What I Learned Selling My Nintendo Stock

I’ve been giving some thought to what I have learned from my experience with investing in and subsequently selling Nintendo stock over the last 5 years.

The story begins in 2012, when I noticed that this beloved company, one whose products I was intimately familiar with growing up, was trading at a price that valued the company little beyond the enormous pile of cash on its balance sheet. This cash stockpile was the result of an enormous run of success with the company’s smash global hit game console, the Wii, and its conservative corporate practices. The Wii-era resulted in the coining of a new term amongst the company’s followers and managers, “Nintendo-like profits”, which translated into layman’s terms simply means “insane profitability.”

Investors came to expect “Nintendo-like profits” from Nintendo as a right, when the reality of looking at the company’s business in the past would’ve shown that it was a cylical business with unpredictable fads and discouraging failures. The Nintendo Entertainment System (or Famicom, as it was known outside the US) put the company on the map as a home gaming company, the Game Boy handheld gaming system proved to be revolutionary and a success and the follow-up 16-bit era console, the Super NES, was also commercially successful.

But the follow-on systems in the Game Boy line, while commercial successes, were not global phenomena like the original. And the home console business took it on the chin two generations in a row. While fondly remembered by fans, neither the Nintendo 64 nor the Gamecube saw wide install bases in the era of the Sony Playstation and Microsoft Xbox, an era that also saw the downfall of SEGA and other one-off competitors. Like clockwork, this led to critics and investors questioning the Nintendo model, which had emphasized creativity and pushing the cutting edge of technology whereas Sony and Microsoft competed on the basis of raw hardware power emulating a home PC and captured the coming-of-age “hardcore gamer” market demographic. Nintendo seemed like kid stuff, for people who weren’t serious about gaming.

Of course, that is precisely where Nintendo scored its home run with the Wii, a console aimed at casual players. I rehash all this history only to demonstrate that the company never was and likely never will be a “blue chip”, steady eddy company with a predictable earnings stream built on a permanent plateau. The nature of creative offerings (like a movie studio) and the insistence on being fresh, original and looking for new ways to play (“blue ocean strategy”) is inherently cyclical and prone to incredible volatility in earnings and expense.

Luckily, Nintendo has a super strong culture that knows and understands their own business strengths and weaknesses and engages in corporate planning accordingly. They don’t carry debt and, as mentioned before, they held on to their massive cash stockpile earned in the boom years, knowing it would be valuable to them in getting through the inevitable lean years. Most companies would go on an acquisition spree after this kind of “windfall”, not knowing what to do with it. And their mercenary management team would be looking for another big score to increase their glory before driving the company off a cliff– and rolling out the door of the vehicle and on to their next disaster before it plummets to its fiery death.

But Nintendo is served by extremely-long tenured managers and creative designers, many of whom have been with the company before it was a dedicated gaming company and was a purveyor of cheap toys and other mishmash business lines.

Additionally, Nintendo has built a powerful library of IP over the years with their character and game world properties, which they have done little to monetize in ways outside of traditional gaming through other creative licensing. And it wasn’t even until recent generations of their game systems, such as the Wii, where they even had the technology or willingness to monetize their own game library for nostalgic customers.

So, let’s review some items discussed so far:

  • Nintendo is a cyclical company prone to booms and busts in its fortunes
  • Nintendo has a strong culture, driven by its long history and dedicated creative and marketing strategy
  • Nintendo has long-tenured leadership with experience and comfort with the cyclical nature of its business
  • Nintendo has a pristine balance sheet driven by its conservative corporate culture
  • Nintendo has an extremely valuable IP library it has barely worked to exploit

Because the company has a cyclical model, it was available at an unreasonable price when I came upon it, trading for little more than the value of the cash on the balance sheet. While it is true that the cash is “phantom” because the company will need it to fund its continued R&D and marketing during off years, that didn’t make it a value trap but rather valuable– outsize success is as predictable as disappointing failure for this company, and over time value is accruing to stockholders on average.

This is a strong franchise business, one that will be worth more and more over long periods of time because of its IP-based business model. And when you’re able to buy it so cheaply, the Margin of Safety is enormous, because the company has so much positive optionality because of its strong culture, strong IP library which remains unexploited and its conservative corporate practices. There are so many things that can go right for it which are surprising and hard to predict, while there are relatively simple and certain threats or things that can go wrong which are already accounted for and factored into the price– a poorly-received system, a change in the industry that makes dedicated home consoles a less valuable offering, etc.

