Gaming Consoles Part 2: Sony - [Business Breakdowns, EP.202]

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1:55This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

2:37This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell, and this is the second episode of our multi -part series on the video game console market. If you've yet to listen to episode one, Sia Kamali is a founder and fund manager at Skycatcher. Join me to break down that video game console market and his thesis for why it's an inflecting opportunity. In this episode, we go micro, and Sia is back to break down Sony. Now, given this episode is part of the series, I'd say it's not your traditional breakdown. We spend the majority of our time talking about Sony's opportunity in the gaming market and the growing anime market.

3:21So Sia and I spend a lot of time talking about the catalysts there and just some of the dynamics that are happening under the hood of this massive conglomerate. Now, please enjoy this episode on Sony. All right, Sia. We're going to get into the meat and bones of Sony here. It's a tech conglomerate. We're going to take the video game angle, I think, a lot through this conversation. But Sony is so much more than that, has this major history to it. Let's just start out with a framing of Sony, a sketch of the business, in the best way that you would describe it today. Absolutely. So I think, Matt, the one -liner here is Sony is this awakening global giant in video games and anime.

4:03And let me tell you a little bit why. It's a company of $120 billion enterprise value. It generates about $80 billion in revenue, $9 billion in earnings across six business segments. And the most important one and the key to our thesis is this division called Sony Entertainment, which makes up three of the six divisions. And that represents about 60 % of revenue and earnings. Now, a lot of people, they'll recognize Sony for its leadership in hardware and legacy media. And they're all really great. But I think when you think about the future of Sony and what we think is really underappreciated and undervalued by the market is that it has two generational consumer platforms and PlayStation and Crunchyroll.

4:47Now, both these platforms capture sector growth in key categories of video games and anime. So PlayStation is typically seen as a hardware business, very cyclical. But for us, we view this as really a critical distribution channel for games. and it functions as the app store, the content library and storage. And we think it's about to hit this magic window where lifetime value of the customers will grow three times over the next five years. And then the other part for Sony that has been really clear in the last 12 months is they're going to tap into the global growth of anime. In fact, they already own the largest streaming platform in Crunchyroll, which you can think of as the Netflix for anime.

5:30This has reached over 150 million users and is entering this next stage of monetization. And so big picture, looking at Sony, this big conglomerate, we think PlayStation and Crunchyroll generate very high margin of software, high margin software earnings of about $2 billion today. But we think this will grow five times over in the next five years and will be really what drives this inflection for Sony where you think of this as this industry -leading, digital -first, software -driven engagement entertainment platform. The history here is so interesting, as you mentioned, whether it's the hardware of the PlayStation or going back in time to the Walkman.

6:11Sony, I always associated with various pieces of electronic hardware. Can you just bring us up to date? It sounds like we're seeing this shift towards more digital, more software -esque model. How did that take place? And any of the interesting anecdotes over the years that turned Sony into what it is today? No, absolutely. So I think it's important to start looking at Sony from 2021. It's when it reorganized itself as a global consumer entertainment company. And it's also when it started its quote, fourth midterm plan. And that plan, they called it evolving Sony. That plan ended last year. And we're now entering this next phase, which Sony calls beyond the boundaries plan.

6:54Now, this fifth midterm plan, which begins this year, it's all about Sony evolving its leadership into what they call creative entertainment, being able to connect the multi -layers of physical and virtual realities. I think you sketched out the segments well for us. Could you put some numbers around just those various segments? I know they have the music, Sony Pictures, any of the high -level numbers just to frame those pieces of the business? Absolutely. So look at the consumer entertainment business, which is 60 % of the business, as one big group. This is the core, what we think is the most valuable part of Sony.

7:36Under PlayStation, you have a business that's called almost $30 billion in revenue. Today, generates about $2 billion in operating profit. And we think this grows to $8 billion plus. and margins go from 7 % to 19%. And it is the number one console ecosystem today with over 160 million monthly active users and 70 % of them purchasing games through the console itself. Then we go look at music. So their music business is number one in publishing. And in fact, you could look at this and say, this is an iconic asset because it captures over 5 million plus songs. And it's a solid business where margins have been steady at 20 plus percent on that front.

8:20And that's roughly a $10 billion business that we're going to be conservative. Let's just assume that Kegger's at the 8 % because it's built on the back of streaming and royalties on that front. Then we look at Pictures. Pictures is about a $10 billion revenue business, but its operating profit is about $800 million. So very low margin. but within pictures you have a historic business of box office movies so like spider -man jumanji ghostbusters and then you have this really gym of the asset called crunchyroll which is the third largest stream platform in the world today and we think this is going to take or grow revenue at 40 plus percent and ultimately take over pictures and maybe even they break it out as its own category on that front.

