The year ending 2002 had an extreme dip in operating income affecting many of the ratios in an extremely negative way (see financials). There was almost a 44% decline in operating income from 2001 to 2002. This decrease in operating income compounded by a negative “other income” and what seem to be payouts to minority shareholders affected the net income dramatically causing most of the ratios in 2002 to be off compared to the preceding and following years (see statements and Exhibits #, #). One example in the extreme difference year to year in the ratios due to a decline in operating income is the degree of operating leverage (DOL). It was the decrease in operating income that dominated this ratio and not the percent change in unit volume. There may be several reasons for this shift in 2002. For example a change in accounting practices, an acquisition, expansion, the payment of past taxes or any number of other business decision could have caused this negative affect. It was difficult to determine any one cause for such a dramatic drop in net income in 2002. There was not anything obvious found in the financial statements and the 6-K and the 2002-yearend report was not available for perusal. Therefore, 2002 will be discounted from much of the DuPont analysis. It is mentioned since it is such an aberration.
Sony’s net income has been decreasing over the last five years. Most of Sony’s earnings come from consumer driven markets (electronics, movies, music, etc.). Its earnings are greatly affected by downturns in the economy. Its earnings follow the S&P 500 and have done a little better than this index over time. Of course past performance does not predict future earnings, but the trend seems to be consistent over time. When the economy was doing well in the late 90’s Sony’s stock did very well, the opposite is also true (See graph of comparison of S&P 500 over time).
In this climate Sony has decided to under go a reformation in order to remain a youthful and energetic company. This restructuring plan is referred to as, “Transformation 60” (TR60) and is scheduled to be complete in 2006. It is difficult to tell exactly how this has been affecting sales, since upper management is generally responsible for aligning a company’s interests to head the “best” direction, but the consistency of the ratios over the last five years seem to indicate that they feel that they are on the right track. They have not made spontaneous changes to their strategic decisions that affect current performance. One indication that they have left day-to-day management to higher-level middle management is the decline in the cost of goods sold (COGS) (see Exhibit #).
Sony’s ROE has fallen in the last 5 years from 5.6 in 2000 to 3.8% in 2004. This declining ROE could possibly mean that the new investments in R&D have not yet paid off and it will take longer to see the affects of this investment. One unusual factor is that the LTD to Equity ratio has risen slightly over the last five years, which normally means that we should see an increase in ROE. However, this ROE is still a reasonable level when compared to the industry level of 3.9% and should not be a major cause of concern.
The Asset Turnover has been declining over the last several years. It has decreased on an average of 4.5% per year for the last 5 years. As explained above for the decreasing ROE this could be a consequence of their investments into new products not paying off affecting sales.
Growth Analysis
The growth rates and correlation analysis indicates that Sony’s growth is at risk in the short term due to a dramatic decrease in Earnings per Share, Dividend per Share, and Share Price over the next five years. This analysis also indicates that both the internal growth rate and the sustainable growth has been decreasing over the past five years and are now at very low levels, 0.3% and 1.2% respectively. However, the analysis shows a 13.94% growth in sales over the last five years and forecasts a continued increase in sales through 2009.
The balance sheet looks fine given the modest debt (see ##). The primary objective for Sony is to heavily invest in research and development. This will not yield a quick improvement in net income in the short term, but it should position them for future gains. Until the restructuring plan is complete, the financial ramifications of this plan have diminished, or the economy in the United States turns, Sony will continue to see an average or declining ROE and thus its share price will also stay average or decline.
Bankruptcy Risk
In the Altman analysis, Sony’s Z score is deteriorating. In 2000 the score, 3.44, was well over the threshold of 2.67 but in years 2001-2003 the score dipped below the threshold of 2.67 and in the most recent year the Z score is 1.66. All of the variables used in this calculation: Liquidity, Profitability, Earning Power of Assets, Leverage, and Activity; have all been decreasing over the last five years for Sony.
The liquidity score is currently at 0.05 this indicates that Sony may start experiencing problems covering their short-term obligations. The cumulative profitability score has seen a 0.09 decrease from 2000 to the most current period. The decrease in the earning power of assets score signifies that Sony is not able to generate as many profits from its assets as it once was.
