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The Arystocrat published an article in the 2022Q2 issue named, “Be Guided by History”, which explained the importance of using history as a framework for making effective decisions. From the words of George Santayana, “Those who cannot remember the past are condemned to repeat it”. However, let’s lighten up and steer clear from the “doom and gloom” inflation and interest rates provided in 2022, and rather tug on the childhood memories of many readers whilst coupling it with our investment process. Most companies provide a blank canvas and grasping where to start can be a tedious process, however, a name like Nintendo comes with a plethora of memories making this canvas more colourful and complex. To our advantage the robust investment approach focuses on what’s under the hood, focusing on the business model, management quality, and financial quality. So come on, let’s pop the hood together.
Our investment guidelines allow us to drown out the noise and go straight to the main event. The process starts with an assessment of management, I am certain you’re not getting on a plane if the pilot is incompetent. The focus shifts to the overall tone at the top, track record of operations, margins of the business, and the alignment of interest with stakeholders.
Shunturo Furukawa - President of Nintendo: ©Nintendo
Nintendo’s management team has extensive experience and expertise across the executive team and board of directors. Shuntaro Furukawa (Nintendo President) has been with Nintendo since 1994 making him a reliable and safe choice at the top. The remuneration policy is a strong indication of the alignment between investors and executives as performance packages need to be structured to only reward executives upon creating sustainable value. Nintendo uses a three-year average on operating profit as one component when calculating their performance bonuses which reduces the risk of once-off performances.
Just like tracking your monthly spending to avoid scavenging for bread crumbs before payday is important, management’s ability to control costs is equally essential. Cost controls have a direct impact on company margins and tell us how well the business is being operated. Nintendo experienced a large margin expansion off the back of increased demand, largely driven by the launch of the Nintendo Switch in 2017. While this was further enhanced by a global pandemic the important takeaway is that Nintendo’s margins expand off the back of revenue spikes, illustrating their ability to keep costs low in a demand-driven environment.
Why is this important? This provides investors with a margin buffer that assures Nintendo can absorb some degree of contraction in its top line without getting pinched by the cost of core operations. Figure 1 (below) illustrates Nintendo’s EBITDA margin expansion during a revenue upswing from the Nintendo Switch release. In contrast, Sony released their PlayStation 5 console over the same period and failed to expand their EBITDA margin to that degree.
Figure 1: EBITDA Margin - Source: Arysteq/Bloomberg
Figure 2: Profit Margin - Source: Arysteq/Bloomberg
In addition to this, from an overall profitability perspective, Nintendo’s net profit margin expanded by 761,3% since the release of their Nintendo Switch console to its current profit margin of 28,2% (see figure 2).
I’m sure everyone has heard of the phrase, ‘There is no such thing as a free lunch’, well similarly there is no such thing as free equity, making return on equity (ROE) an imperative measure to investors. The ROE profitability index highlights a strong performance since the release of the Nintendo Switch, from a mere 7,5% in 2017 to a staggering 20,2% in 2022 (see figure 3).
Figure 3: Return on Equity - Source: Arysteq/Bloomberg
Furthermore, now that we know the pilot can fly the plane a few snacks to enjoy the trip makes a massive difference, especially since we’re taking a long flight. Dividend policies dictate the amount and frequency of dividends paid out to shareholders. Nintendo has a solid track record of upholding their dividend policies as they’ve had a dividend payout ratio (DPR) above 50,0% since 2015, as well as a dividend per share (DPS) 7-year compounded annual growth rate (CAGR) of 41,4%. In addition to a great DPR and DPS, Nintendo has been reducing the amount of diluted weighted-average number of shares since 2017.
There you go, bread buttered on both sides. Safe to say Nintendo ticks the boxes on the management front, but before we take our savings and buy a Nintendo Switch, let’s assess the actual business model.
Big names often don’t need introductions, but I don’t think many realize how big Nintendo actually is, or at least how old. Nintendo is a multinational consumer electronics and software company that was founded back in 1889 (yes the 1800s) as a small Japanese firm producing playing cards. They have now evolved into one of the world’s largest video gaming companies, with three main segments; video game platform, mobile, and IP related segments, and playing cards. The dedicated video game platform accounts for 97,3% of revenues and includes hardware, software, and accessories. Most investors would be familiar with Nintendo’s brands, among the popular are; Mario Bros, Tetris, Legend of Zelda, Super Mario, Donkey Kong, and Pokémon.
An important aspect of the investment world is looking for companies with a moat which roughly translates to how dominant they are in their market. The size of the video game industry was U$196,9bn in 2022 with an expected CAGR of 6,5% to reach U$284,9bn by 2027. With respect to consoles, the market is U$100,0bn with an expected CAGR of 7,6% to reach a market size of U$130,8bn by 2026 (Statista, 2022). In terms of console market share, as of 2021, Nintendo is trailing Sony but remains ahead of Microsoft (see figure 4).
