Description

Nintendo (~$37 billion enterprise value) is a leading Japanese multinational developer and publisher of video games and consoles. Nintendo’s video game business (~$10 billion in revenues) includes some of the most successful franchises in the world, which have remained popular over decades. These include Mario, Pokémon, The Legend of Zelda, Animal Crossing, Kirby, and Splatoon.

We believe this part of the business is undervalued, but it is not the crux of our thesis. Rather, we believe the market is massively mispricing Nintendo’s “App Store Platform,” or third-party software and value-added services (~$1 billion in revenues) business. It is widely known that the company’s current console, Nintendo Switch, is the best-selling Nintendo console system of all time. What is less known is that the Switch has attracted a large and thriving ecosystem of third-party games that are being distributed on the platform. As a result, we believe Nintendo’s console business now supports one of the leading “App Store Platforms” for the console gaming experience.

The Switch as an “App Store Platform” marks a major strategic shift in how Nintendo views its console business. It is already a thriving distribution channel for both its own games and third-party games. This shift means that software revenues have inflected in recent years, with 2022 the year they overtake hardware sales for the first time. Consequently, Nintendo is primed for continued massive margin expansion, from already improved ~35% to 50% based on reasonable extrapolations of trends that are already in place. We believe Nintendo today offers a robust 3x upside to reach our current intrinsic value estimate of ~$110B enterprise value (Fig. 1).

Figure. 1 Nintendo offers 3x upside in coming years on the back of its App Store Platform

Historically, Nintendo’s iconic video game franchises acted as major “pulls” for consumers to purchase its hardware console. These previous consoles were primarily designed to play these iconic games, and did not act as distribution channels that allowed the direct purchase of games.

The Switch is Nintendo’s first console that changes this dynamic. It is more than just a platform to play content; it is also a platform to purchase content. Consequently, the Switch has exhibited a level of longevity in its content library that we’ve never seen before from previous consoles (Fig. 2).

Figure 2. Nintendo Switch is a new paradigm for how Nintendo leverages its console

Moreover, the Switch’s success has been on a relative basis too where it’s now bigger than PlayStation and Xbox with over +108 million annual playing users (Fig. 3).

Figure 3. Nintendo Switch is the largest console platform

With its large user base, the Switch has drawn in numerous third-party developers and publishers. In fact, more than half the number of games sold on the Nintendo Switch are from third-party publishers. By FY27, we believe third-party games will account for ∼70% of unit sales on the platform on the back of a more powerful Switch (Fig. 4).

Figure 4. Switch will drive the majority of its revenue by collecting commissions from third party games

While the Switch is already an important distribution channel for game publishers, there is a transformational change occurring in how this is being done. Most sales are still being done via physical cartridges sold by retailers. But in the last 2 years, we’ve seen the Switch materially grow “Digital Sales” (games bought via Switch’s app store) to ~43% of sales (FY22a). This change in behaviour by gamers to purchase via digital channels is a clear secular trend, and we conservatively forecast that Digital Sales for Nintendo will grow to ~67% of total game software sales by FY27e (Fig. 5).

Figure 5. Nintendo Switch is now a key digital distribution channel to purchase games

There’s more. Nintendo Switch is not just a digital distribution channel, but it is also a hub for multiplayer experiences and additional content. This is best illustrated through “Nintendo Switch Online,” a monthly subscription service that allows players to play online together, access additional game content expansions, and access a catalogue of games. The subscription service today has over +37M subscribers (as of Sept 22, that is 35% of the annual playing user base). This is the most valuable and dedicated player cohort for the Switch, and we believe it is on a path to almost double in size in the coming years (Fig. 6).

Figure 6. The Switch also has a recurring monthly subscription business

Beyond the Nintendo Switch, Nintendo has accumulated nearly ~300 million Nintendo Account users. Nintendo Accounts act as a common account across Nintendo Switch, Nintendo Switch Online, and Nintendo’s mobile games, and therefore serve as a foundation for building and maintaining long-term relationships with Nintendo’s users. Nintendo intends on expanding its Account user base by leveraging its internationally recognized and massively popular IPs in ways that acquire new users that are not already Nintendo Switch users, such as through mobile games (+800 million downloads), merchandising (e.g., LEGO Super Mario series and physical retail stores), theme parks (Super Nintendo World Japan and United States), and visual content (e.g., the upcoming Super Mario Bros. Movie). These initiatives should act as a user acquisition flywheel, with value accruing as a result both within Nintendo’s core video games and its App Store Platform business.

Overall, the combination of a large active user base, a digital distribution channel, third-party support, and a monthly subscription business shows that the Switch is a leading “App Store Platform” for core console gaming.

Most third-party games being marketed on the Switch today are Indie, “A”, and “AA” games. Because of this, third-party revenue per user is significantly lower compared with the Switch’s peers (Fig. 7).

