An Analysis of Nintendo (NTDOY)
Even before last week's announcement from Sony (SNE), it seemed nearly certain that company's dominance in the PlayStation 2 generation of video game consoles would give way to a much more level playing field for the PS3 generation. This time around, Sony faces much stiffer competition from both Microsoft (MSFT) and Nintendo (NTDOY). While the Nintendo name is most closely associated with a video game platform (the NES), the company's real focus has always been the games rather than the platform. Herein lies the true distinction between Nintendo and its two larger rivals. Nintendo seeks to make good games. Microsoft and Sony seek to control a distribution channel. Nintendo is the only company among the three console makers that began life as an entertainment company – and it shows. Microsoft is known for software; Sony is known for hardware; and Nintendo is known for games. American gamers are well acquainted with the Nintendo brand; but, American investors generally know very little about the company. That's unfortunate, because despite all the attention given to Sony and Microsoft's video game operations, Nintendo is the ultimate pure play video game company. Nintendo is big. The company surpasses U.S. video game publishing giant Electronic Arts (ERTS) in sales, earnings, and market cap. On the last count, some may argue that Nintendo only has a larger market cap than EA, because its stock price has risen sharply over the past year, while EA's share price has actually declined. However, there's a much simpler explanation. Nintendo has a larger market cap than Electronic Arts, because Nintendo (the business) is worth more than EA (the business). The run-up in Nintendo's stock price may be entirely due to improved investor perceptions of the company's future prospects as a result of the good press surrounding Nintendo's soon to be launched console, the Nintendo Wii. Regardless, such an increase in the price of Nintendo's shares was justified by the rather low value the market had previously placed on Nintendo's business. The same can't be said of Electronic Arts. Even after underperforming the S&P 500 over the last three years, EA's stock price remains at levels that are nearly impossible to justify using any form of rational thought. So, Nintendo really is the world's largest pure play video game company. Nintendo is an interesting business to write about from an investor's perspective for several reasons. The company operates in an exciting industry with excellent long-term prospects. It's more reasonably priced than many public companies in that industry (although that's not saying much). It's a truly unique business (with a unique past), and it has a clear vision of what it is and what it isn't. Obviously, Nintendo's tremendous intellectual properties add to its appeal both as a subject of an article and as the object of an investor's interest. Nintendo has been a good steward of its intellectual properties. It's been very careful to protect the image of its most beloved characters. In fact, some would say the company has occasionally been too protective of its strongest franchises. For instance, between 1994 and 2002 there were no new Metroid games, despite the popularity of that franchise. The benefit of such a strategy is that when Metroid Prime was released in 2002, it received extraordinary reviews and sold over a million units. The downside to this approach is obvious. Nintendo effectively surrendered the revenue (almost certainly more than $100 million) that could have been milked from the franchise throughout the latter half of the 1990s. Nintendo is one of only a few businesses in this position. It's a rare and valuable property that can benefit from spending some time "in the vault". Nintendo has several such properties. For this reason, Nintendo has more in common with companies like Disney (DIS) and Lucasfilm than it does with manufacturers of consumer electronics. Nintendo is an entertainment company; not an electronics company. Console sales are inextricably intertwined with games sales. Hardware sales account for a large portion of Nintendo's total sales; however, hardware sales don't drive a large portion of Nintendo's total sales. At Nintendo, the games sell the consoles. Of course, the console itself can affect the gameplay experience in its role as a platform. For instance, the console itself is expected to be a differentiating gameplay factor when the Wii launches later this year. Whether it’s a positive or negative factor, we don't know. But, the Wii itself will certainly help differentiate Nintendo's games from their competition. Third party publisher support for the Wii has been the subject of much debate and speculation. Nintendo's consoles have enjoyed less support from third parties than the competing consoles, because Nintendo has been less willing to work with third parties on their terms. While many publishers are now interested in releasing titles for the Wii, there is a new and substantial impediment to successful third party titles. Games will have to be designed around the Wii. In the past, it was easier for third parties to offer titles for Nintendo's consoles, without targeting that console in particular. Now, it will be a lot harder to do that. Expect a few botched attempts early on. A Long, Slow Decline Nintendo's position in hardware has been declining for well over a decade now. In fact, the zenith of Nintendo's fortunes in the console business was the NES itself (launched in 1985). It's been downhill since then. Nintendo launched the Nintendo Entertainment System (NES) in 1985, the Super