What I did wrong is I got scared and I got greedy. From the lows at which I purchased stock in Nintendo, the company rocketed upward over the next 4 years, in spite of the massive depreciation of the Yen (which actually caused major forex headaches, because a lot of the company’s cash has been repatriated and held as Yen), in spite of the sudden death of its beloved and talented president, Satoru Iwata, and in spite of the abysmal fortunes of the Wii U. The company followed its strategy very faithfully and began exploiting its IP in new ways, as predicted– movie studio partnerships, licensing to theme parks, strategic partnership with a mobile gaming company (DeNA) to release official Nintendo smartphone games, the opening up of the company’s game library IP to more “virtual console” sales, greater emphasis on digital product distribution at higher margins, renewed success with the 3DS handheld gaming platform, the rollout of the wildly popular Pokemon GO and most recently, the release of the greatly anticipated Nintendo Switch, which has met both critical and commercial acclaim during its first two, non-holiday sales period months on the market.

I decided to “take profits” during the Pokemon GO craze, thinking this bubbly atmosphere was not sustainable and people would soon come to their senses. I was worried about the Nintendo Switch (still code-named “NX”) being a flop. I was worried about a global recession taking the wind out of consumers’ sails and reducing discretionary income for gaming. I was worried about the lack of news about Nintendo’s “Quality of Life” division. I was noticing a big gap between Nintendo’s new valuation and its actual reported earnings, creating a multiple I wasn’t comfortable with.

I am not trying to engage in hindsight based off of recent price movements. While the company’s stock is off its most recent highs during the Pokemon GO craze, it is still “lofty” compared to where I bought it (as of this posting, the stock trades for about Y29,000 per 100 block unit, and I bought around Y9,800 per 100 block unit). What I am trying to do is evaluate a decision to sell a company that is just now hitting a predictable stride when I bought it at a price closer to it seeming like it was going out of business.

What I have learned from this experience is that when you buy something valuable cheaply, you can afford to wait. You can afford to be patient. You can afford to watch it run up, and potentially run back down again. It doesn’t matter. You make your money in buying it below what it’s worth, not selling it when it’s “too far gone.” That low cost basis becomes an absurd comp for future dividend streams, embedding a high cap rate in the initial purchase, and then you get whatever further corporate value the company generates in the meantime as a bonus.

I really regret selling Nintendo, not because the stock didn’t crash like I thought it would (it was silly for me to think I could “time” it, but that’s a separate issue), but because I had owned it so cheaply, it has done everything I expected it to and I could’ve afforded to be patient.

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Review – Nintendo Magic

Nintendo Magic: Winning the Videogame Wars

by Osamu Inoue, published 2009, 2010 (translated from Japanese)

Two Nintendo legends no one seems to know about

The original Nintendo started out as a manufacturer of playing cards and other toys, games and trinkets near the end of the Shogunate era in Japan, but the modern company we know today which gave the world the Nintendo Entertainment System, the Game Boy, the Wii and characters like Mario & Luigi and Pokemon, was primarily shaped by four men: former president Hiroshi Yamauchi, lead designer Gunpei Yokoi, the firm’s first software designer Shigeru Miyamoto and the first “outside hire” executive and former software developer, Satoru Iwata.

A family member of the then privately-held Nintendo, Yamauchi took the presidency in 1949 when his grandfather passed away. He tried adding a number of different businesses (taxis, foodstuffs, copiers) to Nintendo in true conglomerate fashion, managing in one 12 year period to grow sales by a factor of 27 and operating profits by a factor of 37.

But his most influential mark on Nintendo’s business came with his fortuitous hiring of Gunpei Yokoi, an engineer, who would head up hardware development for Nintendo’s game division. It was this strategic decision to concentrate Nintendo’s efforts on game development that would lead to the modern purveyor of hardware and software known around the world today.

Hardware engineer Gunpei Yokoi is not a well-known name outside the world of hardcore Nintendo fandom, which is not altogether surprising because most Nintendo fans alive today were not users of some of his first toy gadgets such as the “Love Detector” and the “Game & Watch” handheld mini-game consoles. On the other hand, it’s a shock that the man’s reputation is not larger than it is because he essentially single-handedly created the company’s hardware development philosophy in the 1960s which has remained with it today and continues to influence Nintendo’s strategic vision within the video game industry.

