Nintendo (TSE: 7974) | Switching Up On All Fronts

Updated: Jul 9


Key Points

  • Nintendo is a Japanese multinational consumer electronics and video game company headquartered in Kyoto

  • The company possesses strong moats around its robust IP (Mario, Pokémon, Zelda and many more), family-focused gaming ecosystem and its vast experience in console and handheld gaming

  • Margin expansion from selling games digitally and improved earnings quality from generation of recurring revenue through Switch Online

  • Strong IP also creates potential optionality for non-gaming revenue streams from theme park, retail store and merchandise expansion

  • DCF-based fair value estimate of ¥79,700 with a 22% upside from current price (WACC of 8% and terminal growth rate of 2%)

Company Overview


Nintendo is a Japanese multinational consumer electronics and video game company headquartered in Kyoto. The company was founded in 1889 as Nintendo Karuta by craftsman Fusajiro Yamauchi and originally produced handmade hanafuda playing cards. After venturing into various lines of business during the 1960s and acquiring a legal status as a public company under the current company name, Nintendo distributed its first video game console, the Color TV-Game, in 1977. It gained international recognition with the release of Donkey Kong in 1981 and the Nintendo Entertainment System and Super Mario Bros. in 1985.

Since then, Nintendo has produced some of the most successful consoles in the video game industry, such as the Game Boy, the Super Nintendo Entertainment System, the Nintendo DS, the Wii, and the Nintendo Switch.

Overview of Products


As of July 2021, Nintendo’s product lines include hardware products, like Switch and Switch Lite consoles and Amiibo figures, and software products like games, add-on content and Switch Online subscription.

The Nintendo Switch retails for c. US$300. The game console offers three different playing modes: TV Mode, Tabletop mode and Handheld mode. The hybrid nature of the switch enables the user to enjoy the game at home just like a traditional game console or as a portable on the go device.

The Nintendo Switch Lite is a cheaper alternative to the Nintendo Switch, retailing at c. US$200. Unlike the Nintendo switch, it is dedicated to only handheld play and users are not able to detach their joy-con controllers.

To complement their gaming platforms, Nintendo has created numerous major game franchises, including Mario, Donkey Kong, The Legend of Zelda, Pokémon, Kirby, Metroid, Fire Emblem, Animal Crossing, Splatoon, Star Fox, Xenoblade Chronicles, and Super Smash Bros. Gamers can purchase these games from non-digital channels like retail game shops or through the Nintendo eShop on the platform. In September 2018, Nintendo also launched Nintendo Switch Online, a subscription service that gives Switch users access to a suite of premium features including the ability to play online with other users and gaming data cloud storage.

Industry Overview

Although Nintendo is widely known for its production of game consoles, it operates in multiple areas of the video game market including the development and publishing of games, digital retail and gaming platforms. In the developer and publisher space, it competes with traditional players from the likes of Activision, Electronic Arts, Take Two, Bandai, Tencent and many others. Nintendo has held on to the IP for a few major franchises including Mario and Pokémon, which will be elaborated in our investment theses.


Traditional Home Consoles

The traditional game console hardware market is oligopolistic in nature, with Microsoft, Nintendo and Sony taking the majority of market share. Hardware sales for the Nintendo Switch has outperformed its peers recently, overtaking the Xbox One in late 2019 as shown above.

For comparison, Sony’s new entry-level PS5 is US$100 more expensive than the standard Switch and only has 342 games compared to the Switch’s 5,539. The latest generation of the Xbox only has 257 games, and the Series X is US$200 more expensive than the Switch.

In 2020, a survey done by Intepret shared that 75% of U.S. Switch users had 1 or more other consoles which indicates that the Switch is not a direct competitor to Xbox or PlayStation. This could be a result of differences in game genre, game player mode (i.e. multi-player versus single-player) and console type (i.e. handheld versus home console). In addition, in 2020, 25% of U.S. Switch users owned no other consoles, up from 12% in 2019. This suggests that the Switch is increasingly catering for gaming needs of users such that they increasingly do not need to own multiple consoles.


Cloud Gaming

The recent launch of cloud-gaming has attempted to threaten the long-established medium of playing video games through handheld consoles or home consoles.

