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The Deal: Loeb Needles, Prods Sony into Play

The Deal

NEW YORK (TheDeal) -- Third Point LLC chief executive Daniel Loeb's letter to Sony Corp., dated Tuesday, May 14, had all the false modesty and deference to decorum one would expect from a hedge fund in heat. Yet its ripple effect could very well put Sony Pictures Entertainment Inc. in play.

That wouldn't be the first step, of course, provided any steps are taken at all. Nonetheless, as step one, Loeb's proposal suggested a subscription rights offering to current Sony shareholders that would create a separate public stock for 15% to 20% of SPE.

The idea would be to showcase the underappreciated value of SPE, which Loeb called Sony's "hidden gem" and defined as "coveted assets in television and motion picture production, an iconic library of movies and television programming, the leading music publishing business, and an exciting array of international cable networks."

However, as high as the hedgie is on SPE assets, he criticized the Sony division's profit margins for sinking to half of those recorded by its peers. Merely bringing them to industry levels, Loeb wrote, SPE's "EBITDA would increase by as much as 50%." And that would translate into "an incremental ¥625 billion $6.1 billion in market valuation."

This gain in valuation, while hypothetical, represents an increase in Sony's entire enterprise value of 23% -- and that's after the Tokyo-based company's stock jumped more than 10% per share during Tuesday's trading session. Loeb asserted his proposed subscription rights offering could even be used to goad SPE managers into realizing a more industry-normal valuation by having their compensation based on "the growth of an equity security specifically tied to a company they control."

But that was just the half of it. Loeb also envisioned his right-for-cash subscription plan as generating "meaningful liquidity to inject into Sony Electronics." This division, while the historical favorite of Sony management, was depicted as a post-war wunderkind reduced to a stepchild gone astray. "Of particular regret is Sony's venerable TV business, which has sadly languished as a loss leader for the company for nearly a decade," the hedgie wrote.

Loeb further declared the division to be in need of a major makeover: "We see clear paths to increasing Sony Electronics' value if investors turn their attention to its profitable franchises and product cycles as management continues to streamline Sony's product offerings to improve profitability. These initiatives will benefit from the capital investment made possible by our proposed Sony Entertainment transaction."

To be fair to Sony management and the investment banks that serve it, the proposal hand-delivered by Loeb contained nothing they haven't entertained and others haven't addressed. Analysts, for instance, have long decried the unlocked value in SPE, some going so far as to calling for the Sony division to combine with CBS Corp. or Starz Inc. Their analysis has been compelling, too.

In January 2012, Pivotal Research Group analyst Brian Wieser even came up with an enterprise value for SPE of $10 billion at a time the EV for all of Sony stood at $15 billion. Then, using contemporaneous metrics for a joint venture with Starz, Wieser calculated the JV's EV to be $11.6 billion -- an amount worth nearly 80% of Sony's EV at the time for an entity in which Sony ownership would be an overwhelming 86%.

On Tuesday, in response to Loeb's Sony letter, Wieser updated his analysis to acknowledge that the hedgie's aggressive overture "is not evidently intended to lead to an outright sale." But he couldn't resist adding: "News of this action will concentrate investor attention on both SPE's underlying value and on the synergies that potential acquirers such as CBS might eventually realize."

Wieser also addressed the longstanding practice of pursuing what Sony considers powerful synergies between its hardware-making units and its software-creating entities. He called the company "centered around the consumer electronics business ... whose synergies with content production and distribution are limited (not to mention a significant source of distraction for management)." And, as if that weren't enough, the analyst complained in a way SPE's Tokyo parent can be excused for considering callous by charging it "never bridged a significant cultural gap nor overcome its hierarchical bureaucracy to work better with the U.S.-centered operations of SPE." This makes it all the more interesting to see if Sony's new management might eventually, if only tacitly, agree: first, by acting on step one as presented by Loeb; and second, by taking the extra step recommended by Wieser and merging SPE with CBS or Starz in a second value-enhancing transaction.

Written by Richard Morgan in New York

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