Nintendo's Top Line Will Grow At 33% CAGR 2016-19 As Switch Takes Off

| About: Nintendo Co., (NTDOY)
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Summary

The firm’s sales will increase at a 33% CAGR and ROIC will jump from 8% to 28% over 2016-19 as 101m+ Wii users adopt the Switch.

Recent missteps slowed the bulls and confounded analysts.

Based on my analysis I have derived a target price of¥51,459 a 54% premium to the current stock price of ¥33,510.

Executive Summary

Company Profile: Nintendo (OTCPK:NTDOY) is one of three key players in the home console (video game) market. The firm's latest console is on track to outsell the Wii by a margin of 2:1. However, the firm's stock is 63% below the highs of ~¥70,000 it reached during the Wii's heyday (2006-8). If Nintendo can achieve similar sales numbers as it did last generation, the stock is primed to sky rocket. However, we are at a nexus of events that have obscured the stocks true value. Based on my analysis I have derived a target price of¥51,459 a 54% premium to the current stock price of¥33,510.

  • The failure of the Wii U is not well understood: its predecessor the Wii was the only game in town for gamers who wanted to engage in local multiplayer (56%) of the market. The Wii U's tablet controller is a solitary gaming device by design-Nintendo threw out its secret sauce. The Switch doubles down on the promise of local multiplayer-the device is multiplayer ready out of the box unlike any console in modern history. However, Mrs. market is yet to react since she wrongly ascribes the Wii U's failure to the rise of smart devices.
  • Mrs. Market doesn't understand the Exclusive effect: Gameindustry.biz reports that Nintendo has sold 1.5 million units of the Switch to consumers. Making the Switch fastest selling console in the fabled companies history. Whilst GameStop's Eric Bright believes that the Switch might outsell the Wii which sold an impressive 101+ million units. TheSuccess of the console will attract developers to the console which in turn leads to increased console sales. It's a virtuous cycle that will runover short sellers.

Industry Overview (Relevant to Thesis)

Consoles, unlike PCs, are refreshed every 5 years (the previous generation lasted a decade). Console manufacturers tend to launch new consoles in tandem and each refresh counts as one generation. We are currently in the 8 th console generation. The launch of the Switch is an anomaly-it marks the first time a major manufacturer has launched two consoles within one generation.

Sega posted dismal sales numbers when it launched the Dreamcast. After which, Sega bowed out of the console race permanently and began its inexorable march to oblivion. Nintendo, however, chose to double down. After finally retaking the crown from Sony with the Wii, Nintendo ceded ground when it launched the Wii U. The console has only sold ~10% of what its predecessor achieved since its launch in 2012. Mrs. Market has not grasped why the Wii U failed.

Nintendo ushered in the current console cycle on November 18 th 2012, with the launch of the Wii U the successor to the massively successful Wii-it sold a 101+ million units. Unfortunately, the Wii U has floundered since and has sold a paltry 14 million units to date. For comparison, the PS4 that launched on November 15 th 2013 has sold 53.4 million units making it the fastest selling console of all time. Make no mistake the dedicated video game market is alive and well.

Nintendo's fall from grace caught the market off-guard. Mrs. market initially posited that the Wii U's tablet controller was its undoing, whilst phones and tablets have indeed made themselves into the hands of 67% of frequent gamers. The shift towards non-traditional gaming devices should only affect the handheld market and it has Nintendo has posted ~25% declines in its handheld segment's revenues for two years running. Furthermore, the 3DS (Nintendo's flagship handheld) sold only 6.79 million units in FY16, which is less than half the number of units sold in either FY12, FY13, or FY14. Moreover, the latest iteration of the DS is a marginal upgrade to the previous model therefore it is unlikely to turn the tide. Thus, when it came to the Wii U "Casual gamers" were not eschewing the Nintendo consoles in favor of tablets and phones en masse but rather eschewing Nintendo handhelds. Furthermore, 53% of gamers who have tablets and smartphones also own a console-they are not mutually exclusive purchases.

