1. Company introduction

  • The Nintendo Company, Ltd. (TYO:7974 or OTC:NTDOY) is a Japanese multinational consumer electronics and video game company headquartered in Kyoto, which was founded in 1889 by Fusajiro Yamauchi.

 

  • Nintendo’s share price has been gradually appreciating with its profitability improving from its bottom in 2014, and recently skyrocketed to its 10-year high of JPY 60,000 in September 2020. Since the COVID-19 pandemic bottom in March 2020, it has outperformed the benchmark Nikkei 255 Index.

 

Nintendo share price against Nikkei 255

Source: Capital IQ

 

  • Despite its recent run-up on share price, Nintendo is still slightly undervalued and has advantages that its peer companies do not have. This will be explored more in depth in sections 2, 3 and 4 later.

 

Executive summary

  • Nintendo is a buy because it is a good company which:
    • has a proven history of continuing innovation even in the face of adversity and challenges from competitors;
    • has a leading position in the console game market;
    • has a wealth of untapped IP portfolio; and
    • has sound financial metrics.

 

  • Nintendo is currently undervalued because:
    • growth potential in console market is underestimated;
    • value of its IP (intellectual property) portfolio has not been properly priced into the stock price; and
    • discounted cash flow (DCF) model and market comparable analysis show that Nintendo is undervalued.

 

2. Investment thesis

Growing gaming industry

  • Not even the best company can go against the macro trend that is profoundly changing the industry landscape. For example, while brick-and-mortar stores have structurally declined, e-commerce firms have grown significantly in the last decade.

 

  • The outbreak of the COVID-19 pandemic in 2020 has caused a steep decline in some of the traditional industries, such as hotel and airline, while accelerating digitalization process and spurring growth for “untact” industries.

 

  • Among others, gaming industry has been one of the benefactors of COVID-19, as people would naturally spend more time playing games at home. It is an entertainment that can be enjoyed by a single person at home, even during lock-down periods in some parts of the world, without the need for him or her to physically interact with people from outside.

 

  • As a result, the gaming market is expected to record significant growth. According to a research, “the games market will continue to grow in the following years, exceeding $200 billion at the end of 2023. By then, we forecast the games market to grow with a +8.3% compound annual growth rate (CAGR) to $200.8 billion.” The value of global games market stands at $160 billion as of 2020.[1]

 

  • Clearly, the gaming industry is growing rapidly under the favorable macro headwind intensified by COVID-19.

 

Continuation of innovation

  • Nintendo has a proven track history of coming up with innovative ideas to overcome adversity and competition. It pioneered portable game devices with the launch of Game Boy in 1989, and Nintendo DS in 2004, which were mega hit in the global game market.

 

  • Portable game devices declined in the era of mobile and online game, but Nintendo created a new revenue driver from its console device, Switch, in 2017. Nintendo was not afraid to cannibalize its existing products, Nintendo 3DS console, to make necessary adjustments in the ever-changing gaming market.

 

  • Nintendo is also well prepared for the next waves in the gaming industry. While maintaining its video game platform, Nintendo is also diversifying into other future business areas. For example, it is aiming to create opportunities for consumers to play Nintendo IP games in a variety of other ways, such as mobile game devices. It is also committed to research and development for future game technology, such as cloud computing, virtual reality, deep learning and big data analysis.[2]

 

  • In short, since its first game debut in 1975, Nintendo has survived and led the game market for more than 45 years. The game industry will develop further and continue to evolve in the era of artificial intelligence and cloud platforms, but Nintendo has demonstrated that it has the capacity and experience to continue to adapt to the rapidly changing taste of consumers and evolving industry landscape.

 

Leading position in console game market

  • Nintendo has solidified its dominant position in the console game market. According to a research, the console game market has been growing at a compounded growth rate of 2.3% from 2012 to 2021.[3] In 2018, Nintendo’s console market share overtook that of Sony, and Nintendo sold over 22 million gaming consoles, and held 47.8% of the market.[4]

 

  • However, the estimate of a CAGR 2.3% for console market does not consider the current COVID-19 pandemic situation which spurred growth in gaming industry. In an era in which the COVID-19 pandemic forces family members to stay at home together, unlike mobile and PC games which can only be enjoyed by a single person at a time, Switch is best positioned to grow even further as it offers family-oriented entertainment games which can be enjoyed together.

