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This is the second of three research notes covering Sony Group. Part 1 looked at Sony’s semiconductor and electronics businesses and how they have both collaborated to redefine the interchangeable-lens camera market whilst both having their own idiosyncratic growth drivers. This note covers the company’s music business, the incredible behavioural biases currently affecting its perception and the first principles of digital and analog audio that lead to this perception. Secondly, the company’s pictures business is examined with an emphasis on the fact that Sony is the only major Hollywood studio to not have invested in its own streaming service. We show how this strategy to not pursue streaming has resulted in Sony being the sole major Hollywood studio able to supply exclusive content to streaming services, with all other majors unable to due to the fact they are competing with each other in the streaming market themselves. Finally, we look at how walls continue to be broken down between Sony’s business units whilst analysing PlayStation Productions, a collaboration between Sony’s music and gaming business. PlayStation Productions aims to leverage Sony’s extensive catalogue of renowned and maturing gaming IP into Film and TV adaptions, all at a time when exclusive content is commanding a premium price.
Digital Fear & Availability Bias
The word “digital” is taboo in the music industry. It is often coupled with mental images of the industry’s greatest crisis brought on by the advent of computers and the internet. This is a crisis from which the industry has yet to fully recover from 2 decades later.
But what does “digital” even mean, and is the threatening association of the word warranted? When looking at the market’s trepid view of digital streaming services in relation to the record labels it would appear this trepidation is misplaced. Digging further it appears the fear is a hangover of a paradigm shift in the way music was technically reproduced, stored and distributed. This shift during the early 2000s is where the word “digital” gained its notoriety within the music industry.
To understand where the fear was formed we need to first understand the technical basis of analog and digital audio reproduction. Analog audio reproduction is produced through continuous audio waves, with the audio output being able to take an infinite amount of values within a defined range. Digital audio on the other hand is a stepped wave made up of discrete values of either 1 or 0.
The continuous values within analog audio signals create a smoother wave, whilst the discrete values within digital audio signals create a stepped wave, where the 1’s and 0’s are represented by upward and downward movements respectively. This comparison is portrayed below:
Why is this important? Because it allows us to gain a first principles understanding of why digital audio decimated the music industry.
The value of the analog audio signal can be any value within the defined range. When an analog audio copy is made, and noise interferes with the analog audio signal we cannot tell the noise apart from the original information we want, as any value within the range is possible. This leads to degradation with each subsequent generation of copies. As each generation is made, more and more noise is introduced into the analog audio signal.
On the other hand, the digital value can only ever be a 0 or a 1. If due to noise the copy of the digital signal is 0.002, or 0.991 we can still easily see this is meant to be a 0 or a 1, and we would record 0 or 1 in the digital copy. What this results in is the near zero introduction of noise, and an unrecognisable level of degradation, when each subsequent generation of copies is produced.
This fundamentally changed piracy because thanks to 1’s and 0’s the copies could make copies, and the copies of the copies could make copies, and so on. Of course, analog copies could make analog copies, but the quality loss was noticeable to the human ear as more noise accumulated with each new generation of copies. That was the technical first principles shift in audio storage, reproduction and distribution that decimated the music industry throughout the 2000s and early 2010s and why the word “digital” is still associated with threatening change.
Digital Opportunities are Greater than Digital Threats
The numbers show that digital streaming is the best thing to happen to the music industry since record labels started selling digital music rather than analog music. The music labels found it much harder to sell digital music due to it allowing for rampant piracy. During the early 2000s it became all too apparent that record labels only made money if people actually paid for the music they listened to. The devastating impact on the music industry is all too evident in the performance of Sony’s music segment from 1997 to 2002 found in the below chart:
Platforms such as iTunes helped alleviate this problem, but it took until the mid-2010s until streaming services properly solved it. They did this by building platforms that made paying for digital music through a streaming service, rather than downloading a pirated copy from a ubiquitous file sharing service, a “no brainer”.
This creates what is a symbiotic relationship within the music industry between the owners of music content and streaming services that distribute the digital audio to consumers. A biproduct of this relationship is mass confusion within the market, with humans much preferring to think in terms of “winners” and “loosers”, or “black” and “white” scenarios, and then valuing companies accordingly.
If the major music labels wanted to slowly consume the margins of the streaming services they probably could, but why would they? As we can see below the record labels benefit greatly from streaming providers, as they have provided all the growth for Sony’s Recorded Music business.
Due to the digital transition of the early 2000s, and an in inherent availability bias, large parts of the market appear to be viewing the rise of streaming services as a threat rather than an opportunity for music content owners. As is evident in the numbers above, and the chart below, this view is objectively wrong:
If we look at Spotify’s gross margins we can see that recorded music labels and music publishers are still taking a large piece of the pie. The best way to look at this is through Spotify’s COGS, or what the labels more or less get paid as a percentage of revenues.
Spotify’s COGS as a percentage of sales have decreased at a rate of 3.4% per year, due to more favourable content licensing agreements, as disclosed by the company.
Deals between Spotify and music labels are renewed roughly every 2 years, and as can be seen above COGS/sales has been stable since 2018. What we think this shows is that the relationship between Spotify and the major music labels is starting to mature and find an equilibrium.
