Nintendo
Disclaimer: I’m not an investment professional nor have any financial training. I write this substack for my own learning and pleasure. Stop here if you value your time.
In my scouring for value and undervalued assets for my personal portfolio, there are a few asset characteristics that provide a tailwind for reasonable investments. Horizon Kinetic’s Murray Stahl’s writings combined with Michael Mauboussian’s options approach to valuation were helpful in shaping this. Far from comprehensive, here are a few things that come to mind.
1) Hated markets that have under-performed for at least a decade. The lack of investor attention allows opportunities for the markets to not incorporate new structural changes into their prices.
2) Hidden assets in the form of under-monetized intangibles that have taken decades to build and require much less future maintenance spend. Things like brands and intellectual properties are options can be a cash-gushing well if appropriately tapped.
3) 100 year old companies. These businesses often have a culture of conservatism and patience that allows them to be resilient to many market conditions. If appropriately coupled with thoughtful management, the probability of an investment zero is very much reduced.
This brings me to Nintendo.
History
Nintendo was founded on September 23, 1889 by Fusajiro Yamauchi. Nintendo means “leave luck to heaven”. Fusajiro crafted a Japanese playing card company that capitalized on people’s need for entertainment via gambling. He developed a business model with recurring revenues from long-term supply contracts with major gambling houses and captured household market share from contracts with government-operated cigar shops as a distribution mechanism. Playing cards are still a revenue line for Nintendo today.
After Fusajiro passed on the business to his son-in-law, Sekiryo Kaneda. Sekiryo adopted the Yamauchi name but had no sons. He eventually chose his grandson, Hiroshi Yamauchi, to succeed him when his health deteriorated in 1950. Hiroshi ran the business until his retirement in 2002. A lawyer by training, he began by consolidating manufacturing in Kyoto and entered into various businesses to diversify their core holding to varying success. In the 1970s, Hiroshi decided that toys and video games would be Nintendo’s primary focus. The company developed their first video gaming system in 1973 and began selling consoles and arcade game cabinets thereafter.
Hiroshi tapped his son-in-law, Minoru Arakawa, a MIT civil engineering graduate, to expand their business into America. Nintendo eliminated their trading company partners and began direct distribution of their arcade games. Faced with many challenges, their breakout came when a young untested game developer Shigeru Miyamoto, developed their first hit game, Donkey Kong. It’s success invited an IP infringement lawsuit with MGA Universal Studios, which Nintendo ultimately won.
Around this time, console video games became a massive hit in America. Names like Atari, Purina, Dunhill Electronics, and Mystique flamed the fires with a deluge of poor quality games and products. Ultimately, the video game boom of the early 1980s led to its bust in the Americas. Fortunately, Japan was far more conservative and avoided this crash. Nintendo of Japan developed the 8-bit Famicom. Arakawa introduced the Famicom to the US in 1984 and rebranded it as the Nintendo Entertainment System (NES). The NES was bundled with the game Super Mario Brothers. Nintendo saved the US gaming market.
How Nintendo Endures
There are many factors that contributed to Nintendo’s longevity in the video game industry. Nintendo at its core, has been a family business with a unique corporate culture. Its value set has engendered employee loyalty and long-tenures. It focuses on wholesome games that families can enjoy together. Many of their current executive team have been with the company for decades rising from lower ranks over time. In addition to this corporate culture, Nintendo’s patience and conservatism, hyper-focus on quality, customer experience, and lateral thinking with withered technology mindset are the core tenets to its longevity. A few examples of these include:
<1% manufacturing deficit rate,
Gunpei Yokoi philosophy of withered technology continues to dominate as it was still discussed in recent earnings transcripts,
Voluntary recall of faulty Famicom console chip set, in 1983, in order to maintain their reputation for high quality,
Toll-free telephone hotline for 24 hour game counselling and the free Nintendo fun club newsletter,
Willing to sacrifice short term profitability by making their products scarce to avoid over-saturation of games and market fatigue,
Focus on minimizing violence in Nintendo’s version of Mortal Kombat,
Belief in providing high quality games to sell consoles rather than succumbing to marketing gimmicks.