Figure 4: Global Console Market Share - Source: Arysteq/Ampere Analysis
As of 2022, Nintendo dominates global lifetime video game console sales, having sold 50,6% of the top 10, Sony coming in second at 41,7% and Microsoft winning a participation medal at 7,7% (see table 1).
Table 1: Lifetime Consoles Sold - Source: Statista
While past performance does not guarantee future sales, the current environment places Nintendo miles ahead of competitors, having sold 12,4 million more units in 2021 than the closest competitor despite launching their Nintendo Switch 5 years ago (see figure 5).
Figure 5: Current Console Sales (million units) - Source: Statista
It’s no secret that the gaming industry is cyclical, so let’s talk about video game economics. Video game economics is similar to traditional economics in most ways, demand is driven by scarcity, and price is determined by market forces. There is however no such thing as a necessity in gaming and the changes in demand is far more sensitive to individual responses to changes in prices.
Price elasticity in consoles is very high due to the similarity in function of close substitutes, although Nintendo has a slight advantage over PlayStation and Xbox. Nintendo consoles have always been the weird kid on the block, their differentiated console inevitably led to them being somewhat of a compliment console rather than a direct competitor. Nintendo saw no contraction in demand for their Switch console upon the release of the new PlayStation 5 and Xbox series X/S, which meant that most consumers would find a place for both in their houses. In this case being the weird kid paid massive dividends, because we saw the exact same trend when Nintendo released their Nintendo Wii console.
Lets’ put this cyclicality concern to bed. The video gaming industry was a massive benefactor of the Covid-19 pandemic, the likes of Nintendo saw a 34,1% increase in net sales. As the economy returns to normal and the lazy generation eventually starts working we can expect sales to contract and return to normalized levels. The common belief is that disinvesting is the next best course of action, but just like a surfer stays in the water to catch the best wave, great investors have to invest in value companies and wait for the upswings. As my old friend Warren says, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes”.
With economic pressures heating up financial strength separates the survivors from the rest during market turmoil. The financial soundness of the business is evaluated on the sustainability of cash flows, the strength of the balance sheet, and the profitability of continuing business operations.
Nintendo has experienced normalized free cash flow growth of 30,9% on a 5-year CAGR basis and 26,1% on a 7-year CAGR basis. Free cash flow gives us an idea of how much cash is left after paying operating expenses and maintaining capital expenditure, and in this case, they are sufficient and sustainable.
Interrogating the balance sheet is of utmost importance when evaluating financial strength. At first glance, Nintendo’s balance sheet tells a story of little debt with 75,3% of total assets funded by shareholders' equity, during economic contractions companies with less debt on the balance sheet immediately stand out. Particularly impressive numbers were seen in Nintendo’s liquidity which can cover current liabilities with current assets more than three times, with a current ratio of 3,9, a quick ratio of 3,4, and a cash ratio of 3,2 (see figure 6).
Figure 6: Liquidity ratios - Source: Arysteq/Bloomberg
Another key metric is retained earnings. Growth in retained earnings tells us as investors a story about historic profitability. Nintendo’s retained earnings have a 7-year CAGR of 6,9%, which might not seem that impressive at first, but in contrast to Japanese GDP growth since 1980 at only 0,4% it’s a golden star. However, if the recent bull run has taught us anything it’s that stock price and business quality don’t always align.
Mr Market bared the brunt of the slowdown in 2022, mainly driven by fiscal and monetary tightening, China’s Covid restrictions combined with a property slump, and the Russia-Ukraine war all in one year. A decade from now just the headlines will justify the market volatility of 2022. The likes of the Standard & Poor 500 Index (S&P 500) provided its worst year since 2008 and the fourth worst since its launch in 1957 (see table 2).
Table 2: 2022 Performance - Source: Arysteq/Bloomberg
Yes, annually 1,7% is by no means a target return, but performance is relative and in contrast to global equities it’s a stellar performance – on a like-for-like basis outperforming the MSCI World Index by 10,1% and S&P 500 Index by 9,9% (Japanese Yen constant currency basis). With Nintendo trading at a share price of JP¥ 5 483,00 and P/E of 11.9x, the long-term average P/E of 17,8x makes the stock undervalued on a multiples basis. Cyclical or non-cyclical, we are confident that Nintendo has a solid business model and will retain value in the long run. We are therefore comfortable to continue holding this position in our portfolio.
Until next time, stay switched on.
Nintendo® logo, Switch console, Super Mario Bros images: ©Nintendo
