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During the month we fully exited our position in Sony, which we had held since June 2019. Over the life of the investment we generated a Sterling IRR of +16% and an ROI of +48%. This compares with a +4% IRR for the MSCI AC World Ex-Us index and +7% IRR for the MSCI AC World index over the same period (£). Our overall thesis was that the market misunderstood the high-quality nature of Sony’s assets due to the structure in which they sat, and that Sony PlayStation was undergoing a step-change in business quality as it became less cyclically tied to the hardware cycle, with a higher proportion of recurring revenues. This proved correct and, reflective of that fact, we sold at an average adjusted forward EV/EBIT multiple of 10.5x versus an entry multiple of 7.3x. In hindsight we should have been more attuned to earnings risks in 2022 and sold earlier, but notwithstanding this we still generated attractive returns well in excess of broader markets.

Like the kiss of death, on the 17^th of January the Financial Times The Big Read column detailed how Sony had evolved into an entertainment powerhouse. The following day shares in Sony fell some -13%, as Microsoft’s proposed $75bn acquisition of Activision Blizzard upended the gaming industry.

Following the Bethesda acquisition in 2021, the move was a further and larger step in Microsoft’s strategy of acquiring studios, rolling up their IP, and limiting the release of future titles solely on the Xbox through its subscription service – Xbox Game Pass Ultimate. Completion of the deal is far from a foregone conclusion, with only recently the US Justice Department and Federal Trade Commission announcing a joint inquiry into how to better detect and prevent anti-competitive deals.

That said, working on the assumption that the deal does go ahead, Activision licensing fees currently accounts for c.8% of Sony’s operating profits, some of which seem at risk over the medium term. In a broader sense, exactly how this alters the competitive landscape will be seen in the years to come, and will also depend on how Sony responds, with Sony having announced the acquisition of games developer Bungie for $3.6bn at the start of February (although clearly, negotiations were likely on-going well before the Microsoft deal was announced).

Sony’s management have shown themselves to be astute operators, having built an unmatched combination of media content assets and consumer hardware technology, as well as semiconductor design and manufacturing know-how. We believe such a combination will prosper in the years ahead.

Sony was the largest contributor to returns in September, adding +0.5% to AGT’s NAV as the shares appreciated by +10%.

As readers may remember, our investment thesis in Sony is predicated on the opportunity to own four world-class businesses (Gaming, Music, Pictures and Images & Sensors) which, due to misperceptions surrounding Sony’s conglomerate structure, trade at a very reasonable (15x EV/EBIT) valuation.

Conglomerates are simply a type of structure in which disparate businesses, with no obvious relationship between them, are grouped under one corporate umbrella. Conglomerates are often valued at a discount to the sum of their parts, as investors worry about one or several factors, such as management’s inability to run a group of companies better than focused single-business competitors, or poor businesses being propped up by the cash flows of stronger ones.

We do not see this being present at Sony. Indeed, conglomerates who can demonstrate synergies between divisions – which would not be possible without the conglomerate structure – often attract a premium. In Sony’s case there are very real synergies, most notably between Gaming and Pictures, where IP such as Spiderman is developed, enhanced and exploited in both game and film format. Over time, we believe investors will come to recognise Sony as the entertainment and IP power house that it is, and the impressive job management have done in building this. As and when this happens, we would expect Sony’s discount to shrink. Combined with the prospects for continued growth in profits, this bodes well for prospective returns.

Turning specifically to the Music business, Sony Music (28% of NAV) is the world no.2 in the oligopolistic record label business. During the month competitor Universal Music Group (“UMG”) – to which we have exposure via Pershing Square Holdings – listed on the Euronext exchange. The IPO of UMG provides another reference point for our Sony Music valuation, adding +3% to our estimated NAV.

