The Heat Is On (SNE)

By Eugene Bukoveczky | October 05, 2006 AAA

For the shareholders of Sony Corporation (SNE), things just seem to be going from bad to worse.

First came the news that Sony would be hit by a huge product recall of batteries that it supplies as an OEM item in laptop computers manufactured by some of the world's largest computer manufacturers like Dell (DELL) and Apple Computer (AAPL). Seems a lot of them where prone to catching fire.

Scrambling to protect it's reputation as a top quality electronics manufacturer, Sony bit the bullet and announced that it would be picking up the full cost of the recall.

The offer was quickly taken up by its main battery customers. To date, more than seven million affected computers have been turned in for replacement batteries under the deal, mostly by Dell and Apple.

The total price tag for this little bit of corporate damage control is estimated to cost Sony shareholders about US $260-$280 million. However, this is just a preliminary estimate, which could go higher as more battery clients step up to take advantage of the recall deal.

The next bit of bad news to hit came at the largest video gaming expo in the world, the Tokyo Game Show. Sony's eagerly awaited Playstation 3 suffered an embarrassing series of system errors on its show debut, which some blamed on the excessive heat in the venue. Industry analysts were also taken off guard when the company announced that it was cutting the price of the PS3 by 23% to around US $425. Analysts have estimated that this price cut could cost Sony another US $200-$225 million in operating profits.

Competitive heat from rival game console makers Microsoft (MSFT) and Nintendo more than likely forced Sony's hand. Microsoft's own HD-ready entry in the game console wars, the XBox 360 HD-DVD, fetches between US $299 - $399, depending on options, and Nintendo's next generation Wii console comes in at the lowest price point, at only US $250.

All three units are set for released in mid-November, just in time for the Christmas shopping rush. If Sony's engineers can't sort out the glitches in the PS3 by then, or if consumers turn up their noses at its still relatively rich price, the company could see disappointing sales and face further cuts in its profits.

All this has lead to a massive retreat in Sony's share price as investor's and analysts have given the stock the universal thumbs down. Since hitting a 52-week high over US $52 last April, the stock is down 27% and is now down 5% year to date.

Have the shares now pulled back enough to have fully discounted all the bad news? My guess is that the shares could still be vulnerable to further losses.

Sony has traditionally been assigned a premium growth company multiple that has recently been in the 40 times earnings area. Prior to the latest spate of troubles for Sony, analyst's consensus EPS for the upcoming 2007 fiscal year was around US $1.13. Tallying up the earnings impacts connected with the battery recall and the PS3 price-cut, I get a number of around $0.50 per share, which should cut next year's EPS to about $0.63. If you assign a 40x multiple to this forecast EPS and you wind up with a share price of around US $25 – that about 1/3rd lower than the current price.

Even if I'm only half right and the company suffers only a $0.25 per share earnings hit for next year, then the implied US $0.88 EPS for 2007 still only gives us a US $35 price at a 40x multiple. That may be enough of a reason for current shareholders to ease back on their selling, but it's not enough of a reason to be a buyer of the stock at this juncture.

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