A Theory of Corporate Governance

“Good managements produce a good average market price, and bad managements produce bad market prices.”

~Benjamin Graham, the Dean of Wall Street, “The Intelligent Investor”

Introduction

In the world of value investing, which fundamentally concerns itself with securities trading at a large discount to indicated or intrinsic value (the Margin of Safety), one thing investors are always on the look out for is the value trap. A value trap is a company that looks really cheap but turns out to be cheap for a reason, ie, it’s actually fairly valued at its present price. Companies in general become mispriced for a variety of reasons, and while value traps are no different in this regard, one reason stands far above others in generating its unfair share of value traps– bad management.

This essay will explore in greater detail the genesis of bad management value traps via the principle that “corporate value is a function of owner agency.” Companies with bad management tend to demonstrate the least owner agency, sometimes approaching an effective zero. As of the present, the principle of owner agency can be explored across separate 8 sub-domains pertaining to the company’s corporate governance standards.

The 8 Sub-domains of Corporate Governance

Whether a company realizes it or not, it can and must make a decision about its corporate governance policy in at least 8 different areas which affect owner agency and thus corporate value:

  • The Board of Directors
  • Company purpose
  • Communication standards
  • Capitalization/capital structure
  • Reporting
  • Fairness
  • Competence
  • Barriers

Each of these sub-domains and the choices involved will be explored below. At the end, we will summarize the “official positions” with regards to what good corporate governance looks like in light of the theory promulgated in this essay.

The Board of Directors

In a company with a diversified ownership structure, the Board of Directors exists to represent shareholders and direct the behavior of management according to their wishes. In other words, the BoD is the primary tool of agency for shareholders of the company who, without official titles or positions of management themselves, have no direct way to influence the conduct of the company, its strategy or policies as owning individuals. The BoD is similar to a “house of representatives” in an elected republic– the representatives exist to serve not their own interests, or the government’s interests, but the interests of the individual voters who put them into power.

The BoD should have broad authority to put in place an overall competitive strategy for the company (what do we make or sell? how do we do it? who do we compete with?) and to hire and fire key, C-level managers (CEO, CFO, COO, corporate comptroller or treasurer). These managers should be fully “answerable” to the BoD and thus, the shareholders, whose property they are responsible for utilizing and safeguarding in the course of business.

In modern public companies, it is common for these top managers to be represented on the board, for example, the CEO is also often the chairman of the BoD and presides over its affairs. This is an enormous conflict of interest, because the CEO can not hold himself accountable as a member of the board, and the purpose of the board is to be influenced by the shareholders, not the hired management. This is especially problematic when the CEO is not a substantial shareholder himself.

Another common state of affairs in public companies is that the BoD does not represent significant shareholders. Individuals legally important stakes (5%+) or significant economic stakes (10-25%) often do not get offered representation on the boards of the companies they own and sometimes nominally control due to the distribution of share ownership in a company. If the Board of Directors doesn’t include individuals who represent the interests of shareholders, it serves no purpose other than to rubber-stamp the initiatives of the management, which means it serves no purpose at all besides the propaganda value of pretending the company has functioning corporate governance through the existence of a Board of Directors.

Company purpose

Why do companies exist?

Historically, companies were formed for the benefit of their owners in order to turn a profit. Some of the first joint stock companies were engaged in material manufacture or entrepreneurial discovery of new lands and trading routes. Long pre-dating formal joint stock companies of Europe in the early 1500s were numerous merchant combines across cultures and the ages which were formed to pool risk in long-distance hauling of cargoes. Because the owners were the only people who put capital into the company, it was the owners who were the only people expecting to derive a direct benefit from the operation of the company in so far as it generated profits– the agents of the company might earn salary and bonus according to the terms of their employment contract, and of course the prevalent State often wished to interest itself via tax, but otherwise the issue was pretty cut and dry.

The modern era has brought with it many innovations in the area of an answer to that question, but none of them seem to be any good. Today we hear talk of “stakeholders”, where a stakeholder seems to be any economic or political interest, such as customers, communities, employees, vendors, foreign nationals, labor unions, governments, etc. who isn’t an actual equity owner in the company. We hear of “corporate social responsibility” (CSR) which is just another way to plead the case of certain “stakeholders” with regards to the deployment of a company’s capital. In vogue since the late 1980s and still popular today is the idea that long-serving management of the company should be the real beneficiaries of the existence of the company and that they should accumulate a lion’s share of the value the company creates because of the key role they play in making the company capital fecund in the first place.

Yes, it seems today that companies exist to serve everyone but those who own them.

