My thesis from earlier this year on Japan's Macroeconomic output and how to best profit from the poor economic decisions of Japan.

1. 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

2. Global Deficits, GDP Growth and Labor Force in the past decade
5 Largest Economies Dollarized GDP Growth YOY versus
World Deficits as a percent of GDP
Over the past decade global deficits
have increased global growth proxied by
the 5 largest economies has downshifted
•
-
Global deficits (in red) seem to be in a
permanent “new normal” trend, global
GDP growth is in a severe downtrend
•
The population to employment ratio in
the US (blue) peaked after the dot com
bubble burst,
Japan’s Population to Employment
Ratio peaked in the early 90’s
France looks like it peaked in the 80’s.
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 Employment to Population Ratio (ex China)
•
•
•
A lower number of employed funding a
larger number of unemployed workers
creates social, political, and financial
consequences
Eventually the demographics will
compound on the already bad decisions
being made to create a debt crisis.

3. 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 BOJ’s
Balance Sheet (shown in red)
Notice the exponential nature of the increase in the
BOJ’s balance sheet since Abe has entered office

4. 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?
Growing consumption?
•
•
Japan GDP by Expenditure FY 2012
Consumption
Investment
Government
X-M
-2%
20%
20%
58%
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

5. 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 doesn’t 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
•
•
Industrial production has dropped off a cliff
Inventories look to be in a downward spiral (reduction in inventory due to lack of demand)

6. Structural Changes in Energy will compound the weakness in the Balance of Payments
Trade is deteriorating and with no natural resources and no nuclear production, Japan must import almost all of it’s
energy. To add fuel to the fire, Japan’s politics have shifted post Fukushima to not favor any nuclear power.
Japan Abandon’s Nuclear post 2011
40,000
20
18
16
14
12
10
8
6
4
2
0
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Energy
Number of Plants
December 2012 Poll - ASAHI SHIMBUN

7. Adding debt to the most indebted nation on earth
Current Accounts and Fiscal Deficits are
highly correlated. A current account deficit
will mean a increase in the fiscal deficit for
Japan.
•
•
•
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
Japan can’t 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.

8. So how would you trade on Japan’s coming fiscal crises?
Characteristics I want in a company to play the
eroding of Japan’s 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
Net Sales by Region as % of Total
Sales
Other
Areas, 11.96
%
AsiaPacific, 9.80%
China, 7.62%
Sony Pension Underfunded Status
Sony Segment Mix
-¥400,000
-45.0%
30%
-¥350,000
-40.0%
25%
-¥300,000
-35.0%
-¥250,000
-30.0%
-25.0%
-¥200,000
-20.0%
-¥150,000
-15.0%
-¥100,000
-10.0%
-¥50,000
-5.0%
¥0
Funded amount as % of PBO
Underfunded amount (Millions of ¥)
United
States, 18.66
%
Europe
, 19.53%
•
20%
Underfunded
Funded as %
of PBO
Revenue
CAGR
FY09 - FY12
-20%
Imaging Products &
Solutions
Game
Mobile Products &
Communications
Home Entertainment &
Sound
Devices
15%
10%
5%
0%
-10% -5% 0%
10%
20%
Pictures
-10%
-15%
-20%
Operating Margin
0.0%
Scale inverted
•
•
Japan, 32.41
%
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
•
•
•
•
Music
Financial Services
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)

9. Sony’s Fundamental’s
Sony Cash Conversion Cycle
Long Term Debt and Asset Efficency
100.00
80.00
60.00
6.00
Days Paybles
0.00
•
•
5.00
4.00
Days Inventory
40.00
20.00
70%
60%
50%
40%
30%
20%
10%
0%
3.00
Days
Receivables
2.00
CCC
0.00
1.00
Sony has decreased it’s CCC by increasing it’s days payables
Sony was downgraded to Baa3(negative outlook) in 4Q2012
• Because of this downgrade I don’t believe the CCC can
improve by dragging out payables much longer
•
•
•
Financial
Leverage
Asset
Turnover
Sony’s 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 hasn’t effectively
controlled the Balance Sheet
Age and Depreciation of Assets
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
74.00%
CAPEX as % Rev
73.00%
72.00%
71.00%
•
R&D Exp as % of
Rev
70.00%
69.00%
68.00%
67.00%
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

