|Shares Out. (in M):||130||P/E||0||0|
|Market Cap (in $M):||57,371||P/FCF||0||0|
|Net Debt (in $M):||-13,633||EBIT||0||0|
|TEV (in $M):||43,740||TEV/EBIT||0||0|
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Nintendo needs no introduction and I would encourage you to read the previous post by roojoo which provides good background information.
I believe that Nintendo’s best days are ahead of it because its genius as a game maker will be amplified as Nintendo builds a direct and deep relationship with its gamer base whereas the current valuation seems to imply that Nintendo’s earnings are not going to grow. This new relationship with its gamer base will transform Nintendo’s historically cyclical revenue into a recurring one. This is a well-documented argument by now. Two fundamental drivers - 1) the console hardware architecture is such that backward compatibility is much much easier to achieve than before. 2) Unlike previous console generations, most console games are online now which means the game and its progress can be easily downloaded into a new console. The obvious parallel is iPhone - Switch gamers can expect their game to work just as games work on both iPhone 8 and iPhone 9. Not only does the game work in iPhone 9, the gamer can open the game and pick up right where he/she left off in iPhone 8. This is very important because it means persistent game worlds can work on Switch which is critical to increasing gamer stickiness and growing average spend. This effectively means that the install base does not reset to zero with each product cycle. I have no idea when Nintendo would introduce the successor to the Switch but I have a high degree of confidence that when it does, it would build off the existing 90+m install base.
Nintendo is first and foremost a game developer with an excellent track record. They have world-class game franchises - Pokemon, Zelda, Mario and Animal Crossing just to name a few. Typically, a content creator tends to be distribution channel agnostic and wants to maximise revenue while the distribution channel wants to have best content exclusive to their platform. Think of the music labels which distribute their content on all major platforms Spotify, Apple Music and Youtube music. Nintendo faces the classical dilemma as a content creator that happens to own a console platform (which is a game distribution platform) which is that they used to optimise the console for their own game development process and don’t really have the DNA to service third-party game developers well. Wii U failure is a classical example where Nintendo had poor third-party game development support and Wii U was just too different from other consoles for the game developers to dedicate their time and effort to develop games for. Indeed, many investors have argued for a long time that Nintendo should just be a game developer and get rid of the hardware platform to maximise profit.
Nintendo has always stuck to a hardware and software integrated approach because they believe this integration can differentiate their first party games. I do think their game is slightly differentiated due to the integration but it is very subtle. It is kind of like the iPhone where the hardware and software integration helps to improve the user experience by 10% but that 10% makes all the difference. It is interesting to note that Nintendo’s reason for keeping a console platform is such that they can make better games. Sony and Xbox are also making more 1st party games but they only do it to sell more consoles. The three companies could not be more different in their mindset.
I believe a set of factors have converged now such that going forward, Nintendo can benefit enormously from its differentiation as a content creator rather than being constrained by being a content creator in previous console generations. The gaming industry has been rapidly adopting third-party game development engines such as Unreal and Unity and these game engines abstracts away the hardware layer. It means that it is much much easier for game developers to develop for multiple platforms at the same time. Historically, each console platform had its own game development engine and game developers need to choose which platform to publish on and the console that gained the most traction will take outsize rewards. Game developers find it much easier to develop and/or port games over to different platforms. Consequently, cross-platform play is becoming more commonplace. The direct outcome is that Nintendo Switch is becoming much more friendly to third-party game developers. As the library of third-party games on Switch expands, the Switch’s value proposition for the gamer base is rapidly expanding. Furthermore, as the content overlap between the three console platforms overlap, Nintendo increasingly has a credible point of differentiation with its exclusive game franchises. Sony and Xbox will continue to compete on having the best specs to support the latest photorealistic AAA game.
Nintendo’s role as a high quality game developer with strong existing game franchises also helps to mitigate the long term risk of cloud gaming completely destroying the console business. It is possible that the aggregation platform moves from the console to the cloud gaming providers (Xbox is doing a good job on this front) and in which case only by owning the content. In fact one could argue that Nintendo games might become bigger than ever because they are finally released from the chains of their own distribution platform and can finally address a global audience.
Nintendo Switch is a sustainable gaming platform because it is anchored by Nintendo’s world-class games and supported by a mix of long life-cycle games and new games by both Nintendo and third-party game developers. Nintendo Switch is in a positive feedback loop now where its large install base is attracting more third-party game developers which in turn attract more Switch buyers. If my assumption that the Switch gaming platform would defy the previous console lifecycle of peaking in year 5 and ending in year 7, then I assess Nintendo’s intrinsic value with the following factors: 1) Switch install base, 2) software revenue per install base, and 3) operating margin
Install base - I assume that the Switch install base will reach ~125m by the end of 2023 and ~140m by the end of 2025. Here I am assuming that at some point Switch 2 will come out and a lot of existing Switch owners will upgrade but also attract some new players.