The Google Stadia was launched in 2019 as a gaming platform that allow users to instantly play video games on users’ smart devices (compatible smartphones, iPad and computer devices). Stadia Pro is a subscription platform containing a collection of different games and it charges users US$9.99 per month. However, sales have been disappointing due to a lack of strong IP and confusing pricing model. This has caused it to restructure by shutting down its game development studio for partnerships with top game developers due to the long runway and large budget needed to develop hit games.


Microsoft also has Xbox Cloud Gaming in beta currently. With the cloud gaming offering, Xbox users can access games by purchasing an Xbox Games Pass Ultimate for US$14.99/month and connecting their existing compatible controller (i.e. Xbox, Sony DualShock 4) to their devices. In comparison, a Nintendo Switch Online subscription costs US$3.99 per month.


Mobile Gaming

To date, Nintendo has only released 7 mobile games (excluding Pokémon Go) that have accumulated 650 million unique downloads as of 31 Mar 2021.

It is planning to scale back its mobile game ambitions of releasing 2-3 games annually and dominating the space as a result of low return on investment from past releases as seen from the chart above. Furthermore, the continued success of Switch has convinced management to focus their efforts and capital on the Switch.

Revenue

In its latest fiscal year that ended in March 2021, Nintendo clocked a revenue figure of ¥1.76b (c. US$15.8b), growing 34% year-on-year due to the increase in demand for gaming devices due to movement restrictions and work from home policies during the COVID-19 pandemic.


In the same year, Nintendo generated c. 97% of its revenue from video game platforms, with other minority contributions from smart device content, IP-related royalty fees and playing cards. The Nintendo Switch platform contributed c. 98% of video game platform revenue, making it the most relevant platform for the company.

The video game platform segment can be further split into two: hardware sales and software sales. Hardware sales refer to revenue from the sale of the hardware consoles like the Nintendo Switch and Switch Lite and the Nintendo 3DS (discontinued in 2020). Software sales includes sale of packaged games (either through non-digital or digital channels), download-only software, add-on contents and Switch Online subscription. Over the past 3 years, software has been increasing its share of revenue from 35% of revenue in FY3/18 to 47% of revenue in FY3/21.

For the Switch consoles, including Switch and Switch Lite, hardware sales have grown to 28.8 million units at a CAGR of 24% over the past 3 years while software sales have grown at a relatively faster rate to 230.1 million units at a CAGR of 54% over the past 3 years.

The software tie ratio tells us how many games were sold for every console purchased or how many games a system owner buys on average. It is calculated by dividing total software unit sales by total hardware unit sales. As Nintendo’s Switch software unit sales are growing faster than its hardware unit sales, its Switch tie ratio has increased over past 3 years from 4.2 to 8.0. This is a positive for the company, indicating that it has been able to increasingly sell more games per console purchased, on average.

Profitability

Nintendo has been profitable at the net income level for the past 7 years, with margins increasing steadily over the past 4 years. This is driven by its move into the digital space, establishing the Nintendo Switch Online subscription service and selling games digitally through its Nintendo eShop. Its cost structure has remained stable over the years where SG&A has remained lean, taking up c. 20% of revenue, evenly comprising of staff costs (under other SG&A), R&D expenses and advertising expenses.

Investment Thesis


Thesis 1: Nintendo’s strong moat allows it to continue to enjoy dominant market share


Nintendo’s robust IP and its focus on family-oriented games has allowed its gaming franchises to reach a broad audience base, encompassing over 160 countries and regions. This, together with Nintendo’s continuous hardware innovation efforts, form the fundamental pillars of the company’s moat that allows for the sustainability of its market share in the gaming industry. Here is how Nintendo is able to do that:


Strong customer loyalty built through established intellectual property

Nintendo has a strong suit of intellectual property that has been successfully built over the years. As outlined in the overview of products above, some of the major gaming franchises include: Mario, Pokémon and The Legend of Zelda.

From the chart above, Nintendo’s gaming franchises are dominant in the gaming industry, with its sales outperforming its peers by a large margin. Notably, the Mario franchise alone sold over 752.4 million units and is currently the best-selling video game franchise of all time since it was first released in 1985. Nintendo’s other major franchises such as The Legend of Zelda and Pokémon have a long history as well, with The Legend of Zelda first being released in 1986 and Pokémon in 1996.

