Well-Diversified Sony Will Go From Strength To Strength

| About: Sony Corporation (SNE)

Summary

PlayStation division remains main driver of growth.

Diversification equates to strength and stability in this instance.

Some doubts about future of Pictures division.

Q1 2016 profit figures exceed expectations.

Sony (NYSE:SNE) has been going from strength to strength recently. In March, following the quarterly earnings release, I once again recommended the stock as a strong Buy. The stock price graph below for the previous six months shows just what a Buy it has been:

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The latest earnings for Q1 2016 are even better than they look at first glance. Full details can be viewed here.

Q1 profit fell 74% to 21.2 billion yen (US$205 million) on the back of a strong yen, earthquake damage, and a fall in mobile phone sales. Sales were down 11% to 1.6 trillion yen (US$15.7 billion), but only 3% on a constant-currency basis. At the results briefing, the company reckoned that approximately 34.2 billion yen was the negative impact on operating income from the earthquake.

The company is in fact regaining its creative zest and could be heading back to the glory days of Akio Morita and the iconic "Walkman". Current CEO Kazuo Hirai has shown great leadership qualities and carried out a very effective reorganization.

The latest, and probably one of the last, reorganization measures was announced just before the results. Sony has agreed to sell its battery business to the Murata Group. Full details are yet to be announced. It is announced though that the transfer of the battery manufacturing operations of Sony in Japan, China and Singapore should be completed by March next year.

The company has its cost-cutting measures behind it now, and profitability is on the upswing if you take one-offs into account. PlayStation, Music and Image Sensors (once short-term problems are overcome) are high-profit divisions on which the company is concentrating. Much of the reason for the company's improvement is due to its well-organized diversification. This is though a diversification linked by complementary trends. A review of the various divisions reinforces this perception.

Mobile Communications

This remains loss-making, but is seen as a mobile strategic necessity within the Group. In Q1, sales were down 33.8%, and the division was loss-making. Sales in Europe were below forecast. At the earnings conference call, the company continued to maintain it hoped to bring the division into profit this financial year. Mobile phones are seen as an essential plank in its "PlayStation Now" line.

Game & Network Services

This is now Sony's biggest division and is at the heart of the company's success. In Q1, sales were up 14.5%, and operating income up 126.3%. The PS4 has outsold the Microsoft (NASDAQ:MSFT) Xbox by a factor of two to one. Over 40 million units have been sold. This huge user base gives Sony a tremendous platform on which to launch new products and services. The company's forecast is to sell 20 million consoles in FY 2016.

The upgrade to PS4, called the PS4 Neo, should launch soon. Leaked specs show it will support 4K resolution, has improved graphics, faster speed and increased bandwidth. Market talk is that it will probably launch in October to catch the Christmas season. No doubt it will be financially accretive in an important way for Sony.

As I detailed in the March article and another in June, Sony is one of the leaders in developing virtual reality. I won't repeat those details here, but opinion is very much split on how big virtual reality will become. All one can say now really is that if it does become as big as some speculate, then Sony is perfectly positioned to reap the benefits. It has the advantage over competitors of being able to drive hardware and software sales through its PS4 platform. It will also be positive financially to the bottom line.

PSVR is due to launch on October 13th. Its price is seen as competitive: US$399 for the Core Version and US$499 for the Launch Bundle. Pre-orders (believed to be 2.7 million units) all sold out online within minutes of being offered.

A good example of the synergies which Sony enjoys can be seen in its PSVue business, which is growing rapidly. It recently signed a contract with the NFL for live games from the world's most valuable sports franchise. PSVue aligns Sony closely with the strong move to cord cutting that we are seeing.

Deutsche Bank recently upgraded Sony from Hold to Buy specifically on what it saw as increased business in this division. The company guidance for the full year has this division producing 45% of operating income.

Home Entertainment & Sound

This continues to operate in difficult market conditions. Sales were down 6.8%, but operating income up 85.3% in Q1 following reorganization measures. Sony is continuing to roll out good products. Most recently was its well-reviewed new line of portable Bluetooth speakers, the SRS-HG1. The company is pushing its line of "Hi-Res Audio" offering better sound quality than CDs. Its LCD TV sales showed good growth in the quarter. The company has stressed it remains committed to turning around its TV business.

Imaging Products & Solutions

This division has been hit by the worldwide slowdown in mobile phone sales and by earthquake damage to its plant in southern Japan in Kumamoto. This meant Q1 sales were down 25.8% and operating income down 57.7%. However, Sony remains the market leader and in a strong position to resume growth. The company reinforced its belief at the conference call that the image sensor business would be medium- and long-term profit generator for it.

Automotive sensor products are seen as producing meaningful revenue for the company in 2019 or 2020.

Semiconductors

This division was also badly hit by earthquake damage, with sales down 22.7% as a result.

Pictures

In Q1, sales and operating revenue were up 6.9%. The division made a loss because all income is recorded in US$ and the yen strengthened in the period under review. Sony's movie business has been a bit of a mixed business in recent years. This year's slate of movies has looked more promising, and "Angry Birds" was a smash hit for the studio. This followed on the success of the latest James Bond franchise.

The much hyped all-female "Ghostbusters" has had a mixed reaction. Its two week domestic total of US$87 million was at about the mid range of expectations. It is expected to do well overseas.

Some observers have been promoting the idea that Sony should sell off the Pictures division. This looks short-sighted to me and misses the point of Sony's synergies. These synergies extend through games and through its PSVue product. Doubters should look at how successful Disney (NYSE:DIS) has been in turning movie characters into franchises. Sony has the opportunity to do the same. All the studios though are chasing shadows in trying to catch up with Disney's movie and marketing successes. Sony is currently fifth in market share amongst the studios in 2016.

There have been media reports that Sony is cutting its headcount in the USA specifically in this division. These are yet to be confirmed.

Music

In Q1, sales and operating revenue rose 8.7%. Operating income declined 49.8%, but only because of the non-continuation of one-off income in the quarter under comparison. Digital streaming revenues were particularly buoyant.

Sony has been consolidating its products under the fast-growing Music division, and it is its third largest revenue generator. As I reported previously, Sony has been consolidating, investing in new areas within this division and in its current suite of products.

Financial Services

Revenue was down 16.7% in Q1, but operating income was up 5.6%. The division would have done better but for a decline in its investments in the Tokyo Stock Exchange. This division continues to be a strong and steady profit earner for the Group.

Conclusion

S&P Capital recently issued a very bullish report with a stock price target of US$37. This is 25x its full-year 2017 earnings estimates. This is a premium to its peers, but probably justified by Sony's superior EBIT margin (6.3% compared to 2.0%). The 52-week stock price range is US$19.90 to US$31.33. PE averages are quite high, but skewed by depressed profits in recent years.

At its recent Corporate Strategy Meeting, Sony targeted return on equity of over 10% and consolidated operating profit of over 500 billion yen for FY2017. Only small changes were made to this forecast after the Q1 results. The company stated that the three central pillars of its business were electronics, entertainment, and financial services.

The company is also creatively looking for new products and businesses under its "Business Incubation Group." For instance, it is re-entering the robots business and investing in the related field of artificial intelligence. I gave details of these in an earlier article.

The main threats to the business are macro ones. Specifically these are lackluster consumer demand worldwide and the possibility of renewed strengthening of the yen. Q1 results were hit by the earthquake damage and the strong yen, both factors outside the company's control.

The beat on EPS gave the stock an almost 10% hike after the earnings release. The stock is now trading at close to 52-week highs and is up 25% this year. Despite the run-up in stock price, the stock remains a strong Buy in my opinion.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.