Nintendo's Hidden Competitive Advantage

Apr.13.12 | About: Nintendo Co., (NTDOY)

Nintendo's (OTCPK:NTDOY) 2011 annual report conveys management's sense-of-humor or worse, its "sense of uncertainty". The yellow question marked box was made famous by Nintendo's Super Mario Bros, where the user-controlled Mario punches these boxes for coins, potential growth, or unexpected malicious obstacles. This seems all too fitting for the Nintendo shareholders who have watched its stock value plummet in the face of uncertainty - and irony.

In 2012, what does Nintendo NTDOY.PK have hidden in that yellow box? Could it be another revolutionary gaming system like the first generation Wii? Or will its upcoming second generation system, the Wii U, be a bomb? The Wii U will go on sale towards the end of 2012. Its reception will surely answer these questions but birth many others after. A few things are certain, Nintendo needs to take steps to appease investors, get back into the black, and prepare for battle.

Nintendo Ltd. ADR

Key Data

Recent Price

$18.35

12-mo Chg

- 40.87%

Mkt Cap (BIL)

$20.8

3/2013Est Rev

$10.3

3/2013Est P/E

15.2

3/2013Est EPS

$1.21

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Click to enlarge

Bears bite into the Apple

Looming over Nintendo's gaming dynasty is the emergence and market domination of all things Apple (AAPL). Apple's iPhone, iTouch, and iPad also act as a 'gaming' platform that is competing directly with Nintendo's core business and gaining market share. Will the consumer buy the Nintendo DS over the iTouch or iPad? Cheap and free games are flooding the gaming universe via these devices. Bears believe Apple's emergence in this category will bring down sales of all Nintendo products.

The fears of Apple's handheld/mobile devices creating competition, while changing the gaming landscape are all plausible reasons for Nintendo's poor stock performance. What may drag it lower could be the rumored Apple TV, or iTV, which will act as a computer, TV, and iPad in one. An electronic device like this could then compete against home-console platforms such as the Nintendo Wii, Microsoft X-box, and Sony PlayStation.

The Lost Year - FY 3/2012

Nintendo's FY3/2012 will incur its first loss in over 10 years; management has forecasted a loss of approx. $1 billion after losing 20%+ / annually of its revenues since 2009. Many skeptics of Nintendo believe Apple is the culprit for most of Nintendo's woes.

Also, the introduction and sales of its new mobile device, the Nintendo 3DS (featuring 3D gaming), has not met revenue expectations and is suffering from malignant rumors on the viewing of 3D media. Rumors and possible truth that 3D can be harmful to the eyes, create headaches, and harm brain development of children could have adversely affected sales in FY2012. Nintendo does not recommend viewing of 3D images for children under-six. Management is making efforts to dispel these rumors and also communicating the parental controls option to turn off the 3D feature and use of the "3D Depth Slider" to maximize comfort for all users. Only with the successful communication and acceptance of the 3DS will sales meet analyst expectations.

Bear's believe Nintendo will continue to lose revenues and market share with the emergence of Apple's electronic devices, while also cutting into profit margins. Many skeptics figure that Nintendo's new home-console and handheld systems will not meet consumer expectations. The reduction of home console and handheld systems sold equates into less Nintendo games sold, bringing down their overall profitably and revenues.

A Case for the Bull and Nintendo's Competitive Advantage

One could compare Nintendo's "Super Mario Bros" as the Coca-Cola of video games. This brand is known world-wide and has become a cornerstone of pop culture. Nintendo has successfully leveraged this brand to produce games in multiple categories without dilution. Super Mario is only 1 of 6 core brands/titles that Nintendo produced over the years and you will not find this value on the balance sheet. A large majority of Nintendo's customer base are loyal and fascinated by the games they create. This fascination keeps them coming back to buy more games for the DS and Wii. The proof is in the proverbial pudding, Super Mario inspired games sold over 80 million units during the tenure of the Wii gaming system (FY 3/2007-FY 3/2011).