Moreover, as the major gaming franchises have a long history of around 20 years, it creates a nostalgia effect which serves as a powerful marketing tool for Nintendo. This strong set of IP provides stability to its software revenue streams as Nintendo can recycle its gaming franchises and continue to monetise across different generation of consoles. For instance, the Mario franchise alone has produced over 200 different iterations of games, spanning over a period of c. 30 years.

As seen from Nintendo’s upcoming software releases, the company is still leveraging on its IP (Pokémon franchise) while releasing new titles such as Project Triangle Strategy. With stability in its existing software revenue streams, Nintendo has the luxury to develop new hit games without having to worry that it might fail.


Network effects achieved through a family-focused company philosophy

Nintendo is able to achieve network effects through its emphasis on simple and intuitive, family-oriented games, which appeals to a large audience base. For the most part, Nintendo’s games tend not to feature violent or gory gameplay, unlike its peers.

The 6th generation of gaming console era started in 1998 and the consoles include: Sony’s PlayStation 2 (Joined the era in 2000), Nintendo’s GameCube (Joined the era in 2001) and Microsoft’s Xbox (Joined the era in 2001). Analysing the best-selling titles for each company, Nintendo’s game style has always reflected the company’s philosophy of delivering unique and intuitive games for all.

The 7th generation of gaming consoles started in 2005, with Microsoft launching the Xbox 360. In the following year, Sony released the PlayStation 3 and Nintendo released the Wii. As with prior generations, Nintendo’s games embodied the same family-friendly values whereas its peers appealed to a different niche group of consumers.

The latest top-selling consoles between the players include Nintendo Switch (released 2017), Microsoft Xbox One (released 2013) and Sony PlayStation 4 (released 2013). As expected, Nintendo continues to focus on family-friendly games.


As illustrated from the above few charts, Nintendo’s top performing games across console generations tend to cater to everyone, whereas majority of its peers’ games are catered for the mature audience (Age 17+ and above).

By focusing on the theme of family, Nintendo is able to create a gaming ecosystem that is able to achieve network effects. Its family-focused major franchises appeal to all age groups and creates a social element of games that encourages gaming companions to purchase consoles and games. After the purchase, these gaming companions also encourage their friends to purchase consoles and games, establishing the network effect. With this, Nintendo is able to generate strong organic growth for its gaming ecosystem.


Vast experience in handheld gaming consoles enables sustainability of hardware ecosystem

Nintendo has consistently proven to be creative and innovative, and these qualities are essential for a company to excel in the video game industry. The company is regarded as one of the pioneers in the console and handheld gaming industry, creating several iconic gaming franchises and innovative hardware.


The company’s hardware is always at the forefront of the gaming industry. When it first released the Gameboy in 1989, it was regarded as a game changer as portable gaming was not common back then. The 1983 Nintendo Entertainment System (NES) game console substantiated the fact that Arcade culture can be experienced in the comfort of users’ homes and the 1989 Gameboy demonstrated that the gaming experience can be portable. In 2006, Nintendo was the first to introduce motion-controlled gaming in its Wii console, a product that received great reception.

Even though the 2012 Wii U’s sales were lackluster as compared to its prior hardware, Nintendo bounced back and launched the Switch hardware, which combines both the console and handheld gaming experience. The typical lifespan of a gaming console is about six years and even though Switch is in its fifth year, the management has stated the Switch is still in the midpoint of its life cycle and could possibly extend for another three years. Furthermore, the company believes that the hybrid nature of the Switch console prolongs its product life cycle by allowing Nintendo to offer a wider variety of different games as compared to a standalone handheld or home console. In addition, Bloomberg reported that here might be a upgraded version of Switch that is forecasted to be released end 2021 and this is likely to extend the Switch product life cycle.


Thus, given Nintendo’s track record of continuous innovation and refinement of the hardware gaming experience, as well as its niche in hybrid consoles, we believe that the company that its hardware ecosystem will be sustainable in the medium to long-term.

Thesis 2: Virtuous shift in business model to improve earnings quality


Since 2018, Nintendo has revamped its business model to focus on building recurring revenue through Switch Online and increasing gross and operating margins through selling games digitally.


Increase recurring revenue through subscription-based Nintendo Switch Online

Historically, Nintendo has been very dependent on the success of its consoles as seen from the chart above.