Nintendo Entertainment System (SNES) in 1991, the Nintendo 64 (N64) in 1996, and the GameCube in 2001. Here are the worldwide unit sales for these four systems as of March 31st of this year: NES: 61.9 million SNES: 49.1 million N64: 32.9 million GameCube: 20.9 million That's not a pretty trend. To add injury to injury, the number of games sold per console had been steadily declining until the GameCube dramatically reversed that trend. Here are the number of games sold per console for each of the four systems: NES: 8.08 games SNES: 7.72 games N64: 6.84 games GameCube: 9.05 games GameCube The above GameCube number is especially interesting, because sales of GameCube games in the Americas has been extraordinarily strong considering its modest installed base relative to what previous Nintendo consoles had enjoyed. The GameCube has performed much better in the U.S. than it has elsewhere. The Americas account for 58.37% of worldwide GameCube unit sales while Japan accounts for merely 19.14% of worldwide sales. In the Americas, the number of games sold per GameCube is approximately 10; while in Japan it is only 7. While a difference of 10 games per system to 7 games per system may not sound that important, it is a far greater difference in the number of games sold per system between geographic regions than exists with any other current Nintendo platform. As a result, the Americas account for nearly two out of every three games sold for the GameCube. Nintendo DS At first, it appears the situation is reversed with the Nintendo DS. Japan accounts for more than 4 out of every 10 sales of both DS games and the handheld platform itself. However, at the beginning of this year, the ratio of software to hardware sales was still a bit higher in the Americas than it was in Japan. That's the case for all of Nintendo's platforms, although the games per platform gap varies from very wide (GameCube) to quite narrow (DS). Game Boy Advance Nintendo's Game Boy sales have always been pretty impressive. The Game Boy Advance, which launched in 2001, has sold more than 75 million units and more than 325 million games. That doesn't include sales of the various Game Boys of the 20th century (the original launched in 1989) which have sold well over 100 million units and 500 million games. The Game Boy has helped Nintendo's financial results, because it has been a much more consistent performer. Taking part in the "console wars" is expensive, time-consuming, and risky. The risks are incurred upfront; the rewards come on the back half of the journey. Having the support of regular revenues derived from the Game Boy certainly doesn't hurt when you're involved in such an uncertain undertaking as launching a new console every half decade or so. Financial Performance Considering the industry it operates in, Nintendo has been a solid performer. The company consistently turns a profit, which isn't easy when there aren't other divisions to smooth out any of the bumps brought on by launching new consoles and essentially launching new products constantly. After all, that is the greatest difference between the video game business and almost every other business around. All your sales are coming from "new" products, even if they are variations on the same theme or sequels within an established franchise. The lifecycle of each product is unnervingly similar to the lifecycle of a fruit fly. So, the business depends upon doing an adequate job a great many times. As a general rule, businesses where you only have to do one really smart thing every couple of decades are better bets. Conclusion Apparently, most Japanese gamers now believe the Nintendo Wii will come out on top in this round of the console wars. That's a surprising and somewhat disturbing finding. If the Wii really is a revolution in the making, I suppose they'll be right. But, I still think this is Sony's race to lose. What will the price of a PS3 be in December of 2007? Until I know that, I can't predict anything other than a much tighter race this time around. What about Nintendo as an investment? The stock isn't expensive, if you expect it to win the next round of the console wars. Otherwise, it's difficult to value. There are two big issues: the Wii and handheld gaming. I'm not convinced there are going to be serious competitive threats to Nintendo's position in handheld gaming coming from high-tech cell phones that are quickly becoming the Swiss Army Knife of the 21st century. I just don't think the three great obstacles of clumsy controls, a lack of focus from the manufacturer, and a lack of interest from the user are going to be easy to overcome. Nintendo is in the best position of any company to profit from handheld gaming in the future. They will face competition; but, they will start with the advantage of knowing what their product is (a game machine). So, if you are comfortable with Nintendo's position in handheld gaming and you truly believe in both the company and the Wii, it would be a reasonable long-term investment at this price. However, even considering the large amount of cash and securities on the balance sheet relative to Nintendo's market cap, it isn't a "value" style purchase based on past performance alone. Buying shares at the current price is a bet on a brighter future. While I like Nintendo's prospects at the moment, it's usually safer to bet against the revolution. So, I'd have to say Nintendo is a very interesting business that's priced a bit too high to be a very interesting investment. Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at: www.gannononinvesting.com |
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