Description

The conventional wisdom is that Nintendo is a hit based company that every couple of years brings out a successful game console. This is usually followed by prolonged periods in which they don’t have a successful console during which they have to try and reinvent themselves. Nintendo has never been a good long term holding, but investors who have managed to time the product cycle have been able to do well. The only time on VIC that Nintendo has been written up as a long in 2011, the thesis was based on the timing of the Nintendo 3DS product cycle.

In this write-up I argue the opposite, that at current levels Nintendo is an attractive long term position. Mr. Furukawa, who has been the company’ president since 2018, is doing a good job on a) digitizing sales, which is a huge driver of revenue growth and margin expansion, b) monetizing IP in other ways than through gaming and c) launching mobile games. Nintendo has also started selling the Nintendo Switch on the Chinese market since December 2019, which is a first ever. Finally, I’ll argue that Nintendo should be able to prolong the product cycle of the Nintendo Switch by launching incrementally better consoles (e.g., Switch Lite, Switch Pro) that can play the exact same games. 

Digitalization of sales

This is core to the investment thesis. Digitalization of sales has the highest impact on profitability and is the easiest to realize. In fact, everything else I mention below is a bonus and Nintendo should do really well as long as this part of the thesis is correct.

Let’s first dig into the business model of Nintendo. Nintendo sells consoles. At the moment that’s the Nintendo Switch. You can buy a switch for about 300 USD. Nintendo doesn’t break out margins on hardware sales, but has always suggested that console sales are profitable. Of course this is a numbers game, as a large portion of the costs are fixed R&D expenses and if hardware sales are high enough, profitability per console can be quite significant.

Then Nintendo sells games which can be played on the console, which is where the real money is made. A game sells for about 60 USD. In the old fashioned way, games are printed on a physical disc and sold in a store or bought online after which the physical medium gets shipped to the customer. In both cases, the retailer captures about 30% of the retail price and the printing on the disc could cost another ~8%.

Nintendo also sells games developed by independent developers. Those sales are 55% of units sold and 15% of revenue. Nintendo generally earns a 10 USD royalty on those sales, which comes in at ~100% margin.

However, when a consumer downloads his game instead of buying it in a store, Nintendo captures an extra 24 USD on each sale. That’s the 18 USD retail margin and the 6 USD of cost savings from having to print it on a disc. This shows up in the P&L both as revenue growth and cost reduction. The consumer is happy because he has immediate access to his game and Nintendo is happy because of its much higher profitability. Digital sales averaged 24.8% of all video game software in 2019. In H1 2020, it has risen to 36%. Peers EA, TTWO and UBI all have digital of 78%, 72% and 81%, respectively. Their share prices have benefited a lot from the move to digital.

In FY2019/2020, Nintendo should sell about 210m games. 54m games are already sold online. What if 3/4^th of all games is sold online, so another 100m? 45% of these games are developed by Nintendo and should benefit from a 24 USD uplift in margin per game. 55m of games are developed by 3^rd parties. I think Nintendo should be able to capture the entire benefit of owning the consumer relation, or the entire retail margin, and therefore the uplift should also be 24 USD. Arguably, some of this uplift might be shared with the developer. In this case, PBT should go up by 264b JPY which is almost what it is currently. I’m not even going to pretend to know how long this transition will take. I do think digital sales at some point in time will be 100%. What laptop still has a cd-rom drive? Once digital sales exceed a certain percentage, adjusting a console to be disc-compatible just isn’t worth it anymore.

On top of all this, making the purchasing of software easier (a few clicks on your console versus having to go to the store) will probably drive more software sales as well.

Other than selling a game as downloadable software, there is also add-on content (think a fighter pass for Super Smash Bros) that is sold online. Finally, there is revenue coming from Nintendo Switch online, which is a 4 USD / month or 20 USD / month subscription that allows you to play multiplayer games, play classic Nintendo games, or access cloud storage.

Nintendo last reported 10m paying subscribers. I don’t see why this can’t grow to 20-30m in the next years, especially as Playstation Plus has 36m subscribers and Xbox Live is at 64m subs and both cost 60 USD per year. This is another 40b-60b revenue opportunity that comes in at much higher margin than Nintendo’s current (mix of hardware and software) business. It’s also quite likely that ARPU will go up once they have reached critical mass.