However, this changed in September 2018 when it released Nintendo Switch Online, a subscription service that gives Switch users access to a suite of premium features. The subscription allows gamers to play online with other users, a feature which became even more relevant as people around the world seek to connect with others during stay-home restrictions during the pandemic. This is demonstrated by the 73.3% spike in Switch Online users during the first 9 months of 2020. In addition, members can enjoy more than 100 classic NES™ and Super NES™ games with the added functionality of online cloud saves, which prevents losing game progress in the event of a misplaced/spoilt Switch. The service is also priced competitively in relation to peers at c. US$8 for a 3-month membership. In comparison, for the same membership duration, Xbox Live Gold charges c. US$25 while Playstation Plus charges c. US$25.

These benefits/advantages have caused c. 39.6% of the Switch installed base to be converted to Switch Online members as of Sep 2020.


This has created Nintendo’s first meaningful recurring revenue stream which now accounts for c. 41% of its digital sales and c. 8% of its total sales in FY3/21. This not only brings some stability to Nintendo’s total revenue but also provides high free cash flow to reinvest into further monetization of its intellectual property which will be further explained under Thesis 3.


Harvesting Benefits from a D2C Distribution Model

In the past, Nintendo predominantly sold physical games through brick-and-mortar stores but with the creation of the Nintendo Online Game Store in FY3/17, the ratio of digital game sales has trended upwards and surged even further in FY3/21 on the stay-home restrictions and an increase in download-compatible games.


Circling back to the value chain, Nintendo is able to cut out the retailer by selling its games digitally on the Nintendo eShop. This shift provides benefits such as improvements in gross and operating margins, reduction in game sharing which could lead to higher game unit sales and potential add-on content revenue. Here’s how this happens:


Improvements in gross and operating margins

When Nintendo sells its games to a brick-and-mortar store for distribution, it typically sells at a price lower than the retail price, to allow for the retailer to make a front margin from distribution. On the other hand, when Nintendo sells its games digitally through its proprietary eShop, they sell them directly to the customer at the retail price and make a higher gross profit by cutting out the retailer. In addition, selling digitally reduces manufacturing costs and as a result, both gross and operating margins will improve further.


Reduction in game sharing which could lead to higher game unit sales

Traditionally, physical games can be shared or resold by handing over the used game cartridge to another user, allowing for multiple users to access the game via a single game cartridge, albeit not simultaneously.


In order to share a digital game, one must share his/her username and password to his/her Nintendo account which includes any credit card information and rewards on file. In addition, the individual that shares the account is unable to simultaneously play while the other user is using the account.


We believe that this potential compromise of personal privacy and inconvenience will deter many users from game sharing that could incentivize more users to purchase games by themselves and could lead to higher game unit sales/user.


Potential add-on content revenue

Through the Online Game Store, Switch users can now purchase add-on content for their games (i.e. skins, in-game tokens). This allows Nintendo to tap into the semi-casual to hardcore gamer space who could spend hundreds to thousands of dollars for add-on content. For reference, some game developers earn the bulk of their revenue from add-on content as opposed to game sales such as in the freemium model, and thus, Nintendo can now capture some of this high-margin revenue as it imposes a take rate on third-party sales and conducts 1st-party sales as well.

Despite the strong uptrend of Nintendo’s digital sales proportion since FY3/17, we believe there remains significant room for continued growth as Nintendo’s Digital Sales to Software Sales proportion is still on average 30.0 ppts lower than that of its peers (i.e. Ubisoft, EA) which should strengthen Nintendo's earnings quality.

Thesis 3: Significant Optionality from Strong Intellectual Property


As outlined in Thesis 1, Nintendo has extremely strong IP but we believe it has been severely under monetized as seen from the small proportion of revenue outside of gaming. However, since the company’s new President Shuntaro Furukawa took over in 2018, it has laid plans to reverse this by leveraging its IP through theme parks, movies and TV shows, merchandise and retail store expansion.


Theme Parks

Nintendo has partnered with Universal to create multiple Super Nintendo Worlds, with the first one completed in Japan in March 2021. For the attractions, Universal will front the entire construction cost and Nintendo will receive a licensing fee for its IP and as such, this revenue should have a high gross margin given the lack of costs Nintendo bears.


Furthermore, as the Nintendo attraction is expected to be permanent given Universal’s high construction cost (i.e. US$578m for USJ’s Super Nintendo World) and Universal Studios’ visitors numbers has historically been stable, we believe it will provide a long-term, stable recurring revenue which further reduces the dependence on hit game consoles for revenue.