 

  • Switch’s success can be attributed to several factors, but the biggest one is its family-friendly game features. Unlike other ad-filled and constant upgrade pushy mobile games and violence ridden Xbox and PlayStation games, Switch offers a healthy alternative for kids and parents.

 

  • Another innovative part of Switch is that players can play games while carrying it like a mobile phone. In addition, they can either attach a controller to the device or just separate the controller and hold it in their hands and play, enabling them to play in different modes. Now, Nintendo generates most of its revenue from Nintendo Switch Platform.

 

  • As a result, Switch is growing even more rapidly. While it was almost non-existent in the year it was launched, 2017, Switch overtook Xbox One in just 2 years and approximately grew at a CAGR of 130% from 2017 to 2020.[5]

 

Rich IP Portfolio

  • One of the most well-known gaming IPs in history is undoubtedly Pokémon. First launched in 1996, Pokémon is still one of the most popular and profitable brands. For example, Pokémon Go in 2016 has created a syndrome where everyone on the street was looking at his or her mobile phone to catch Pokémon via augmented reality, which is another proof of Nintendo’s innovation. The latest series of Pokémon, Sword and Shield released in 2019, was sold more than 18 million copies world-wide by August 2020, making it one of the most successful franchises.[6]

 

  • Other famous IPs include Super Mario, Legend of Zelda and Donkey Kong, to name a few. Such a wealth of famous IPs has the potential to be monetized in various ways, one of which could be a creation of Nintendo themed parks and films. For example, the Marvel comics brand has its own universe of heroes and stories, and its IPs have been widely used in movies, merchandises, character licensing etc. Although a perfect parallel is hard to draw between Nintendo and Marvel, Nintendo’s IP is simply under-utilized at the moment, and it can seek ways monetize its IP portfolio at any time.

 

  • As Nintendo set out its ambitions beyond its core of consoles and software in 2020,[7] there is much more potential to be unlocked by having synergy from combining game IP characters and entertainment via unconventional channels, an advantage that no other competing game companies have.

 

Sound financial metrics

  • Financial ratio analysis shows that Nintendo:
    • is growing in profitability and size, thereby producing good returns on its investment; and
    • has sound liquidity to withstand the short-term volatility in this uncertain period.

 

  • Nintendo’s revenue and profit continued to grow from 2017 to 2020, with net income margin increasing from 13% in 2017 to 26% in 2020. As a result of continued revenue and profit growth, return on equity (ROE) has also increased from 11% to 22% in the same period. Return on equity is purely a result of operational improvement as Nintendo does not have debt, and thus does not use leverage.

 

  • In particular, the huge increase in net income margin is a result of recent explosive growth of Switch consoles and its game Animal Crossing. Switch consoles were sold out quickly as the COVID-19 pandemic forced lockdown, and more than 22 million copies of the game title Animal Crossing have been sold since its release in March.[8] The game’s popularity boosted profits.

 

Source: Capital IQNintendo's financial ratio analysis

Note: Net income growth and revenue growth from 2016 to 2017 is out of scale, 71% and 165%, as sales of Switch started to explode.

 

  • Furthermore, Nintendo’s liquidity has been sound. Current ratio is above 4.0, showing that it has ample liquidity to deal with unexpected contingencies. Specifically, balance sheet as of June 2020 shows that it holds cash and equivalent assets equal to JPY 914 million, holding more than half of its assets in the most liquid form of asset enough to cover all of its liabilities. This liquidity acts as a safety margin for potential liquidity crunch in the financial market when there is so much uncertainty amid the COVID-19 pandemic.

 

  • All of these financial indicators paint a positive picture for Nintendo both in short and long term.

 

3. Discounted cash flow model

Discounted cash flow model

  • The DCF model based on the last 3 years of financial information and 5 years of financial projection shows that the inherent value of Nintendo’s share is JPY 61,809. This is roughly a 7% undervaluation against its current share price JPY 57,470 as of 28 October 2020. The result of the DCF model is summarized in the table below.

Nintendo DCF analysis

Source: Nintendo financial model by Joon Young Kwon

You can download my spreadsheet model here.

 

Assumptions

  • In projecting Nintendo’s future financial performance, the latter half of the year 2020 is assumed to be the same as the first half. This is based on the assumption that the first and second half of the year 2020 will have similar business environment, as the world has been struggling with the COVID-19 pandemic throughout 2020.

 

  • In projecting Nintendo’s revenue, it is assumed that 90% of future revenue will come from the console related sales while 10% will come from other categories, which consist of mobile, playing cards and IP related income. This is based on the product breakdown disclosed in 2020 annual financial statement.

