Nintendo
a fundamental analysis
Part 1
By Manuel Maurício
April 02, 2021
Symbol: 7974 (TYO); NTDOY (OTC Markets)
Share Price: 62.92 JPY; $71.82
Market Cap: 8.28 Tr JPY
Introduction
What if you could go back in time and buy Apple 10 years ago? What if it wasn’t just Apple, but a hybrid between Apple and Disney?
Even better, right? That’s what Nintendo may become in the future. Interested? Read on.
* Before we proceed, I must thank Ryan O’Connor of Cross Roads Capital, who has done extensive research on Nintendo, for his enormous patience and willingness to help me better understand the business.
The Problem
The business of selling consoles is a cyclical one. Nintendo (and others) releases a new console, there’s the initial hype that can last anywhere between 2 to 5 years, and then the curve flattens until Nintendo releases a new console only for the cycle to start all over again.
In the meantime the company tries to sell as much video-games as it can. Consoles are lower margin while the games are the juicy part of the business so these companies might even lose money selling the consoles only to gain it by selling the games.
In the case of Nintendo the company has had its fair share of successes (Wii, NES) but also some flops along the way (Wii U and GameCube). Together with the fact that it’s a cyclical business, I would say that these are the main reasons why the shares look cheap.
You see, in a cyclical business the company will look the cheaper right before it becomes expensive and vice-versa. Here’s a drawing.
Today the most important console makers are Sony with the Playstation, Microsoft with the XBox, and Nintendo with the Switch.
The problem with the current model of launching a new console every 5 to 6 years is that every time a new console is launched the installed base of users goes back to zero, mostly because of the lack of backwards compatibility between consoles (you can’t play the old games on a new console).
That’s obviously bad for everyone. It’s bad for the players who can’t keep playing their favorite games, and it’s bad for the console maker because it has to start from scratch: acquire the customers, create new content and incur in new costs for software development; all of this without the guarantee that the console will sell.
On top of that Nintendo has always offered 2 consoles at any given time, a home console and a handheld console. This implies doubling the costs of customer support, software and hardware.
To make matters even worse, there’s the chicken and the egg problem. The third-party game developers will only develop new games for the consoles that are in high demand whereas the gamers will only buy the consoles with the most games.
What if you could buy a new console and play the same games you had before, just like with a smartphone? What if the console maker could somehow reduce that cyclicality and guarantee a stable number of users? And what if you didn’t actually need to go to the store to buy the physical games?
The Solution
The Nintendo Switch stands to change all of those issues.
First, it’s one single platform that can be used as a home console connected to a TV, while it’s also a handheld device that can be taken anywhere.
This alone allows for more focus on development and lower costs as Nintendo doesn’t need two teams for everything (development, customer support, etc).
The Switch is the platform with which Nintendo’s management wants to revolutionize its business model. They want to go Apple’s way.
Nintendo wants to extend the life cycle of the Switch, much like Apple did with the iPhone. With incremental improvements every couple of years instead of big breakthroughs every 6 years or so AND with backwards compatibility Nintendo is going for a smoother sales curve.
That way it can continuously have an installed base of around 100 Million users (which was the top for the Wii console).
The more consoles in use at any given time, the higher the number of games developed, the higher the game sales, the stickier the ecosystem.
Nintendo has also been late to the party of online distribution. Most of its games have been sold in physical format in brick-and-mortar stores. The company is finally serious about online distribution.
This is obviously very good for the company. With online distribution (direct downloads onto the console) comes a whole bunch of advantages; no need for manufacturing and storing the physical games, no need to sell inventory for a discount if the game is a commercial flop; it also allows for instant distribution, and because of all of these reasons, the margins are higher.
Also, with the combination of backwards integration and digital downloads, the installed base of users will always be there. Nintendo doesn’t need to gain the customer over and over again. I’m still baffled by the time it took these guys to understand all of this and make a move.
With the ability to play the games on the new consoles the gamers will have more and more games. And they’ll need to store them somewhere. That’s where the Cloud comes in. More specifically Nintendo Switch Online, Nintendo’s online subscription.
For a small sum of money gamers will be able to store all of their games in Nintendo’s Cloud. They’ll also be able to play multiplayer games online, play classic NES games, and much more. This means recurring, high margin revenue. For now, Nintendo’s subscription costs $19.99 for 12 months whereas Sony charges $59.99 for the Playstation subscription. Clearly Nintendo still has the ability to increase prices.
