The Curious Case of the Big N

April 19, 2010

Here at ANT we are bullish Nintendo (the “Big N”).  We have a long position in the equity at average entry price of $38.50 USD (note this is for the ADR’s which trade over the counter in the US, as the equities trade in Japan and are not listed anywhere else)

Simplified business model:

  • Console Sales: revenue derived from the sale of 2 consoles: (1) the portable Nintendo DS, (2) the living room based Wii;
  • First-party Game Sales: revenue from games based on franchises where Nintendo owns the IP (i.e. Mario, Zelda, Metroid etc…)
  • Developer Licenses: fees  from the sale of licenses to game publishers. These licenses enable a publisher (i.e. Electronic Arts or Sega) to create games for the abovementioned systems.

Off the top of my head, console sales generate by far the most revenue, followed by first party games and then licenses.

Without explaining much more about the company, which you can easily look into yourself (or talk to your kids), we will now explain the Bear case against the stock.  This will be followed by the Bull case.

Bear Case

By far the biggest threat to Nintendo is Apple.  Nintendo has almost singlehandidly dominated the mobile gaming space.  From Gameboy through to the current DSi XL, Nintendo has had the preeminent platform.  The iPhone and iPod Touch and now even iPad ecosystem threaten this.

Apple  – the massive success of the iPhone and iPod Touch (basically a fully featured iPhone minus voice calling and 3G data) threatens to undermine the dominance of Nintendo’s DS in the handheld.  The combined number of iPhone/Touch’s sold must be approaching  aprox. 100mm globally (WSJ says 50mm iPhones at April 20th). While Apple did not initial position these devices as gaming systems, it is evident to all observers gaming has been one of the most popular uses from both a consumer perspective and a developer perspective (in both paid and un-paid the top downloads are often games and developers have 1,000’s of games listed for sale).  The point here is that out of the ‘clear blue sky’ apple has built a massive gaming platform with a unique style of play (touch screen and accelerometer) and a highly profitable distribution method (all games are downloaded and apple get a 30% cut of each paid download and developers save money (might not be a net saving though after paying Apple that cut) by not having to distribute CDs or cartridges the way it has always been done on traditional gaming platforms.  Of course, there is also the competitive threat posed by Sony who’s recently released PSP Go builds upon the success of the PSP.  We discount the threat Sony poses as it has trailed Nintendo significantly in the current generation and has not shown itself to be a technological innovator (at least not since the orginal PS1) in the same vain as Apple and Nintendo.  Sony is a hardware focused shop whereas Apple can be thought of as holistically focused and while Nintendo has been focused on unique hardware attributes and their implications for fun software experiences.  Apple has built a formidable gaming machine that will pose a serious challenge to final few years of the DS and to the upcoming sucessor to the DS, the 3DS.  Apple is challenging Nintendo’s dominance in the handheld segment in a way that Sony’s PSP was (suprisingly to many analyst) never able to.

The second prong of the Bear case is potenial inability of Nintendo to maintain its dominance in the home console market, a dominance established only in the most recent round of the console wars with its unexpectedly innovative Wii product.

Can Nintendo Innovate Cyclically? –  The Wii was a breakthrough smash hit.  It sold more units than any other home console and did so on a cashflow positive basis (whereas PS3 and Xbox 360 were cashflow negative on a unit basis for years).  Nintendo was counted as dead in the hardware space with Gamecube flop (preceding the Wii) and even when the Big N demoed the Wii, most analysts didn’t believe the thesis that a system like this would appeal to a braoder segment of consumers than past systems (i.e. outside of the 18-34 male segment).  The Wii proved most observers wrong and Nintendo right.   The issue now facing the company is that its competitors, Sony and Microsoft, have internalized the innovations that make the Wii unique (Sony with its Move stick and MSFT with its full body Natal camera).  Therefore in the coming console wars (which have yet to be scheduled, Nintendo will likely loose its top spot unless it can create another suprisingly fun way to play games.  If the next system is just a Wii HD with a few maringal improvements, it will not outsell an updated Xbox with Natal and it might not even sell respectively given the likelyhood that most current Wii owners would not upgrade as they are not ‘hardcore’ gamers.  The key challenge for Nintendo is to create a new console which has a massively differentiating element to it.  Some feature (on the Wii it was motion control) that will be popular with consumers and take Sony/MSFT years to catch up to (given the front loaded nature, in terms of cash out, of console development). As of today, no information has leaked about the sucessor to the Wii.  The leaked information on the DS sucessor bodes well in the sense that a no glasses required 3D handheld is truly unique and cannot be quickly copied by the competition in that space (Apple).  At ANT we think that the demonstrated (albiet there is not yet much info) innovation on the mobile side bodes well for home console side.

Bull Case

The primary argument in favour of the equity is that the current period is a trough valuation, a calm between the the height and the hype.  What do we mean by that?

The Height and the Hype – Nintendo’s stock toped out at in late 2007 at ~$76.00 (at this point Nintendo was the largest market cap company on the Nikkei).  This period coincideded waith maximum ramp up in Wii sales and was basically when the investing world woke up to the fact that Nintendo had won this round of the console wars.  Sales were so brisk that MSFT/Sony were never going to catch up.  Since then, as Wii sales have tappered off and the stock price has fallen along with it to its current price of ~41.00 (which is a 45% drop from its high).

[Note: someone needs to tell the Google Finance people to make theircharts embedable, Wikivest “allows this” but it doesn’t work]

The following chart is a simple conceptual recreation of a chart produced by an equity research analyst (as we here at ANT respect copyright and hard work).  The actual chart show detailed P/E and EV multiples over time and it allows you to see that as the a particular generation of consoles reach there peak of sales, so to does the companies trading multiple.  It also shows you that in the period of time before the release of a new generation and after the peak of the old, the stock trades at a trough multiple.  YES, THIS GRAPH LOOKS TERRIBLE (THE TEAM AT ANT HAS DAY JOBS WHERE WE MAKE FANCY GRAPHS so we don’t have time for that here, just getting the point across):

Growing Apples in Tokoyo – Nintendo is the closest comp to Apple and most analyst and observers don’t realize it.  They don’t talk about this and you very rarely hear the Big N being brought up in discussion of Tech at all, never mind being mentioned in same sentence as the Cupertino deity. Consider just a few of the the similarities between the companies:

  1. Both have been around since the late 80’s
  2. Small number of products (Apple: laptops, desktops, phone, pad, pod) (Ninentendo: handheld, home, games)
  3. Secretive corporate culture – unlike the HPs/MSFT of this world, when these guys release products its an event and the media amplifies it
  4. Both have had near death experience – Nintendo with its GameCube and Apple prior to the return of Steve Jobs and the launch of the iMac – and each company was able to bounce back and even exceed its past sucess (Nintendo with the Wii and Apple with the iMac/iPod/iPhone)

In conclusion, ANT believes Nintendo will run up over the coming year existing product lines continue hit market expectation and as new details are released about the upcoming DS sucessor and the Wii sucessor.

The key short term catalyst is the E3 conference in June.  Here the 3DS will be unveiled.  The shares should run up following the conference because the event will give the market fresh insights into Nintendo’s go forward strategy (i.e. will there be increased focus on online game delivery? social networking? communications applications?).

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