Nintendo Analysis
To quote Mario, "Let's GO!"
Summary Financials in dollars (as of Aug21 earnings update)
Market Cap - $57.02 billion
Cash = $10,068 billion
Cash + Securities = $13.731 billion
EV = $48.062 billion
EV + Securities = $44.399
FCF = $5.488 billion
EBIT = $6.181 billion
Summary Ratios -
EV/EBIT = 7.78
EV(including securities)/EBIT = 7.18
FCF Yield = 8.7%
Debt/Equity = no debt
Return on Equity = 12.96%
Dividend Yield = 2.56%
Introduction
Overview
It’s likely that at some point in your life, you have owned a Nintendo console. My first experience was spending hours playing Pokémon Red on my Nintendo Colour. Nintendo is one of the world’s most recognisable brands, the 76th in the world according to Interbrand.
Founded in 1889, Nintendo has created or popularised household names including Mario, Zelda & Pokémon.
Fast forward from my Gameboy button bashing days, and the Nintendo Switch is the fastest-selling video game system in the US, this generation. From launch in March 2017, the console sold more than 80 million units.
As a household name and globally recognised brand, why is the market pricing Nintendo like a cyclical?
History
Nintendo was founded in 1889 in Kyoto. The precise meaning is lost to history but it roughly translates to ‘leave luck to heaven’. The company started off selling hanafuda, a style of Japanese playing cards. In 1964, in an attempt to diversify, the company invested in instant meals, a fleet of taxis and ‘love hotels’.
On the back of a slew of failures, the company hired a local electronics graduate, Gunpei Yokoi. Gunpei was an inventor, tinker and inventor of the ‘Ultra Hand’, an extending toy hand. After decades of successful and innovative toys Gunpei was drafted into a team to partner with and reuse old Sharp LCD screens. In 1980 Nintendo released its first Game & Watch models, using the old screens. They went on to sell 600,000 copies, unable to keep up with demand. Game and Watch remained in production for 11 years, going on to sell 43.3 million units.
Following the success of the Game and Watch, Nintendo brought arcade games into the home with the launch of the Nintendo Entertainment System, the NES. The Gameboy soon followed in 1989, going on to sell 118.7 million copies.
The Nintendo 64 launched in 1996. More than 500,000 units were sold on the first day alone, with total sales of almost 33 million. The GameCube launched in 2001, and flopped in comparison, with only 21 million units.
In the mid-2000s the Wii was launched. Focusing on fun and engagement, the Wii went on to sell a whopping 100 million units! However, the follow up console, the Wii U, sold only 14 million units.
The mid 2010’s were some of Nintendo’s darkest days, until the launch of their current champion, the Switch.
Management
When current Nintendo president, Shuntaro Furukawa was appointed in 2018, he was only the sixth person to assume the role since 1889. Nintendo leadership can remain in the position for decades at a time (for better or worse).
Hiroshi Yamauchi was the third president of Nintendo from 1949-2002. He drove the company to become the video game publisher it is today.
In August 21 it was announced that Nintendo would buy back 1.51% of shares. Although a conservative amount, this was a change of tact for the Nintendo’s management team and first utilization of their cash pile. I am no expert on Japanese businesses (I’d recommend reading Jeremy Raper’s commentary), but buybacks are not as common in Japan as they are in the US. This buyback gives shareholders hope that the board is starting to consider shareholder value.
The Console Cycle
Gaming console cycles have added a cyclicality to the industry for a number of decades. Nintendo's console cycles normally last 5-6 years, with handheld consoles sprinkled in between. This has meant Nintendo has historically had to keep several billion dollars in reserve in case the next console flops, just like the Wii U did. In this scenario there’s a real risk that the company can go bankrupt, hence the healthy cash reserves.
This is the reason that Nintendo trades at EV/EBIT of 7. The market fears a return of the dark days, post the Switch’s success. This narrative is baked into the price, meaning that the cash is not recognised as an asset and the market expects an element of cyclicality with a downward trajectory for Switch sales
The Gaming Industry
To offer a brief insight into how gaming infrastructure works, there are Developers, Publishers & Consoles (First Party). Using the original Halo game as an example, it was developed by Bungie, published by Xbox Game Studios and was exclusive to Microsoft consoles, such as the Xbox.
Back in the 80’s Nintendo held a monopoly on the industry, as it was the sole manufacturer of games for it’s NES counsel, setting out strict quality content requirements and high licensing fees.
However, Nintendo’s stranglehold left a sour taste with developers, allowing the likes of Sega & PlayStation to steal market share.