The fact that Nintendo is building a digital ecosystem much like Apple’s means that it will be able to sell more and more paid “stuff” on its e-shop. And exactly like Apple, Nintendo takes a 30% cut from all things sold on its e-shop by 3rd party developers (games, skins, characters, superpowers, etc).
And yes, Sony and Microsoft have been offering digital solutions for some time now. And they’re about to release their new consoles in the next few months. These consoles should be more powerful than the Switch (as always).
But the truth is that the Switch doesn’t actually compete directly with the Playstation and the Xbox. You can’t play violent games with the best graphics in the world on a Switch. Nintendo was smart enough to carve out its own little niche, a more family-friendly niche.
Mobile, baby!
And then there’s the mobile opportunity, the games for smartphones. With around 2.7 billion smartphones in the world, this is a gigantic market for Nintendo.
Creating games for mobile isn’t just a matter of picking existing games and adapting them. There’s a lot of things to think about. For instance, mobile players want shorter bursts of gratification than console players.
Monetizing mobile games is also tricky and Nintendo has had some headaches with that too.
While Super Mario Run was a huge hit in terms of downloads, it was a financial flop due to its Free-to-Start model where players have free access to a few levels but then they have to pay for the remaining levels.
With Fire Emblem Heroes, Nintendo was more successful. It monetized though a Free-to-Play model where the game is free but players then buy in-app “stuff” like new characters, items, etc.
Hopefully Nintendo will find the right formula going forward; and when it does, it will be in an enviable position. The mobile market is characterized, not only by super-high gross margins, but also by high marketing costs thus favoring the well-known brands such as Nintendo.
Right now Mobile is still a fairly small segment for Nintendo amounting to 4% of total revenue, but it represents a massive opportunity.
Squeezing those lemons - Intellectual Property
As if all of this wasn’t enough, Nintendo also has its Intellectual Property to monetize. Think Disney. There’s theme parks, toys, stores, and a collection of many different items that can be licensed. Nintendo has been slow to monetize its IP, it’s true, but it looks like it’s getting its act together.
The new Super Nintendo World in Osaka opened its doors to the public just this month. This is a partnership with Universal and there are plans to open more parks in other cities like Orlando and Singapore.
Here’s a video tour of the Super Nintendo World with none other than the legend Shigeru Miyamoto himself, creator of Super Mario, Zelda, and Donkey Kong.
The company is also working on its new movie. Let’s hope it doesn’t suck like the previous one.
Going forward, I believe that this segment could become very profitable if only the management can get its act together.
Why is it cheap
Confirmation Bias: Apple
Management:
It’s Japan: sub-optimal capital allocation
Cash on the balance sheet: Now the company wont need the cash
LONGEVIDADE IPHONE
Another reason for the iPhone’s longevity is the fact that today’s models run on essentially the same operating system, iOS, as older versions. There have been updates to iOS, of course, but it hasn’t been replaced wholesale with an entirely different operating system incompatible with older apps. Similarly, today’s Android devices use fundamentally the same OS as previous iterations.
https://www.nintendolife.com/news/2020/01/more_than_40_percent_of_switch_owners_in_the_us_have_another_video_game_system
Financials
Now that we’ve talked about the opportunity, let’s take a look at the financials.
When we look at the revenue chart, we can clearly see the time when the new consoles were launched leading to the ciclicality I was referring to before.
Looked at it in another way, we can see how the different consoles have influenced the total revenue. While the DS and Wii were enormous successes, the Wii U was a major flop.
It’s no surprise that 2020 was THE year for online products. Nintendo was no exception.
The digital products have much higher gross margins than the physical ones so the record 54% gross margin we see on the chart below is the first tell-sign of what’s to come.
Too much cash?
A quick mention of the balance sheet is also important. Historically Nintendo has held considerable amounts of liquidity on its balance sheet in the form of cash and other liquid investments.
Once again this is due to the cyclicality of the business. In order to endure the pronounced downturns such as when the Wii U was released, a high cash balance is necessary.
But if things turn out as expected, that cash could be significantly reduced. If and when the business turns into a recurring revenue model, the cash can be deployed back into the business or given back to the shareholders in the form of dividends and buybacks.
