A Turnaround in the Making

08/19/2008 12:00 am EST

Focus: GLOBAL

Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, editor, Morningstar InternationalInvestor, sees great potential in Sony's recent transformation.

Sony (NYSE: SNE) has regained some of its former luster after playing catch-up with the competition. Its smartphones, PlayStation game consoles, and Bravia line of flat panel televisions are all market darlings. Sony's Blu-ray technology win as the next-generation video format ensures that the firm earns licensing revenue every time a Blu-ray DVD is printed. However, if Sony wishes to restore its electronics franchise, it needs to convince consumers of its vision-namely, how its multiple products and services work together.

Sony has made significant progress in the past three years. It has slashed nearly $2 billion in costs by cutting jobs, outsourcing nonessential operations, and selling assets. It has partnered with Samsung to make the popular Bravia TV line and Ericsson ERIC for phone-Walkman players. Management is working hard to change the compartmentalized corporate structure to aid in the transition from an engineering-centric to a consumer-oriented company.

At the heart of Sony's turnaround strategy is PlayStation 3 (PS3). Although the game console business is relatively small in terms of sales, it can be a disproportionately large contributor to profits at the peak of a product cycle. Normally, a console follows the razor and blade cycle, where the firm breaks even or loses money on selling the hardware but eventually makes a killing from selling high-margin games and accessories. The Blu-ray DVD drive embedded in the console provides the PS3 with another appeal for consumers.

Now that Blu-ray has become the de facto high definition standard, the PS3 is one of the cheapest next generation DVD players on the market and is the only game console with that feature. Sony's ultimate goal is to replicate Apple's (Nasdaq: AAPL) success in music and videos, with a vision toward the future when it will be commonplace to download movies over the Internet. Sony aims to make the PS3 a home entertainment hub.

We are maintaining our fair value estimate at $60 per ADR. We assume new product demand and the restructuring will improve free cash flow during the next five years. We forecast about 5.5% annual sales growth over the next several years, driven by sales of flat-panel TVs, gaming software, and consumer electronics. Our model does forecast improvements in operating margins with the restructuring effort; we forecast 5% margins (after film cost amortization) by 2011.Despite the recent softening in the worldwide handset market, the Sony Ericsson joint venture should be a key driver behind the earnings growth over the next few years.

Subscribe to Morningstar InternationalInvestor here.

Related Articles on GLOBAL