This current market dynamic seems somewhat in-line with what we imagine a market equilibrium between the major music labels and streaming companies would look like. This equilibrium would be a product of a music market where more people are paying for digital music, the concentration of music ownership amongst labels and publishers is unchanged, and where major tech companies continue to try and enter the music streaming market and establish a viable position.
We do not see this equilibrium as the return to the golden years of music labels where music was distributed through physical analog mediums. We do see it as a defining structural shift in their favour, as people are now actually paying for digital music. Whilst Spotify and other services are vying for control of this new form of distribution, it is the recorded music labels that ultimately own the content that is being paid for, and they own it in great concentration.
This is a profound development that sees companies within the music industry finally catching up with the first principles shift of the early 2000s. Music companies and artists can now earn a return on their content that is linked to its success.
The ubiquity of paying for digital audio is a fundamental shift for the music industry and its importance should not be underestimated, hence we have used a 15% growth rate for the next 5 years decreasing to 10% for the following 5 year and then a terminal rate of 3%.
These growth rates are in-line with the benefits Sony’s business unit has reaped from the growth of streaming over the past decade, and we believe these tail winds will continue into the future. We have also considered the ever expanding installed base of portable smartphones/music playback devices within developing markets, and the bargaining power inherent in the concentration of music ownership amongst the big 3 labels.
What this gives us is a valuation of roughly USD $43 billion. This is in-line with Universal Music Group’s SPAC valuation. Investors have their reasons to be concerned that these valuations are “frothy” however the fundamentals appear incredibly positive. The general market scepticism of these valuations, which we ourselves experienced before peeking under the hood, is what we believe to be the product of incredibly strong availability biases, resulting in a view that any digital change within the music industry is bad news.
Content is King
Much has been written on the current battle within the video streaming market, so here we will focus solely on Sony’s strategy. It will become quite evident through this explanation how Sony’s strategy contrasts significantly with those of the other major studios, providing unique opportunity.
Sony Pictures Entertainment and Sony Pictures Television are the company’s two primary content creation, distribution, and licensing subsidiaries. Whilst being smaller than the other major Hollywood studios Sony is still considered one of the majors. Unlike its peers has not invested in its own streaming service. Instead, Sony has decided to licence its content to the highest paying bidder amongst the numerous streaming services competing for eye-ball time.
Why does this matter? Well, the strategy has allowed Sony to be nimble and to strike unique content deals. The company’s most recent deal was the first of its kind. The deal is two-tiered in nature and includes distribution through Disney and Netflix. In this deal all new Sony films will first become available on Netflix after their initial release in theatres. More on theatres later. After their initial release on Netflix, Sony’s content will then be distributed exclusively through all of Disney’s distribution channels, including Disney+, cable channels, ESPN, FX and so on.
Furthermore, Sony’s commitment to releasing films in theatres is acting as a large drawcard for artistic talent. To leading directors and actors the artform of putting films in theatres is nearly as important as money. We have seen artist dissatisfaction manifest with the strong pushback Warner saw from the likes of Christopher Nolen when the company announced it will be releasing films on its streaming service and in theatres on the same day.
Has this strategy led to increased profitability? Not really, at least not yet. Sony’s pictures segment has notoriously low operating margins when compared with its peers. Operating margins have trended higher though, as is evident below. When combined with the segments increase in overall revenues this has seen operating profit increasing at a CAGR of 3.1% since 2015.
As we have mentioned, Sony is one of the last major Hollywood studios to exclusively release its Marquee films in theatres. The pandemic made this option unviable, leading to multiple big-budget films still awaiting release. This should be considered when viewing their above performance. Two of these titles include the sequel to Venom and the theatrical adaption of the PlayStation game Uncharted, the latter we will explore further below.
There are obvious tale winds to Sony’ pictures business, all mainly due to the current insatiable appetite for content by streaming services. These tailwinds, however, are hardly complex and are easy to understand, meaning the market is in all likelihoods completely aware of their existence and has priced them in accordingly.
So where is the value in Sony’s pictures business that is misunderstood? Well, that lies in the company’s unique position as an owner of the world’s largest console gaming platform, a major Hollywood film studio, and an extensive catalogue of critically acclaimed gaming IP.
Cross-Medium Content
PlayStation Productions is Sony’s play, excuse the pun, at mining its extensive catalogue of award winning gaming IP into compelling TV and Film content. The business unit is based at Sony Picture’s Culver City lot and is currently working on 3 movies and 3 TV series that utilise Sony’s first party gaming IP.
No other major Hollywood studio has access to such an expansive and quality catalogue of gaming IP. Whilst other major studios can partner with gaming content owners it is simply not as fluid. Gaming execs are reluctant to expose their incredibly valuable IP to movie studios to interpret. In the must read article by Mathew ball, 7 Reasons Why Gaming IP Is Finally Taking Off in Film/TV, Ball puts this friction down to the risk-reward for gaming companies.