The leverage score in 2000 was 1.7, and in the most current period the score is 0.36. This indicates that if Sony were to become insolvent, their market share before liabilities would exceed assets and would quickly decline. The activity score has decreased over the last five periods as well; however, the decrease isn’t significant which represents that Sony is still managing their competition well and is efficiently using their assets to generate sales. Sony’s strong market share is also another factor that is helping the activity score to remain steady.
According to Altman, Sony has a very high probability of becoming bankrupt. Although there are exceptions to this rule, this score does cause some concern as to the financial future of Sony.
Regression
The regression analysis provides some additional information in regards to the risk of investing in Sony. For instance, the beta is 1.16. This implies that since the beta is greater than one, the stock will be more volatile than the market and therefore bears more risk but could garner a greater reward. In comparison to the industry beta of 1.03, Sony is higher than the average; however, one of their competitors, Philips Electronics, has a higher beta of 1.65. The total risk value displayed in the regression is 0.0187. The systematic portion of this value only constitutes 17% meaning that the remaining portion, 83%, represents the unsystematic component.
The R Squared is pretty low (0.1699) which is an indication that our regression is not a good fit for predictability and that the percentage of variation that can be explained by the market is low as well. The alpha in the regression was -0.25% which indicates that the stock price has been falling. The reasons for this negative alpha as well as discovering the keys to offsetting the unsystematic risk will be covered in the next section.
Risk Analysis
The markets that Sony is involved in are undergoing dramatic changes. The consumer electronics industry is seeing rapid advances in semiconductor technologies. There is also more competition now than before, and new participants are emerging from China, India, and Russia driving margins down. The customers are also becoming more diverse and all of these changes will only continue to accelerate.
In order to better adapt to the changing markets Sony is working to streamline operations with their TR60 “reformation” plan. Sony believes that this plan will enable them to withstand dramatic shifts in business conditions by becoming a leaner organization that will be more responsive to change. This plan has been in place for a couple of years which has caused their financials to suffer due to the large amount of early retirement packages that they have incurred by letting go 9,000 employees. These employees were mainly from Japan, Western Europe, and the U.S.
TR60 has two central purposes, to enhance the operational profitability and growth strategy. The first goal of enhancing operational profitability is being realized by cutting fixed costs through downsizing the workforce and consolidating the manufacturing, distribution and customer service facilities. Sony is also looking at reducing variable costs by reassessing the strategy for procuring production materials. The second goal, growth strategy, focuses on the core business of home electronics, mobile electronics, and entertainment. TR60 is a significant risk to the future of Sony since it is not known how long this restructuring will take until they find the right balance. Therefore, the outcome is unpredictable. For instance, the plan could take longer to implement and be more costly than originally planned. A potential investor needs to watch this plan very closely to see if it does in fact make Sony more profitable and more responsive to the global consumers market.
Key Factors for Minimizing Risk in the Future
For Sony to continue to maintain their strong brand and influence they have to successfully minimize the systematic and unsystematic risks that they are facing. The following is a list of the risks and key factors for the future success of Sony.
The systematic risks that affect Sony are anything that will interrupt consumer spending and change their buying habits. Therefore, the global economic environments, interest rates, the war on terrorism along with many other factors are systematic risks that will affect Sony. These variables have a direct correlation towards the spending habits of consumers.
There are several unsystematic risks that Sony faces. Some of those unsystematic risks are maintaining market leadership in technology, changing strategy to suit the business environment, restructuring the company to better adapt to the changing business environment, and new acquisitions as part of there overall strategy.
Historically Sony has been able to demand a premium on its products because they produced cutting-edge technology that was difficult for their competitors to replicate. However, now that technology is more accessible to their competitors, it will be tougher for Sony to differentiate their products in order to command a premium price. They need to continue to invest in research and development to continue to differentiate themselves from their competition. This will keep them on the cutting edge of technology. This will help them to keep the Sony brand value high.
