By John Yang
Sony finished another year with many questions for investors. For fiscal 2003 (ended March 31, 2004), it posted net income and operating income of $851 million (104 yen = $1) and $951 million, respectively. Revenue of $75 billion was mediocre, in our view.
However, we believe that Sony (SNE ; 5 S&P STARS, or buy, recent price: $38.40) is on track to recovery. When its 60th anniversary comes in 2006, we expect the Japanese consumer-electronics and entertainment giant to have gone through major overhauls in two areas. The first is slashing costs. As a whole, Sony will incur $3.2 billion in restructuring expenses during the next three years to realize a projected savings of $1.6 billion to $1.9 billion in fixed costs at the operating-income level. Consequently, Sony plans to achieve a 10% operating margin (excluding its financials segment) by the end of fiscal 2006.
For fiscal 2003, Sony posted restructuring expenses of $1.6 billion. For the electronics segment alone, those expenses were $1.4 billion. To speed up the process, an additional $240 million was taken in that fiscal year. As of March, 2004, Sony booked 82% ($2.6 billion) of the planned restructuring expenses. We praise Chairman and CEO Nobuyuki Idei's aggressive effort, but one must not forget that his attention isn't aimed only at cutting costs but also at increasing revenues.
Sony plans to stir growth beyond March, 2007, with the integration of digital consumer electronics in six areas -- digital still cameras, flat-panel displays, home servers, cell phones, DVD recorders, and PCs. Leveraging Sony's vast store of "software" such as movies, music, and games, Idei's vision is to become an all-in-one provider of the latest consumer electronics, or a Wal-Mart of the digital community (see BW Online, 1/9/04, "Sony Sells Itself for a Change").
In our opinion, Idei's vision is quite grand and unique compared with past chairmen like Akio Morita and Norio Ohga. Knowing that software would play an important role in Sony's business, the two execs integrated CBS Records in 1988 and Columbia Pictures in 1989 (renamed Sony Music Entertainment and Sony Pictures Entertainment). However, the expected positive impact did not come that easily, especially in the movie business. In 1994, Sony posted a $2.7 billion write-off related to its film business.
Idei's strategy is to transform Sony into a company that can provide the products consumers will want in the coming digital boom. However, we believe that it can't afford to make big acquisitions because, in our view, it lacks the earnings drivers to offset the potential purchase price. Back when Columbia Pictures nearly crippled Sony, the parent had earnings from compact-disk titles to offset the losses.
TEAMING WITH A RIVAL.
To become a digital powerhouse, we think Sony needs to compete in flat-panel displays. Now, it purchases panels for plasma and liquid-crystal displays from other manufacturers, which cuts into the bottom line. While Sony-made parts are preferred, given the tremendous amount of research and development and capital spending involved, we think in-house production may turn out to be an expensive and unwise venture.
Quality control is another issue. In December, 2003, Sony recalled 10,400 units of a 32-inch plasma TV model (retail price of $2,500 to $3,000) that were made by Sony itself between November, 2002, and August, 2003. The recall was due to the inability to project images stemming from circuit problems. As a result, Sony booked a $4 million extraordinary loss in the third-quarter of fiscal 2003.
To reduce spending and also gain technological advantage, Sony partnered with Samsung Electronics, a competitor with strong market share. The two signed a deal in October, 2003, to jointly produce amorphous thin-film-transistor liquid-crystal-display panels. The jointly owned new company, called S-LCD, will aim to produce seventh-generation (2.2 meters x 1.87 meters) TFT LCD panels with a production capacity of 60,000 units per month.
Headed by the Samsung's CEO and Sony's CFO, S-LCD should be established soon and operational in the second quarter of 2005. Samsung would be the majority owner since its stake would be 50% plus one share. The panels made by S-LCD would be used for big-screen LCD TVs.
This venture should put Sony in a position to leverage Samsung's technology and meet the current demand for large-area TFT LCDs. Samsung had the leading market share in 2003 in the panels, according to research provider DisplaySearch. With the joint venture, Sony not only can control its capital spending and R&D costs but it can also potentially increase its market share in LCD TVs. DisplaySearch says LCD TVs are among the fastest growing applications, measured by shipments and revenue, based on the latest available data.
Sony already owns the proprietary Wega Engine, a technology for processing digital broadcasts, which we believe creates images with more clarity compared to other high-definition TVs. With Wega Engine in tandem with TFT LCD panels from S-LCD, the synergy could translate to increased revenues, and we believe that has the potential to lead to an improvement in Sony's fundamentals -- and could lift the share price.
BACK TO THE LEAD?
We believe Idei's efforts are positive and that what's crucial isn't whether Sony can achieve a 10% operating margin in a given time frame, but whether it's taking the right steps for change. As long as Idei is making progress, we think Sony has a chance to regain its presence as a price setter and market leader, not a price taker and market follower.
Given our view of the cost-cutting measures, growth potential, and Idei's forward-looking overhauls, we believe Sony still has the potential to recapture its old glory and magic.
Note: John Yang has no stock ownership or financial interest in any of the companies in his coverage area. Other S&P affiliates may provide services to the companies under discussion.
Analyst Yang follows technology companies in Tokyo for Standard & Poor's Equity Research
Edited by Karyn McCormack