Regardless of the answer to this question, it is important to simply have an answer. It becomes a standard of value that a company’s management and employees can be held to in observing their choices and behavior. It can serve to answer the simple question, “Are they doing a good job?” from which many other questions and decisions might emanate.

Without a stated purpose, it is not only impossible to agree to where everyone is going but it is impossible to govern the corporation so that it gets there. Certain purposes exclude certain ends and certain methods while allowing certain others.

Communication standards

With regards to how the company and the Board of Directors communicates with shareholders, there are also certain standards that can be implemented to guide action.

A common policy seemingly in place at many companies is clubsmanship and secrecy– executive management is unwilling to provide basic answers to shareholder questions and requests for information, often going so far as to put up unnecessary obstacles to proving they are in fact a shareholder in the first place. And the Board of Directors, captured by the management, facilitate this by refusing to assist the shareholders in their requests, to bring pressure upon management to provide the information (legally) requested and often times they will even make themselves unavailable or unresponsive to shareholders entirely.

The opposite pole would look like this: the management of the company assumes a goodwill posture and provides answers to any (legal) information request made. If the company is of sufficient size and scale and it is fielding a lot of such requests, it may make a special individual (such as an IR agent) available to help source answers. It might also look for a scalable solution, by putting commonly requested corporate documents (financial statements, records of ownership, minutes from board meetings, etc.) into the public domain via its website, and to also offer an FAQ session for answers to repeated inquiries.

As such information is legally due to shareholders anyway and can’t really harm the company by being shared, it makes sense to offer it to anyone who asks, shareholder, potential shareholder or simply a curious stranger. It is not a redacted espionage memo and it doesn’t require any special classification system or hierarchy of security clearances to access.

The Board can facilitate this process as well by being in regular contact with larger shareholders to understand their needs and concerns for the company they own, and to communicate these thoughts to management in board meetings and report back their findings to shareholders in the process.

Capitalization/capital structure

Public companies are in a unique position in terms of their ability to raise capital and finance their projects. Because of their public nature, it is a relatively simple affair to do a rights offering and issue new shares, debt or other securities. Even more important, if ever the market treats the company unfairly, they have the opportunity to buy back their shares from concerned shareholders at a discount to intrinsic value. The company is always in a better position when it is owned by people who believe in the vision and direction of the company, which can be achieved by buying back shares from those “distressed” sellers who have lost confidence.

One role of the BoD and corporate governance is to determine what the best capital structure is at any given time in a company’s life given its future plans and strategies. This means making high level decisions about the debt to equity ratio, if applicable, and also about the issuance or buyback of shares more generally.

Another thing the BoD can facilitate as an act of corporate governance is being efficient with the company’s capital– dividending it out when the company has more capital than projects, and issuing rights to bring capital back in when it has more profitable projects than it has capital to deploy on them.

This is not a one-time decision. It is something a company should be examining on a periodic basis– either quarterly, annually, or any time a major change in its market price or project pipeline occurs. Companies that hoard capital they don’t need do their investors a disservice because they forgo the economic returns available on the surplus capital, which could be deployed at higher rates of return in other enterprises. And companies that refuse to expand the share base in response to important project opportunities make a similar mistake but inverse.

Reporting

Markets move on information. Without information about a company, investors are left with nothing to make a decision off of and so they can not act rationally. They become forced to gamble and speculate. For a company that is not in a hyped industry, the gamble is often made in fear– shareholders sell out at any price to avoid association with a “black box.” It is a critical aspect of corporate governance to have a consistent reporting policy in place to update shareholders on the performance of the company’s strategy over time and to explain key financial data to them.

This kind of reporting requires: transparency, honesty and articulate capabilities. The chairman, being the head of the Board of Directors which represents the shareholders, is the most likely individual to communicate with shareholders about the state of their company. He might append letters from the CEO and other key executives as well if he so desires, but each of these individuals has an incentive to patronize their reader and focus on what went well. The chairman, having no duty to anyone but the shareholders and reality, is in a better position to see the whole hog and not just the lipstick on the pig.

For reporting to be meaningful, it must take into consideration the entire strategy and how the operations worked to achieve it or fail it. Glossy PR brochures highlighting the charity and good works of the management or employees, of the high level successes that did not translate to the bottom line, or to a stylized, marketing view of the company and its operations that does not drive to the key objectives and how they were met or missed, do not do shareholders any good.

While it’s true that the annual report is a key “marketing” piece in attracting knowledgeable shareholders, its primary purpose is to inform, not to sell. It must focus on the good, the bad and the ugly, not the positive or the bright side.