10. The Weavers (Thirdpoint) proposal and why Sony shouldn’t agree
Point
Counter-Point
Point
Counter-Point
Sony Entertainment Box Office and Music Sales and
Market Share
35%
32%
30%
25%
20%
15%
10%
5%
0%
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 & Billboard’s Yearly Music Industry Report
*Film Market Share source – BoxofficeMojo.com
*Third Point’s Steps taken directly from the letter to Sony posted on businessinsider.com
17%
$2,000
$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
Gross Film
Revenue MM
USD
Gross Music
Revenue MM
USD
Film Market
Share
Music Market
Share

11. Does Sony’s Board Composition make Thirdpoint’s proposal less likely to be adopted?
Current Sony Board
•
For Thirdpoint’s proposal to be successful the
board must be convinced that it is in Sony’s
best interest to spinoff the Entertainment
division.
Key Board Insiders
Masaru Kato
Chairman – Former CEO - Sir Howard
Stringer
• Former Head of Sony Entertainment
Division
Current President & CEO - Kazuo Hirai
• Started at Sony Music Entertainment
(Japan)
Takaaki
Nimura
Tsun-Yan
Hsieh
Member of Sony Board – Roland A.
Hernandez – Ex-CEO of Telemundo
Kanemitsu
Anraku
Kazuo Hirai
Sir Howard
Stringer Chairman
•
•
Yorihiko Kojima
Ryoji Chubachi
– Vice
Chairman
•
Yukako
Uchinaga
•
Ryuji Yasuda
Peter Bonfield
Roland A.
Hernandez
Osamu
Nagayama
Mitsuaki
Yahagi
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 won’t think they know
what is best for Sony Entertainment?
• I don’t think the spinoff is likely to
happen

12. Valuation and Sensitivity
Valuation Output
•
•
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
FCFF 2013
Key Assumptions
¥3,461,033.4
Growth
WACC
¥1,356.1
Share Price in $
$13.96
11.77%
¥1,452,062.4
FCFE/Sh
8.24%
Cost of Equity
Adjusted with
CDS Premiums
FCFE 2013
2.5%
Growth Sensitity on SNE Share Price
$40.0
$30.0
$20.0
Share Price in $
$10.0
$0.0
Share Price in $
4.50%
3.50%
2.50%
1.50%
0.50%
$34.3
$22.2
$14.6
$9.2
$5.3
Japan CDS Sensitivity Share Price
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
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
$16.00
$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
Japan CDS
WACC
Share Price

13. Why I could be wrong
Thirdpoint’s
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 shouldn’t
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 hasn’t helped Sony’s stock much

14. Sony – Details of the Trade
Stop at 22.63
Entry after the
gap is filled at
19.01
Long Term
Target 14.06

15. USDJPY Paired with SNE
Long Term
Target 105
Entry at
the
confluence
of 101.00
Stop at the
61.8 Fib Level
(98.475)
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 don’t
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)

16. Scenario Analysis and Risk’s of Trade
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
• Sony’s 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
Scenario Analysis – Short SNE & Long USD/JPY
Sony Stock Price
$14.06
$17.06
98.475
11.36%
11.36%
99.475
$19.63
$21.13
-2.92% -12.20%
-15.16%
-22.29%
16.26%
1.98%
-7.30%
-10.25%
-17.39%
100.475 21.07%
USD/JPY
Spot
$15.56
16.26%
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%
103.475 34.94%
34.94%
20.67%
11.38%
41.69%
27.41%
18.13%
105
41.69%
**Gross of trading costs
$19.01
Risk Reward Ratios
USDJPY
1.58
-3.24%
SNE
1.37
8.43%
1.29%
Total Trade
1.87
15.18%
8.04%