Why the Emperor (Japan) still has no clothes

even as the weavers (Thirdpoint and Abe) furiously try to

convince the market the Emperors clothes are real
Authored by: Daniel Russell
5/30/2013
Global Deficits, GDP Growth and Labor Force in the past decade
Global deficits (in red) seem to be in a
permanent new normal trend, global
GDP growth is in a severe downtrend



-
-
-
-
US GDP + Germany GDP + Japan GDP + France GDP Dollarized YOY % Change
World Deficit as % of GDP
US YOY GDP Growth
China YOY GDP Growth (not dollarized)
5 Largest Economies Dollarized GDP Growth YOY versus
World Deficits as a percent of GDP
5 Largest Economies Employment to Population Ratio (ex China)
Over the past decade global deficits
have increased global growth proxied by
the 5 largest economies has downshifted
Eventually the demographics will
compound on the already bad decisions
being made to create a debt crisis.
The population to employment ratio in
the US (blue) peaked after the dot com
bubble burst,
Japans Population to Employment
Ratio peaked in the early 90s
France looks like it peaked in the 80s.

A lower number of employed funding a
larger number of unemployed workers
creates social, political, and financial
consequences



Japan The Emperor
Japan A Developed Country with huge
debt load
The nominal debt dipped during 2008 because the debt was
refinanced at a lower rate. Since 2008, the debt has again
accumulated at a rather quick pace.
Nominal Gross Debt shown in blue and estimated Gross
Debt shown in Red.
.and whose answer to low GDP growth
seems to be just expand the balance sheet
of the BOJ
Nominal GDP in (shown in blue), the only answer
for a massive drop in GDP seems to be the BOJs
Balance Sheet (shown in red)
Notice the exponential nature of the increase in the
BOJs balance sheet since Abe has entered office
Possible ways to clothe the Emperor
Traditionally there are three ways to solve
debt problems:
I. Grow
II. Inflate
III. Default

Which one will Japan choose?
58%
20%
20%
-2%
Japan GDP by Expenditure FY 2012
Consumption Investment Government X-M
Growing consumption?
Growing Investment?
New orders are picking up of a much lower base post 2008.
The flow of fixed capital being utilized is in a massive downtrend, less capital means the expectation s for using capital for creating
new businesses is very low
Industrial production has dropped off a cliff
Inventories look to be in a downward spiral (reduction in inventory due to lack of demand)
Possible ways to clothe the Emperor
Current account should go full negative 3Q 4Q 2013
The massive move in the JPY could help trade bounce back but global growth doesnt seem to be picking up
Without increases in investment or consumption, growth seems out of reach, to further compound the
dilemma, Japan will hit a full negative current account for the first time in years
Structural Changes in Energy will compound the weakness in the Balance of Payments
0
2
4
6
8
10
12
14
16
18
20
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Japan Abandons Nuclear post 2011
Energy
Number of Plants December 2012 Poll - ASAHI SHIMBUN
Trade is deteriorating and with no natural resources and no nuclear production, Japan must import almost all of its
energy. To add fuel to the fire, Japans politics have shifted post Fukushima to not favor any nuclear power.
Adding debt to the most indebted nation on earth

The debt non-linearity is shown by the
exponential growth in the interest cost even
though the cost of borrowing is at an all time
low
Adding more debt will just add more interest
expense to the budget
When you spend 25% of your budget on
your debt, adding debt is not really a
solution
Current Accounts and Fiscal Deficits are
highly correlated. A current account deficit
will mean a increase in the fiscal deficit for
Japan.
Japan cant grow, and Abe wants to inflate,
but when you try and inflate with your debt
spring-loaded like Japans you have a debt
crisis.

I believe Japan will try and inflate and then
default on its sovereign debt in the next 5
years.
So how would you trade on Japans coming fiscal crises?
Characteristics I want in a company to play the
eroding of Japans Fiscal situation:

Highly levered to debt
Credit risk includes the Sovereign risk of the home
country
High rate of production in Japan
Inputs with a higher yen will be more expensive
Poor positioning within the industry
Poor product mix
Revenue mostly from Japan
Higher inflation should mean lower purchasing
power and combined with poor market position
should spell real trouble with the firm
High pension costs



-45.0%
-40.0%
-35.0%
-30.0%
-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
-400,000
-350,000
-300,000
-250,000
-200,000
-150,000
-100,000
-50,000
0
F
u
n
d
e
d

a
m
o
u
n
t

a
s

%

o
f

P
B
O

U
n
d
e
r
f
u
n
d
e
d

a
m
o
u
n
t

(
M
i
l
l
i
o
n
s

o
f

)