Software rev per install base - Instead of using the industry average of tie-ratio (units of software sales per install base), I prefer to use software revenue per install base which is simply taking total software revenue (a dollar amount) and dividing it by the total install base. This metric was first introduced by Nintendo CEO, Mr. Shuntaro Furukawa, and he argued that as online membership revenue and in-game item sales increase, it is less effective to use software units to understand the software performance. And I agree with Mr. Shuntaro Furukawa.
Software revenue per device declined 11% YoY from JPY 10,749 to JPY 9506 in FY 2021. This decline in FY 2021 is smaller versus the decline in FY 2020. If my thesis that Switch is a sustainable gaming platform is correct, then I expect the software revenue per install base should at least stabilize if not increase further from here.
There are quite a few dynamics that impacts the software revenue per install base and I will try to call out a few big ones here:
The most hardcore Nintendo fans will buy Switch first and they have the highest revenue per install base. As the less fanatic gamers join the Switch platform, they pull down the average software revenue per install base because the mix of casual fan base outweigh the most hardcore Nintendo fan base
Ramp up of a new gamer – it takes time for a new gamer to ramp up their spending on the platform as they slowly discover the games that really appeal to them. Generally speaking, new gamers might discover one or two games that they really like, and then, voila, the spending would increase dramatically
There are two kinds of game revenue on Nintendo Switch – the one-off revenue that comes from single-game releases and the “recurring” revenue that comes from free-to-play games. Most of Nintendo’s game revenue derives from one-off game sales. The “recurring revenue” includes 1) online membership, 2) sales of in-game items, and 3) season passes for games like Fortnite.
Not all free to play games will be long lifecycle games, but as the number of free to play games increases on Switch, there will inevitably be more long lifecycle ones
As the number of long lifecycle games increases, the “recurring” revenue per install base should start to increase slowly. This impact is less observable due to low base and obstructed by the lumpy new game release schedules.
Again if my thesis is right, then the “recurring” revenue from long lifecycle games, such as Fortnite and Tetris, should form the bedrock of Nintendo’s software revenue. And new games releases’ contribution to total software revenue would be volatile in nature.
Taking the various factors into consideration, I assume that software revenue per install base would continue to decline by 15% in FY 2023 and reach JPY 8127. It is very likely that it would stabilise from there on - either declining very slowly in base case or even start to grow in bull case.
Nintendo’s operating profit margin - Given that Nintendo’s hardware revenue is break-even at best, I like to define operating profit margin as total operating profit divided by software revenue. Hence both hardware and software R&D is expensed through the software revenue line which is consistent with the razor and blade business model.
In my definition, Nintendo’s operating profit margin expanded from 24% in 2017 to 80% in 2021.
There are a few key drivers for the operating profit margin expansion.
1. The increase in the proportion of total software sales sold through the digital channel (42.9% in FY 2020) has been increasing steadily over the last 5 years. Digital sales carry a much higher margin than offline retail channels because 1) there is no cost to produce physical copy and 2) Nintendo earn the full retail price instead of the wholesale price.
Mr. Furukawa gave us an update on the purchasing behavior of gamers which gave me confidence that digital sales % can only increase from here albeit more slowly from here:
“And in terms of digital sales, consumers who purchased hardware during the year-end holiday season are relatively inclined to purchase their next game digitally, leading to a tendency for the ratio of digital sales in the fourth quarter to be higher than the third quarter. But even so, the fourth-quarter digital sales in the previous fiscal year were comparable to those in the third quarter, which indicates that purchasing software digitally has become quite widespread as an option for our consumers.”
Also as the “recurring” revenue from online membership, in-game items sales, and DLC sales should also help to grow the digital sales percentage.
2. Another driver for operating margin expansion has been the growth of third-party games on the Switch platform.
Nintendo charges an estimated 30% take rate on sales of third-party games on its Switch platform. Since this revenue stream carries close to 100% margin, the growing percentage of the third-party games will drive the overall operating margin. Nintendo recognizes first-party games at gross revenue and third-party games at net revenue (i.e. only the 30% take rate revenue). If I try to compare first-party and third-party games on a comparable gross revenue basis, then third-party games would have accounted for ~46% of total gross revenue on the Switch platform.
This indicates a very healthy 3rd party developer ecosystem on Switch. I think Switch has a lot of work to do in terms of improving the discoverability of games on Switch.
I assume that they would need to incur more R&D spend on both hardware and software and hence I assume a 70% adjusted operating margin in 2022.
Putting it together, I get 125m install base in 2023, JPY 8127 software rev per install base and 70% adjusted operating margin. I have JPY 1000bn of software revenue (~USD 10bn of software revenue) and JPY 700bn of operating profit and JPY 530bn of net profit. Or USD 5bn of net profit in FY 2023. Nintendo’s current market cap is USD 57bn which implies 11x P/E for a very high quality business that is growing its top line albeit more slowly around 5-10% after 2023. I dont know what is the right multiple it should trade at, 11x is too low.
Now I could be way too optimistic in estimation. There are still many risks – Nintendo launching another weird console just like they did with Wii U, iPad becoming a stronger console platform. And most importantly, Nintendo fails to fully embrace gaming as a service. On balance, I think Nintendo’s risk-reward feels very good here to justify the high portfolio weight.
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