That hardware philosophy was summed up by Nintendo’s first head of its hardware development section as “Lateral thinking with seasoned technology”. In concrete terms, it is the idea of using widely available, off-the-shelf technology that is unrelated to gaming in new and exciting ways of play, for example:

  • Yokoi’s “Love Detector” game, which used simple circuitry and electrical sensors to create an instrument that could supposedly detect romantic chemistry between two users when they held hands and held the machine
  • A blaster rifle toy that used common light-sensing equipment to deliver accuracy readings of the users target shots to the rifle, registering hits and points
  • More recently, the Nintendo “Wiimote” concept, which was simply the idea of repurposing the common household TV remote into a tool for play

Yokoi’s lasting impact on the hardware (and software) philosophy at Nintendo is best captured by current president Satoru Iwata who once said,

It’s not a matter of whether or not the tech is cutting egde, but whether or not people think it’s fun

Similarly, this focus on repurposing existing technology for fun rather than investing in brand new technology helps to explain why many of Nintendo’s systems have been knocked for their not-so-hardcore hardware (think non-HD Wii vs. HD-enabled Sony PS3 and Microsoft Xbox 360) but nonetheless became massive consumer hits– the focus was on fun, not flash.

The Wii particularly was the response to the failure of two systems which preceded it (Gamecube and N64), which were extremely technologically advanced for their era and which departed as swiftly from Yokoi’s philosophy as they posed monumental development challenges for software developers due to their complex, proprietary nature. Instead of creating yet another whizbang console, Nintendo decided that if Wii’s costs were kept down and developers were free to focus on things like a new, intuitive controller and built-in connectivity functions, fun and market success would follow.

Essentially, the game hardware is a commodity with zero barriers to entry. Anyone can have the latest, greatest technology if they’re willing to pay for it. There is no way to establish a competitive advantage on the basis for hardware sophistication alone. It must come from design, or, as Yokoi put it,

In videogames, these is always an easy way out if you don’t have any good ideas. That’s what the CPU competition and color competition are about

Nintendo’s two leading lights: Satoru Iwata and Shigeru Miyamoto

Rounding out the Fantastic Four are Satoru Iwata, the company’s current president, and Shigeru Miyamoto, the star software developer.

Iwata came from relative privilege and studied computer programming in school. He had a passion for making and playing games from an early age. He joined a software developer, HAL Laboratory, early on. He successfully turned around the flagging HAL Lab before it was acquired by Nintendo.

Meanwhile, Miyamoto first came to fame through development of his Donkey Kong arcade game, which introduced the characters Donkey Kong and Mario and which was originally based off of Popeye until the IP could not be acquired for licensing. As a small boy he spent hours running around the hills, forests and mountains outside his home, which inspired many of his later game creations such as Pikmin, Animal Crossing, The Legend of Zelda, etc. He was the first designer Nintendo had ever hired. Miyamoto often utilizes his “Wife-o-meter” to help him understand how to make games that are more broadly appealing.

Miyamoto’s design ethic is best synthesized as populist-perfectionist:

When creating a game, Miyamoto will occasionally find employees from, say, general affairs who aren’t gamers and put a controller in their hands, looking over their shoulder and watching them play without saying anything

He creates game characters, game designs and immersive environments that appeal to everyone, not just the archetypical “hardcore gamer.” But this desire to serve a mass, unsophisticated audience does not mean that Miyamoto considers quality as an afterthought. Miyamoto will “polish [an idea] for years, if he has to, until it satisfies him” and “shelving an idea does not mean throwing it away. Those huge storehouses are full of precious treasure that will someday see the light of day.”

This is part of the value of Nintendo– they have many unrealized ideas waiting to be turned into hardware and games and the only thing preventing them from seeing the light of day is someone like Miyamoto who wants to make sure that when they eventually emerge into the light, they don’t just shine but sparkle.

And this thinking carries over to the company’s hardware efforts, as well. According to a lead engineer, the DS

had to work consistently after being dropped ten times from a height of 1.5 meters, higher than an adult’s breast pocket

Nintendo is “obsessed about the durability of their systems due to an overriding fear that a customer who gets upset over a broken system might never give them another chance.”

