Since 1889 Nintendo has been an innovator in entertainment, first as a maker of playing cards and now as the gold standard of a standalone video game company. The company was not immune to the financial crisis and adding to its woes, the Wii product cycle has been winding down over the last 2 years. It seems that this generation's video game cycle won't die. With Microsoft's Natal and Sony's PlayStation Move, these companies hope to compete with Nintendo's all powerful waggle while extending their systems' useful lives. This leaves Nintendo is a precarious situation. Adding to their problems is the entrance of Apple into the mobile gaming industry. The App Store is putting deflationary pressure on the entire industry with video game prices plummeting. iPad, iPod Touch, and iPhone have all become valid alternatives to the Nintendo DS. All of these factors lead us to believe Nintendo's revenue growth is at risk.
The big box retail environment is not helping either. Walmart, Gamestop, and Best Buy are able to exact pricing pressures on console makers. Consoles already provide minuscule operating margins to both retailers and vendors, with software sales making up for the losses. Nintendo, Microsoft and Sony must walk a fine line with their incorporation of DLC in order to maintain solid retail relationships. An example of this tightrope walking act would be the exclusive DLC that is bundled with some GameStop purchases, although it remains to be seen if that will be sustainable in the long run. Apple does not face this problem with their App Store. Not only is the App Store easy to use, but it is effectively changing people's expectations of how they consume digital media and entertainment.
Have no fear, 3D is here. Movies like Avatar, Alice in Wonderland, and How to Train Your Dragon have shown us that consumers are opening up to 3D technology. On March 23, 2010, Nintendo announced their next mobile device. The Nintendo 3DS will not require glasses but will create a new user experience while allowing for backwards compatibility for older DS games. As well as the DS has sold, this can only be good for Nintendo's future earnings (barring a Virtual Boy-like disaster). A new product cycle is needed for any future revenue growth to be had. The 3D technology will also differentiate the device from smartphones and other mobile devices. Anti-piracy is another benefit of this 3D technology. Piracy has been a thorn in the side of the video game industry for quite some time and this is a considerable effort to combat it. There would be little reason to rip a 3D game and play it on an emulator. We believe this to be true in the motion picture industry as well.
On February 25, 2010, Nintendo was named the World's Best Company by BusinessWeek. Nintendo has one of the best balance sheets in Japan with over $10 billion in cash and a very small amount of long term debt. They have a vast war chest of intellectual property, which allows for a slightly higher Price to Book Valuation. Trading at 3.4 times book, the stock is at its cheapest levels since 2005. It also is trading at a low Price to Sales Valuation of just 2.4 times sales. Gross Margins (43.2% in 2009) and Operating Margins (30.2% in 2009) are at their highest levels in at least 10 years. The only other consumer electronics company with these types of margins is Apple and that stock trades at much loftier valuations. Nintendo's stock trades at a Price to Earnings Valuation of 14.4 and a Price to Cash Flow Valuation of 15.5. The company experienced a decrease in Operating Cash Flows of 13.4% from 2008 to 2009 mainly due to currency exchange losses. After peaking in October 2007 at around $77/share and bottoming in the fall of 2009 at $28.26/share, this stock is worth taking a look at. With Return on Assets of 15.4% and Return on Equity of 22.08%, this company is poised to benefit from their next product cycle.[Financial Information pulled from Morningstar]
The biggest risk to Nintendo's future earnings remains the value of the Yen. Nintendo distributes its products globally with overseas sales accounting for approximately 80% of total sales [source Nintendo 2009 Annual Report]. Japan has battled deflationary pressures for decades, and the Bank of Japan has effectively run out of ammo. There is an ongoing debate between the Bank of Japan's Finance Minister, the Japanese Prime Minister and his party about the Yen. "As finance minister, I am always supposed to say that markets should determine foreign exchange rates," Finance Minister and Deputy Prime Minister Naoto Kan said when asked about the proposal to force down the yen [source WSJ]. This laissez-faire philosophy towards currency led to the Yen appreciating to absurd levels in 2008-2009. "I think we need to take firm steps against such yen strength," said Prime Minister Hatoyama suggesting he wants joint international action to push the yen lower, saying there is a need to "politically cooperate on the world stage." [source WSJ] Japan cannot fix the Yen by themselves, and China's pegging of the Yuan to the US Dollar has not helped. In addition, weakness in the Euro currency will lead to a stronger Yen. Europe represented 39.5% of Nintendo's sales in 2009. It is entirely possible that these macroeconomic headwinds were priced into Nintendo's stock when it bottomed last fall.
So why should you invest in Nintendo? The video game industry is a slave to its product cycles. This leads to volatile earnings and revenue growth. Sales grew 89.8% from 2006 to 2007 and 73% from 2007 to 2008, during the heart of the Wii product cycle. If you were to get in ahead of this product cycle in the fall of 2005 and were lucky enough to sell at the top of the stock market in 2007 you could have returned 470% on your investment. This present trough in Nintendo's earnings may be providing investors with a similar entry point, although no one can be sure that their next products will be as successful. The company's amazing track record, exemplary brands, and dedication to innovation lead us to believe that this is a great long term investment. It has been able to reinvent itself over time and has outlasted many companies that were formed in the 19th century. Nintendo trades as an American Depository Receipt (ADR) on the NYSE. ADRs provide investors with exposure to foreign companies but they also lack the liquidity of the underlying foreign stock. There is also a currency risk to owning ADRs. Nintendo's ADR, NTDOY, trades an average daily volume of 265,000 shares compared to the 620 million shares of Citigroup that trade daily.
Adam H. Kraus also contributed to this article.
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Investors should do their own research or consult their advisor before acting on this information. Panoptic Management Consultants, Inc. is a Registered Investment Advisor that was founded in 2008. Please go to our website www.panopticinvesting.com for more information about fundamental investing as well as technical analysis. For prospective client inquiries please contact us at panopticmc@gmail.com
Full Disclosure:
Our CEO, Asif A. Khan, CPA and/or his family members have the following positions:
Long Apple
Long Citigroup
Long Microsoft
Long Nintendo
Our COO, Adam H. Kraus, JD, MBA and/or his family members have the following positions:
Long Citigroup
1 Comments
May 3, 2010
Nice analysis on the financial side, but lacking on the specifics of the game business. I see the 3DS as a very questionable move for the long-term; unless the 3D (or other features) enable new types of game play (the way the Wii and DS did with their hardware features) I don't see the 3DS as being a blockbuster. The Wii also needs a boost; it's showing its age versus the PS3 and the 360, not being HD and with no capacity to hop onto the 3D display craze (which may not ever amount to much on consoles, either). Third-party support has been lagging, and it's unclear what the long-term picture looks like for that (with exceptions like Epic Mickey notwithstanding). The tie rate is still too low, and I've seen nothing to indicate Nintendo is addressing that.
Perhaps E3 will bring some news of how Nintendo intends to deal with some the trends cited in this analysis (Apple's effect on prices, DLC, the powerful grip of retail chains). Until the picture changes, I'm not sanguine about Nintendo's prosperity in the next year or two.