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


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My thesis from earlier this year on Japan's Macroeconomic output and how to best profit from the poor economic decisions of Japan.

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

  1. 1. 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 Russell 5/30/2013
  2. 2. Global Deficits, GDP Growth and Labor Force in the past decade 5 Largest Economies Dollarized GDP Growth YOY versus World Deficits as a percent of GDP Over the past decade global deficits have increased global growth proxied by the 5 largest economies has downshifted • - Global deficits (in red) seem to be in a permanent “new normal” trend, global GDP growth is in a severe downtrend • 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. US GDP + Germany GDP + Japan GDP + France GDP Dollarized YOY % Change World Deficit as % of GDP US YOY GDP Growth China YOY GDP Growth (not dollarized) 5 Largest Economies Employment to Population Ratio (ex China) • • • A lower number of employed funding a larger number of unemployed workers creates social, political, and financial consequences Eventually the demographics will compound on the already bad decisions being made to create a debt crisis.
  3. 3. 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
  4. 4. Possible ways to clothe the Emperor Traditionally there are three ways to solve debt problems: I. Grow II. Inflate III. Default Which one will Japan choose? Growing consumption? • • Japan GDP by Expenditure FY 2012 Consumption Investment Government X-M -2% 20% 20% 58% 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
  5. 5. 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 • • Industrial production has dropped off a cliff Inventories look to be in a downward spiral (reduction in inventory due to lack of demand)
  6. 6. Structural Changes in Energy will compound the weakness in the Balance of Payments 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. Japan Abandon’s Nuclear post 2011 40,000 20 18 16 14 12 10 8 6 4 2 0 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Energy Number of Plants December 2012 Poll - ASAHI SHIMBUN
  7. 7. Adding debt to the most indebted nation on earth Current Accounts and Fiscal Deficits are highly correlated. A current account deficit will mean a increase in the fiscal deficit for Japan. • • • 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 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.
  8. 8. 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 Net Sales by Region as % of Total Sales Other Areas, 11.96 % AsiaPacific, 9.80% China, 7.62% Sony Pension Underfunded Status Sony Segment Mix -¥400,000 -45.0% 30% -¥350,000 -40.0% 25% -¥300,000 -35.0% -¥250,000 -30.0% -25.0% -¥200,000 -20.0% -¥150,000 -15.0% -¥100,000 -10.0% -¥50,000 -5.0% ¥0 Funded amount as % of PBO Underfunded amount (Millions of ¥) United States, 18.66 % Europe , 19.53% • 20% Underfunded Funded as % of PBO Revenue CAGR FY09 - FY12 -20% Imaging Products & Solutions Game Mobile Products & Communications Home Entertainment & Sound Devices 15% 10% 5% 0% -10% -5% 0% 10% 20% Pictures -10% -15% -20% Operating Margin 0.0% Scale inverted • • Japan, 32.41 % 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 • • • • Music Financial Services 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)
  9. 9. Sony’s Fundamental’s Sony Cash Conversion Cycle Long Term Debt and Asset Efficency 100.00 80.00 60.00 6.00 Days Paybles 0.00 • • 5.00 4.00 Days Inventory 40.00 20.00 70% 60% 50% 40% 30% 20% 10% 0% 3.00 Days Receivables 2.00 CCC 0.00 1.00 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 • • • Financial Leverage Asset Turnover 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 Age and Depreciation of Assets 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 74.00% CAPEX as % Rev 73.00% 72.00% 71.00% • R&D Exp as % of Rev 70.00% 69.00% 68.00% 67.00% Depreciation/Amoriz ation 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
  10. 10. The Weavers (Thirdpoint) proposal and why Sony shouldn’t agree Point Counter-Point Point Counter-Point Sony Entertainment Box Office and Music Sales and Market Share 35% 32% 30% 25% 20% 15% 10% 5% 0% 1. *Music data only goes back to 2008: *Music Market Share source – Nielsen Company & Billboard’s Yearly Music Industry Report *Film Market Share source – *Third Point’s Steps taken directly from the letter to Sony posted on 17% $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 Gross Film Revenue MM USD Gross Music Revenue MM USD Film Market Share Music Market Share
  11. 11. Does Sony’s Board Composition make Thirdpoint’s proposal less likely to be adopted? Current Sony Board • 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. Key Board Insiders Masaru Kato Chairman – Former CEO - Sir Howard Stringer • Former Head of Sony Entertainment Division Current President & CEO - Kazuo Hirai • Started at Sony Music Entertainment (Japan) Takaaki Nimura Tsun-Yan Hsieh Member of Sony Board – Roland A. Hernandez – Ex-CEO of Telemundo Kanemitsu Anraku Kazuo Hirai Sir Howard Stringer Chairman • • Yorihiko Kojima Ryoji Chubachi – Vice Chairman • Yukako Uchinaga • Ryuji Yasuda Peter Bonfield Roland A. Hernandez Osamu Nagayama Mitsuaki Yahagi 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
  12. 12. Valuation and Sensitivity Valuation Output • • 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 FCFF 2013 Key Assumptions ¥3,461,033.4 Growth WACC ¥1,356.1 Share Price in $ $13.96 11.77% ¥1,452,062.4 FCFE/Sh 8.24% Cost of Equity Adjusted with CDS Premiums FCFE 2013 2.5% Growth Sensitity on SNE Share Price $40.0 $30.0 $20.0 Share Price in $ $10.0 $0.0 Share Price in $ 4.50% 3.50% 2.50% 1.50% 0.50% $34.3 $22.2 $14.6 $9.2 $5.3 Japan CDS Sensitivity Share Price 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1 2 3 4 5 6 Japan CDS 0.78% 1.78% 2.78% 3.78% 4.78% 5.78% WACC 8.23% 9.38% 10.52% 11.66% 12.80% 13.95% Share Price $13.97 $8.44 $4.49 $1.53 $0.00 $0.00 $16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 Japan CDS WACC Share Price
  13. 13. 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
  14. 14. Sony – Details of the Trade Stop at 22.63 Entry after the gap is filled at 19.01 Long Term Target 14.06
  15. 15. USDJPY Paired with SNE Long Term Target 105 Entry at the confluence of 101.00 Stop at the 61.8 Fib Level (98.475) 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)
  16. 16. Scenario Analysis and Risk’s of Trade 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 Scenario Analysis – Short SNE & Long USD/JPY Sony Stock Price $14.06 $17.06 98.475 11.36% 11.36% 99.475 $19.63 $21.13 -2.92% -12.20% -15.16% -22.29% 16.26% 1.98% -7.30% -10.25% -17.39% 100.475 21.07% USD/JPY Spot $15.56 16.26% 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% 103.475 34.94% 34.94% 20.67% 11.38% 41.69% 27.41% 18.13% 105 41.69% **Gross of trading costs $19.01 Risk Reward Ratios USDJPY 1.58 -3.24% SNE 1.37 8.43% 1.29% Total Trade 1.87 15.18% 8.04%