More specifically he states that “the risk-return for IP owners is shaky (see the 1993 ‘Super Mario Bros.’ movie) and we must examine ‘why’ a gaming studio wants an adaptation in the first place and why they suddenly feel the need to adapt now. After all, there are lots of other things they can do - like make more games - and the core business is doing very well”. What we believe this results in is most of the best gaming IP being locked up.
The potential return in exchange for risking their most valuable IP in the hands of movie studios has never been great enough for gaming companies. The respect for the quality of gaming IP is also questionable, with what appears to be B-grade production companies (based on their previous works) being assigned to the production of movies based on games. This is all too evident with the same company who was responsible for producing the low-budget Barbiedirect-to-DVD films being assigned by Universal to the production of the film adaption of PlayStation’s Ratchet & Clank (2016).
PlayStation Productions does not face the same constraints, with a catalogue of high-quality gaming IP and Hollywood’s 5th largest studio falling under Sony Group’s control. Collaboration between PlayStation Production’s and Columbia Pictures, both based on Sony Pictures Culver City lot, is yet another example of how Sony is breaking down the walls between its business units to create products other companies simply cannot. This is reminiscent of the collaboration between Sony’s semiconductor and electronics subsidiaries that saw Sony revolutionise the interchangeable-lens camera market over the past decade, which I covered in my previous note on Sony.
We will have to wait and see how this collaboration plays out, excuse the double pun. The first product of PlayStation Productions and Sony Pictures Entertainment to hit theatres is Uncharted, now slated for release in 2022. The level of resources going into the film makes it appear promising, with Avi Arad being hired as the producer. Avi Arad played a major role in resurrecting Marvel comics in the early 2000s where he was the producer on the following films: Spider-Man 2 (2004), X-Men: The Last Stand (2006), Iron Man (2008) and Ghost Rider (2007). For the movie industry layman, a producer is like a film’s CEO. Whilst the director, writers, cinematographers, and actors are largely responsible for the artistic elements, it is the producer who is ultimately responsible for making the movie a financial success.
When valuing the pictures segment, I have decided against using a DCF valuation and rather to use a valuation based on current deal multiples. The reason for this is that we have been lucky enough to have a couple of recent market transactions that can shed some more accurate light on the business’s true value. As one of Australia’s most renowned investors once said to me in regard to business purchases “this is a real life business, not some idiot in a fund paying for something”. With that, I’ll give more merit to Amazon’s purchase of MGM Studios and Disney’s purchase of 20th Century Fox’s studio assets than my own DCF assessment.
The May 2021 Amazon purchase valued MGM Holdings, the operator of MGM studios, at 5.9x revenue. In comparison Disney’s 2019 purchase of 21st Century Fox’s studio assets valued that company at 2.8x revenue. The value of exclusive content has incidentally risen for streaming providers over that time. Sony Pictures fiscal 2020 revenue was USD $10 billion, implying a current valuation of USD $44 billion based on the midpoint revenue multiple of the Fox and MGM sales.
This may appear outlandish, but I’d be confident to argue that Jeff Bezos and the team at Disney know the value of exclusive content to a streaming company looking to grow aggressively over the coming decade. For reasons previously discussed it appears that Sony pictures is terrifically positioned to profit from supplying this exclusive content to all the major movie studios competing in streaming. Compounding this is that all other major studios cannot profit from supplying exclusive content to other streaming services as they are all competing with each other. Taking this into account the USD $44 billion valuation appears ever more reasonable.
Arms Dealer in an Arms Race
The music and film industries are experiencing immense and complex structural shifts. The benefits and drawbacks of these complex changes is harder again to comprehend, as they will only be felt over the long term. Based on our understanding and judgment it appears that Sony finds itself in a position to capitalise on the benefits of consumers ubiquitously paying for digital music through streaming services. We also think that the company finds itself insulated from any dominant streaming service’s market power by the high concentration of ownership amongst the major music labels.
In film Sony is evidently zigging where others are zagging. It also finds itself uniquely positioned to capitalise on its ever maturing gaming IP at a time when streaming giants are demanding more and more exclusive and differentiating content. Lacklustre operating margins have been persistent at Sony Pictures for a considerable time, however, the company now faces its best opportunity yet to increase its levels of profitability. The potential offered by the company’s unique position to unlock Sony’s gaming IP, in combination with its strategy to be the provider of content to major streaming services, and to not have to compete with them, provides SPE with its best opportunity yet to increase its profitability.
Summing up, it appears Sony management has examined itself and found a company with vast amounts of quality content, and the expertise to continue producing more of it. Their strategy to be the arms dealer in an arms race has allowed Sony to position itself unlike other content owners and streaming services. With what appears to be the right strategy to create more value that others cannot, in our judgement it incidentally appears to be a strategy that only Sony could pursue.
Part 3: TBA
Work on part 3 has begun, and it is scheduled for release next month. It will focus mainly on Sony’s gaming business, PlayStation. It will also include a capstone summary and valuation of the company, including its financial services business, a dominant life insurer in Japan. Sony’s gaming business is incredibly complex and vast in nature and deserving of the attention in what is for the most part its own report. For a deep-dive on PlayStation and the conclusion to this trilogy, that includes a sum of the parts valuation of Sony Group, please make sure to subscribe below now.
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