The music industry, having seen revenues fall some 42% from 1999 to 2014, has been revived by streaming. We believe content owners are the primary beneficiaries of this, capturing the lion’s share of the profit pool. As well as Sony Music we have exposure to this via UMG (Pershing Square Holdings) and Hipgnosis Songs Fund, the largest pure-play music royalty company in the world. In total we have c.7% of your NAV invested in this “theme” and are excited about prospective returns here in the coming years.

Sony Group reported full year results towards the end of the month, posting profits of almost JPY1 trillion – an all-time high for the company. Barring the Images & Sensors division, average profits for each segment grew by +39%. As a reminder for investors, Sony’s four core businesses are: Gaming, Music, Pictures, and Images & Sensors. We estimate that these segments account for c. 80% of the value of the group.

The best-performing division was the Gaming segment, where sales grew by +15% and margins expanded from 10% to 13%, driving total profit growth of +44%. This was achieved despite the launch of the new PS5 console, which is typically a costly affair. As we have been saying for some time, Sony’s Gaming division is transitioning from a hardware-driven, cyclical business model to a digital-focused model that emphasises recurring transactions. It was therefore encouraging to see a further shift away from physical CDs: digital games accounted for 65% of total sales, up from 53% last year. PlayStation Plus also saw subscriber numbers grow +15% to 48 million. As this transition continues, we expect further profit growth, driven by a higher mix of digital downloads and recurring transactions, which are higher margin. These types of revenues are also likely to be awarded a higher multiple by the market given their increased stability and visibility.

Despite good performance from the group, Sony’s shares fell in the days following the results, reflecting management’s guidance that profits would be -4% below consensus estimates for the following year. However, it is worth noting that Sony has a conservative bent in its estimates: over the past five years, Sony’s profits have, on average, been one-third higher than management’s forecast.

We initiated a position in Sony approximately two years ago, since when it has generated an IRR of +39%. Today, Sony trades on an EV/EBIT multiple of 13x, or a discount of c. -30% to our estimate of net asset value. We believe that Sony deserves to trade at a permanently tighter discount to NAV for a number of reasons: (1) the growth prospects and quality of the four core businesses; (2) the quality of management, which successfully launched the PS5 in the face of criticism that consoles are dying out; transitioned the Gaming division to a higher-quality model; and improved margins at the Pictures and Electronics divisions; and (3) the ability to drive synergies between divisions, which argues for the group remaining whole rather than being run as separate businesses.

We retain high conviction in the stock and its weighting in AGT’s portfolio, viewing it as a core, long-term holding.

Sony Corp was this month’s largest contributor, adding 46 basis points (bps) to returns as its share price rose +8% on the back of a 5% tightening in its discount. As we have been saying for some time, our investment case is predicated on Sony’s four core businesses – Gaming, Music, Pictures and Semiconductors – the attractiveness of which is masked by the conglomerate structure that packages businesses with unique characteristics into a single entity.

The Gaming division is the single-largest segment within Sony, and perhaps its most attractive. Historically, Sony’s gaming business has been cyclical as it was dependent on the ‘console cycle’. This model, however, is changing, as evidenced by 37% of PS4 owners subscribing to Sony’s online gaming service, PS Plus, as well as the release of the diskless PS5. Over the lifetime of the PS4, Sony has improved its subscription offering, introducing microtransactions, platform fees and a streaming service, all of which allow Sony to earn increasing volumes of recurring revenues. These revenues, being sticky, stable, and high margin, are highly prized by investors as they lend higher visibility to future earnings growth. With the introduction of the PS5 in the 2020 holiday period, Sony is well-positioned to capitalise on further digitalisation, particularly as COVID-19 has accelerated the shift towards digital consumption. We believe that the prospects of a shift from hardware-only revenues to a recurring-revenue model are highly exciting, and think that Sony’s gaming division could be one of its top performers in the future.