9:05Now, when we get to the historical part of Sony, where this is where we pretty much value very conservatively, we're not trying to take a strong view. In the hardware business, this is when you're looking at TVs and just the traditional stuff that you know Sony for. Their image and censoring business is about a $10 million business, and that's high single -digit margins. Their dominant leader in this category in terms of camera sensors, about 53 % market share of the world. And then there's a category which is the, they call entertainment technology and services. And this is a $16 billion business, but it has all the other different hardware devices in that buckets.

9:45And then last but not least is financial services where a bright spot to our thesis was this is something that they will spin off next year. And it shows a commitment from management team to really become a more leaner focused consumer play. Yeah, it's always interesting when you hear conglomerates start to make some type of focus on different categories. And it seems like that's happening here. But as you run through all of those different categories, there's still a lot of moving parts. I want to get into the Sony Pictures a little bit and that Crunchyroll theme. I do have to mention the book, the big picture on the Sony Pictures hack was one of the more interesting things that I've read in recent years.

10:27And it's just been so interesting to see how they've dealt with all of the shifts in movies, with theaters, with streaming, and adjusted their business as such. But there's not much talk about Crunchyroll in there. And it's a name I'm familiar with, but I don't have too much detail on it. So you mentioned it's a massive anime audience. Just go into a little bit more detail in terms of what that looks like from a financial perspective and what the actual business is and business model is there. Yeah, absolutely. So going back to this 2021, Sony went and consolidated the anime streaming platforms.

11:06They bought a few players and they rolled it up into this business called Country Roll. And with that, they basically own the market and live streaming of anime content. Now, let me take even a step further back. Anime is one of those categories that's been in secular growth. But what's interesting is the tipping point of industry has grown outside of Japan for the first time in domestic Japan. And it's about a $30 billion industry. Most of it's in merchandise. But one of the things that's, I think, interesting is that you saw post -COVID behaviors around medium content become more nuanced. And anime saw huge growth on that.

11:48When you think about this category, we estimate there's almost, call it, 600, 700 million fans on its way to a billion plus. And it's people that you wouldn't necessarily expect, but it's also exciting to be this countercultural, but at the same time, pretty mainstream. because it's more than just cartoons. It's adult cartoons in that sense. Now let's get to the numbers for Crunchyroll. So Crunchyroll is the third largest streaming platform. It's about 150 million users. Now it's got, of that 150, about 15 million are monthly paying subscribers. The rest are being monetized via ads. And so the thesis here is that over time, you're going to see users convert from the advertising model to the paid model.

12:33And with that, you see this Netflix story happening all over again. Because imagine buried in this agglomerate called Sony, you have a business that's almost half the size of Netflix in terms of user base. But monetization -wise, it's early days. This is Netflix in 2011. We have a long way to go to get these paying subs up. So one of the key things that we're really tracking here is the growth of the paying subscribers on that front. And then if you think about, let's go back to this Netflix comparison. In terms of Netflix average revenue per user, it's about $140 per monthly active user. For Crunchyroll, it's $9.

13:12So there's a long way for this to grow. And we also know that by tracking the behavior of Netflix, you can see anime content on Netflix picked up massively in the last few years. you may say oh this is competitive to Crunchyroll well not necessarily because one of the key things about Crunchyroll and anime is that most of the content being watched is licensed content it comes from the manga it's come from Japan itself you can't just go in so many relationships and exclusive licensed content on their side and Netflix has tried into this category by doing their own originals and to some extent, but nowhere near the success of major anime IPs like Naruto or Dragon Ball Z, etc.

13:59It's very interesting because I think Sony was the poster child for not going down the path that Disney and Paramount and so many others went down where they chased the streaming app themselves to compete with Netflix idea. They were happy to license things, yet they do have this business inside the company that's doing just that. So there's some thoughtfulness around it and just interesting to hear. When you think about all of the business lines together, how much synergy do you think exists from operating these? And do you think there's a lot of cross -functionality? If there is a great IP title within the PlayStation universe, is that something that is very likely to get led into something that can happen at Sony Entertainment?

14:46Is that part of the thesis at all or just anything around the culture with those synergies and that collaboration in mind? Yeah, I think one thing that you, and this is more unique to the Japanese gaming companies is they've all been building transmedia IP. What I mean by that is it's across, building IP across multiple channels. So whether it's games, books, movies, merch, that's something that you don't really see done anywhere else as well. And so for Sony, they're in a unique distance where going back to this anime number of 30 billion, most of it's merchandise. And the video game part of it is not actually tapped into as much as we think.