“Nintendo-ness”: how Nintendo competes by not competing

In 1999, then-president Yamauchi saw a crisis brewing for video game developers:

If we continue to pursue this kind of large-scale software development, costs will pile up and it will no longer be a viable business. The true nature of the videogame business is developing new kinds of fun and constantly working to achieve perfection

The solution was to adhere ever more closely to “Nintendo-ness”. Nintendo picks people with a “software orientation.”

“Nintendo-ness” is the company’s DNA, once someone has grasped Nintendo-ness, it is rare for them to leave the company. That tendency protects and strengthens the company’s lineage and makes employees feel at home

Manufacturing companies create hardware which are daily necessities, which compete based on being better, cheaper products. Nintendo is in an industry of fun and games, software, where polished content is the goal. Compare this to rival Sony, where hardware specs are key and the software is to follow.

According to Iwata,

Do something different from the other guy is deeply engrained in our DNA

Similarly, Nintendo-ness means delighting customers through creation of new experiences because

if you’re always following a mission statement, your customers are going to get bored with you

This way of thinking goes back to Hiroshi Yamauchi, president of Nintendo for 50 years, according to Iwata:

He couldn’t stand making the same kind of toy the other guy was making, so whatever you showed him, you knew he was going to ask, ‘How is this different from what everybody else is doing?’

For some reason, Nintendo observers and critics don’t get this– why isn’t the company doing what everyone else is doing? Why are they making a console with a TV remote instead of HD graphics (the Wii)?

To Nintendo, the risk is in not trying these things and trying to do what everyone else does. Iwata sums it up nicely:

Creators only improve themselves by taking risks

Of course, not all risks are worth taking. Iwata as a representative of Nintendo’s strategic mind makes it clear that the company is keenly aware of its strategic and financial risks:

The things Nintendo does should be limited to the areas where we can display our greatest strengths. It’s because we’re good at throwing things away that we can fight these large battles using so few people. We can’t afford to diversify. We have overwhelmingly more ideas than we have people to implement them

For example, Nintendo considers the manufacturing of game consoles to be outside its purview, a “fabless” company.

Then there’s the reason for the huge amount of cash on the balance sheet:

The game platform business runs on momentum. When you fail, you can take serious damage. The risks are very high. And in that domain, Nintendo is making products that are totally unprecedented. Nobody can guarantee they won’t fail. One big failure and boom– you’re out two hundred, three hundred billion yen. In a business where a single flop can bankrupt you, you don’t want to be set up like that… To be completely honest, I don’t think that even now we have enough [savings]… That’s why IBM, or NEC, or any number of other companies are willing to go along with us. We’d never be able to do what we do without being cash-rich

That being said, Iwata has not been shy about his policy toward dividends and acquisitions. He has stated that assuming Nintendo’s savings continue to accumulate, passing 1.5T or 2T yen, a large merger or acquisition may become a possibility. Otherwise, excess capital will be distributed as dividends.

The next level

Nintendo’s philosophy is to avoid competition. It sees the hardware arms race as an irrelevant dead-end. The key is to create new ways to interact with game consoles and software that keeps game players on their toes and brings smiles to their faces. According to Iwata,

We’d like to avoid having players think they’ve gotten a game completely figured out

Thus, for Nintendo the next level logically is integration of  User-Generated Content into their software environments, which would have inexhaustible longevity. First they sought to increase the gaming population, now they’re looking at how to increase the game-creating population.

The company’s true enemy is boredom. Whatever surprise you create today becomes your enemy tomorrow.

In the end, Iwata says,

Our goal is always to make our customers glad. We’re a manufacturer of smiles

This is what the company calls “amusement fundamentalism” and it’s what sets them apart from their perceived competition, especially comparisons or criticisms aimed at the company in terms of how it stacks up against a company like Apple. To Iwata, this just doesn’t make sense:

We’re an amusement company and Apple’s a tech company

A Thought On Nintendo

Although Nintendo missed its sales targets for the Nintendo 3DS platform, they still sold enough of the systems and its games to give credence to the argument that Nintendo’s business model (independent hardware manufacturer plus proprietary franchise software development) has not been killed and buried in a ditch by the transition to mobile, freemium, changing lifestyles, etc.

What is missing in most discussions of Nintendo’s fortunes, however, is the following fact: what has appeared to die is the profitability of Nintendo’s business model.

