Time for the Switch?

Time for the Switch?

Decades before Sony, Microsoft, and even Disney began their operations, Nintendo was in the business of selling playing cards in Kyoto, Japan. Flash forward from 1889 to 2021 and the business has expanded into video game hardware & software, media content, character-based merchandise, and theme parks.  With strong IP and a continuous effort to push the industry forward, Nintendo has proven time and time again that it is a lasting force. The firm has recently shown tremendous financial improvement with the success of their Nintendo Switch console, and the stock may continue to follow suit.

The most conceivable source of Nintendo’s moat – a financial term for the fortitude or advantage a company has over challengers, that tends to demand a premium on valuation – flows from their intellectual property rights. Many are likely aware that Nintendo Co. has the rights to the Mario universe of characters (Bowser, Luigi, Peach, Toad, Wario, Yoshi etc.). But they have many other notable franchised stars include Donkey Kong, Zelda, Kirby, and Metroid. Furthermore, the firm has a partnership with Game Freak and Creatures Inc. which gives Nintendo about 1/3 ownership of The Pokémon Company. In addition to that universally recognized IP, the firm has also been innovating, pushing the industry forward by combining a television compatible gaming console and a handheld device with the release of the Nintendo Switch in 2017.

The revolutionary hybrid console has exhibited continually growing sales in both total units and revenues every successive year since its 2017 launch as indicated in the graphics below.

*The two graphics above were taken from the Nintendo Investor Relations website. https://www.nintendo.co.jp/ir/en/finance/index.html

As of December 2020, the Nintendo Switch console had sold 79.87 million units since its launch. Nintendo’s software sales have correlated strongly and positively with their hardware sales, reaching over 532-million-unit sales over the same time span7. That success can be attributed to a multitude of hits like Mario Kart 8 Deluxe, a kart-based racing game, Animal Crossing: New Horizons, an open-ended social simulation game, and Splatoon 2, a third person shooter which utilizes colorful ink guns. These characters and titles have earned Nintendo a family-friendly niche amongst the other large video game console makers (Sony and Microsoft) further bolstering their competitive moat.

In addition to strong sales and unit growth, Nintendo has remained disciplined in their operating efficiency. In the most recently reported 9-month period, ending December 2020, Nintendo showcased a 37% increase in sales while improving their net profit 92% compared to the prior year’s 9-month period. This improvement on both the top and bottom lines of Nintendo’s income statement brought the firms’ net profit margin to 27%. One likely factor positively contributing to this impressive performance is the increase in digital sales of packaged software as well as download-only add-on content (such as Nintendo Switch Online). The firm disclosed growth of 105% in digital sales during the December 2020 9-month period compared to the same period in 2019; digital sales as a proportion of total video game platform software sales, went from 29% to 41% during the same time span.6 Digital sales have higher profit margins, and this trend could help Nintendo’s margins continue their expansion upward in the years ahead.

Fortunately for owners of the stock, Nintendo is a shareholder friendly firm. The dividend policy is organized to pay out with consideration to the profit level each fiscal year and is paid in semi-annual distributions. The fiscal year ending March 31st, 2021 is forecast to yield about a 3% dividend based on the 4/23/2021 closing stock price (1,880 Yen divided by 62,420 Yen). This is an aggressive dividend policy, paying out over 33% of profit annually; however, Nintendo’s balance sheet is so strong that the dividends are not a concern to the financial stability of the company. In fact, the firm has more cash on hand than total liabilities by nearly 2X.

In addition to the impressive IP, and financial strength, Nintendo has also been ahead of curve on ESG reporting. The firm began to formulate its “CSR Procurement Journey” in 2007; this effort is based around “Putting smiles on the faces of everyone Nintendo touches”. Through inspections, guidelines, and upgrades, Nintendo has worked to make continuous improvements for the betterment of its stakeholders.

*The graphic above was taken from the Nintendo Investor Relations website. https://www.nintendo.co.jp/csr/en/index.html

Since Nintendo is in the unique position of having business segments in both hardware and software, they do not have a pure peer comparison. The two main competitors on the hardware side are Microsoft’s Xbox, and Sony’s PlayStation. Since both of those firms are exceptionally large conglomerates, neither is a good comparison for Nintendo. On the software side the main players in the industry are Activision Blizzard, Inc., EA – Electronic Arts Inc., and Take-Two Interactive Software Inc. These software competitors are better comparisons for Nintendo because of their size and their direct focus on software.

Nintendo’s enterprise value is about $55B according to Koyfin data. This figure takes the market cap of the firm and adjusts for the cash and debt held to give a more complete picture of the valuation of the entire firm. Comparing this valuation figure to sales, net earnings and cash from operations can give some insight on the fundamental valuation of Nintendo compared to the forementioned software peers.

*The graphic above was created on Microsoft Excel using data from Koyfin as of 4/23/2021. https://app.koyfin.com/

In the data table above, it can be readily seen from the color scale that Nintendo has the lowest EV to sales multiple, lowest EV to cash from operations multiple, and the second lowest EV to net income ratio compared to the selected software peers.

Lastly let us take a gander at what is in the Nintendo warp pipe, I mean pipeline. There are several software titles with 2021 release dates of note in the US market alone. To the delight of many Pokémon fans, the new Pokémon Snap game is releasing at the end of April. Later in the year both Metroid Prime 4 and the sequel to The Legend of Zelda are expected. Personally, I am looking forward to the Mario Golf game coming this June. Next year the much-anticipated Pokémon Legends: Arceus will release, which is an open-world style game that will be an interesting evolution from the Pokémon games seen in years passed.

On the hardware side of the business, the switch console got a bit of a redesign in September of 2019 with the Switch Lite release. The Switch Lite is a smaller, less expensive handheld-only device; compared to the Switch which is dockable and then can be played on a TV. But there have been rumors circling for months now about a Switch 2 (or Switch Pro) console in the works that may support 4K and have a larger screen along with other improvements.3 Nintendo has also begun to enter new verticals with the opening of Super Nintendo World at the Universal Studios Japan theme park.4 Furthering that partnership with Universal, it has been reported that the producer behind “Despicable Me” and “The Secret Life of Pets” has been tasked with the making of an animated version of “Super Mario Bros” believed to be coming in 2022.5  

These various business lines and their ongoing transformations are all part of the master plan at Nintendo headquarters. Here is what the president had to say in the latest press release:

“To continue growing our core business, our fundamental strategy is to expand the number of people who have access to Nintendo IP. To this end, we seek to broaden the touch points of Nintendo IP with consumers in areas beyond dedicated video game platforms. This includes applications for smart devices, which are ubiquitous throughout the world, as well as visual content, theme parks, and character-based merchandise.”1 -Shuntaro Furukawa

With strong IP and financials, a relatively low fundamental valuation compared to select peers and metrics, and a diverse pipeline, the opportunity for Nintendo Co. shareholders seems bright.

Disclaimer: I am both a shareholder and long-term client of Nintendo and continue to be both in the years ahead. I hold positions in the following mentioned firms as of the publishing of this article: NTDOY, MSFT, & TTWO.

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