Newsletters - Asset Value Investors

AGT

Nintendo • Newsletter July 2021

Nintendo was the single-largest detractor for the month of July. At the time of writing, its share price has declined -19% over the past five weeks.

The culprit, we believe, lies in the recent announcement of the Nintendo Switch Pro – where the market had been expecting a new, more powerful “Switch 2” to be announced – and the recent quarterly earnings release, which may have stoked fears of a cyclical peak in earnings.

Turning to the first, Nintendo announced on 6th July that it would be releasing a Nintendo Switch Pro, an upgraded version of the Switch which will be fully backwards compatible. The new console sold out within minutes on pre-orders. Some market participants had been calling for a “Switch 2” style console with a much more powerful chip, instead of the more modest upgrade that Nintendo has opted for with the Switch Pro. We had maintained that this would be a mistake, as such a console would not have been backwards compatible with existing Switch games, effectively making it much harder for Nintendo to build a sustainable ecosystem around the Switch. While we see why avid gamers might be disappointed with this outcome, we think that the announcement of the Switch Pro confirms our initial investment thesis: Nintendo is moving away from the cyclical business model dependent on successful new console releases, and focusing instead on building an environment in which digital and recurring revenues – stickier and higher-margin – play a larger role.

The recent quarterly earnings release revealed that net sales were down-10% year-on-year, while operating profits and margins declined, and digital sales fell as a proportion of overall revenue. At first glance, these figures are discouraging, suggesting that Nintendo may still be exposed to cyclical swings in earnings. However, it is important to remember that the quarter one year ago was a tough one comparatively, as during the COVID-induced lockdowns many subscribers increased their levels of gaming (and, necessarily, digital downloads) in the absence of regular socialising. Furthermore, due to the pandemic, the Switch has suffered from delays to the production of major new titles which were tipped for release this year. If we take 2019 as a baseline, we see much more encouraging figures: sales of the Switch have doubled, revenue is up +87%, and digital sales have grown +148%.

Overall, while the share price reaction to date has been disappointing, we see no contradictory evidence that would shake confidence in our thesis. At the current share price, Nintendo trades at 8x forward operating profits and 14x forward earnings, a valuation which we believe does not adequately reflect the quality of Nintendo’s business. Nor does it reflect the importance of the switch (apologies) from a console-driven business model to one focused on digital and recurring revenues and increased monetisation of existing IP.

AGT

Nintendo • Newsletter February 2021

AGT has initiated a new position in Nintendo, the Japanese-listed video-game company. The investment thesis for Nintendo is predicated on its high-quality and unique IP (e.g. Super Mario, Pokémon), net cash and investments covering approximately a quarter of market cap, as well as a digital transformation of its business that reminds us strongly of Sony during the PlayStation 4 cycle. The insights garnered from our deep-dive research into Sony’s gaming division allowed us to spot similarities between it and Nintendo’s business, highlighting how insights in one area can be leveraged or ported over to another. As a reminder, the video game business has historically been characterised by earnings cyclicality, with revenues and profits driven by the periodic release of new consoles. Sony transformed its own gaming business by introducing a subscription service, microtransactions, platform fees and streaming services, reducing reliance on hardware sales, and introducing higher-margin, recurring (sticky) revenue streams which are prized by the market for being stable and highly visible.

In our view, Nintendo is at the beginning of a similar process. In 2020, management took large strides in shifting its videogame business towards an attractive, digitally focused model by introducing both subscription revenues and downloadable content onto the Switch platform. The pandemic served as a catalyst to move consumers online, making the digital subsegment the fastest growing part of Nintendo, now accounting for 42% of software sales and helping drive operating margins to 37% (+11% over last year). In addition to the digital transformation, Nintendo has the option to further monetise its world-class IP by expanding into new areas – for example, through opening its first-ever theme park and the release of a new Super Mario movie, slated for 2022. Despite the deep moat given by IP and the ongoing transformation of the business, Nintendo trades at c. 10x operating profits, which we believe reflects fears that management will attempt to re-invent the wheel with each hardware cycle, meaning that profits will continue to be cyclical and the business will always be exposed to the risk of an unsuccessful console launch – for example, the introduction of the Wii (highly successful) and the Wii U (less successful). In our view, this risk is overstated, and we believe there is strong evidence to suggest that Nintendo is moving away from unpredictable hardware cycles, towards the Switch becoming the sole platform, upgraded each cycle, similar to the PlayStation. The release of the Switch Lite in 2019 and the upcoming release of the Switch Pro, with upgraded hardware, highlights Nintendo’s desire to extend the Switch lifecycle, offering consumers a better experience on refreshed versions of the platform. Furthermore, the introduction of microtransactions, subscription services, and different price point consoles suggests that Nintendo is starting to build an ecosystem where consumers will store their Switch game data on the cloud and in turn, upgrade their console every few years. We are excited about Nintendo as an investment opportunity and believe that it holds out the prospect of both significant earnings growth and valuation upside as the market comes to appreciate the new and improved business model.