The Current Business Model
Hardware - The Switch
In 2017, Nintendo released the Switch console. The switch can be docked, meaning it can be used at home and is portable. Since its launch, it has shipped just shy of 80 million units, and over 532 million Switch games have been sold (surpassing my beloved Gameboy).
The console cycle means that the Switch sales should be on the decline, whilst Nintendo lays out plans for future consoles. However, Nintendo now has over 200 million registered accounts and 26 million Switch Online subscribers. During the pandemic, demand for the Switch was 35.8% up on the same period in 2019.
Nintendo has many of the attributes of large tech companies, Apple in particular, however they have been slow to transition to cloud gaming. This is a significant risk to the future of the business. If the management remains stuck in their ways there is a real risk of the business going the way of Atari, or at least taking a sizable chunk out of their $11 billion cash war chest.
The Switch OLED is released on the 7th of October, with pre-orders unable to keep up with demand. It’s not the Switch Pro which fans wanted to compete with the PlayStation 5 and Xbox Series X, but it’s enhanced 7-inch OLED screen is an improvement on the existing model. I’ll wait with baited breath on those early reviews and sales numbers.
Software - Games
Nintendo’s software (games) include a plethora of household names including Mario, Zelda, Pokémon and Animal Crossing to name a few. Nintendo’s games dominate the top 25 best-ever selling games ever, demonstrating the strength of their IP.
Nintendo's digital software sales have skyrocketed since the pandemic began. Digital sales for 2020 year grew by 104.9% year-on-year to 256.0 billion yen. Software sales were up 40.9% of total digital sales. Nintendo's digital sales were up over 200% year-over-year as of August 2020 and for the first time ever, digital sales exceeded that of physical game sales.
Nintendo Direct 2021 announced titles such as Kirby and the Forgotten Land & Bayonetta 3, but left fans frustrated with the lack of announcements for the likes of Zelda ,Breath of the Wild 2.
The tie ratio for a console is the number of games the owner purchases per console. Using the extrapolated numbers below the tie ratio for Nintendo now sits around 7.5. This has increased over the past 2 years from 3.88 and 5.4 respectively.
Digital - Switch Online & eShop
The real opportunity for Nintendo to break the console cycle and increase gross margins lies in the switch to digital.
If you are an iPhone owner and move onto a newer model, your iCloud has you set up within a few minutes. Historically, consoles lost their entire userbase when they launched a new version. The introduction of Switch Online means that Nintendo is creating a userbase that does not need to be reclaimed with the launch of each iteration. If Nintendo can pull this transition off, it’s a complete gamechanger for the business.
In 2018 Nintendo launched Switch Online (NSO). Despite being almost 2 decades late to the party in comparison to competitor networks. NSO has achieved over 26 million users who pay around $20 per annum, depending on where they are located in the world. Xbox live retails at $80 per year with 90 million monthly users. Xbox’s total console sales are around the 140 million mark. Applying similar ratios to the forecast 100m Switch units, Nintendo could be looking at an untapped market of over $2 billion is high-margin revenue.
However, taking a step back from blue sky dreaming, NSO is currently my biggest cause for concern with the entire Nintendo business. Take a few minutes to review the latest NSO trailer on YouTube and scroll through the comments and likes. NSO subscribers and fans are dissatisfied with the service they are receiving. NSO is clearly a long way off Xbox Live and PlayStation Plus. This is worth keeping an eye on.
NSO and their online store means that users will be more inclined to purchase games with one click, increasing the tie ratio and Nintendo’s gross profit. Nintendo’s back catalogue of historic games means they are sitting on a wealth of content that can be further exploited (think of all the old movies on Disney+).
At Nintendo Direct it was announced that Nintendo 64 (N64) and Sega Genesis games are coming to NSO. Customers can also purchase a N64 controller, to the tune of $50! If that’s not an example of Buffett’s oil seeping back into the ground, I don’t know what is.
Within the next decade I believe there is a real possibility that all consoles will move to cloud-only gaming. This will ensure a healthy gross margin increase across the industry.
Mobile
Nintendo has historically been way behind the curve when it comes to mobile (noticing a trend here). However, they may, and take that with a pinch of salt, be getting their act together.
Pokémon Go is the jewel in the crown - despite not technically being owned by Nintendo. Niantic are the developers and publishers behind it. Mario Kart Tour has passed the 200 million mark in both downloads and revenue but Fire Emblem Heroes generates around 60% of Nintendo’s mobile revenue.
