Would You Buy This Business? A Bargain In The Videogame Industry (#valueinvesting, $NTDOY, #videogames, $AAPL)

The Nintendo investment thesis in one paragraph

At Y9020/share (June 1, 2012), you are buying a strong global entertainment franchise for Y1278T which has earned Y126B on average over the last ten years and generated Y120B in average FCF, with Y1191B in book value, Y958B in cash and investments and no debt. Global financial market pessimism coupled with hyperventilating technology futurist forecasting and a recent misstep by management that is now behind the company can be used to your advantage to buy this good business at a fair price.

The Nintendo investment thesis in several paragraphs, with links and charts

Nintendo ($NTDOY – ADR, JP:7974), the cherished childhood video game icon and global IP behemoth behind such hit game franchises and characters as Super Mario Bros., Pokemon, The Legend of Zelda and more, has stumbled recently. The company rolled out its new 3D handheld video game system, the Nintendo 3DS, around the world in the spring of 2011 at a price point that proved out of reach to many consumers.

To sale initial sales were disappointing would be an understatement– the system was a flop and with little software support from Nintendo out the gate, gamers had even less reasons to purchase this pricey new system. Realizing their mistake, the company quickly slashed the retail price of the system and offered retroactive credits and concessions to select customers who had purchased the system prior to the price drop.

With a new slate of software titles by Nintendo and premium 3rd party developers released in the 2011 Holiday season and thereafter, and the new price point, the system has finally caught momentum and software and hardware sales are both impressive. As of March 2012, worldwide sales of the Nintendo 3DS reached 17 million units and sales of related software amounted to over 45 million units. Consider this in comparison to the 151 million hardware units and 900 million software units sold over the last 7 years with the predecessor system Nintendo DS and its generations, and the 95 million hardware units and 818 million software units sold over the last 5 years with the smash hit Wii home game console (data source PDF).

Game console hardware and software sales tend to grow and then peak 3-4 years after release (software especially, as its dependent upon a hardware install base for growth, while hardware is in turn dependent on hit software releases to coax gamers to purchase the system to play their favorite games). Even with the poor initial release, the Nintendo 3DS has already outsold the wildly popular Nintendo DS over a comparable time period.

The world’s biggest game expo, E3, starts the first week of June and Nintendo will make a new announcement about their 2nd generation Wii system, currently named Wii U. Sales of the predecessor, revolutionary motion-controlled system have continued to show strength as the company has strategically discounted the system over its lifecycle to maintain sales and the hardware install base, thus driving software transactions as well, although they are slowing as any game system will after long enough after its introduction into the market.

The pessimism about the initial 3DS rollout and the uncertainty about the potential success of the new Wii U system mean that the market is not looking forward to anything good for Nintendo. The stock has been left for dead as the company trades near book value of Y1,191B with a current market cap of Y1,278B.

The fear and pessimism about this company is not just related to the hardware issues (which appear to be solved). Nintendo’s fortunes have been swept up in the whirlwind Tech Bubble 2.0, where everyone insists that all old things will be torn down and ruined and new, cloud-based (and primarily Apple owned and operated) variants will rise in their place. Analyst opinions, professional and amateur alike, have revolved around an obsession with the idea of Nintendo giving up its hardware business completely and selling itself to Apple and focusing on its software franchises. The company’s stated disinterest in following any course resembling this option has left many to conclude it is an absurd dinosaur, cluelessly waiting for the asteroid apocalypse to arrive and destroy its once powerful and profitable franchise in a massive thermonuclear explosion.

That’s what’s being imputed into the stock price, which has continued to plummet like a rock. But, the reality is quite different. Nintendo’s hardware is not being abandoned en masse by former fans. Nor is the world moving to a permanent, entrenched and exclusive model of casual gaming via cell phone apps. The value of the “casual gamer” is likely severely overblown to begin with (which, by the way, calls into question the value of Nintendo’s strategy of “games for everybody” and expansion of the gaming population, as noble as it may be and as successful as it may appear with the blockbuster sales numbers of the Wii). And Nintendo, while initially hesitant and reluctant to jump into the online transaction and gaming space, is by now doing much more than just dipping a toe in.