A couple excellent reading sources for the above include: a) Console Wars by Blake Harris, and b) Super Mario - How Nintendo conquered America by Jeff Ryan.
Criticisms of Nintendo
Matthew Ball is a well-known respected venture capitalist who writes a lot on the metaverse, media and gaming. His blog is excellent and recommended reading. He wrote a lengthy critique on Nintendo and their inertia to innovate and failure to evolve as the gaming environment has rapidly changed over the decade. My understanding of his arguments are:
Nintendo is stuck on an old business model of selling consoles to sell AAA games. Their innovation cycle is too focused on the interplay between their own hardware & software causing their AAA games to follow this timeline (5-8 years).
They demonstrate ineptitude or poor desire to make their IP truly accessible at all access points (mobile devices, PCs, other consoles) and inability to monetize them properly.
They are branching out to non-gaming royalty streams through partnerships (eg NBCUniversal studios to build their theme park, Illumination’s Super Mario Movie), but the lions’ share of profits will accrue to NBCUniversal. Although these partnerships will help keep their IP mindshare, with a lack of gamer growth, erosion of their value will occur over time.
A few of my own critiques include:
Their R&D and SGA spend is closely tied to their total assets since 2004. If the value of their IPs (intangibles) are growing in value, Nintendo has been under-spending on R&D and marketing efforts to maintain their know-how and brand.
Their executive bonus compensation is tied to operating profitability, which can be artificially increased by cutting R&D and marketing to the detriment of future company outlook.
With the Yamauchi family reducing their personal Nintendo holdings (10% —> 4%) due to succession tax rules and the executive managers having next to no personal holding of Nintendo shares, what incentive will there be for growth and performance? Perhaps the only mitigating factor is that the executive team is underpaid relative to their American counterparts.
Although I’m not a Japanese cultural expert, the commonly held belief of their conservatism and ‘mandatory’ lifetime employment, suggests that risk-taking is not in their DNA. This could hamper Nintendo from reaching its potential.
Nintendo’s actions to control game quality and distribution made past partners (retailer, game developers & game magazines) view them as arrogant as they conspired to “bring them down” during the Sega era of the ‘90s.
Mario is their greatest asset, which in turn is their greatest crutch. Their brand makes people only see them as an game entertainment company. This limits their ability to branch out to adjacent areas such as education and non-Mario media entertainment due to people’s emotional/cognitive association with it. They have tried in the past with poor results.
How Nintendo’s unique strategy interacts with the gaming ecosystem
As Peter Main, executive VP of sales and marketing, has been famously quoted saying, “The name of the game is the game”.
Nintendo’s primary focus is creating games that families can enjoy playing together. Games compete for our attention and leisure time. Nintendo competes not just with Sony’s Playstation and Microsoft’s Xbox, but also with new entrants such as Epic’s Riot Games, Valve’s Steam, Google’s Stadia, and Disney’s mobile gaming apps. It also competes indirectly with Netflix, Facebook, WeChat, Hollywood, and “playing outside”. Gaming is one of the cheaper forms of entertainment.
To succeed, Nintendo needs to contend with not only with the intense competitors, but also the hits-based nature of entertainment, the boom-bust potential of the gaming industry, the increasing R&D costs to develop ever more advanced gaming hardware, the escalating AAA game development expense, and the long-tail risk of government regulation to control addiction and violence especially among children.
To combat these external forces, Nintendo, past and present, has chosen to be conservative in strategy. They sought control of the vertical stack and more specifically their distribution channels and supply management. Their goals, I surmise, is to outlast their opponents, let their competition make unforced errors, keep their quality IP availability scarce and irregular (to maintain demand), and to sell quality family-friendly games.
Historically, Nintendo implemented a number of actions to highlight this mindset:
Installed the 10 NES lock-out chips to prevent uncontrolled games to be played on their consoles.
Limited the number of games 3rd party publishers can develop for their consoles (5 per year).