That is to say, Nintendo still has a market for its proprietary business model, but going forward it appears to be a marginally profitable effort. However, a business with marginal profitability could have strategic (ie, competitive, brand) value, which is why Nintendo may have decided to keep their hat in that ring.

But it is clear now that Nintendo is a box of cash, with potentially valuable franchise IP sitting on top of it, pursuing a “blue ocean” market.

In other words, Nintendo is not presently an operating company, but a development company that might transform back into an operating company at a later date.

Therefore, the analysis of the value of Nintendo now and in the future hinges on the answers to several questions:

  1. How much, and at what rate, will Nintendo Development Company (NDC) burn through their cash stockpile before finding a new operating business? And will they burn through all of it?
  2. What potential valuable uses do their existing IP have that they are not yet considering them for?
  3. Will NDC’s existing franchise IP have value in their new, blue ocean market?
  4. How valuable will the new, blue ocean market be relative to the past size and scope of the company, its present market cap, size of present cash hoard, etc.? (That is, how big is the potential future market?)
  5. Will they abandon their previous markets once they’ve secured a new market?

What Does The Future Hold For Gaming? Interview With Gabe Newell

Gabe Newell, head of the innovative and successful game software-plus-gaming platform developer Steam, was interviewed at a recent shindig put on by Silicon Valley venture capital and technologist sponsors (is Valve in play?!).

Somehow, the world of app-gaming and smartphones-as-game-platforms haven’t torpedoed Valve’s growth and financial success. More cold water thrown on that unsophisticated theory. Meanwhile, Newell had some interesting concepts on the future of game distribution and design:

Everything we are doing is not going to matter in the future. … We think about knitting together a platform for productivity, which sounds kind of weird, but what we are interested in is bringing together a platform where people’s actions create value for other people when they play. That’s the reason we hired an economist.

We think the future is very different [from] successes we’ve had in the past. When you are playing a game, you are trying to think about creating value for other players, so the line between content player and creator is really fuzzy. We have a kid in Kansas making $150,000 a year making [virtual] hats. But that’s just a starting point.

Now, this is something Apple has figured out and it’s something Nintendo has figured out but is still in the early stages of implementing– users as content-creators and value-adders. I will have my review of “Nintendo Magic” up soon which goes into this a bit more but one of the most interesting takeaways I had was the fact that Iwata discussed empowering users themselves to create content and experiences with their hardware and software that would add infinite replayability to their games. This was part of their strategy for addressing the main challenge of game-making, which is that over time your game becomes stale and boring.

Related to this, Newell discussed creating open-platforms:

In order for innovation to happen, a bunch of things that aren’t happening on closed platforms need to occur. Valve wouldn’t exist today without the PC, or Epic, or Zynga, or Google. They all wouldn’t have existed without the openness of the platform. There’s a strong temptation to close the platform, because they look at what they can accomplish when they limit the competitors’ access to the platform, and they say ‘That’s really exciting.’

Part of creating an open platform means designing something that is easy to develop for. Nintendo struggled with this with the N64 and Gamecube, systems which were technologically sophisticated and powerful, but not easy to develop games for. Meanwhile, the Sony Playstation and Playstation 2 were relatively simple to develop for. The end result? Much wider software library on the Sony systems. And it is software desirability that drives hardware adoption.

Finally, the Wiimote and its new control scheme was central to the Wii’s success and Nintendo’s strategy to expand the gaming population and allow users to enjoy new experiences. The smartphone/iPad revolution has introduced the value of touchscreen control (which, by the way, the Nintendo DS adopted prior to the smartphone revolution) which has continued with the Nintendo 3DS and which is now coming to the Wii U with the touchscreen, tablet-style game controller to be packaged with the system.

But Newell actually thinks touch is a temporary control measure and that it’s “back to the future” when it comes to the next evolution, which he sees as being more motion control-oriented again:

We think touch is short-term. The mouse and keyboard were stable for 25 years, but I think touch will be stable for 10 years. Post-touch will be stable for a really long time, longer than 25 years.

Post touch, depending on how sci-fi you want to get, is a couple of different technologies combined together. The two problems are input and output. I haven’t had to do any presentations on this because I’m not a public company, so I don’t have any pretty slides.