A few choice quotes from the latest President’s address by Nintendo head honcho Satoru Iwata are below.

On digital downloads and digital game delivery:

it is true that downloading software with 10 gigabytes of memory cannot be done in an instant today, even with broadband connections. So, compared with the situation of portable gaming devices, where comparatively compact-sized software can be downloaded, we have to ask our consumers to wait for a longer time before the download process is completed. However, consumers will be able to use the Wii U effectively by finding convenient times to download software such as when they are sleeping at night. Some consumers prefer to download digital software so that they can play with them on their system anytime without the need to exchange the games’ storage media. Some other consumers find it easier to purchase the medium at a retailer and play it as soon as they insert it into the game hardware. These consumers think it advantageous that they can exchange games with their friends. In order to offer consumers options to choose from, it is important for the company to first make the situation (where digital downloads of packaged software are offered to our consumers in addition to the existing packaged software sales) a reality, and we are ready to offer these options now.

Nintendo is taking a flexible approach, trying to allow gamers a variety of options for receiving games and game content ranging from traditional retail distribution to digital distribution, all with respect for the current limitations of average broadband connections.

On digital versus retail pricing:

we are proposing the two formats of sales mechanisms from which our consumers can make their own choices. The needs of society shall be determined by the choices to be made by the consumers. We do not hold such a premise that digitally distributed software has less value. In fact, as we have discussed this with a number of software publishers around the world, we have found that their opinions are completely divided on the topic of the price points of the digital distribution of packaged software. Some publishers believe that the digital versions should be cheaper while others insist that both versions must be set at exactly the same price. So, it is not only Nintendo’s idea. Each publisher has various ideas on this point and, among them, Nintendo is now offering both versions at the same price point (the same suggested retail price).

Again, the focus is on flexibility– not wedding the company to one model but taking a wait-and-see approach that alienates neither consumers nor distribution partners and allows the market consensus to finally guide the company to the best process over time.

On management’s responsibility for the flop:

with the financial results that we have announced, it is natural that I am being criticized. I do not feel that I have been experiencing something unreasonable. I am making efforts so that the situation can change as soon as possible.

How often do you see the president of a public company accept responsibility for a problem, and, better yet, still feel like there’s hope for a resolution?

On the lessons learned from the failed 3DS launch that will be applied to the Wii U launch:

As we look back, when we launched the Nintendo 3DS, we failed to prepare a software lineup which could satisfy our consumers in addition to other factors, and the Nintendo 3DS could not initially increase the sales as we had originally expected. This is why the company needed to carry out such a drastic markdown measure by sacrificing the profitability. As a result, and supported by a strong software lineup, the Nintendo 3DS was able to regain momentum during the year-end sales season of 2011. We laid out such a drastic measure by understanding that regaining the momentum which had been once lost, is much harder than trying to create momentum from scratch. Without it, the Nintendo 3DS could not have realized positive results at the end of last year or the current sales pace in Japan. It did hurt our financial results, but it was a necessary measure. So, how will we be able to use this lesson for the Wii U? There is always a limit to our internal resources. The company now has to develop software for the Nintendo 3DS, has to prepare for the Wii U launch and has to finalize the hardware functionalities. With these circumstances in mind, if I said that an overwhelmingly rich software lineup would be prepared from day one, it would be too much of a promise to make. On the other hand, we are making efforts so that we will be able to make several proposals even from the launch period that can eventually become evergreen titles for the Wii U. We have learned the lesson that we have to make that kind of preparation for the Wii U, or the Wii U will not gain enough momentum to expand its sales.