Sony Pension Underfunded Status
Underfunded
Funded as %
of PBO
Scale inverted
Product mix Bubble size is the amount of segment Revenue
Largest business lines have low or negative margins, major warning sign
Revenue growth is low for the most profitable Segments
Goal is to be in the top Right (Large operating margin large revenue growth)
30% underfunded pension as a percent of PBO
As of 2012, the asset class breakdown is 23% Equity and 45% Fixed income,
of which ~65% is invested within Japan
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-20% -10% 0% 10% 20%
Revenue
CAGR
FY09 - FY12
Operating Margin
Sony Segment Mix
Imaging Products &
Solutions
Game
Mobile Products &
Communications
Home Entertainment &
Sound
Devices
Pictures
Music
Financial Services
Japan,
32.41%
United States,
18.66%
Europe ,
19.53%
China, 7.62%
Asia-Pacific,
9.80%
Other Areas,
11.96%
Net Sales by Region as % of Total
Sales
Sonys Fundamentals
Sony has decreased its CCC by increasing its days payables
Sony was downgraded to Baa3(negative outlook) in 4Q2012
Because of this downgrade I dont believe the CCC can
improve by dragging out payables much longer
Sonys Long Term Debt/Equity Ratio continues to rise, making the
firm more levered
Leverage can hurt the firm if conditions externally and
internally continue to weaken
Managements use of assets has become more and more
inefficient as shown by the Asset Turnover Ratio
Both of these metrics show that management hasnt effectively
controlled the Balance Sheet
0%
10%
20%
30%
40%
50%
60%
70%
0.00
1.00
2.00
3.00
4.00
5.00
6.00
Long Term Debt and Asset Efficency
Financial
Leverage
Asset
Turnover
0.00
20.00
40.00
60.00
80.00
100.00
Sony Cash Conversion Cycle
Days Paybles
Days Inventory
Days
Receivables
CCC
67.00%
68.00%
69.00%
70.00%
71.00%
72.00%
73.00%
74.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
Age and Depreciation of Assets
CAPEX as % Rev
R&D Exp as % of
Rev
Depreciation/Amoriz
ation over Capex as
% of Rev
Avg Age in %
Sony allowed its assets to age without any plan to replace aging
assets
For the past 5 years, Depreciation/Amortization has outpaced
CAPEX spending, this mathematically cannot continue into
perpetuity unless all assets are expensed

The Weavers (Thirdpoint) proposal and why Sony shouldnt agree
*Third Points Steps taken directly from the letter to Sony posted on businessinsider.com

Step 1: Take Public a 15--20% Stake
in Sony Entertainment, Allowing It to
Thrive Independently with the Support
of the Sony Parent Company While
Increasing Capital to Revitalize Sony
Electronics


Sony entertainment is an industry
leader in the entertainment industry

Sony Electronics doesnt just need
more capital it needs better products
Sony laptops batteries exploded in
2006
Sony didnt introduce a tablet until
2011
Sony needs to trim its failing
Electronics segment to only include
the most profitable and best units
Point
Counter-Point
17%
32%
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
$2,000
0%
5%
10%
15%
20%
25%
30%
35%
Sony Entertainment Box Office and Music Sales and
Market Share
Gross Film
Revenue MM
USD
Gross Music
Revenue MM
USD
Film Market
Share
Music Market
Share

Step 2: Focus on Industry-Leading
Businesses to Bring Growth to Sony
Electronics


Sony should center on narrowing their
focus and eliminating any segments
that are outside of their circle of
competence
Sony Entertainment and Gaming can
be leveraged to the existing product
portfolio to add value and cash flow to
fund the trim electronics division
Why cant you buy movies and music
on your Sony phone?
80% of smartphone users shop on
their phone (1)
Point
Counter-Point
1. http://techcrunch.com/2012/09/19/comscore-4-out-of-5-smartphone-owners-use-device-to-shop-amazon-most-popular-mobile-retailer/
*Music data only goes back to 2008:
*Music Market Share source Nielsen Company & Billboards Yearly Music Industry Report
*Film Market Share source BoxofficeMojo.com
Chairman Former CEO - Sir Howard
Stringer
Former Head of Sony Entertainment
Division
Current President & CEO - Kazuo Hirai
Started at Sony Music Entertainment
(Japan)
Member of Sony Board Roland A.
Hernandez Ex-CEO of Telemundo
Does Sonys Board Composition make Thirdpoints proposal less likely to be adopted?
Sir Howard
Stringer -
Chairman
Ryoji Chubachi
Vice
Chairman
Masaru Kato
Takaaki
Nimura
Tsun-Yan
Hsieh
Kanemitsu
Anraku
Kazuo Hirai
Yorihiko Kojima
Yukako
Uchinaga
Ryuji Yasuda
Peter Bonfield
Roland A.
Hernandez
Osamu
Nagayama
Mitsuaki
Yahagi
Current Sony Board
Chairman, President & CEO both started in the
Sony Entertainment Division
Another member of the board ran a large
entertainment division
Does Thirdpoint think the board will admit it
has mismanaged the entertainment division
and agree to a spinoff?
Does Thirdpoint also think the insiders that
started in that division wont think they know
what is best for Sony Entertainment?
I dont think the spinoff is likely to
happen
Key Board Insiders
Using Comps
(VIAB, DIS,
TWX) The
average
EV/EBITDA is
10.66.
Sonys
Entertainment
Division would
then be valued
at 906BB and
the spinoff
would be
valued at
181BB for
20% of the
segment going
to the public
under Loebs
plan.
This is without
any discount
for lack of
control of the
division
For Thirdpoints proposal to be successful the
board must be convinced that it is in Sonys
best interest to spinoff the Entertainment
division.