Monetization of IP

Since the appointment of Mr. Furukawa as president, Nintendo has been talking about different ways to monetize their IP. Simply put, Mario, Zelda, Donkey Kong, Kirby and Pokémon are all brands that have value, which can be monetized either through games or in some other way. Specifically, Nintendo is increasing monetization through:

-       Opening a flagship store in Tokyo. This store was opened last November and is the second such store after the one in NYC. Lines to enter the store in the first week were reportedly several hours long. People go to Nintendo stores to try out different consoles (including all the old ones), see demonstrations of new video games and to buy merchandise. While I’m sure such stores are very profitable, I think the main value is in its use as marketing.

-       Opening Super Mario World themed parks within Universal Studios. Universal Studios in Osaka will open a Nintendo themed park this summer, before the Tokyo Olympic games. This will be followed by Hollywood (2021), Orlando (2023), Beijing, Moscow, South Korea and Singapore. The economics of the parks are not disclosed, but hopefully the Q3 earnings release will give some disclosure. Universal Studios has several Harry Potter themed parks, on which Time Warner earns ‘tens of millions of euros per year for each park’ and royalties of at least 12% on merchandise sales [1]. If Nintendo earns 100m USD – 200m USD per year in 100% margin royalties, this should be worth anywhere from 2b-5b USD, or 4-10% on today’s market cap. More importantly is the marketing function this will have on reviving the Nintendo brands. Disney’s movies manage to generate related merchandise sales, and I don’t see why that would be any different for Nintendo.

-       Movies, such as Detective Pikachu and Super Mario Bros. Detective Pikachu netted 430m USD on a production budget of 150 USD. Super Mario Bros was a failed movie in 1993 that grossed 21m USD on a 48m USD budget. Nintendo is currently working on a Mario new movie in collaboration with Illumination (Universal Studios subsidiary), to be launched somewhere in 2022.

While I find it difficult to estimate the financials, I’m convinced that there is a large market for Nintendo themed cartoons, especially as Disney has just withdrawn their content from Netflix. What I find important is that current management looks for different methods to monetize the Nintendo brands.

Chinese market opening up

Since December 2019, the Switch is available for sale in China through a partnership with Tencent. Previously, the Nintendo consoles were only available on the grey market. China has never had a console mentality. The Switch gets sold for about 300USD each (similar to elsewhere) but games are 20% cheaper at ~46 USD. Details of the Tencent partnership are not disclosed. Because of the lower price per game and revenue sharing agreement with Tencent, margins will definitely be lower. Sell-side talk about only single digit upside to Nintendo’s valuation. Nintendo generally plays the long game and is probably more interested in building a loyal customer base in China, rather than maximizing profit.

Mobile games

Nintendo has been slow in making their games available for online. Their most notable launches were:

-       Mario Run, downloaded 300m times

-       Fire Emblem heroes, netted 500m USD since February 2017 (ARPU of 30 USD / month)

-       Mario Kart Tour, launched in September 2019. A multiplayer option is currently in its second beta test. In general, Mario Kart does a good job at launching new options to the gameplay every 2 weeks (new tracks) to keep players engaged.

While the initial move into mobile games has been slow, Nintendo has committed to launching 2-3 mobile games per year going forward.

Other than being slow in launching games, they have also been very conservative in monetizing online games to minimize the risk of reputational damage. Mario Kart Tour is the most ‘aggressive’ of their games. It offers the option to buy credits which can be redeemed for new carts and characters. There is also a 5 USD / month gold pass which allows you to drive faster (200cc) carts and more importantly, are the first people who get to use multiplayer. From browsing online, I believe by charging 5 USD / month they might have overshot a bit.

Nintendo has a huge advantage over other mobile game producers because they hardly need any marketing spend to reach the same number of players. That’s the power of Nintendo’s brands.

For peers, 2%-10% of players end up paying anywhere from 20 USD / month to 50 USD / month. Let’s be conservative and assume Nintendo has 120m MAU per game, of which 5% end up paying 5 USD / month. That’s 120b JPY in incremental revenue, with about a 50% EBITDA margin, or 60b EBITDA, which is about 20% upside on current EBITDA. Admittedly, these are very rough numbers but I believe to be very conservative with my assumptions.

From hit based model to continuous hardware model

After Nintendo has created an installed base of console owners, it enjoys strong network effects. Developers make games because they might get bought by up to 100m console owners (in the case of the best-selling Wii), and consumers buy the console because of all the games that are available. Then, after 5 years, a console becomes obsolete, or out-of-fashion, the network collapses and Nintendo has to reinvent itself all over again.