On November 15, 2013, the market found its second scapegoat-the PS4. Analysts argued that Wii users simply graduated to the PS4. However, even though the PS4 is the fastest selling console of all time it has penetrated only 19.5% of the 268 million (users) market. 168 million of those gamers bought either a PS3 or an Xbox 360 last cycle, these gamers fall into the hardcore category where bleeding edge graphics are prerequisite for a purchase. The other 100 million are still on the fence and have not replaced their Wiis with Wii U's. Therefore, not only is it more likely that the PS4 is carving out the Xbox One's market share, the system has sold only 26 million units to date, but it is far too early to test the "graduation" hypothesis. Furthermore, the PS4's controller is no less intimidating to casual gamers than the PS3's. Consequently, the PS4 is no more attractive to casual family players than its predecessor.

Nintendo's secret sauce

So why did the Wii U fail? The market was half right it was due to the controller. It significantly diminished the console's local multiplayer capability relative to its predecessor. An astonishing 9 out of 10 parents play video games with their children and 56% of frequent gamers play video games with members of their household. A tablet device by design is a solitary gaming device which closed the door to local multiplayer centric games. Nintendo essentially threw out their secret sauce. They went so far as to highlight the change by naming it the Wii U.

Nintendo's ascension to the top of the industry last generation was due in part because of its novel controller. If the controller was the only ingredient in their secret sauce Sony's Move controller (left) would have stymied the Wii's ascension.

Source: Amazon

The Wii's success was mostly the result of Sony and Microsoft priming the pump for a local multiplayer centric video game device. Prior to the beginning of the 7 th generation of consoles Sony and Microsoft invested heavily on their internet infrastructure. Microsoft and eventually Sony began to charge consumers a monthly toll of $9.99 to play games online. The comparative ease of programming games for online vs. offline multiplayer and the revenue share from online subscriptions led to an avalanche of games with no local multiplayer support on these systems.

Nintendo did not follow her peers lead. The move was seen as a strategic blunder at the time proved to be fortuitous in hindsight. Developers had to include local multiplayer functionality into their games. The Wii became the only game in town for 56% of the population that used to play video games with members of their household.

The proof is in the sales data. Of the 10 bestselling games on the platform 9 had a heavy focus on local multiplayer, Super Mario Galaxy was the odd man out. It supported cooperative offline play but it did not focus as heavily on it as its peers.

Game

Position

Multiplayer

Sales (m units)

Wii Sports

1

Yes

82.54

Mario Kart Wii

2

Yes

35.61

Wii Sports Resort

3

Yes

32.79

Wii Play

4

Yes

28.92

New Super Mario Bros. Wii

5

Yes

28.4

Wii Fit

6

Yes

22.7

Wii Fit Plus

7

Yes

21.79

Super Smash Bros. Brawl

8

Yes

12.87

Super Mario Galaxy

9

No

11.36

Just Dance 3

10

Yes

10.12

Source: VGChartZ

On March 3, 2017 Nintendo released the Switch and not only course corrected, but it also doubled down on the promise of local multiplayer-the device is multiplayer ready out of the box; it includes two Joycon controllers-all other consoles ship with one controller in the SKU. However, its average review score was in the 60-70% range at the time of launch. The middling reviews deterred would be bulls and added to the confusion on whether the Switch has the legs to maintain momentum. However, console reviews do not hold much water. They reflect the tehncial capabilities of the console which is not primary driver of console sales.

For example, both the PS2 and the Wii lagged their counterparts in overall reviews. However, during the 6 th console war the PS2 handily beat out the Xbox. In fact the PS2 sold over 155+ million units globally versus her technically superior peer that racked up 24 million in sales. Similarly, the Wii trounced (102 million units) both the PS3 and the Xbox who sold ~84 million units a piece.

Like her technically deficient ilk the Switch is on track to dominate the current cycle. Gameindustry.biz reports that Nintendo has sold 1.5 million units of the Switch to consumers. Making the Switch the fastest selling console in the fabled company's history. Following the launch, Nintendo doubled its production forecast of the console to 16 million units next fiscal year.

Nintendo's secret sauce is developing consoles that favor local multiplayer and with the Switch it brings the entire pot to the table. The only question now is, does Nintendo have the games?

