exposure to Western players has weighed heavily on growth. From outgrowing the auto market by 10 percentage points a year ago, Aptiv is now struggling to grow in line with a softening market driven by this unfavourable customer mix.
These headwinds are well documented, and the stock has been comprehensively de-rated. However, we judge the path back to attractive growth for the business to be lengthy. It remains a leader and is eligible for inclusion in the future. For now, capital is better allocated elsewhere.