Figure 7. Switch third party games are primarily indie games

While we do see some AAA games on the Nintendo Switch, there are significantly fewer of them compared to other console platforms and PC, and these are often older-gen or significantly downgraded versions. The main reason we don’t see more AAA-quality games on the Nintendo Switch is the hardware’s technical limitations. The Nintendo Switch’s technical limitations stem from its aged Nvidia Tegra X1 chip (2015), which has hindered AAA game publishers from fully embracing the platform.

We believe that the next Nintendo Switch hardware device, which will arrive in 2023, will solve for this, with the device likely using the newer and more powerful Tegra239 system on a chip that could support PS4, or even PS4 Pro-level graphics and performance, with potential for added upscaling technology and raytracing support.

We think a higher-powered Switch will have a profound impact on the Nintendo Switch App Store Platform by unlocking the latent spending power of Nintendo’s sizeable “core” gamer demographic (Fig. 8) of 18–39-year-olds. This demographic accounts for 70% of Nintendo Switch annual playing users, significantly higher than what is perceived as the Nintendo Switch’s primary demographic – the under 18 and over 40-year-old cohort that wants to play only “family-friendly games.”

Figure 8. Switch’s core demographic is a much older audience that has higher spending power

As more AAA games come to the Switch, we estimate that the number of third-party titles that gamers purchase annually will increase in the coming years. This combination of purchasing more titles each year and the higher average selling price of AAA games ($60 vs $30 indie games) will lead to supercharged growth in third-party revenue (Fig. 9).

Figure 9. The Switch is about to unlock the value of third-party AAA games

We expect the new high-powered version of the Switch to arrive in 2023, with it accelerating the growth of Switch as an App Store Platform business.

The Switch as an App Store Platform is driving forward transformation change at Nintendo, where software revenues can exceed hardware revenues for the first time in its history (Fig. 10). We believe that this “inflection moment” happened this year, and estimate that software revenues could represent ~70% of the overall mix by FY27e.

Figure 10. Nintendo will soon predominantly be a software business

But it is not just the growth in software revenues per se that will have an impact. Even more importantly, Nintendo’s shifting revenue mix means its operating margins could increase to as high as ~50% in the coming years (Fig. 11).

Figure 11. Nintendo is in the midst of a step change in its margin profile that the market is ignoring

Looking over the last few years, Nintendo has already expanded its operating margin from ~4% in FY15 to ~35% today (Fig. 11). Incredibly, its stock has hardly seen any multiple expansion (Fig. 12), despite numerous value-unlocking events that have happened at the company (margin expansion, digital sales ratio expansion through its proprietary App Store, +108M engaged Nintendo Switch users and almost 300M Nintendo Account users, a thriving third-party publishing network, a growing recurring revenue stream from Nintendo Switch Online, and above all else its establishment of an App Store Platform which allows it to monetize its user base in perpetuity). We still think concerns around Nintendo’s user-base longevity and hardware cyclicality are weighing on the share price, with the market not correctly valuing the Switch as an App Store Platform. This creates an incredible opportunity going forward.

Figure 12. In last 5 years since the Switch launch, Nintendo has transformed itself into a robust business but it has not been reflected in its valuation yet

We believe however you look at Nintendo, it’s currently being valued at deep discount to its true intrinsic value. Our preferred long-term valuation method is a sum-of-the-parts analysis where we directly value the most important part of our thesis.

Our sum-of-the-parts of Nintendo separates the company into 1) Nintendo the “video game business,” which we define as Nintendo’s first-party software business and its hardware business (both of which go hand-in-hand, as Nintendo software is exclusive to its hardware devices), and 2) Nintendo the “App Store Platform,” which we define as Nintendo’s third-party software business and Nintendo Switch Online, its app store value-added service. We then do a sum-of-the parts valuation to arrive at Nintendo’s intrinsic value of ~$110B (Fig. 13).

Figure 13. Nintendo offers 3x upside to our intrinsic value estimate

First, for Nintendo’s video game business we estimate that the business will generate ~$12 billion in revenue over the next twelve months and generate a +33% operating profit margin. We apply a ~23x FWD EV/NOPAT multiple, in line with industry-leading video game companies, to arrive at an intrinsic value of ~$65 billion (Fig. 12). We think the market is still viewing Nintendo as a hit-driven cyclical hardware business, whose installed base resets to zero with each new hardware cycle, weighing on its valuation. For reasons we’ve explained above (specifically in assumption 1), we believe that Nintendo has established a platform and can continue to monetize its user base in perpetuity.  

Second, for Nintendo’s App Store Platform we estimate that the business will generate ~$3.5 billion in revenue by FY27e, growing at a +40% CAGR vs. FY22a on the back of more powerful Nintendo Switch hardware attracting more AAA-games. We think the business will reach long-term margins of +87% on the back of the digitization of software sales. This is because Nintendo charges an app store commission (which we estimate at +30% take-rate of gross sales) for third-party games sold through its app store. We apply a ~30x FWD EV/NOPAT multiple, in line with leading platform holders, and discount our FY26e enterprise value by 8% to arrive at a fair enterprise value for Nintendo’s App Store Platform of ~$45 billion today.