There’s some crazy speculative stuff. This is super nerdy, and you can tease us years from now, but as it turns out, your tongue is one of the best mechanical systems to your brain, but it’s disconcerting to have the person sitting next you go blah, blah, blah, blah.

I don’t think tongue input will happen, but I do think we will have bands on our wrists, and you’ll be doing something with your hands, which are really expressive.

Was Nintendo ahead of its time? Will Nintendo “return to its roots” on this? Perhaps the design team is already thinking this way? They haven’t abandoned the Wiimote with the next-gen Wii U.

Personally, what Newell is saying makes sense to me. I think touch has been innovative, and for certain applications it is both clean, intuitive and as complicated as control need be. But it is not deep enough. You will not be playing Call of Duty or a modern shooter with touch alone. RPGs could be handled with touch but it would restrict some. A 3D platformer would be a boring disaster with touch. I don’t think critics of Nintendo (gamers and non-gamers alike) pay attention to details like this.

Would You Buy This Business? A Bargain In The Videogame Industry

The Nintendo investment thesis in one paragraph

At Y9020/share (June 1, 2012), you are buying a strong global entertainment franchise for Y1278T which has earned Y126B on average over the last ten years and generated Y120B in average FCF, with Y1191B in book value, Y958B in cash and investments and no debt. Global financial market pessimism coupled with hyperventilating technology futurist forecasting and a recent misstep by management that is now behind the company can be used to your advantage to buy this good business at a fair price.

The Nintendo investment thesis in several paragraphs, with links and charts

Nintendo ($NTDOY – ADR, JP:7974), the cherished childhood video game icon and global IP behemoth behind such hit game franchises and characters as Super Mario Bros., Pokemon, The Legend of Zelda and more, has stumbled recently. The company rolled out its new 3D handheld video game system, the Nintendo 3DS, around the world in the spring of 2011 at a price point that proved out of reach to many consumers.

To sale initial sales were disappointing would be an understatement– the system was a flop and with little software support from Nintendo out the gate, gamers had even less reasons to purchase this pricey new system. Realizing their mistake, the company quickly slashed the retail price of the system and offered retroactive credits and concessions to select customers who had purchased the system prior to the price drop.

With a new slate of software titles by Nintendo and premium 3rd party developers released in the 2011 Holiday season and thereafter, and the new price point, the system has finally caught momentum and software and hardware sales are both impressive. As of March 2012, worldwide sales of the Nintendo 3DS reached 17 million units and sales of related software amounted to over 45 million units. Consider this in comparison to the 151 million hardware units and 900 million software units sold over the last 7 years with the predecessor system Nintendo DS and its generations, and the 95 million hardware units and 818 million software units sold over the last 5 years with the smash hit Wii home game console (data source PDF).

Game console hardware and software sales tend to grow and then peak 3-4 years after release (software especially, as its dependent upon a hardware install base for growth, while hardware is in turn dependent on hit software releases to coax gamers to purchase the system to play their favorite games). Even with the poor initial release, the Nintendo 3DS has already outsold the wildly popular Nintendo DS over a comparable time period.

The world’s biggest game expo, E3, starts the first week of June and Nintendo will make a new announcement about their 2nd generation Wii system, currently named Wii U. Sales of the predecessor, revolutionary motion-controlled system have continued to show strength as the company has strategically discounted the system over its lifecycle to maintain sales and the hardware install base, thus driving software transactions as well, although they are slowing as any game system will after long enough after its introduction into the market.

The pessimism about the initial 3DS rollout and the uncertainty about the potential success of the new Wii U system mean that the market is not looking forward to anything good for Nintendo. The stock has been left for dead as the company trades near book value of Y1,191B with a current market cap of Y1,278B.

The fear and pessimism about this company is not just related to the hardware issues (which appear to be solved). Nintendo’s fortunes have been swept up in the whirlwind Tech Bubble 2.0, where everyone insists that all old things will be torn down and ruined and new, cloud-based (and primarily Apple owned and operated) variants will rise in their place. Analyst opinions, professional and amateur alike, have revolved around an obsession with the idea of Nintendo giving up its hardware business completely and selling itself to Apple and focusing on its software franchises. The company’s stated disinterest in following any course resembling this option has left many to conclude it is an absurd dinosaur, cluelessly waiting for the asteroid apocalypse to arrive and destroy its once powerful and profitable franchise in a massive thermonuclear explosion.