There are several examples of how they have invested into research and repositioned themselves to mitigate the risk of decreasing market leadership in technology. Sales of flat panel televisions have significantly increased in the market over the last year. To keep up with the competition Sony has expanded their flat panel lineups. They have also invested in joint ventures for the production of flat panels (find industry report). However, they do not have core leadership in these technologies. They are looking to exploit their LCOS and LCD micro-display technologies in 2005.
They have outsourced much of their manufacturing for mature technologies like CRT displays and the Playstaion 2. Sony decided to shut down the production of these in Japan, and they are manufacturing these in China. This has reduced cost of production while allowing them to focus on the development of new technologies.
Another example of decreasing the unsystematic risk of technology leadership is with their DVD product. Sony has increased their market share by introducing several new DVD recorder products. They are also on the cutting edge of developing the “blue ray” HD DVD format. At this time they are shipping components to other electronic companies to broaden the support base for the blue ray technologies.
There are several divisions that are adding to the bottom line to help off set the cost of doing research. Their best selling product, digital still cameras, continues to contribute to their profitability. Sony also continued leading the video camera market, which happens to be the most profitable category in the Electronics segment. Other areas that are helping the bottom line their semiconductor products. This category saw an increase in sales of 23.7% due to the increases in sales of CD-R/RW and DVD-R/RW drives and memory sticks.
Another way that Sony is looking to decrease the unsystematic risk is through “reforming” the business organizations. Their ability to implement personnel reduction and other business reorganization activities in its Electronics, Music and Pictures segments should help in reducing risk. The TR60 plan will prove beneficial if it provides a leaner organization that can more easily adapt to the changing business environment.
Sony Entertainment continues to contribute by expanding their content and signing key deals to make that content more available for sale. The entertainment industry is difficult to forecast, because it is dependent on consumer’s preferences. An example of this volatility was the success of Spiderman. Its success busted the financials for 2003, but the absence of a similar success the following year reflected poorer numbers. However, according to Sony the last 10 films they have produced in 2004 were profitable and the home entertainment segment (DVD and VHS) is forecasted to increase by seven billion dollars over the next five years.
Sony’s music segment also contains a great deal of risk due to the unknown future of the industry in general. The music industry as a whole has slowed due to the economy as well as the effects of piracy and other illegal peer-to-peer downloading. Sony needs to look for a better and more profitable business model for this segment. To this end, Sony has shutdown a CD manufacturing facility in the U.S. in order to minimize costs. They have create the joint venture with BMG, Sony BMG Music Entertainment, to increase the amount of content available to Sony to market.
One way that Sony is looking to capitalize the illegal distribution of music is through creating a listening device to compete with the iPod. This way the music may be pirated, but the electronics that consumers listen to them on will not bet. This will also be an effective use for the expanded content created by the joint venture Sony BMG.
Conclusion
Sony’s financials and the analysis indicate that they are positioning themselves for future growth. It is expected that as the economy turns around Sony will enjoy continued growth at a rate a better the S&P 500. The recommendation for Sony’s stock is to buy and hold. They should continue to be a good value.
Jim works for MOXTEK, Inc. that works closely with the most of the Japanese electronics companies. These companies tend to give information in general terms of their direction. The information is more than 3 layers out from the management’s team direction committee, and is not information that hasn’t already been speculated on by other industry professionals.
Value Line information for Sony Corporation, June 30, 2004
Sony Press Release April 24, 2001
Associated Press, Monday September 27, 2004, Price at Issue with PlayStation Portable, on the web:
Sony BMG Music Entertainment Press Release, August 5, 2004,
Associated Press, Thursday September 23, 2004, Sony-Led Group to Buy MGM in $5B Deal, on the web:
Comcast Press Release September 13, 2004,
Sony Fiscal Year 2004 Annual Report, page 4
Sony Fiscal Year 2004 Annual Report, page 60
See Exhibit ## for a discussion center on these display technologies.
Sony Fiscal Year 2004 Annual Report, page 6
Sony Fiscal Year 2004 Annual Report, page 65
Sony Quarterly Investors Conference Call 2004
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