This vertical expansion would require little upfront capital and build a high gross margin and recurring revenue stream which would strengthen Nintendo’s business model.


Movies and TV shows

Nintendo is developing its 1st film after Detective Pikachu which grossed US$436 mil in the box office. It is a Super Mario movie in collaboration with Illumination, the film and animation studio behind Minions that has an average gross of US$695.4 million per film. The movie is scheduled to be released in 2022, which will hopefully be when herd immunity is achieved and thus, movie-goers return to cinemas. In addition, Shigeru Miyamoto, the creator of Mario, is serving as a producer and is said to be “very, very hands-on with the production of this movie” which could indicate a high quality of animation and film that relates well to the large loyal base of Mario fans.


Furthermore, Nintendo has shared that it is already developing ‘multiple other visual content expansion projects’, possibly Movie/Anime/Others, that signals that visual animation will be a continuous revenue stream stemming from both initial and refresh releases in a similar way to Disney.


Beyond the initial release of movies in theatres or TV shows, Nintendo can recycle the content by licensing it out to streaming platforms such as Netflix and HBO Max or digital marketplaces like Apple App Store and thus, build another recurring revenue stream.

Merchandise and Retail Store Expansion

Nintendo is expanding its merchandise segment by producing their own products and partnering with reputable brands (i.e. Lego, Levi’s, Puma).


In addition, it could be looking to increase its offline presence on top of the 3 existing retail stores in Tokyo, New York, and Tel Aviv as seen by the opening of pop-up stores in Japan during Summer 2021 that could be serving as trial runs for their future stores.


As highlighted by Crossroads Capital, these retail stores can serve as a gathering place for Nintendo afficionados in a similar fashion to Apple stores which have classes to educate users on how to take their devices to the next level and dedicated servicing centres. Furthermore, Nintendo can leverage its existing games to host eSports competitions/gatherings similar to how Pokémon holds its Championship Series. We believe this will greatly improve the user interaction and experience and thus, add greater connection to the brand in a way only offline can.


In total, we recognise the significant optionality that Nintendo has and if executed well, will go beyond generating more mutually exclusive revenue sources but really increase Nintendo’s touch points that will hopefully grow its ecosystem as said best by Nintendo’s President, “To connect and entertain more consumers with Nintendo IP, in the hopes that they may become interested in the world of our dedicated video game experiences”.

Valuation

Based on our Excel financial model, which is accessible to our Snowball Community members for download [sign up here], we derived a fair value/share of ¥79,700 using a Discounted Cash Flow analysis (DCF) with the Gordon Growth Method as our primary valuation method. This represents a possible upside of 22% from the last closing price of ¥65,150. Our valuation implies a NTM P/E of 25.9x.

Key Assumptions

  • Hardware sales units at 24.8 million in FY3/22, below Nintendo’s public target of 25.5 million units and internal target of 28 to 29 million units

  • Hardware sales units growing at 3.3% year-on-year after FY3/22

  • Tie ratio of 7.5, below 2-year average tie ratio of 8.0

  • ASP for games at ¥2,929 and hardware at ¥30,000, according to historical levels

  • Zero revenue growth for mobile, IP related income and playing cards

  • Hardware sales as a % of total sales to decline to 48% in FY3/24 from 53% in FY3/21

  • Digital sales as a % of software sales to increase to 65% in FY3/24 from 43% in FY3/21

  • Digital sales as a % of game sales to reach 48% in FY3/24 from 31% in FY3/21

  • Download-only software, add-on contents and Switch Online Subscription as a % of total sales to reach 16% in FY3/24 from 8% in FY3/21

  • Tax rate of 30%

  • Weighted average cost of capital of 8%

  • Terminal growth rate of 2%

Risks


1. Poor reception for Switch Pro release

The Switch Pro is speculated to be priced around US$100 higher than the current standard Switch which could deter many from buying it if they feel there is a lack of differentiation between the 2 versions. However, we note that in the iPhone 12 series, the most expensive iPhone 12 Pro Max sold the best despite it being US$300 more than the standard model and the lack of meaningful improvement to the common person. Thus, if the Switch Pro is released at a reasonable price point and has the expected hardware upgrades, we believe that its unit sales will be similar to the current iteration of the Switch.


2. Chip shortag