That’s what’s being imputed into the stock price, which has continued to plummet like a rock. But, the reality is quite different. Nintendo’s hardware is not being abandoned en masse by former fans. Nor is the world moving to a permanent, entrenched and exclusive model of casual gaming via cell phone apps. The value of the “casual gamer” is likely severely overblown to begin with (which, by the way, calls into question the value of Nintendo’s strategy of “games for everybody” and expansion of the gaming population, as noble as it may be and as successful as it may appear with the blockbuster sales numbers of the Wii). And Nintendo, while initially hesitant and reluctant to jump into the online transaction and gaming space, is by now doing much more than just dipping a toe in.

A few choice quotes from the latest President’s address by Nintendo head honcho Satoru Iwata are below.

On digital downloads and digital game delivery:

it is true that downloading software with 10 gigabytes of memory cannot be done in an instant today, even with broadband connections. So, compared with the situation of portable gaming devices, where comparatively compact-sized software can be downloaded, we have to ask our consumers to wait for a longer time before the download process is completed. However, consumers will be able to use the Wii U effectively by finding convenient times to download software such as when they are sleeping at night. Some consumers prefer to download digital software so that they can play with them on their system anytime without the need to exchange the games’ storage media. Some other consumers find it easier to purchase the medium at a retailer and play it as soon as they insert it into the game hardware. These consumers think it advantageous that they can exchange games with their friends. In order to offer consumers options to choose from, it is important for the company to first make the situation (where digital downloads of packaged software are offered to our consumers in addition to the existing packaged software sales) a reality, and we are ready to offer these options now.

Nintendo is taking a flexible approach, trying to allow gamers a variety of options for receiving games and game content ranging from traditional retail distribution to digital distribution, all with respect for the current limitations of average broadband connections.

On digital versus retail pricing:

we are proposing the two formats of sales mechanisms from which our consumers can make their own choices. The needs of society shall be determined by the choices to be made by the consumers. We do not hold such a premise that digitally distributed software has less value. In fact, as we have discussed this with a number of software publishers around the world, we have found that their opinions are completely divided on the topic of the price points of the digital distribution of packaged software. Some publishers believe that the digital versions should be cheaper while others insist that both versions must be set at exactly the same price. So, it is not only Nintendo’s idea. Each publisher has various ideas on this point and, among them, Nintendo is now offering both versions at the same price point (the same suggested retail price).

Again, the focus is on flexibility– not wedding the company to one model but taking a wait-and-see approach that alienates neither consumers nor distribution partners and allows the market consensus to finally guide the company to the best process over time.

On management’s responsibility for the flop:

with the financial results that we have announced, it is natural that I am being criticized. I do not feel that I have been experiencing something unreasonable. I am making efforts so that the situation can change as soon as possible.

How often do you see the president of a public company accept responsibility for a problem, and, better yet, still feel like there’s hope for a resolution?

On the lessons learned from the failed 3DS launch that will be applied to the Wii U launch:

As we look back, when we launched the Nintendo 3DS, we failed to prepare a software lineup which could satisfy our consumers in addition to other factors, and the Nintendo 3DS could not initially increase the sales as we had originally expected. This is why the company needed to carry out such a drastic markdown measure by sacrificing the profitability. As a result, and supported by a strong software lineup, the Nintendo 3DS was able to regain momentum during the year-end sales season of 2011. We laid out such a drastic measure by understanding that regaining the momentum which had been once lost, is much harder than trying to create momentum from scratch. Without it, the Nintendo 3DS could not have realized positive results at the end of last year or the current sales pace in Japan. It did hurt our financial results, but it was a necessary measure. So, how will we be able to use this lesson for the Wii U? There is always a limit to our internal resources. The company now has to develop software for the Nintendo 3DS, has to prepare for the Wii U launch and has to finalize the hardware functionalities. With these circumstances in mind, if I said that an overwhelmingly rich software lineup would be prepared from day one, it would be too much of a promise to make. On the other hand, we are making efforts so that we will be able to make several proposals even from the launch period that can eventually become evergreen titles for the Wii U. We have learned the lesson that we have to make that kind of preparation for the Wii U, or the Wii U will not gain enough momentum to expand its sales.