Intrinsic Value

The majority of Nintendo's gaming brands have been developed in-house and not through costly acquisitions or expensive royalty licenses. Because of this, you will not find Nintendo's 'brand equity' on its balance sheet. If one were to put a value on these assets, it would dwarf any current book value calculations.

Proprietary-ism

Through proprietary hardware and software Nintendo has maintained complete control over the user's gaming experience. This strategy has worked very well for a little company you may know called Apple AAPL. There are actually many similarities between Nintendo and Apple that help reinforce Nintendo's ability to stay successful and profitable. Each has a cult of very loyal core customers. Both have revolutionized their industry starting from the industry's infancy to present day. Most importantly, both emphasize the importance of user-experience. This is why Nintendo games are not found on the PlayStation or Xbox platform. Through innovation and technology Nintendo builds games from the ground up to maximize user experience. This gives them an advantage over most competitors who have to develop under the constraints of the platform.

Beginning of the next Platform Cycle

As stated earlier, Nintendo's next gaming platform, the Wii U, will be selling by the end of 2012. Currently, the stock is priced as if failure for the Wii U is certain. At its current price, the Blackberry Playbook and HP Touchpad were given more credence. According to Nintendo's CEO Iwata, the Wii U will be "Deeper and Wider." To quickly explain this, the new gaming system will support traditional/conventional gaming in HD. Many blockbuster games offered on other consoles were not compatible nor offered the same experience with HD. So this HD upgrade alone will boost 3rd party development and sales for Nintendo. The Wii U will not awe you as the arrival of the first generation Wii did, but many vital improvements have been made.

Valuing the next Product Life-Cycle

During the 5 year life-cycle (FY 3/2007-FY 3/2011) of the Wii and DS, Nintendo earned very respectable average EPS of $2.01/annually. During the life-cycle of the ill-received GameCube home-console and its extremely successful handheld device, the Gameboy Advance, EPS averaged at $0.62/annually (FY 3/2002- FY 3/2006). Let’s assume Nintendo mends operating margins, EPS should average at least $1.50/annually during the next 5-year cycle (FY 3/2013-FY 3/2017); at the current stock price of $18.35; a patient investor will pay a P/E of 12.23 including an annual dividend yield of 4% based on a 50% payout.

High Quality Fundamentals and Past Success

Since we are finished discussing some very positive tangible and intangible attributes of Nintendo, let's finish by examining the fundamentals. First off, Nintendo has a ton of cash and no debt. Profit-making has been long time habit for Nintendo. Executive compensation is not excessive and results driven. It is extremely investor friendly and shares its success with lofty dividends.

Competitive Advantage Attributes

Consistent Profit Maker

Yes

While core revenue growth has doubled in 10 years, avg. Net Income margin % has stayed steady at approx. 15%

Management invests capital wisely

Yes

Avg. ROIC during Wii's life-cycle= 40%

Average ROIC during GameCube's life cycle= 18.6%

Management's ability to rebound from temporary defeat

Yes

GameCube's failure was followed by Wii's outstanding success

Has little or No debt

Yes

No LT debt for over 10 years

Cash to get through the bad times?

Yes

Quick Ratio > 2.5x for over 10 years

Strong Brand Recognition

Yes

Nintendo, Super Mario, Donkey Kong, Zelda, Metroid, Pokémon, etc.

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Know your Costumer

Kids from the ages of 4 to 12 years make up the majority of Nintendo's audience. One could compare Nintendo games to 'G' movies that are fun for kids and entertaining enough for adults. As Nintendo's foundation of gamers from the '80s,'90s, and '00s become parents, the familiarity and trust Nintendo earned will naturally resonate to the children. The price points are also in Nintendo's favor. The Apple AAPL iPad, iPhone, and iTouch are very expensive toys for children to have versus the more durable and cheaper systems Nintendo offers.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in OTCPK:NTDOY over the next 72 hours.