What Should Sony Spin Off?


By John Yang On June 22, Sir Howard Stringer will replace Nobuyuki Idei as chairman and group CEO of Sony Corp. (SNE

; ranked 3 STARS, or hold; recent price: $40). Ryoji Chubachi will assume the position of president, and the other five board members will resign. We at Standard & Poor's Equity Research think these moves resulted from shareholders' dissatisfaction with the current board and management's restructuring efforts.

In our view, the event that triggered Idei's resignation was the lowered guidance for fiscal 2005 (ended Mar. 31) given on Jan. 27. Also, Idei indicated at a press conference held on Mar. 7 that meeting Sony's original target of a 10% operating margin (excluding financial businesses) has become a challenge.

MORE PROGRESS NEEDED. Given these management changes, we believe the market expects Stringer to conduct a major overhaul of Sony's current business portfolio (see BW Online, 3/10/05, "Sony's Sudden Samurai"). We think Wall Street perceives it as a two-sided issue: Stringer will keep the hardware business or the software business, but not both. At S&P, the betting is that he'll likely keep the software unit and spin off the hardware unit one way or another.

In our opinion, recent as well as more-distant events make a case for this argument. For example, in December, 2004, Sony announced a cross-licensing agreement and a joint venture involving LCD panels, with Samsung. Doing so will ease the research and development burden, Sony hopes. To revive the cell-phone business, Sony created a joint venture with Ericsson (ERICY

; 3 STARS; $29).

However, we think that joint ventures alone may not improve the margin. Meeting Sony's target of 10% operating margin would require Stringer to make more progress in the hardware business than the previous management did, we believe.

KEEPING KEN HAPPY. One possible scenario we see is for Sony to focus on semiconductor and core technology and key devices -- such as a charge-coupled device (a semiconductor used in digital cameras and camcorders) and a superfast chip called Cell developed jointly with Toshiba (TOSBF) and IBM (IBM) -- and outsource the rest of hardware, imitating Dell's DELL

; 5 STARS, or strong buy; $38) model. The ratio of parts procured internally would drop dramatically, but by keeping "the engine," Sony could still compete due its own proprietary technology and reduced costs in low-end parts, we believe.

If not, Sony could spin off the semiconductor businesses as a totally independent operation. We believe this would serve two purposes. First, it could ease Sony's capital spending burden. We estimate that, in fiscal 2006, the company will expend $2 billion on the chip business alone. If the spun-off company can procure funds from capital markets, we think Sony can spend the leftover capital on struggling businesses.

Another purpose of a potential spin-off: Stringer can appease Sony Computer Entertainment President and CEO Ken Kutaragi, whom we view as disgruntled, and keep him as a critical member of management. Stringer could name Kutaragi, the disappointed heir apparent who earned respect by launching PlayStation game consoles from scratch, as the head of the new semiconductor company.

HANDHELD STRENGTH. An alternate scenario, spinning off the consumer-electronics division completely as an independent entity, would create more accountability within the segment. The division's complacency and lack of urgency has largely contributed to Sony's downfall in consumer electronics, we believe. Becoming a stand-alone enterprise would force the division to improve its product line and cost structure.

Sony could also spin off its games business. This unit and the semiconductor business are similar in nature in that both are capital-intensive. However, we believe that such a spin-off is unlikely.

In our view, the successful launch of the handheld game console PlayStation Portable in Japan and the U.S should help improve the division's bottom line in fiscal 2006. The launch of PlayStation3, which could happen by the middle of fiscal 2006, should also strengthen the games business. Since the next-generation game console could turn into a big earnings driver, Stringer may want to keep the division within the Sony group to protect secrecy and prevent any leakage of technology.

RATING STEADY. We believe that to meet the 10% margin target, Sony needs to refocus its cash and assets to certain areas. If it continues to compete in electronics and entertainment under one umbrella, we think Sony may experience a cash crunch -- relative to peers -- by March, 2007, considering fiscal 2004's cash balance of $8 billion.

For the next two fiscal years, on yearly average, the semiconductor and games businesses together would require $2 billion to $3 billion in investment for R&D and capital spending. In addition, electronics would require an additional $1 billion to $2 billion yearly. We believe that if the chip and games units can procure funds from capital markets rather than from internal resources, Sony as a group can prevent any cash shortage in the future.

The new management hasn't disclosed any different concrete measures in corporate strategy. We maintain our 3-STARS (hold) recommendation on the shares with a 12-month target price of $39.

To our surprise, Stringer maintained Sony's commitment to the 10% operating margin by the original deadline of March, 2007. Whether it's hardware or software, we think he must consider the spin-off options and execute them quickly.

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Yang follows technology stocks in Tokyo for Standard & Poor's Equity Research


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