Estimates and valuation
Currently Nintendo is valued at 17x earnings (discounting the cash). Taking into consideration what I’ve laid out so far, that seems cheap. Especially so when both Disney, Apple, Electronic Arts, and Activision Blizzard are all trading for more than 30x earnings.
But the thing with cyclical companies, as we’ve seen before, is that they seem the most undervalued exactly at the top of the cycle and the most overvalued at the bottom.
Here’s a picture that illustrates this by comparing the operating income to the Price-to-Earnings ratio.
What investors looking to invest in Nintendo must safeguard is that the future won’t be anything like the past. And that’s the hard – and important – part.
Sum of the parts. Core business. multiplo going forward
Pokemon.
Nintendo’s stake in Niantic could one day become more valuable than Nintendo’s current market capitalization.
Nintendo owns 33% of The Pokemon Company, the company overseeing the licensing of Pokemon. But that’s not the whole story.
With that in mind, TPC’s latest TTM revenue is about $3.5 billion. If we assume an EBIT margin of 75% (reasonable, given the low-cost nature of TPC’s primary business model of collecting royalties), that gets us to annual FCF of approximately $2.6 billion. So at a conservative 10 times FCF, TPC is worth about $26 billion, putting the value of Nintendo’s stake at approximately $13.2 billion. But even if we assume an EBIT margin of only 50%, we’re still talking about some $1.8 billion in pretax free cash flow and an implied valuation of $17.5 billion. That puts the value of Nintendo’s stake at roughly $8.8 billion in a truly worst-case scenario.
Nintendo is valued today based upon its success and failure within a console release cycle.
On a forward basis Nintendo trades about at <15x earnings, though we are likely at the peak of the Switch cycle. To value Nintendo conservatively, we can use a cyclically adjusted price-to-earnings ratio (CAPE), estimating mid-cycle earnings opportunity. Assuming an 8-year console cycle and current year as the peak, we arrive at an inflation adjusted earnings of $2.0B. Based upon the assumptions below Nintendo trades at 27x CAPE, adjusting for a full hardware cycle. This valuation will prove to be highly conservative assuming Nintendo can unshackle itself from a traditional hardware cycle.
Risks
- Inability to switch to an iPhone like model instead of the cyclical model
- The company has to innovate endlessly
- Management has had some missteps
Conclusion
I’ve been playing around with the numbers, making estimates for the different segments, making assumptions for other investments that the company holds such as Pokemon (which I didn’t mention yet), but I have yet to gain a better understanding of the business.
Over this past week, I’ve been having an ongoing conversation with Ryan O’Connor of Cross Roads Capital on Twitter, challenging his assumptions and getting to know Nintendo better.
I’m inviting him for a chat next week and I’ll come back to Nintendo when I’m knowledgeable enough to make some estimates.
To sum it all up, the company is 1) de-cyclifying the business, 2) shifting to digital, 3) going after the smartphone games, and 4) starting to monetize its Intellectual Property.
This makes me very interested in Nintendo. It’s a mix of Disney and Apple; and who wouldn’t want to have owned those two for the past 10 years?
Further research material
Fazer a digital penetration.
Quantos subscritores? They have 26M+ subscribers up from 15M in January and digital mix is over 50% of their SW business
Other investors have said that what we’re seeing here is Apple a few years ago. Let me remind you that one of the major reasons for Apple to have become such a successful investment story was the low ….. that investors were giving it back in…. When investors finally understood the power of the ecosystem, its multiple re-rated quite strongly.
And with more recurring, high margin revenues I don’t doubt for a second that investors can give Nintendo a much higher multiple.
Share price and blocks of 100de-cyclifying the console business, moving to digital distribution, making smartphone games, and effectively monetizing its IP
Digital (higher gross margins);
The most recent quarter’s results showed the gross margin expansion potential. During quarantine, Nintendo saw a spike in digital downloads. For the quarter, 49% of software sales were digital and we estimate that it was between 70-80% during the last few weeks of March. Due in part to the shift toward digital, gross margins expanded from 41.7% in fiscal 2019 to 49% in fiscal 2020. A digital-only version of Switch – one that does not use physical cartridges – might also accelerate digital sales.
Subscription: price point. Installed user base
Third Party developers (store).
They repackage and sell decades old games at full price, games you could easily just download on an emulator, but people will instead gladly pay full price for a more authentic experience.
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