On the role of their 3rd party software publishing partners in the success of their systems:

It is imperative for Nintendo that our new hardware offers new proposals and potentially new play experiences so that developers will be interested in this hardware and be motivated to make attractive software. At the E3 show this June, you will be able to experience not only Nintendo’s Wii U software but also the titles being prepared by the third-party publishers. As a result, I think you will be able to notice that a number of developers are creating software (for the Wii U) even today. As for the Nintendo 3DS, there may appear to be fewer commitments from the U.S. and the European software publishers than those of their Japanese counterparts. This is due to the different timing (between Japan and overseas) when they noticed that the Nintendo 3DS would surely expand widely into their markets and, thus, the different timing when they started the actual development of the Nintendo 3DS software. You will also notice a change in this situation when a richer Nintendo 3DS software lineup in the overseas markets is announced around the time of the E3 show.

The first bold part is critical– this is one of Nintendo’s competitive advantages. The company has a purposeful policy of creating new play experiences that will provide incentive for software publishers to publish for their hardware and not others.

The second part is an explanation for why it appears that non-Japanese publishers have not been excited to produce software for the 3DS after the failed launch. They were last to see the sales momentum for the system turn in their markets so they’re behind on the development schedule as a result.

On the “gaming population expansion” philosophy:

Without making efforts to increase the number of new consumers and make video games accepted positively by society, we cannot expect a brighter future than now, so we will continue to make these efforts.

Once consumers have a notion that “this system is not for us,” we have learned that it is extremely difficult to change their perceptions later. Therefore, in promoting the Nintendo 3DS and the Wii U, we have announced that we would like “width” and “depth” to coexist. With the Nintendo DS and the Wii, the approach of “width” was well accepted by many people; however, what we did in terms of “depth” was not satisfactory for some consumers. This time, we would like consumers to be satisfied in both aspects. In order to do so, we started to work on the “depth” aspect first, and the current and existing software you can see for the Nintendo 3DS is based on that idea. In the future, the approach will evolve. By exploring the development both from width and depth standpoints, it is our intention to satisfy a wider audience with one gaming platform. Our approach for the Wii U is basically the same. By doing so continuously, we are expecting that the number of game users per household will increase and as the gaming population increases, we believe we can create a sustainable video game market.

Nintendo is not going away. It’s not a clueless dinosaur. It made some mistakes with the 3DS launch that it has learned from. The industry may have some challenges, headwinds and uncertainties as the distribution model transitions to digital over time, but none of this changes the integral value of this business drastically, which is that it is a premium provider of desired game IP on innovative 1st party hardware platforms that a growing audience of gamers enjoy using.

It might be a different story if Nintendo were in a different financial position than the one it actually occupies but the reality is as of Q4 FY2012 (Mar 2012), the company had Y958B of cash and short-term investments against TOTAL LIABILITIES of Y177B. The company has no debt. According to this link on the Nintendo IR website, at a current share price of Y9020 the company actually is selling below book (NAV) of Y9313/share.

If you’re not yet getting an idea of how cheap this company is, consider the following table:

Nintendo Trading Multiples
10yr 5yr Pre-Wii
Market cap 1277863 (millions Yen)
EV 319541 (millions Yen)
P/S 1.3 1.0 2.5
EV/EBIT 1.5 1.2 2.7
P/E 10.2 8.0 17.9

I created three periods to consider– 10 year average (full system cycle from 2003-2012), 5 year average (since the global recession started, 2007-2012) and the pre-Wii era (these are average earnings generated by the company prior to release of the hit Wii console, 2003-2006).

As you can clearly see, the company is trading for abnormally low multiples of sales, operating and net earnings. The future for Nintendo will probably be better than the pre-Wii era (it is a larger company with an even more expansive market and fan base than then) but may not be as successful as it was with the Wii. That remains to be seen.

Here is the company’s historical margins over the last 10 years:

  • Gross – 40%
  • Operating – 22%
  • Net – 13%
  • FCF – 12%

I think these margins demonstrate Nintendo is a good business with stable earnings power and strong ability to generate FCF from sales.

Relative to its average earnings power and franchise potential, the company seems to be unreasonably priced. Businesses like Nintendo do not deserve to trade below book or anywhere close to 1.5-2x sales. The stumble on the 3DS was temporary and the company is moving on. It’d be nice if the company was even cheaper, and with all the pessimism in global financial markets it might still be. But at these prices, it’s “cheap enough” for a business like this.