Sony builds a moat with music and games while Morningstar raises fair value

It’s taken many years, but Sony Group’s long-standing strategy of diversifying into content appears to be finally paying off amid shifts in technology and consumer habits. Morningstar analyst Kazunori Ito upgraded the company’s moat on Friday, raising his fair value estimate of the company by 9 to 12.5 percent, depending on currency.

“Over the past decade, Sony has shifted to an asset-light business model that focuses on acquiring content and developing businesses with recurring revenues that enable long-term customer monetization,” Ito wrote. “Although Sony’s track record of return on capital is poor, we believe the company’s current business portfolio is much stronger than before and can generate a return on capital above the weighted average cost of capital over the long term.”

Crucially, Ito also raised Sony’s “moat” rating – a measure of the uniqueness and value of a company’s products – from “None” to “Large.” Ito attributes this to the company’s massive investments in Sony Music, as well as PlayStation and related gaming activities.

Sony founders Akio Morita and Masaru Ibuka founded the company in 1946, amid the devastation of post-World War II Japan, as a manufacturer and seller of consumer electronics and began international sales with a portable transistor radio.

Today, Sony still makes a wide variety of consumer electronics, from well-regarded TVs to smartphones, speakers and headphones, and more, but it competes with Korean heavyweights Samsung and LG, as well as a seemingly endless armada of cheap Chinese, Turkish, and other rivals. The company is also a pioneer in optical sensors, from high-end video equipment for broadcast to its market-leading Alpha interchangeable-lens “mirrorless” cameras for consumers.

However, this traditional focus on hardware has made the company “highly dependent on consumer electronics and has a very fragile and volatile earnings structure in the face of economic fluctuations,” Ito wrote.

Over the past three decades, the company has acquired a number of content creation companies in games, music and film/TV. These ventures have had their own ups and downs as each industry cycles and changes, but Ito said the company is now seeing the benefits of digital distribution, which offers it far more permanent revenue streams.

“Sony’s profitability has become significantly higher and less volatile than before because 1) the Internet has increased the sales and profitability of the game console business and the music business, both of which have made the largest contributions to operating profit; 2) Sony has become the leading brand in interchangeable lens cameras; and 3) the company has implemented a major business model transformation in the consumer electronics business to become less vulnerable to economic fluctuations, such as restructuring and reorganizing production facilities for televisions and smartphones and divesting personal computers,” Ito wrote.

He thanked the long-serving management team led by CEO Kenichiro Yoshida and COO/CFO Hiroki Totoki for transforming the company in recent years into “a more disciplined company that does not seek to gain market share in the hardware business, but invests effectively to expand its user base and maximize revenue per user in the content business.”

Sony’s most notable diversification project is probably the PlayStation gaming consoles, the first of which was released 30 years ago. The consoles were the center of a vast ecosystem of game developers and equipment that has continued to grow as the overall gaming industry has exploded in size.

Analysts estimate that global gaming revenues will be around $180 billion per year. And thanks to new experiences and revenue models through blockchain, immersive headsets and artificial intelligence, there is potential for another huge leap.

The investment in games has paid off as the business has shifted to internet-based sales, marketing and gameplay, Ito wrote. Of particular note is the rise of PlayStation+, the three-tier online gaming subscription service that offers access to online games and hundreds of new and older games.

Sony’s acquisition of CBS Records in 1988 survived a collapse in the music business in the early 2000s, when Spotify, Apple Music and others dominated digital distribution. In the last two years, the music industry’s revenues finally surpassed pre-collapse figures, as millions of fans rely on subscription services for their music.

Sony’s investments in film and television (Columbia Pictures and its related operations) also experienced a bumpy transition into the digital age. Crucially, however, Sony Pictures Entertainment resisted the temptation to launch its own streaming subscription service to compete against Netflix and its Hollywood rivals.

Instead, SPE became an “arms dealer,” selling its own small Crackle service and focusing on the profitable production and sale of feature films and series through traditional film and television channels and other streaming services. This strategy likely spared Sony some of the billions in losses that crippled rival studios – aside from the profitable Netflix.

Thanks to the company’s ability to evolve with dramatic changes in its original business and all the content promotions it has undertaken since then, Ito was able to significantly raise the company’s “fair value estimate” from 16,000 yen to 18,000 yen, or 12.5 percent, and for American Depositary Shares from 103 dollars to 112 dollars, or 9 percent.

Sony Group ADR shares closed the week on the NYSE at $86.82, up $1.17. So far this year, ADRs have fallen 7 percent.