Fairness

Tied up in the ideas of representation and company purpose is the idea of fairness– are all shareholders treated equally? And are all managers and employees treated the same with regards to their duties to the shareholders?

There are two separate but related concepts of fairness at stake. One is the fairness of decisions between majority and minority shareholders, aka, “taking minority capital hostage.” The other is the fairness of decisions between shareholders and agents of the company, aka, “being subservient to loyalty or tradition.”

It is a sadly common sin amongst many public companies with decisive majority owners, especially owners who are insiders and part of management, that they find ways to employ the company’s capital or govern the company which benefit them at the expense of the passive, minority shareholders. An example of this would be a majority shareholder who is also a manager, who is earning an outsize salary and delivering a subpar return on equity compared to the industry or market, who refuses to “fire” themselves as a manager or scale back their pay. The minority shareholders are in effect subsidizing this poor performance with their capital, which is trapped in the company controlled by the majority shareholder.

This is not “fair” because it doesn’t treat the minority and majority shareholders as economic equals– the majority shareholder enjoys a special benefit or subsidy that the minority shareholder pays for. If the company did not exist, and this arrangement was being proposed as a condition of forming the company, no rational minority shareholder would agree to it. If they wouldn’t agree to it de novo, they can’t be thought of as agreeing to it as part of a going concern. This would be similar in a political system where some citizens are treated as “second class” by the law and discriminated against to the advantage of the privileged class.

The other sin amongst public companies is holding on to operating units or employees or managers who are underperforming in their jobs by some agreed upon, objective standards. These units are typically retained out of a sense of tradition (“We’re an X company, we’ll always be an X company”) or personal loyalty (“Y has been with the company for so many years, we can’t put them out on the street now”). Clearly, these kinds of decisions could easily conflict with a stated purpose such as “To maximize profits to shareholders.” They again represent subsidy. And the fact is that no company has infinite resources or can afford to engage in charity without limit; and if it can’t afford without limit, it can’t afford WITH limits, as the economic consequences are the same– the company is wasting capital on ineffective means.

Adhering to loyalty or tradition at the expense of shareholders means turning the business into a charity. Charity is a private virtue and a public vice and it has no place in a public company in this sense.

Competence

Modern companies are complex organizations with extensive economic resources at their command. The average public company, regardless of market price, has millions to tens of millions of dollars of shareholder capital involved in ongoing operations. There is too much to keep track of, and too much at stake, for a company to allow incompetent people to manage this level of responsibility.

Corporate governance serves another function here in setting standards of value for managers and employees in terms of the competence required in their positions of relative responsibility. Importantly, the Board of Directors can set standards in specific areas, such as financial or economic concepts which have an important bearing on the company’s risk position or the stability and profitability of its operations over time. Internal capital allocation, that is, the determination of how to deploy the company’s capital (buybacks, dividends, the raising of finance, or the investing of capital into operations or liquidating of capital so employed), is a seemingly simple discipline which nonetheless has a magnified impact on the company’s operations and its wealth as a whole– it requires a specific level of competence in the basic concepts and dilemmas involved for a person to add value. Many companies are run by people who do not understand capital allocation, have never studied the issues involved and often aren’t even aware of the momentous decisions they are making with regards to it, instead letting personal prejudice or momentary whim be the arbiter of decisions costing millions of dollars with long-lasting consequences for the company into the uncertain and unknowable future.

The Board of Directors can strongly influence the competence of the company and its management by researching and instituting relevant standards of competence needed in key decision-making areas and working to educate and provide resources to the company’s agents employed in these areas.

Barriers

In economic and business literature the concept of “competitive advantage” often revolves around a related concept of “moats”. A moat is a barrier to entry in a competitive market that preserves the value of incumbent firms by allowing them to spend resources on deploying their business model rather than spending those resources on defending it from competitors looking to do the same.

In the world of corporate governance, a similar phenomenon exists: “shareholder defense” tactics aimed at preventing “takeovers.” However, there is a subtle difference in the nature and virtue of each.

In the business competition sense, moats which provide competitive advantage usually exist as a structural part of the industry– they are embedded in the nature of the economic activity itself or the incentives competitors would face that are innate to margin structure, human behavior, etc. They usually can not be constructed or developed purposefully. Not so with takeover defenses. These are things that a company can or can not choose to employ and which the law often gives power to, implicitly or explicitly.

Competitive advantages protect companies from other companies. But shareholder defense mechanisms do not protect shareholders from other investors– they protect managers from their shareholders!

The actual effect of takeover defense mechanisms, when employed, is to drive a wedge between the people who own the company (the shareholders) and the people who control it (the management) by limiting the authority and control the shareholders have over dismissing or countermanding the management’s decisions.

