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Nintendo: Corona-Proof, But Not A Buy At This Valuation (OTCMKTS:NTDOF)

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Via SeekingAlpha.com

Many of you will know Nintendo (OTCPK:NTDOY) for its popular consoles like the Wii and famous characters such as Mario, Pikachu, and Zelda. For those that are not familiar with the Japanese video gaming giant, the company is based in Kyoto and primarily engages in the production and sale of video games and consoles. The company released its new flagship, the Nintendo Switch, in early 2017. Since the launch of the Switch, Nintendo has discontinued the development of its handhold DS series. Consequently, virtually its entire business revolves around the Switch. It has experienced an impressive run since then with shares increasing roughly 70%, mainly because of the success of Switch. Although we think there is still room to run, we exercise caution since it has an unimpressive list of upcoming games. The remainder of the article is outlined as follows: First, we will explain the business model of Nintendo, then we will highlight upcoming games which is one of the main sources of profit, then we will discuss the competition and the company’s entrance into the mobile market, finally we will discuss the fundamentals, its dividend policy, and give concluding remarks.

Business model

Nintendo’s business primarily relies on the development, manufacturing, and sale of video game software and hardware. The two pieces of hardware currently on the market are the Switch and 3DS. However, the former is supposed to replace the latter and therefore unsurprisingly the number of DSs sold has dwindled over the years. While 6.4 million handhelds were sold between March 2017 and 2018, this number decreased to 2.55 million in the year after. On the other hand, almost 17 million Switches were sold in this timeframe. Little profit, however, is derived directly from the sale of hardware. Independent sources have estimated that, as of April 2017, the individual parts of a Switch cost $257. Considering this is excluding development and labor costs, we see that selling the console itself is not exactly profitable. Where the company does generate profit from is the sale of software. A majority of the best-selling games for the Switch are either developed, published or both by Nintendo. This is in contrast to its main competitors (Xbox and PlayStation) who to varying degrees rely on third-party developers. Consequently, instead of receiving a fee from the sale of games, Nintendo acquires all the profit. This is a double-edged sword, however, since it means the company also takes all the losses in case the games fail. Nevertheless, in the case of Nintendo there is mostly merit to this approach. It has shown a strong record in creating its own first-party games. The top 5 best-selling games on Switch have sold equal or more copies than the best-selling game on PS4. This is despite the fact that there are fewer than half the number of Switch owners compared to the PS4. Compared to the Xbox One, the best-selling Switch game has sold more than four times as many copies as the best performing Xbox game.

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Upcoming games

As mentioned in the previous paragraph, games are quite important to the profits of Nintendo. As a result, it is disappointing to see a lack of AAA games slated for release in 2020 and beyond. Among those listed here, aside from the sequel to the hugely popular Breath of the Wild, most are either indie games, ports or remakes from older games. Additionally, while new games such as Bravely Default on the 3DS were considered a success and received critical acclaim, it only sold 1 million copies. Although this is certainly good given its budget, sales of this magnitude will not boost profits considerably. Furthermore, there is little reason to believe its sequel, which is one of the larger releases, to be released on the Switch will sell considerably more. In comparison, mainstream titles such as Mario Kart and Super Smash Bros have sold almost 23 and 18 million units, respectively. While these games remain to sell, in this regard the sentiment towards Nintendo is somewhat bearish, until it announces another AAA game.

Competition

The console gaming industry is currently partitioned into roughly three platforms. Namely, Xbox, PlayStation, and Switch. These are produced by Microsoft (MSFT), Sony (SNE), and Nintendo, respectively. If we consider only the current generation of hardware, then as of the 21st of March 2020, Sony leads the market with 108 million units sold. Nintendo is a distant second with 52.8 million units sold, while Microsoft lags behind its competitors with only 46.7 million consoles. An important note to take into account is that the Switch was introduced in early 2017, while the other two began their life cycle in late 2013. Consequently, although the Switch presumably still has much life in it, the PlayStation 4 and Xbox One X are nearing the end of their life. Their successors, the PlayStation 5 and Xbox Series X are expected to hit the market before the holidays of this year. Nevertheless, we do not expect this to affect the sales of the Switch heavily. With the release of the Wii in 2006, Nintendo has diverged from Sony and Microsoft in terms of the target audience. The Switch, unlike its competitors, is mobile and offers a different library. Therefore, we do not expect the sales to be affected heavily by the launch of the next generation consoles. However, some caution is not unwarranted as there is still an overlap in audiences, albeit it is relatively small.