15:28And if you look at the overlap of people who love anime and people who play video games, it's actually very high. And so you wonder yourself, why isn't there more monetization happening on the games front? Because that's actually a really great place to monetize. Well, there is this company called Bandai Namco that is doing this, and they have a strong hold on top anime IP in games. And I think Sony is in a great place to start going down this path of building out anime content for games, but being able to say, we'll leverage our global presence of PlayStation, and then we'll leverage the fact that we have the platform that everyone is watching on.

16:07And remember, part of that power of having a streaming platform is you see what people watch, you can then tailor your future content to that. If we went down the rabbit hole and you had more hours to share, the rabbit hole of sub -genres within anime is absolutely fascinating. And you'd be blown away of how much creative content there is because there's things you can do with that medium that you can't do with traditional and in many ways open up the world of philosophy and life and the challenge that we as humans face in storytelling. So Sony is definitely thinking about this. They've talked about this.

16:47And I think we're also quite excited to see how they connect these dots. Are there unique or innovative ways that they're going about this collaboration or synergy across the platform? They are, Matt. So one of the most interesting moves Sony made this past August, they announced launching a layer two blockchain called Sonium. And if I take a step back even further, about two years ago, Sony filed patents around the usage of NFTs to move digital assets across different ecosystems. And so I think when you think about the blockchain application of IP and idea of owning a digital asset, Sony is really, I must say, the best positioned person in the world executed.

17:39And they've already started. They've already made a couple of moves. And I'm really excitedly looking to see how this evolves. And I think the other thing that you have to appreciate is Sony, their move here will be very much consumer led. This is not going to be the iterations of what you've seen before, how you think of NFTs, but really the idea of this is a public blockchain, you own these assets, because the concept of owning a digital asset, it's quite novel. but it's something that I really think is one of the game changer aspects of enabling the video game industry to expand its total addressable market in a way that we cannot fathom today.

18:18I mean, just imagine the scenario where in 20 years from now, your portfolio of assets is your home, your car, but also my sword and World of Warcraft that's worth $100 ,000. It's not too crazy, But I think it's when these big TAM expansions happen is usually when you have big outcomes. And we're really watching very closely what Sony is doing here because they also have IPs across music, film, anime, and video games. When you put the pieces together, I think you referenced it. You're looking at a $130 billion company in terms of enterprise value. What does it look like just from a consolidated margin standpoint?

19:01any of the high -level metrics that are important to just frame what the business looks like today? Overall, we think margins double from here, which sounds aggressive, but it's around 10%. It's low, 9 % to 10%, $80 billion in revenue. And we think if they can double this in the next four or five years, one, you'll surprise everyone. But two, it's on the back of what I've went back to our core thesis, it's in the back of PlayStation and Crunchyroll, really hitting this next stride of software -driven businesses and software margins on that front. And I think if you look at Sony at that next stage, so today, Sony's earnings are around 11 billion, and you think earnings are going to double from here and get to 20 billion plus.

19:50Well, that's an easily double in terms of return from here. But let's go back to the argument I'm making earlier that I think the multiples should be much higher. Why is this trading at called single digit multiples? Shouldn't this trade on much higher multiple? And if that's the case, we have this multiple expansion part. And so one thing that we always think about in our investment process is we want the double kicker or what I say is the magic window. Our needs growth and multiple expansion. And in that case, we see Sony as this $400 billion company, a triple from here, but it's because it's being recognized for its leadership in these categories.

20:28And it's really a one -of -one in both of these. I think the question just comes as, why are the margins not reflecting that? We're now entering this next stage where I think you'll see that. And it kind of follows the same playbook that management has laid out for everyone. They've been very good about communicating more so now than I think in previous iterations. If I were to just dive into those numbers a little bit more on the doubling of the overall Sony margins. It's going to be driven by what is a higher margin business with PlayStation and I'm sure Crunchyroll versus as much the increase in the PlayStation margins themselves that are also going to increase because you need massive incremental margins to get to that true doubling of the overall doubling of margins.

21:15So remember, PlayStation ecosystem margins have been compressed. They're on 11%, 12%. 11. Okay. They should get much higher. And that's part of because of the last four years, this ecosystem has been weighed down by the hardware sales of PS5s and not doing as well as they expected. That changes, I think, next year when you have a console selling title and then you're also entering this next stage of them leaning into live service games, which feeds more people to subscription. So PlayStation actually margins get to 20 plus percent. That's how we're looking at it to make it work. And then you look at Crunchyroll and you say, look, so Crunchyroll is this early stage of a business where we think revenue is today around $1 .1 billion.