Staggered boards, for example, help to ensure that change at the board level happens slowly (if at all), rather than as quickly as shareholder ownership changes. If there are 5 board seats and all are held by “insiders” and only 2 come up for bid every few years, then it may be 6 or more years, for example, for a shareholder who manages to obtain a majority of shares of the company to see his majority influence reflected in the composition of the board. That means a long period of time where existing management can work against the shareholder or at cross-purposes.

Poison pills, another common strategy, work to similar effect. A poison pill provision essentially neuters the voting power of a shareholder who manages to accumulate a substantial fraction of the company’s outstanding shares. If the provision says that any shares owned over 10% will vote at 10%, it prevents any specific shareholder from obtaining voting control, which protects the management from being told to change their tune or from being thrown out entirely.

It seems counter-intuitive, but removing barriers to entry for ownership of the firm is an important piece of corporate governance policy to work out. And much like the popular theory of democratic politics or republicanism, reserving the “right to vote” or the legitimate authority of the voters over their political appointees results in a situation where the appointees behave irresponsibly and often build up power and prestige at the expense of the people they were hired to represent.

“Official Positions” of Good Corporate Governance
Outlined below is an attempt at an “official” good corporate governance doctrine that any concerned company, its Board and shareholders could adopt to improve the corporate governance situation at the company. In so doing, it is believed that the company will attract quality, long-term oriented shareholders willing to pay a fair price for a properly managed and profitable enterprise. The items elaborated on below serve to maximize owner agency and with corporate value being a function of that agency, they should also serve the maximize the value of the company.
  • The board of directors should represent — meaning, be constituted of — significant shareholders and/or their agents
  • The company should be run for the purpose of maximizing the present value of expected cash flows to shareholders
  • There should be a constant dialog at the board level which includes larger shareholders about the best way to achieve the stated purpose
  • When the opportunity for capital/equity is low, money should flow out of the company; share buybacks and dividends are the way for money to flow out; when the opportunity is high, capital should flow back in; a rights offering (with transferable rights) is the cheapest and fairest way for money to flow back in
  • The annual report should have an essay or letter by the chairman (who is ultimately responsible for achieving the stated purpose) reiterating the objective, discussing the level of achievement in the prior year and outlining the strategy that has been agreed upon to pursue it going forward
  • It is unfair for a majority or manager to retain employees or operations for sentimental reasons unless they satisfy the purpose of maximizing the present value of expected cash flows to shareholders
  • Anyone responsible for achieving the objective should have the necessary grounding in finance and economics to understand how to carry the work out (study an agreed upon bibliography)
  • Management/corporate “shareholder defense”/takeover defense mechanisms such as staggered boards, poison pills, limits on shareholder meetings and proposals, secrecy/lack of disclosure, etc., destroy shareholder value by driving a wedge between ownership and control

More Interviews With David Baran Of Symphony Fund (#JNets)

For reference purposes, here are three more recent interviews with David Baran of the Tokyo-based Symphony Fund, which is involved in shareholder activism and management buyouts of undervalued (especially net-net and net cash bargain) Japanese equities:

Investing in a ZIRP environment:

I’ve been trading Japanese equities since 1990, so I’ve seen it all twice [laughs]…

I think [it’s influenced] our views on how the world is going to look as a result of, not just the current sovereign debt crisis in Europe, but the entire cycle of over-leveraging in the world and the shifting to an almost perpetual low interest rate, low growth scenario.  We’ve lived it in Japan already—we know what it’s like, we know what it does to asset prices, we know you’re going to get attractive bull market runs but you’re still going to be in a long-term bear market. Being able to look back at our own experiences of having dealt with that in Japan gives us a completely different perspective, I think, from other managers who would be relatively new to the market—by relatively new, I mean, they’ve got 10 years experience—and they’ve only seen bull markets with some deep corrections that are reversed by policy.

I don’t think there’s a policy solution for what we have now. You’ve got to get rid of all the debt. The global debt overhang is huge, it’s historic. The amount of unfunded liability in the U.S. can cripple the country. And you have that situation amplified in Europe with fewer policy tools to rectify the problem.

The M&A trend in Japan:

MBOs [management buyouts] first came to prominence in Japan in 2006 with the Skylark MBO. This caused corporate Japan to first sit up and take notice that this was a possible road that management could take. At the same time, there began a series of changes to Japanese corporate governance that aimed to increased corporate disclosure and increase transparency. The most recent of these came out in 2010 and included requirements for director/statutory auditor independence, disclosure of executive compensation, and explanations for cross shareholdings. All of these are hard to swallow for many Japanese companies. In addition, with all these new rules, including IFRS accounting rules that will soon be introduced, the costs of being a listed company was getting high. Too high particularly for smaller cap companies for whom these costs were now of a material size relative to earnings. It is no coincidence that we have seen a steady increase in MBO activity in Japan, with 2011 on track to be the highest in five years.