On the role of their 3rd party software publishing partners in the success of their systems:

It is imperative for Nintendo that our new hardware offers new proposals and potentially new play experiences so that developers will be interested in this hardware and be motivated to make attractive software. At the E3 show this June, you will be able to experience not only Nintendo’s Wii U software but also the titles being prepared by the third-party publishers. As a result, I think you will be able to notice that a number of developers are creating software (for the Wii U) even today. As for the Nintendo 3DS, there may appear to be fewer commitments from the U.S. and the European software publishers than those of their Japanese counterparts. This is due to the different timing (between Japan and overseas) when they noticed that the Nintendo 3DS would surely expand widely into their markets and, thus, the different timing when they started the actual development of the Nintendo 3DS software. You will also notice a change in this situation when a richer Nintendo 3DS software lineup in the overseas markets is announced around the time of the E3 show.

The first bold part is critical– this is one of Nintendo’s competitive advantages. The company has a purposeful policy of creating new play experiences that will provide incentive for software publishers to publish for their hardware and not others.

The second part is an explanation for why it appears that non-Japanese publishers have not been excited to produce software for the 3DS after the failed launch. They were last to see the sales momentum for the system turn in their markets so they’re behind on the development schedule as a result.

On the “gaming population expansion” philosophy:

Without making efforts to increase the number of new consumers and make video games accepted positively by society, we cannot expect a brighter future than now, so we will continue to make these efforts.

Once consumers have a notion that “this system is not for us,” we have learned that it is extremely difficult to change their perceptions later. Therefore, in promoting the Nintendo 3DS and the Wii U, we have announced that we would like “width” and “depth” to coexist. With the Nintendo DS and the Wii, the approach of “width” was well accepted by many people; however, what we did in terms of “depth” was not satisfactory for some consumers. This time, we would like consumers to be satisfied in both aspects. In order to do so, we started to work on the “depth” aspect first, and the current and existing software you can see for the Nintendo 3DS is based on that idea. In the future, the approach will evolve. By exploring the development both from width and depth standpoints, it is our intention to satisfy a wider audience with one gaming platform. Our approach for the Wii U is basically the same. By doing so continuously, we are expecting that the number of game users per household will increase and as the gaming population increases, we believe we can create a sustainable video game market.

Nintendo is not going away. It’s not a clueless dinosaur. It made some mistakes with the 3DS launch that it has learned from. The industry may have some challenges, headwinds and uncertainties as the distribution model transitions to digital over time, but none of this changes the integral value of this business drastically, which is that it is a premium provider of desired game IP on innovative 1st party hardware platforms that a growing audience of gamers enjoy using.

It might be a different story if Nintendo were in a different financial position than the one it actually occupies but the reality is as of Q4 FY2012 (Mar 2012), the company had Y958B of cash and short-term investments against TOTAL LIABILITIES of Y177B. The company has no debt. According to this link on the Nintendo IR website, at a current share price of Y9020 the company actually is selling below book (NAV) of Y9313/share.

If you’re not yet getting an idea of how cheap this company is, consider the following table:

Nintendo Trading Multiples
10yr 5yr Pre-Wii
Market cap 1277863 (millions Yen)
EV 319541 (millions Yen)
P/S 1.3 1.0 2.5
EV/EBIT 1.5 1.2 2.7
P/E 10.2 8.0 17.9

I created three periods to consider– 10 year average (full system cycle from 2003-2012), 5 year average (since the global recession started, 2007-2012) and the pre-Wii era (these are average earnings generated by the company prior to release of the hit Wii console, 2003-2006).

As you can clearly see, the company is trading for abnormally low multiples of sales, operating and net earnings. The future for Nintendo will probably be better than the pre-Wii era (it is a larger company with an even more expansive market and fan base than then) but may not be as successful as it was with the Wii. That remains to be seen.

Here is the company’s historical margins over the last 10 years:

  • Gross – 40%
  • Operating – 22%
  • Net – 13%
  • FCF – 12%

I think these margins demonstrate Nintendo is a good business with stable earnings power and strong ability to generate FCF from sales.

Relative to its average earnings power and franchise potential, the company seems to be unreasonably priced. Businesses like Nintendo do not deserve to trade below book or anywhere close to 1.5-2x sales. The stumble on the 3DS was temporary and the company is moving on. It’d be nice if the company was even cheaper, and with all the pessimism in global financial markets it might still be. But at these prices, it’s “cheap enough” for a business like this.