Required developers to only use Nintendo game cartridges and limited supply to them.
Slow turnaround time to approval 3rd party developer game submissions and limited roll-out of their software development kits (SDKs).
Limited the number of consoles and game cartridges that retailers could buy from them.
Their irregular game releases may be a function of their high-quality standards and understanding of the power of irregular rewards. Although frustrating gamers and public shareholders alike, it kept gamers wanting Nintendo products. Cognizant of their addictive potential, they focused mostly on quality family-friendly games which allowed them to walk away with its reputation unscathed from the 1993 US Congressional hearings on video games.
By focusing on story-telling with familiar characters using reliable, cheaper, older hardware reduces the uncertainty of success from their R&D and marketing efforts. It is recognized that expensive consoles with the cutting edge graphical capabilities do not guarantee their success. Overall, this downstream effect helped keep them profitable, with only negative profitability in 2012, 2014 , and over the 2004-2020 timeframe. This, in turn, reduces the need for employee turnover and better long-term team cohesion, both of which are important in their creative processes. [Average sales to employee ratio at Nintendo is $1.8 million USD per person vs ~ $0.5 million USD per person at Electronic Arts, Activision Blizzard, and Sony, vs ~ $0.75 million USD per person at Microsoft]. This is in contrast to American game development where developers are subjected to hire then fire tactics and recurrent studio shutdowns.
It would be reasonable to expect some of the same from them in the future. Nintendo mostly certainly recognizes the opportunities with mobile, in-game and whale monetization, utility of loot boxes, cross-platform IP exposure and the need to extend console lifespans. Matthew Ball poses that Nintendo is not willing to change due to their discomfort to innovate. Perhaps, an alternate viewpoint (“excuse”) is the following question, “Why do we need to rush?”.
Technological growth and progress in new domains encompasses uncertainty. Buffett seeks certainty among things he understands. Greater traders, like Drunkenmiller, look for reliable and consistent signals that flag a change in the trend. In the world of gaming, media and entertainment, it is certain that it will NOT be a winner-take all dynamic that requires one to “move fast and break things”. Disney was late to streaming with Disney Plus but with a stable of valuable character IPs, waiting for the streaming market to prove it’s worth and pitfalls, provides good returns on the amount of risk/capital taken. Nintendo and its conservative culture, net cash on its balance sheet, overall business strategy, and valuable IPs could afford to wait and innovate incrementally.
Their past consoles have been hit and miss every other cycle, their push into mobile has been tepid, and their online store offerings has been less robust compared to Sony and Microsoft. However, the past is not necessarily their future. I think Nintendo has been waiting for their ducks to line up. They needed a hybrid mobile console device (they controlled) to allow people to play where and when they want. They would achieve manufacturing efficiencies by not having to contend with 2 systems (home and hand-held) anymore. With the Switch in place, they now can focus their efforts on getting their online offerings up and running. I speculate that management will monetize its IPs conservatively, avoid many of the more controversial tactics (eg ‘play to progress’, ‘play to win’, token box ‘engagement’ coupled with whale monetization) to maximize the $ per game and per user to protect their reputation. More likely, they will focus on new downloadable content (DLC) for non-essential bonus material to enhance play, and new levels and characters to lengthen the game’s lifespan all the while methodically releasing classic games online at a deliberate pace, lengthening their active console lifespan.
This strategy coupled with the tailwinds from the overall gaming industry make Nintendo compelling. This is from Sony’s investor presentation.
This industry growth will not be a zero-sum game. As with consoles and their household ownership overlaps (see below), there will be potential synergies between all the companies along the value chain.
It will be interesting to watch how Nintendo deals with cross-platform data saving and game progression onto other systems in addition to how they share gamers and royalties. Microsoft’s Xbox Network has been working on their Nintendo partnership since 2019. Nintendo has entered into many partnerships in the past with varying success. Their biggest notable failure was with Philips in developing their CD-i after snubbing Sony. I will be curious to see how successful its current partnerships with Universal and Microsoft turn out.