Nintendo’s mobile division is growing at 13.8% annually and generating $500 million dollars. I can’t help but feel that Nintendo needs to swim or sink when it comes to mobile, to truly add value for shareholders. Perhaps the mobile games are best left to the likes of Niantic or spun out entirely.
Other Income
Nintendo’s other income comes from their retail shops and licensing ventures such as their partnership with Universal Studios Japan, which finally opened in 2021. These won’t move the dial but are important in marketing towards the next generation of Nintendo fans.
In September 21 it was announced that Chris Pratt world star as the titular character in the Mario reboot, with Jack Black co-starring.
Nintendo’s IP Opportunities
Nintendo’s IP is a treasure trove that, until lately, has largely been underutilized.
Mario, Pikachu and Link are three of the most recognisable fictional characters on the planet. Other stalwarts include Donkey Kong, Kirby and Samus.
There now appears to be a move towards cracking this Yoshi sized egg with the company undertaking the following: -
Historic games catalogue available on NSO
At Nintendo direct it was announced that an expansion pack upgrade for Nintendo Switch Online members would go live in late October. Members will receive access to a library of classic games for the Nintendo 64 and Sega Genesis. This money for old rope and looks like a no brainer.
The Mario Movie
With Chris Pratt starring as the titular character and Jack Black as Bowser, no expense has been spared. The Nintendo board will have looked on enviously as Lego’s three consecutive movies grossed just shy of $1 billion worldwide (it could even be argued that Nintendo are looking to copy Lego’s movie playbook by casting Christ Pratt, who voiced Lego protagonist Emmet). It’s not just revenue that a successful movie will add, but additional marketing and engagement with a new generation of fans.
Licensing
Pokémon is one of the best companies in the world of licensing, with $3-4 billion generated annually. Nintendo can learn a lot from its sister company. There does appear to be visible change. Nintendo recently partnered with Lego, going so far as to release a Lego NES. With circa $300 million in licensing revenue, there is certainly a gaping opportunity to close the gap with the likes of Pokémon.
Niantic Tie-in - Niantic and Nintendo announced a joint partnership to publish real-world, AR applications. After the phenomenal success of Pokémon Go, the Pikmin app is scheduled to be released later this year.
Theme parks
After years of development and delays, Super Nintendo World opened Match at Universal Studios Japan, in Osaka. It’s already been announced that a Donkey Kong expansion will expand the park's size by 70%.
Super Nintendo World’s are under construction at Universal Studios Hollywood, Universal Studios Singapore and the upcoming Universal's Epic Universe at Universal Orlando Resort.
Pokémon
The Pokémon brand is generally associated with Nintendo and really deserves a special shout out. Conservatively Nintendo owns 33% of the Pokémon company. Nintendo also owns a percentage of the other two owners (rumoured to be as high as 50%), Game Freak and Creatures Inc, who own the remaining 66%.
Nintendo is the sole owner of the Pokémon trademarks, meaning that their true ownership is not fully reflected by the 33%. The name, logo and every character are owned by Nintendo.
Pokémon Go was one of the first examples of how augmented reality may truly be applied to the wider world, demonstrating the future for both Pokémon & Nintendo’s IP.
The Pokémon company generated $143m in profits in the latest fiscal year. At a conservative PE of 20 values the Pokémon Co at least $2,860 billion and Nintendo’s stake at $953 million. However, at a conservative 3x revenue (Disney trades at 5x) values the company at $15 billion and Nintendo’s stake at least $5 billion.
Moat
When writing about a Moat it’s obligatory to start with a Warren Buffet quote.
There’s no better system than something where .. you get a new crop every seven years and you get to charge more each time - Warren Buffet on Disney
Wide and global demographic reach (family-friendly games) - Nintendo’s IP includes Mario, Zelda, Pokémon, and Animal crossing to name a few. They speak for themselves. Nintendo has been churning out games featuring the same characters for 30+ years and to this day they continue to rack up global best ever selling games.
Economies of scale (software and digital sales).
Global recognition of a 100 year old company and brand.
Network effect and user installs mean that these numbers are growing and will not need to be recaptured as users move to a new console.
The Business in Numbers
The gaming industry has experienced a pullback after pandemic as restrictions ease. This has led Nintendo to forecast a 9% pullback in revenue and 29% drop in operating profit, however, the management have historically been overly conservative.
Using Nintendo’s most recent earnings, I have attempted to extrapolate Nintendo’s sources of revenue and unit numbers across the rest of the year. I have also used these numbers to tease out data around console and software sales. Unless stated, each figure below is in billion Yen. This gives us an insight into numbers Nintendo have not publicly declared in their earnings report.