 

  • In projecting console related revenue, the revenue growth rate of 3.5% is assumed, which then decreases evenly over 5 years before reaching the terminal growth rate. This 3.5% is based on the fact that Switch sales have exploded since 2017, and thus deserves a higher growth rate than 2.3% growth rate of the console game market.[9]

 

  • In projecting other income, the revenue growth rate of 4% is assumed to continue before reaching the terminal period. This is above inflation and GDP growth rate, and has taken into consideration the possibility that new revenue drivers can come out in the future, such as IP related items and mobile games.

 

  • Gross profit margin, EBITDA margin, EBIT margin, EBT margin and profit margin are all assumed to be the historical average from 2017 to 2020. This is a conservative estimate as Nintendo has shown impressive growth and margins in recent years, especially in 2019 and 2020.

 

  • In the terminal period, the terminal growth rate is assumed to be the product of the average of the forecast GDP growth of Japan, US, Europe and world from 2021 to 2025, and ratio of Nintendo’s sales exposure to each geographical region.[10] This is again a conservative estimate because the growth rate of gaming industry is higher than the GDP growth rate of the world, and thus the terminal growth rate can be higher.

 

  • As Nintendo does not hold any loan or debt, Nintendo’s stock is valued using free cash flow to equity. The cash flow is then discounted by using the discount rate that is just the cost of equity, which is derived by using the Capital Asset Pricing Model.

 

  • In projecting free cash flow to equity, change in net working capital and capital expenditure are assumed to be proportional to the revenue, with the ratio being a rough approximation of ratio in recent years.

 

Sensitivity analysis

  • Sensitivity analysis on discount rate and terminal growth rate shows that the DCF model is sensitive to the growth rate in the terminal period. This is understandable as the share of the terminal value to the entire stock valuation is at 78%, which makes sense as gaming companies typically have long duration income generating assets. The table below shows sensitivity analysis, which shows that intrinsic value per share ranges from JPY 49,613 to JPY 82,184 as the terminal growth rate changes from 1.77% to 3.77%.

 

Nintendo sensitivity analysis table

Source: Nintendo financial model by Joon Young Kwon

Note: Slight difference appears as there is a rounding issue with rates used in the table.

 

  • In short, the DCF model shows that the intrinsic value of Nintendo’s share is currently undervalued against the market share price even under some of conservative projections and assumptions.

 

4. Comparable company analysis

Comparable company category

  • In conducting comparable company analysis, several game companies were chosen based on their categories, which include:
    • Asian: NCSoft Corporation (South Korea), Nexon (South Korea), Tencent (Hong Kong), Netmarble (South Korea), Square Enix (Japan) and Netease (China);
    • Western: Activision Blizzard (USA), Electronic Arts (USA) and Take-Two Interactive Software (USA);
    • Mobile: Glu Mobile (USA), SciPlay (USA) and Zynga (USA); and
    • Console: Sony (Japan) and Microsoft (USA).

 

Asian game companies

  • Asian gaming companies in general tend to have a large exposure to Asian market, especially China. While the exact sales ratio of Nintendo to Asia except Japan is not publicly disclosed, Nintendo is slowly increasing its exposure by slowly releasing its Switch games in China and launching partnership with Tencent.[11]

 

  • Relative valuation of Asian comparable gaming companies shows that Nintendo is currently undervalued on a historical basis. On a forward basis, Nintendo seems to have been priced either fairly or slightly undervalued against its peers.

 

Asian gaming comparable company

Source: Capital IQ

 

Western game companies

  • Western game companies tend to have more diversified business model structure, and largely focus on the US market. For example, more than 50% of revenue of Take-Two Interactive comes from the US market and it has diversified business portfolio including PC games, digital online and physical retail divisions. This diversification of business model may be a reason that some of these companies have a higher P/E ratio.

 

Western gaming comparable company

Source: Capital IQ

  • Nintendo is clearly undervalued against this peer group.

 

Mobile game companies

  • Mobile gaming industry is growing most rapidly by the sheer scale of the market. In other words, as any people with mobile phones are their potential customers, the mobile game companies have the highest growth potential. But at the same time, the market is much more fragmented and game trends quickly change, forcing companies to compete more fiercely to survive than those in more established oligopoly market, like console.