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The mobile segment

With smartphones having become increasingly powerful throughout the years, mobile gaming has become hugely popular. As a result, Nintendo does not only face competition from its console peers, but possibly also a rising segment. The mobile market already takes up 45% of the gaming market in terms of revenue and grew 10.2% in 2019 as reported by Newzoo. Nintendo has had varying success in joining the mobile market, with on one hand Pokemon Go, which became a worldwide phenomenon, and on the other Super Mario Run, which fell short of expectations. This was mainly due to the fact that Super Mario Run employed a one-time purchase model, while most mobile gamers seem to prefer a freemium model, which means that the game is free but comes with in-game microtransactions. Nintendo has seemed to have adapted to the microtransactions approach with the release of Mario Kart for mobile. The app was downloaded over 123 million times in its first month, which makes it Nintendo’s most successful release.

In FY19, mobile games accounted for less than 4% of Nintendo’s revenue, which is too little knowing the size of the mobile gaming market. Only time will tell whether Nintendo will be successful in integrating into the mobile market. Some may argue that the popularity of mobile gaming comes at the cost of the Switch, but despite the aforementioned, this is untrue in our opinion as of now as there is a significant difference in terms of the quality of games and the target audience is therefore completely different. The Switch, despite its portable nature, still focuses on expansive games that require considerable time investment, while successful mobile games are generally very simple and require very little time.

Fundamentals

Before discussing the fundamentals, We would like to point out that Nintendo is a Japanese company and thus reports its earnings in Japanese yen. Currently, one dollar is around 107 yen. You should realize that by investing in Nintendo as a U.S. investor, you are exposed to (unwanted) exchange rate wins or losses. To make the article easier to read, we will put dollar amounts in parentheses.

Shares of Nintendo currently trade at around 40,400 yen ($377,57) on the Tokyo stock Exchange. The company is trading at a P/E of 21.76. Because Nintendo is a one of a kind company, it is hard to compare the company to peers. The company makes both hardware and software. While you have peers as PlayStation and Xbox, they both are part of a conglomerate. Gaming revenue makes up for, respectively, 7.4% and 26.6% of Microsoft and Sony’s revenue. For Sony, one could make the case that one-fourth is enough to compare the valuation, however, for Microsoft it seems pointless since segments such as cloud are far more important. Nintendo trades at a significant premium compared to the S&P 500 (15.7). However, Nintendo has increased revenue by 118% in the last 5 years, which is something most companies cannot say. The company has also increased its earnings per share by 5x to 1,615 ($14) in the same period. Although these are great results, we do not know when the next flagship product will be announced and whether it will be a success. While most of you know the Wii, which sold over 100 million copies, you have most likely never heard of the Wii U, which was supposed to be the successor of the successful Wii. The Wii U sold only 13.5 million copies during its lifespan, which is less than the Switch’s sales in one year. What we are trying to say is that buying Nintendo shares comes with a huge risk. If the next console is less popular, we are not surprised to see profits plummeting 50%.

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Dividend

Nintendo has a dividend policy which states that the company pays out only 33% of the consolidated operating profit. Because of this policy, the dividend is everything but steady. A dividend cut in the US is often seen as a really big deal, while in other countries it’s pretty common to cut the dividend when the company faces headwinds. In FY19, Nintendo paid out 7,35 dollars per share (1.54 interim and 5.81 year-end). This would set the yield of the company to 1.8%. The dividend yield is thus not that impressive, but it is still higher than pure software plays Activision Blizzard (ATVI), which has a dividend yield of 0.72% and Take-Two (TTWO), which does not pay a dividend at all.

Conclusion

Nintendo’s stock price has risen 70% since the successful release of the Switch. Sentiment could possibly change quickly if competitors (PlayStation and Xbox) release their new consoles. There is also the risk of Nintendo’s new flagship product not being as popular as the Switch. We saw this with the Wii and the Wii U. While the company can benefit from the coronavirus (people sitting more at home and gaming), we think this is already priced in. While we do not recommend selling shares, we also think at this valuation one should not add shares or start a position. We are planning on adding shares at a P/E ratio of 19, or a share price of 35.300 yen ($266).

Disclosure: I am/we are long NTDOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.




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