Valuations
Nintendo can be valued on a DCF basis or based on it’s assets. Nintendo is a business whose intangible assets are globally recognized.
DCF Valuation
Scenario 1 - Sales of the Switch follow the same trajectory as Wii and start to decline post 2021. They reach 100m installs with Switch and Lite, but sales begin to slow after 2022, only tracking GDP growth after 2025. The Switch Pro struggles the same way the WiiU did. Nintendo requires a new console, squandering the $10 billion on the balance sheet. Gross margins increase with transition to digital software. Assuming 80% of software becomes digital, this increases gross margin by at least 3% to 53%. Nintendo Switch Online subscribers stagnate at 26m.
Value per share - $64 dollars
Scenario 2 - Switch sales extend the console cycle and the introduction of the Pro extends it for several years beyond 2021. The Switch Lite & launch of the Switch Pro continues to catalyse growth, increasing revenue at 10% per year across the next decade. The company continues to move towards software only downloads, increasing Gross Margin to 55% by 2023
Value per share - $85 dollars
My Thesis
Why I’m Bullish
The Switch should reach 100m installs of by end of 2022
Nintendo accounts are now signed up and no longer need to re-captured, building a network
Sales of Switch continue to increase despite end of lockdowns, with circa 18m units per annum, driven by launch of OLED in 2021/22
Gross profit continues to rise 2-3% per annum with transition to digital & online
Switch Pro console is released 2022 to further drive sales
Cash position is larger than the market cap of the ‘dark days’ pre Switch
IP underpins the business and is undergoing an unlock process
The release of the Mario Movie (assuming similar success to the Lego Movie) will capture a new generation of fans, plus the revenue the movie and merchandise generate.
How Could I Be Wrong and Risks
Switch sales fall off a cliff as the world continues to return to normal and never reaches the 100m installs
The OLED is a flop and this is the other side of the console cycle (despite largely being sold out pre-launch)
There is still no sign of the Pro by the end of 2022
IP unlock makes little to no difference (Mario movie flops big time)
Lack of release of blockbuster game titles in 2021/22, no sign of Breath of the Wild 2 etc
My personal lack of understanding of Japanese companies, cash etc. I’ve never been to Japan (Covid cancelled a trip to Tokyo/Kyoto/Osaka)
Bull Case
Nintendo’s move to digital, spearheaded by Nintendo Switch Online ensures Nintendo’s install base no longer has to be recaptured each time a new console is released. This moves Nintendo towards an Apple style model.
Nintendo fully unlocks their IP, through the likes of the launch of their Nintendo/Universal theme parks, Niantic partnership, Mario movie & back catalogue added to NSO.
Nintendo aggressively moves towards digital software, increasing gross margin of software sales and eShop sales.
Nintendo (at least) keeps up with the crowd and we see a digital only console within the decade.
Bear Case
Gaming moves to cloud gaming in the next 5-10 years, eliminating consoles, and management are too stubborn to embrace the shift. This is a real cause for concern I harbour with the likes of Google Stadia redirecting the market to mobile and desktop. Historically, the Nintendo board has been notoriously late to adapt (NSO launched 16 years after Xbox live)
Nintendo is solely reliant on the Switch for its foreseeable earnings, struggles to get the OLED right and cannot break the counsel cycle.
Future attempts at unlocking IP flop, the Mario Movie is a failure (Detective Pikachu may have been the best they could do).
Nintendo is unwilling to invest the $10 billion cash on the balance sheet until they are confident they have escaped the console cycle, which could be several years.
Investors get caught up in 'blue sky' scenarios where the company grabs all opportunities to monetize, yet the management remains unwilling to commit, as has been the case historically.
Nintendo’s entertainment time reduces as they compete for eyeballs on the screens with the likes of Disney+, Netflix, Roblox, YouTube and every other source of entertainment the younger generations engage with.
Conclusion
Nintendo is a global business with IP recognised around the world. Nintendo's low EV/EBIT ratio of 11 (Activision & EA are both around the 20-25 mark), appears to be skewed towards the business's historic console cycle. There are a lot of positives about Nintendo. The pandemic may just have forced management’s hand in switching to digital (pardon the pun).
I am a happy and optimistic shareholder, however I will keep a watchful eye on any updates outlined in my bear case.
Further Reading
If you have made it this far and are interested in reading more about Nintendo, Crossroads Capital’s 2018 letter is the definitive deep dive. Matthew Ball’s essay is also a must read.