 

  • Many of these comparable companies are still loss making, meaning that although they have the potential to grow fast, profitability of these companies may be in question. The relative undervaluation of these companies may stem from the fact that they are still financially struggling, competition is fierce and hence profitability in the long run is not guaranteed. Therefore, the valuation of this peer group provides a context, but is not a good benchmark for Nintendo.

 

Mobile gaming comparable company

Source: Capital IQ

Note: Trailing P/E ratio does not provide useful benchmark as some of these companies are still loss making.

 

Console game companies

  • Comparison with the other two big console game companies—Sony and Microsoft—shows that Nintendo is slightly undervalued at the current level. This group may be the most appropriate peer group in product type as they share largest market share in console market with their products, Switch, PlayStation and Xbox.

 

Console comparable company

Source: Capital IQ

 

  • However, Nintendo’s valuation comparison with Sony and Microsoft is not an apple-to-apple comparison. Sony has many other business divisions, such as music, imaging products and a wide range of consumer electronics, whereas Microsoft has cloud service, office product and LinkedIn divisions.

 

  • Sony’s relative undervaluation is a result of underperformance of other business divisions, such as movies, music and image sensing unit while gaming division accounts for more than 50% of Sony’s total operating profit. Its strong revenue was largely driven by its sales of PlayStation and digital content, and revenue for Sony’s gaming business is forecast to jump over 26% year-on-year to 2.5 trillion yen in 2021.[12] Sony’s current valuation is another proof that the game industry is growing as a whole, and thus deserves a high multiple.

 

  • On the other hand, Microsoft’s relative overvaluation is a result of outperformance of other business divisions, such as cloud service, and thus must be viewed with caution. Microsoft’s cloud service, Azure, grew more than 400% from 2018 to 2020, driving up Microsoft’s share value.[13] While Microsoft’s Xbox gaming division is a profitable business, it contributes to less than 10% of Microsoft’s total revenue. Although getting the implied P/E ratio of Xbox division is difficult due to availability of data, Microsoft’s current valuation may act as an upper boundary as Microsoft’s share is more buoyed by other rapidly growing sectors.

 

Relative valuation

  • Even though the exact comparable company is difficult to find as companies have different business model, geographical exposure and product types, comparison against different gaming company peer groups shows that overall, Nintendo is quite fairly priced or slightly undervalued at the current price, except in the case of mobile game companies which have quite different industry characteristics, and thus are not reliable comparable companies for Nintendo.

 

Ratio comparison

  • I compare Nintendo’s financial ratio against Asian peer company group. In comparison against its Asian gaming company peers, Nintendo has:
    • average revenue growth rates (3% and 5%) lower than the industry average in 2019 (8%) and in 2020 (17%);
    • EBITDA margin (38%) higher than the industry average in 2020 (29%); and
    • net income margin (26%) at around the industry average in 2019 (27%).

 

  • This shows that compared against its Asian gaming company peers, Nintendo has lower recent revenue growth compared to the industry average. However, as I have mentioned in section 2, growth in console market and untapped value in IP portfolio will be the future drivers of growth for Nintendo, which I think are underestimated by the current market.

 

5. Investment risks

  • There are a number of inherent risks to buying Nintendo stocks:
    • COVID-19 may disrupt Nintendo’s global supply chain for assembly of finished products and procurement of key components;
    • Competition in gaming industry intensifies, and competitors take away Nintendo’s market share;
    • Nintendo faces volatility of exchange rates from USD and Euro, as its exports to the combined market of the Euro Zone and US exceeds more than 50% of its total sales;[14] and
    • High dependence on the Nintendo Switch platform for its revenue.

 

  • While these risks are still noteworthy, many of them do not pose a significant threat to Nintendo for the following reasons:
    • COVID-19 risk is present for all global equities and is not only specific to Nintendo. All equity investors currently face similar COVID-19 pandemic risk as the biggest market risk. However, this can be somewhat hedged by diversification of asset into bonds, alternative investment, cash and other asset classes;
    • While there is no telling how gaming industry will change, the ability to innovate and accumulated experiences of Nintendo in game industry significantly reduces the risk of lagging behind innovation and market trend; and
    • Currency risk is not significant as Japanese yen is a historically stable currency. Nintendo also hedges some of its exchange exposure via exchange forward contracts and options.