22:02And I think Topline is going to grow at a 40 % CAGR for five years. You're looking at a business that's close to $9 billion in revenue. And with, let's say, Netflix -like margins, that's going to really get us there. where we're probably being the most aggressive or the most, let's say, non -consensus is looking at a country role through this lens of this Netflix playbook. Until today, I think because it's not broken out separately in its nice, clean way, you have to do a bit of back -of -envelope math to figure it out. But we're not there yet, but if that's representing that big of a part of the business, then it will make sense.

22:42And then people will say, oh, this is the tech giant who was able to go into streaming platforms in a way that was very niche, looks niche, but then super successfully because it's an area that necessarily, it's hard for Netflix to compete with directly in that sense. For the Crunchyroll thesis, just in terms of that evolving and playing out over time, How much do you hear the company talk about it, if at all? And just the timeline for something like that, as you mentioned, substantial growth, but still at a billion, even with 40 % revenue growth, showing up in an $80 billion revenue business, it's going to take some time before it feels like that really moves the needle.

23:25So what do you think the timeline looks like for that to really become a meaningful piece of the business? And are you hearing it from the management team that that could be a possibility or a focus for them. Never known any management teams to get very loose guidance like that. Certainly not that. Yeah. I guess how much does Crunchyroll just come up in the conversation? They've definitely communicated we're going to focus on anime. I think the question just becomes is how big of an opportunity? What does it mean for the overall? Too soon. Yep. That's something that we're willing to step out and be a little bold and say, well, based on what I know today, let's be a little visionary because if you ever think about these big outsized returns, they never come from thinking in a linear way.

24:11You have to think directionally, am I right? And then more importantly, is there accelerating growth here? And we think all those pieces are here. And it's a story that's not getting a lot of talk about, but next year will be an important year for it because there's a bunch of events happening in terms of anime next year. Yep, that makes total sense. And yeah, just given the size and where it is today, it's hard for management to spend a lot of time on that when they have the rest of the business. What would you say are their key areas of focus when you hear them? Does it tend to align with the way that you see, especially in terms of the video game business, the console business?

24:52How much of the focus seems to be pointed in that direction, both for the management team, from investors versus other initiatives within the business? sometimes these can be challenging because conglomerates can have problem childs or different focus areas when there are crown jewels sitting inside. So what does that look like for Sony? Yeah, I think if I didn't feel like they were not focused on the right things, we wouldn't be having this conversation. I do feel like the management team really gets it from that. But you're also moving this big tank or 800 -pound gorilla. And so what happens in the hardware segment?

25:28You know, what happens in the chip segment? When you look at Sony, it was basically for us, it was building six different businesses in one. And then seeing, okay, well, the ones that matter, the one that management teams want to go towards, it's clearly entertainment. They have clearly focused that. And then where they've spent a lot of their messaging, which it's not fully grasped by us, this idea of creative entertainment technologies. because they are a leader in the picture sensors and obviously they have an investment and partnership in Epic Games. They see this world where they've got this huge unique position of capturing the physical world, right through cameras, and at the same time in tooling, at the same time creating content, and then looking at their distribution channels.

26:16They own the gaming distribution channel PlayStation and now they already have this distribution channel through anime. So I think this next iteration is like, how do we connect these dots? So Sony Music, incredible assets. Like it's really a time capsule of human songs, the greatest songs. And great business too. But what's interesting is when they sign up new artists, a lot of artists say, look, we want to do a concert and a video game. And they've done it. They were the pioneer in terms of doing concerts in Fortnite. And I look at that and I say, what music publisher can give you that kind of access?

26:52There's unique moats and there's unique relationships that Sony has. If you put it all together, you're like, wow, this is a real one -on -one. And the Manchin team sees it and gets it. Thinking about the industry dynamics, the conglomerate dynamics, M &A is a key piece of this. It sounds like I'll put the spinoff in the M &A category just as a right sizing of the business. What does that look like just in terms of their historical activity, whether it's being an acquirer, whether it's being someone who divests a lot of assets? And then how do you think they exist within this world of M &A going forward?

27:31Because they do have so many interesting assets that could also be an acquirer of assets. Just a general thinking around Sony and M &A would be useful. Yes, we were in this period of the fourth term where it's the evolving Sony part. So during this period, they've made a bunch of acquisitions. They bought a few game studios, probably the most notable one you know was Bungie, which has made a game called Destiny. And then when you look at the divestor parts, which will happen next year in financial services, this is all part of this Sony as a creative entertainment company and really focusing on IP.