They’re not activists, they’re advisors:

We are not activists. The whole activist approach doesn’t work in Japan. It probably works better in the U.S. because the shareholder base is more diversified and economically motivated. Shareholders in Japan may not necessarily use the same formula. The activists who tried a hostile approach here before, and this is where the cultural biases come in, they never had the ability to force management to do anything because they never had control. So they were requesting management to do something but doing it in such a way that management would just turn their back on them and say, ‘Well, we don’t even really need to talk to you,’ and the other shareholders really didn’t care, and would side with management.

We take a much more cooperative approach with management…We’ll act more as their counsel, their consigliere, guys they can talk to about things as opposed to the squeaky wheel.  We’re not interested in being the squeaky wheel.

Interview With David Baran Of Tokyo-Based LBO Fund Symphony (#JNets, #valueinvesting)

This is worth watching if you’re a value-investor interested in the Japanese equity market.

Description of the video from YouTube:

David Baran, Co-Founder of Symphony Financial Partners, has over 20 years of experience investing in Asia. He has lived in Asia and Japan for nearly 3 decades and is fluent in Japanese.

Baran’s SFP Value Realization Fund was launched in September 2003 when Nikkei was about 9,500. The index has fallen since then, yet his fund is still up 56% after fees.

The secret to achieving returns in Japan is that you’ll have to do more than just long-only investing. The unloved, under-covered nature of the Japanese market creates opportunities that ordinary fund managers are not capable of pursuing because it’s too hard to extract the value. Many Japanese firms, particularly the smaller ones, can boast about 40+% operating profits and 30+% EBITDA margins. They can have net cash positions and trade at 50+% net cash to market cap. Hundreds actually trade at over 100% net cash to market — which means the market is valuing these viable businesses at zero.

“Investors in the U.S. equity markets would be falling over themselves to invest in a company like these – net cash, strong business moat and growth prospects,” says Baran. But being “cheap” isn’t enough — you need catalysts to unlock the value.

M&A activity flourishing in Japan

Corporate activity is such a catalyst. MBOs have an average premium of 50% (!) and sometimes reach triple digit numbers. Many of the large Japanese conglomerates started to buy back listed subsidiaries. Baran also advises on the Sinfonietta Asia Macro hedge fund, one of the best performing Asian hedge funds in 2001.

Hear David speak about:

* The 8 reasons why management buyouts are gaining popularity

* Why you need catalysts to unlock value in Japan equities

* What investors are missing by considering Japan as an “asset class”

* How to avoid “value traps”

* Considering tail risk: Why Baran’s Sinfonietta hedge fund is “geared towards a disorderly market”

Notes – Sanborn Maps, Dempster Mills, Nintendo’s Rise (#casestudy, #valueinvesting, #buffett, #nintendo)

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

  • Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
  • Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
  • By 1959, represented 35% of partnership assets
  • Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
  • Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
  • Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
  • In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
  • Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
  • The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
  • Additionally, Buffett took a control position which gave him an added margin of safety
  • Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

  • In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
  • Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
  • Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
  • Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
  • Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
  • Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
  • Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
  • Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
  • Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
  • Harry Bottle’s effect:
    • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
    • Correspondingly freed up capital for investments in marketable securities
    • Cut SG&A by 50%
    • Cut factory overhead expenses by 25%
    • Closed 5 unprofitable branches leaving the company with 3 profitable branches
    • Eliminated production lines tying up capital but producing no profits
    • Adjusted prices of repair parts to yield additional annual profits
  • Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
  • Other notes:
    • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
    • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
    • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

  • Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
  • The cost of video game consoles has been falling in real terms since the 1980s:
    • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
    • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
    • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
  • Home video game systems were a growing market:
    • 1982, 17% of US households had a video game system
    • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
  • Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
  • Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
  • Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
  • Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metriod (1987), the first two of which were developed by hit designer Shigeru Miyamoto
  • Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
    • Namco
    • Hudson (later acquired by Nintendo and brought in-house)
    • Taito
    • Konami
    • Capcom
    • Bandai
  • By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
  • Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
  • On average, Japanese consumers bought 12 games for every Famicom system purchased
  • Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
  • NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
  • By 1991, 100 licensees with only 10% of software development in-house at Nintendo
  • Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
  • NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
  • WMT did not stock competing video game systems
  • In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
  • 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
  • By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
  • In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business