 

 

  • However, some risks need to be taken into consideration seriously as they may adversely affect Nintendo’s business models in the following ways:
    • Disruption in global supply chain is evident with the COVID-19 pandemic. Nintendo hedges production risk by procuring parts and materials from and outsourcing production to multiple companies.[15] But delays in the launch of new products and procurement of key components can happen; and
    • Nintendo switch is currently making up most of Nintendo’s revenue. While Nintendo is leading the console market which continues to grow and is diversifying its revenue channels, high dependence on Switch exposes some dependency risk.

 

6. Trading recommendation

  • The DCF model in section 3 shows that the intrinsic share value of Nintendo’s share is at JPY 61,809.

 

  • The market seems to be slightly discounting Nintendo because of some of the risks mentioned in section 5, especially with respect to high reliance on Switch, and current low revenue growth rate compared to its peers.

 

  • However, the potential for untapping Nintendo’s strong IP portfolio, its ability to innovate, and continued growth in console market in the future do not seem to have been fully factored into the current stock price. This mismatch creates an investment opportunity for value investors, who seek to exploit a temporary mispricing by the market.

 

  • In that regard, a pull back from the current level, most likely due to uncertainty and volatility in the short-term with the resurgence of the COVID-19 pandemic, may create an attractive entry point.

 

  • As Nintendo is paying dividend at around 1.5% yield as at the end of October 2020, entering Nintendo stock at approximately JPY 54,000 and holding for dividend income until new value is created from its expansion of IP business model and innovation seem to be an appealing strategy.

 

7. Conclusion

  • COVID-19 has created a positive macro environment for game companies to grow. With a proven track history of innovation to overcome challenges, leading position in the console game market, trove of IP rights and sound financial metrics, Nintendo is a solid long-term investment.

 

  • Moreover, Nintendo is undervalued at the current stock price compared to its most of peer companies, and reward/risk prospect seems favorable as it has good financial strength to stomach short-term volatility. The DCF model also shows that the intrinsic share value of Nintendo is slightly undervalued as well.

 

  • It is true that the stock price of gaming companies in general have appreciated much recently, and the current stock price may not be attractive for growth investors who seek another story of Tesla and Amazon. However, the current valuation of Nintendo still presents an attractive opportunity for value investors who look for a potential long-term stock appreciation while enjoying stable dividend yield.

 

  • Therefore, I remain bullish for Nintendo for those investors seeking exposure in their portfolio to gaming industry with relatively low down-side risk in the short-term but wishing to maintain an upside potential in the long-term.

 

Footnotes

[1]         Newzoo, The World’s 2.7 Billion Gamers Will Spend $159.3 Billion on Games in 2020; The Market Will Surpass $200 Billion by 2023, 8 May 2020.

[2]         2020 Nintendo Annual Report.

[3]         Newzoo, Mobile revenues account for more than 50% of the global games market as it reaches 137.9 billion in 2018, 30 April 2018.

[4]         Gaming Console Market 2020, Gaming Console Market 2020 Global Industry Analysis by Trends, Size, Share, Company Overview, Growth and Forecast by 2026 Latest Research Report by Market Reports World, 3 September 2020.

[5]         Switch vs PS4 vs Xbox One Global Lifetime Sales – July 2020.

[6]         Game Rant, Pokémon Sword and Shield Hit Impressive Sales Milestone, 6 August 2020.

[7]         Financial Times, Nintendo sets out plans to unlock value from IP treasure trove, 31 January 2020.

[8]         BBC New, Animal Crossing boosts Nintendo sales, 6 August 2020.

[9]         Switch vs PS4 vs Xbox One Global Lifetime Sales – July 2020 and Gaming Console Market 2020, Gaming Console Market 2020 Global Industry Analysis by Trends, Size, Share, Company Overview, Growth and Forecast by 2026 Latest Research Report by Market Reports World, 3 September 2020.

[10]        Nintendo website, Financial Highlights, Geographical Sales Breakdown.

[11]        Reuters, Tencent gets green light to publish two Nintendo Switch games in China, 12 March 2020

[12]        CNBC, Sony shares are at a 19-year high. Analysts are bullish on PlayStation 5, say stock could rally 20%, August 5.

[13]        Cloudwars, As Microsoft Azure Growth Declines, Should Satya Nadella Worry? 12 August 2020

[14]        Nintendo website, Financial Highlights, Geographical Sales Breakdown.

[15]        2020 Nintendo Annual Report.

 

Disclosure: I am long Nintendo. I wrote this article to myself, and it expresses my own opinions. I am not receiving compensation for it other than from the Macrotrend. I have no business relationship with any company whose stock is mentioned in this article.

 

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