I believe the Nintendo Switch could be a game changer here. In September 2019, Nintendo released the Switch Lite (together with the game Legend of Zelda, which was a Gameboy favorite). This is a pure handheld device, whereas the normal Switch can be used as a hand held device or can be connected to your TV. Most importantly, the Switch Lite can play the same games as the Switch, so buyers don’t have to start a new collection of games. Next Christmas, Nintendo will launch the Switch Pro. This is beginning to look much more like the product life of a smartphone. Smartphones might be replaced by better ones, but can generally still play the same software / apps. Over time, apps also get updated to make use of a new phone’s capabilities. In a similar fashion, Nintendo should be able to significantly prolong the life cycle of the Switch. If future consoles are compatible with current games, this completely changes the Nintendo business model for the better.

In general, software sales (where the money is made) peak a few years after the hardware sales have peaked. If for some reason my thesis is flawed, Nintendo remains a hit based business model and this volatility in earnings is not offset by higher margins through digitalization or other forms of income, I believe there is a lot of time to exit Nintendo.

Valuation

Nintendo owns 32% of the Pokémon company, which is equity accounted. The other parts are owned by 2 companies called Game Freak and Creatures. However, there are suggestions that Nintendo owns part of those 2 companies as well. However, Nintendo refuses to disclose ownership in companies where they hold less than 20%. I believe there to be certain ‘hidden value’ in Nintendo that the market does not account for. However, since this is unlikely to change, I wouldn’t assign any value to this. For a more elaborate discussion on the topic, check:

https://toucharcade.com/2016/07/28/who-owns-pokemon-anyway-its-complicated/

There are also various hidden assets, including Nintendo’s 10% ownership of DeNa (25b JPY, 1.73% of Bandai Namco (20b JPY) and the Seattle Mariners (15b JPY).

Finally there is Niantic, which is 1/3^rd owned by Nintendo, 1/3^rd by Google and 1/3^rd by The Pokémon Company. Niantic owns the augmented reality that was used for Pokémon Go. The same platform as used for the mobile game Harry Potter Wizard Unite (I tried playing it and can’t believe this would ever become a hit). Niantic earns royalties whenever a game uses their platform.

The current market cap is 5.5t JPY. There is 1.0t JPY in Net Cash, so EV = 4.5t JPY. Nintendo historically needed a cash buffer because of the prolonged periods in which they had to reinvent themselves, which I’m claiming in this article might no longer be necessary. However, hoarding cash is just what Japanese companies do.

Ex cash, Nintendo trades at 20x P/E or 13.5x EV/EBITDA on FY2019/2020 financials. As shown, digitalization has the opportunity to double profits. I don’t expect the market to reprice Nintendo based on 80% digital sales overnight, but I do expect Nintendo to increase EBITDA at double digit margins for several years to come as the digitalization rate increases steadily.

Apologies if the above calculations seem very rough. In the end, the only thing that matters are the number of Switches that get sold and the % of digital sales. All the rest is a bonus. I could pretend to be more precise in my valuation, but disclosure on many subjects is poor and it would lead to some false sense of accuracy.

Risk:

So the big risk here is that in 2020 the new PS5 and new Xbox will be way more popular than the Switch and Nintendo will stop selling hardware. Then I’m the idiot that’s shouting at the top of the market that this time it’s different.

[1] https://www.wsj.com/articles/harry-potter-conjures-comeback-for-universals-parks-1460512158

Catalyst

-       Increase in margin and revenue as digitalization rate increases from 35% to 80%.

-       Mario Kart Tour starts contributing to earnings

-       Continued launch of mobile games.

-       Chinese sales coming in

-       Nintendo disclosing economics of Super Nintendo World parks

-       Switch sales during the holiday period will likely be strong. As per Gamestop in their holiday sales update: “On a positive note, we continued to see growth in the Nintendo Switch platform, which supports our view that our sales will strengthen as new consoles and innovative technology are introduced.”

-       Sales of Nintendo Switch adding to sales. In Q2 it was already shown that sales do not cannibalize normal Switch sales.

-       Product lineup for 2020, including Mario Kart 8 Deluxe, Super Mario Odyssey, Mario Tennis Ace, Super Mario Party, Kirby Star Allies, Yoshi’s Crafted World, Pokémon: let’s go and the Legend of Zelda: Breath of the Wild.

-       Q3 financials on 30 Jan should give more insight in the profitability of many of the initiatives mentioned in this write-up.