The Driver of Console Sales

The real money-maker in video games, unsurprisingly, is video games. Nintendo's flagship launch title for the Wii Zelda The Breadth of the Wild stands at commanding a 97/100 at Metacritic, placing it in the same echelon as Super Mario 64 (94), The Last of Us (95), and Halo: Combat Evolved (97) three of the most beloved first party exclusives of all time. Nintendo has been languishing in mediocrity for the better part of this generation. Zelda marks a welcome return to form for Nintendo and its current production pipeline is as compulsively as it was in the glory days.

90+ Exclusives over 20 years.

Source: Finder.com.au

Here's some perspective, Finder.com.au's analysis of 20 years of Metacritic (think rottentomatoes for videogames) data found that the number of 90+ console exclusives have been steadily declining since their heyday in 2001. Sony has bucked the trend thanks to homegrown favorites such as the Uncharted franchise and The Last of Us. However, Nintendo didn't produce any AAA games in 2016 and its sales languished. The importance of exclusives is glossed over by analysts; console sales begets exclusives that in turn increase console sales. Creating a model that can simulate that virtuous cycle is the key to valuing the firm correctly.

Forecast assumptions and statements

Nintendo P&L

Source: Company reports

Nintendo's revenues are highly generational-not cyclical. The firm nearly doubled its revenues from ¥509 billion in 2006 to ¥967 billion in 2007. It peaked in 2009 at ¥1,839 and proceeded to fall off a cliff in 2010. Revenues currently stand at ~¥505 billion vs. ¥509 billion in 2006, its uncanny but it is no coincidence. ~¥500 billion is the (typically) the lower bound of Nintendo's end of generation sales. The bell curve revenues trips up many analysts since they tend to think and forecast in straight lines. Consequently, most models represent adoption and adopters as depicted below.

Standard modeled sales pattern

Observed sales patterns

However, Nintendo's sales are non-linear, their consoles sales exhibit S-shaped take up rates. These types of adoption rates are best modeled using System Dynamics, specifically Bass diffusion models. Wait. Please don't run. I'm not going to get into the math. Instead (using Vensim) I will depict a graphical depiction of the model in its entirety.

Nintendo Switch Adoption Model

First a note on how to read these models. Stocks of a finite resource are represented by the squares. Whilst the black arrow represents a flow into a stock, out of a stock, and like in our case both.

The other set of characters that populate the model (with no box around them) are auxiliary variables that can either reinforce, mean revert, or negate stock flows. The blue lines denote the direction of the impact.

Here's the key takeaway: as the number adopters increase, the more developers want to produce games on the platform and those games increase the number adopters by increasing the adoption rate: the Exclusive effect as console sales heat up developers are drawn to the console which in turn leads to increased console sales. It's a virtuous cycle. However, AAA games takes at least two years to publish consequently the stellar sales numbers publishers have most likely greenlit projects in third-party studios. That is a key part of the puzzle that the market is missing; the first-year sales numbers has already primed the pump for continued sales in the middle of the cycle.

The S-shaped take up rates are a result of the finite pool of potential adopters-as the number of adopters increase the number of potential declines. Whilst, the rate of flow in and out of a stock occurs at fractional pace which gives rise to the curvature of adoption rates. Once these factors are accounted for the model begins to conform to reality.

Forecasted P&L

Revenue patterns mirrors the adoption rates and adopters summarized above. In the early stages of the console's life-cycle the firm's top-line is dominated by sales of the consoles and in the late years' the sales mix shifts towards video game sales and royalty fees. The drop-in revenues in 2022 are on the back of the discontinuation of the firm's handheld line of products; Nintendo may release a handheld this year and the typical generation lasts five years. In the out years, I expect revenues to settle at ¥842 billion. Given the highly generational nature of the firm's revenues this number represents a normalized top line figure thereby avoiding violations of steady state assumptions, which can cause significant distortions in the valuation of the firm.