Valuation Output
FCFF 2013 3,461,033.4
FCFE 2013 1,452,062.4
FCFE/Sh 1,356.1
Share Price in $ $13.96
Valuation and Sensitivity
4.50% 3.50% 2.50% 1.50% 0.50%
Share Price in $ $34.3 $22.2 $14.6 $9.2 $5.3
$0.0
$10.0
$20.0
$30.0
$40.0
Growth Sensitity on SNE Share Price
Share Price in $
Key Assumptions
Growth 2.5%
WACC 8.24%
Cost of Equity
Adjusted with
CDS Premiums
11.77%
One stage FCFE model was used because
Sony is a mature company with estimated
guidance issued by the company
My target price based on intrinsic value is
$14.55 which is a 30% drop from its
current price
The twelve month target price
also fits with the technical levels
on the chart
1 2 3 4 5 6
Japan CDS 0.78% 1.78% 2.78% 3.78% 4.78% 5.78%
WACC 8.23% 9.38% 10.52% 11.66% 12.80% 13.95%
Share Price $13.97 $8.44 $4.49 $1.53 $0.00 $0.00
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
Japan CDS Sensitivity Share Price
Japan CDS
WACC
Share Price
Why I could be wrong
Thirdpoints
Reputation
Thirdpoint has an
excellent track record
being an activist
Thirdpoint has brought
a deal that is relatively
small and not very
intrusive to the board
Sony is ready
to turnaround
its business
Shareholders might be
ready for change
Institutional ownership
is at a 5 year low, so
entrenched
shareholders shouldnt
be a problem
Overall
Environment
With Abe doing
whatever it takes
Sony could find
renewed vigor for
change
Kazuo Hirai has placed
an emphasis on the
turnaround and not
status quo
Sony has lagged the major indices over the past two years
The JPY weakening hasnt helped Sonys stock much

Sony Details of the Trade
Long Term
Target 14.06
Stop at 22.63
Entry after the
gap is filled at
19.01
USDJPY Paired with SNE
Why pair Short Sony with
USDJPY Long?
Sony could possibly benefit in
the very short term from a
weaker yen if they decide to
take off their hedges
When CA goes negative the
Yen will have to weaken or
foreign investors will have to
invest in Japan
With the lowest yields
in the world I dont
see foreign investors
jumping to Japan

Levels
A small contract, long at the
current spot (101.000) with a stop
at 98.475 and a target of 105.
The 61.8 Fibonacci level
was previously rejected
this should be set as the
stop level
Structure of Trade:
Short SNE at 19.01
Buy the spot USDJPY
(utilizing the standard leverage
for spot currency contracts)

Long Term
Target 105
Stop at the
61.8 Fib Level
(98.475)
Entry at
the
confluence
of 101.00
Scenario Analysis and Risks of Trade
$14.06 $15.56 $17.06 $19.01 $19.63 $21.13
98.475 11.36% 11.36% -2.92% -12.20% -15.16% -22.29%
99.475 16.26% 16.26% 1.98% -7.30% -10.25% -17.39%
100.475 21.07% 21.07% 6.79% -2.49% -5.44% -12.58%
101.475 25.79% 25.79% 11.51% 2.23% -0.72% -7.86%
102.475 30.41% 30.41% 16.13% 6.85% 3.90% -3.24%
103.475 34.94% 34.94% 20.67% 11.38% 8.43% 1.29%
105 41.69% 41.69% 27.41% 18.13% 15.18% 8.04%
Sony Stock Price
USD/JPY
Spot
Scenario Analysis Short SNE & Long USD/JPY
Risks to this trade:
Events in Europe cause a flight to safety in
USD/JPY
Sony takes off some currency hedges and
reports an upside EPS surprise due to FX
Translation
BOJ gets skittish when inflation occurs and
talks down further easing
Sony starts an early marketing campaign for
the PS3 (expected Holiday of 2013) and the
market bids up SNE
Macro concerns ease as global central
banks continue to ease Monetary Policy
Sonys 5 step turnaround plan succeeds
Namely, TV turnaround and
Realignment of business portfolio
and optimizing resources
Sony decides to spinoff Sony Entertainment,
this would result in a price spike
Tailwinds to this trade:
Asian trade relations worsen
Global Macro data worsens
BOJ doubles down on asset purchases and
further weakening of the yen in an effort to
boost the Current Account
Japan 2QGDP misses expectations and
causes the BOJ and Abe to institute further
inflation expectations
Sony hedges incorrectly causing the
headline EPS to miss by more than expected
due to FX translation

Risk Reward Ratios
USDJPY

1.58
SNE

1.37
Total Trade

1.87
**Gross of trading costs