Finally, like energy markets, where new forms of energy build on top of existing sources, new game play methods build on-top of prior hardware instead of fully replacing them. With the Switch’s hybrid design success, it is possible that Nintendo can capture a slice of both console and mobile markets simultaneously.
Crossroad Capital’s 2018 Annual Letter
Ryan O’Connor at Crossroad Capital wrote up a seminal piece on their Nintendo thesis. This 70-page letter goes over why Nintendo is a good investment. Any attempt at summarizing it would do it a disservice. It is required reading.
I will highlight a few of the major negative perceptions and the variant insights:
1) The traditional burden of 5-6 year console cycles and their intermittent profitability.
Variant view: The lollapalooza effect of focusing on single hardware design, slowing of incremental improvements on industry game console iterations, proven benefit of vertical integration of hardware and software business model combined with digital distribution of DLC and 3rd party game content will make Nintendo’s revenue more stable and recurring.
2) Nintendo’s reputation of being difficult to work with.
Variant view: The progressive growth of 3rd party content in their E-shop due to developer success and good customer support for the Switch platform (O’Connor’s scuttle-butting at the GDC 2019 conference) as well as allowing co-ownership of non-in-house 3P IP. This may be a reflection of their new openness to collaboration and a more flexible mindset by current management. This will create a stickier marketplace-type recurring revenue source for Nintendo (current 30% take rate) taking advantage of their growing install base.
3) Game streaming by Google’s Stadia, Apple’s Arcade, Sony’s Playstation Now, and gaming projects by Amazon, Facebook, and ?Netflix will make console gaming obsolete.
Variant view: This new form of play is only partial competitive with Nintendo and may actually be a tailwind. These players target a different demographic market (teens vs children) with their more violent games. The chance of their success may be over-hyped given their historical track record (especially Google) and focus on high performance over quality content. Paradoxically, the success of cloud gaming makes Nintendo’s content IP even more valuable.
Nintendo Numbers
Recognizing my numerical insufficiencies, I built a simplified DCF model to help explore my assumptions.
Reality check on Assumptions of this base case:
The current install Switch owners is ~ 90 million over 5 years. Their past systems have a shelf-life of ~10 years. If they could continue their run rate of ~17 million units per year for the next 5 years, they would have a total install base of 175 million units. This would require the Switch to achieve the highest unit sales among all console generations.
Annual Digital Sales per hardware unit sold is ~ 12 million Yen per hardware unit. This has been growing (albeit a bit volatile) since 2012 with a median growth rate of 60%. What is not reflected in these historic number is their initiatives to developed tiered subscription products and grow 3P game royalties over time. At a conservative growth rate of 35% over the next 5 years, this would result in 45% of their revenues being digital. In contrast, Sony’s gaming sales are currently 70% digital.
Console and console-related gaming revenues, are projected to be $88 billion by 2025 as seen above. With this base case, Nintendo would comprise ~20-25% of the console market revenue. This would be consistent with their current market share in consoles and gaming revenues.
Assuming the margin profiles above, a blended terminal PE multiple based on % of digital operating profits, and Crossroad’s conservative (not their reasonable case) estimate of Pokeman rights, equity stakes in Niantic, Bandai, DeNA, and Mariners, I arrived at a conclusion that at $47-55 USD/share of NTDO.Y, a 10-15% earnings yield could be obtainable. This won’t include the free options in mobile (TAM $170 billion?) or non-gaming royalty fee streams.
Conclusion
In summary, Nintendo is:
A Japanese company in that has been traded in a Japan stock market that has been underwhelming for 30 years. This market, however, is experiencing many structural reforms that will be better for future shareholders. Although beyond the scope of this little substack, these changes are worthwhile learning about. Horizon Kinetics has written a whitepaper that I recommend reading.
It has substantial established IPs and know-how that are under-monetized.
It’s a 130+ year old company that has proven it can survive.
Nintendo is not for everybody, but if patient, it does have the set-up to provide some decent future returns.
Thank you to those of you who made it to the end. I appreciate your time.