Currently 56% of video games are bought online. I expect that number to rise since purchasing games online have benefits outside the realm of the typical e-commerce transaction; if you preorder a game through the online store, then you can play the game as the clock strikes midnight on the day of the release-no waiting! For first adopters, this a huge boon. It also alleviates the main gripe consumers have with e-commerce…the wait. Moreover, console manufacturers will reap the lion's share of the secular boon. Since the Nintendo eShop is the only avenue through which gamers can buy games digitally.

Source: OnLive

Every game sold at retail nets Nintendo $7 in royalty fees, however if the consumer bought the game through Nintendo's eShop that number jumps by $15 to $22. I expect NOPLAT margins to increase from 4.4% currently to 31% in 2019. The firm's NOPLAT margin hovered in between 18-19% during the Wii's heyday. At a time when less than 30% of games were sold online versus 56% currently.Consequently, the increased profitability simply reflects the evolution of the industry to date and lie on the conservative end of the spectrum.

The increased profitability and the new digital revenue stream should help offset the demise of Nintendo's handheld; 67% of gamers already frequently play video games on tablets and smartphones. Furthermore, Nintendo has begun publishing games on Android and iOS. Thus, gamers can still enjoy the Nintendo experience without owning a Nintendo handheld.

Historic Balance Sheet

Forecasted Balance Sheet

Source: Company reports

In deriving both NOPLAT and FCF, I the eschewed the net debt approach in favor of the operating asset (NYSE:OA) view, which states that all assets are required for the operation of the firm and thus cash and deposits are classified as operating assets and not financial assets. Nintendo¥570 billion in cash and deposits, furthermore it also has almost no debt except for¥6,061 million in operating leases. Implying that the firm is more than 100% financed by equity, if you subscribe to a net debt view of the world. Furthermore, most players in the industry are in net cash positions, they use their cash stockpile as a rainy-day fund. Given the generational nature of the firm's revenues I believe it is a good practice. Therefore, the replenishing of its cash reserve hits its FCF.

Risks

Virtual reality takes off: VR is considered by some investors as the next big thing in video games. Nintendo doesn't have the resources to compete in the high-end market; its consoles have always been technical laggards when compared to its peers. Most virtual reality games also fit into the same niche as Nintendo-if VR takes off Nintendo will nose dive.

Nintendo doesn't discontinue the Wii U: I assumed that the Wii U will get axed next year increasing the production capacity allocated to the Switch. If Nintendo attempts a balancing act it will either underperform or deploy needless capex.

Valuation

The FCFU and FCFE calculations are summarized in the table below. Given, the miniscule debt burden the disparity between the two metrics is but slight. Note that I do not subtract interest earned on cash as I would in a net debt valuation of the firm.

Beta U derivation

Source: Company reports, Google Finance, Yahoo Finance

Nintendo's regression beta is too low (0.47). Therefore, I opted to use harmonic average of the unlevered Beta's of its peers and re-levered to match Nintendo's capital structure. The levered beta came in at 0.67. It might still sound too low sum but recall that Nintendo's sales are generational and that 2008 and 2009 were some of its best years.

I used an iterative WACC calculation to determine the appropriate discount rate for my model. The assumptions for the accrual and cashflow models are listed below.

Accrual and Cashflow valuation model assumptions

Abnormal Earnings Valuation

EVA Valuation

FCFU Valuation

FCFE

Target price comparison

The target price is based on the EVA model. Why go to the trouble of using four?

The Abnormal Earnings and EVA models are accrual based and are derived essentially the same fashion. However, the EVA model takes into account the capital structure. Therefore, a stark difference between the valuation models suggests that my capital structure assumptions are not in harmony with the firm's steady state structure.

As move down the matrix you run into the cashflow based valuations and the main difference between them and their accrual counterpart are the capital expenditure assumptions. Therefore, if there is a difference between the accruals and cashflow models. Once again, the closeness of the target prices suggests I did not violate the steady state assumptions, I chose the correct capital structure, and capex assumptions are correct. Moreover, it implies that Nintendo is fairly valued at ~¥52,000. To be precise it is fair value is¥51,459 (I'm biased towards the EVA model) which implies a upside of 53.56% to the close price of ¥ 33,510 on the 25th of May 2017. Nintendo's got game!

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Disclosure: I am/we are long (OTCPK:NTDOY).

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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