Moving to look at the conglomerate structure, it seems that our original thesis of a ‘clean up’ of the structure is likely off the table, notwithstanding smaller actions, such as the sale of the stake in Olympus and a pickup in the buyback programme. Whilst this was not our preferred outcome, our base case was always that the potential spin-off of certain assets was a free option on top of the appeal of Sony’s attractive businesses. We take some solace in the decision to introduce higher management accountability at each business line, leading to a more decentralised holding structure and better decision making. Management has also demonstrated advantages to holding music, pictures and gaming under one entertainment holding company, as divisions can cross-collaborate in content creation (e.g. as has been seen with the Spider-Man film and video game franchises).

Sony is a classic AGT investment – attractive assets, misunderstood by the market, with multiple levers to drive growth and create value for shareholders. At a 37% discount currently, we continue to see significant upside in Sony.

SoftBank added 43bps to returns in October, making it the second-largest contributor to returns. The share price rose +5% over the month, propelled by a tighter discount and a 2% rise in NAV. We have spoken at length on Softbank in recent missives, and will provide an update in next month’s newsletter following the release in early-November of its Q2 results. It remains a high conviction position for us.

Sony Corp contributed 28bps to returns, with discount contraction (from 36% to 33%) being the primary driver. We initiated the Sony position in June 2019 and to date it has been a highly successful investment, generating an IRR of 57% and a multiple on cost of 1.33x (local currency). Our investment was predicated on the thesis that Sony’s four “crown jewel” businesses (Gaming, Music, Pictures and Semiconductors) were misunderstood by investors, and that the complexity of Sony’s corporate structure further obscured the value on offer. Our own research indicated that the four businesses were of high quality and likely to drive strong earnings growth in the future; we also believed that there were several levers that could be pulled in order to unveil the value on offer: (a) a spin-off of the Semiconductor business as a stand-alone entity; (b) disposal of listed stakes in Sony Financial, M3, Spotify and Olympus, which would have the benefit of providing capital for re-investment and deconsolidating Sony Financial; and (c) the deployment of a moderate amount of gearing. The presence of activist investor Third Point on the register was also encouraging.

In a sign of Japan’s changing attitude to corporate governance and shareholder influence, Sony didn’t immediately rebuff Third Point’s advances; it disposed of its stake in Olympus and increased its buyback. While it did not go so far as to enact all the suggestions above, neither did it dismiss them entirely and the door remains open for further value-unlocking actions in the future. Looking forward, Sony continues to trade on an attractive 33% discount despite the strong performance since June. Our initial thesis remains intact: we are confident about the prospect of NAV growth driven by the underlying core businesses’ earnings, as well as the prospect of further discount narrowing as the market comes to appreciate and understand Sony. Several avenues remain open to management to help uncover this value.

Sony participated in the unwinding of business ties by selling a 5% position in Olympus for $760m, prompted by calls from Third Point to sell non-core positions. It stated that “Sony will continue the business alliance and collaborative partnership with Olympus…regardless of its sale of the shares”, echoing the views of Mr Tsukano.

Sony Corp is a new position in the portfolio, with our initial purchase made in mid-June, and was the third-largest contributor to AGT’s returns, adding 46bps. Sony is a Japanese holding company with myriad underlying businesses; however, there are four “crown jewels” – Gaming, Music, Pictures and Semiconductors (image sensors) – which account for 68% of sales and over 100% of operating profits (ex-financial services). Operating profits for these four businesses have grown at an annual compound rate of 24% over the last four years. Despite the attractiveness of the underlying businesses, the market prices Sony on a 42% discount to our sum-of-the-parts NAV.

This discount is likely driven by the complexity of the conglomerate structure, which packages businesses with different characteristics into a single entity. The complexity also drives misperceptions which are hard to dispel, such as: (a) the Gaming business is cyclical and dependent on the “console cycle”; (b) the Semiconductor business is exposed to growth in smartphones; and (c) the Mobile Communication division will continue to generate losses indefinitely. Our research indicates that, in fact, the reality is different: Sony’s gaming business is moving to a subscription-based digital model; the Semiconductor segment manufactures genuinely differentiated products and will benefit from the increasing use of cameras in smartphones and automobiles; and with a focus on cost cutting the mobile business will turn a profit.