Besides the sum-of-the parts valuation, when we look at near and medium-term valuation metrics, Nintendo is trading at a discount to its peer group of video game companies. Over time, as Nintendo executes on continued expansion of margins, we believe it could see a material revenue multiple re-rating  (Fig. 14).

Figure 14. Nintendo trades at a massive discount to its best-in-class peers

This discount is even better illustrated by analysing Nintendo on an earnings multiple basis. For example, Nintendo is valued at ~7x EBIT and consensus forecast for EBIT CAGR is low single digits. We strongly disagree and expect earnings to CAGR at a minimum of +15% over the next two years (Fig. 15). A more fair multiple, considering both this growth and the quality of the asset, is ~17x EBIT.

Figure 15. Nintendo’s future earnings growth is not correctly priced

Taken together, we believe Nintendo could easily trade at double its current enterprise value, and it would if the market correctly valued the asset quality and the earnings growth we see ahead. Longer-term, the Switch as an “App Store Platform” thesis will drive Nintendo to become a software business with an accompanying robust margin expansion opportunity.

• A major slowdown in the Switch hardware sales or “peak” Switch. Even though we see ample room for the Nintendo Switch to expand its user base to multiple devices per household (the Switch is a highly personal device like mobile, and games are becoming more social), our thesis effectively boils down to high user retention and expanding average revenue per user on the back of more AAA-games coming to the Switch. We think the Nintendo Switch being a platform with increasing third-party support and a growing number of games launching on the platform each year means the player base will continue to be extremely sticky and engaged. The market needs to focus on software support and user retention rather than hardware unit sales.
• Nintendo releasing a completely new console that’s different from the Switch, and in doing so shifting software support away from the Switch resulting in user cannibalization. We think the failure of the Wii U and the challenges Nintendo has faced in the past to “reacquire” its user base with each new hardware cycle has shaped their strategy around building a persistent App Store Platform and operating system. The below quote from Satoru Iwata, the current president of Nintendo, says it all: “Apple is able to release smart devices with various form factors one after another because there is one way of programming adopted by all platforms. Apple has a common platform called iOS. Another example is Android. Though there are various models, Android does not face software shortages because there is one common way of programming on the Android platform that works with various models.” We therefore think this risk is highly unlikely to play out since the major difference today vs. Nintendo’s previous hardware cycles is that multiple hardware devices can and will share the same single software platform (or operating system). In other words, we think the future of Nintendo is one in which we have multiple hardware devices (with different form factors), all plugging into a single shared App Store Platform and operating system. Different hardware thus just becomes an interface for accessing the same Nintendo App Store Platform.

Nintendo is an iconic company that owns some of the most valuable intellectual property (IP) in video games today. We believe most people know this, and that these franchisees themselves are worth much more than the current market cap of the company. But in our opinion, the most important variable to driving an asymmetric outcome for shareholders of Nintendo is the value of the “App Store Platform” business, which starts with understanding that Nintendo today is different from Nintendo in the past. We summarize below some of the important changing factors at Nintendo:

• Nintendo has converted its boom-bust hardware business from a single-use device with a finite lifespan to one that is now an App Store Platform that Nintendo can use to monetize its user base in perpetuity, a proprietary digital distribution channel, a vibrant ecosystem for third-party publishers, a hub for multiplayer and social gaming, and ultimately a software-driven longstanding platform to plug in multiple hardware devices that target different demographics and gamer behaviour.
• Nintendo is committed to maintaining long-term relationships with its users by setting up its Nintendo Account and using this as the connecting factor across multiple Nintendo touchpoints.
• Nintendo is focused on expanding its iconic franchises and using them to “pull” more users into its core App Store Platform by taking a more openminded approach to IP value maximization. For example, by using its IP to create a transmedia flywheel to attract traditionally non-gamers through other entertainment media such as visual content (film and video), merchandising (or toys), theme parks and mobile games.
• Nintendo has adapted its culture from being one where top-down decisions were made with little contribution coming from employee proposals to one where employee proposals are encouraged and contributions are meaningful, with decision-making shifting to a group style across the management team. This change began with previous President Tatsumi Kimishima (2015 – 2018), who oversaw the release of the Nintendo Switch (an inflection moment in creating a single software platform or operating system).
• Nintendo is going to be rolling out a stock-based compensation plan as part of its management compensation package. This will align investor and management interests in a better way than in the past.
• Nintendo’s capital allocation decisions have also seen improvement, with the company earmarking about 28% of cash for items such as expanding its game and non-gaming software development teams, maintaining and expanding its relationship with customers through its Nintendo Accounts, and continuing to develop value-added services with a shift to digital in mind. This is a major improvement vs. Nintendo’s historical risk-averse attitude to capital allocation. We think this is a big step in the right direction to Nintendo being more thoughtful around capital allocation, and believe this will continue to improve as Nintendo sees its business become more software-dominant and thus lower-risk.  

Catalyst

The release of a higher-powered Nintendo Switch which we expect will launch within the next 15 months.