Nintendo: The Switch Dilemma

| About: Nintendo Co., (NTDOF)

Summary

During Q1, Nintendo sold 1.97 million of Switch consoles.

Our analysis shows that the company trades at ~27% premium from its fair value.

We continue to hold short position in Nintendo.

Since the publication of our latest article on Nintendo (OTCPK:NTDOY) (OTCPK:NTDOF), the company’s stock didn’t move much higher, despite the strong Q1 results, which makes us to believe that there are a number of issues that the company will need to tackle in order to assure growth in the long run. Thereby, we believe that bearish thesis continues to be relevant at the moment, and we are currently short selling more shares of Nintendo and increasing its exposure to our portfolio.

If we go through Nintendo’s latest earnings report for Q1, we will find out that Switch is the main reason of the company’s success in the recent months. However, it could be its biggest problem in the upcoming months due to the shortages of the console and, at the same time, not an impressive growth of its sales in comparison with its rivals. Since the launch of Switch, Nintendo sold 4.7 million of units, 1.97 million of which were sold in Q1. This means that during the last quarter, the company sold only around 660 thousand units per month. And here is the dilemma. On the one hand, there is a great demand for the console, as there are supply shortages among worldwide retailers, while the demand from consumers is still high. And on the other hand, the company wants to sell 10 million consoles by the end of this fiscal year that ends in March 2018, which translates into 835 thousands of consoles per month. Now let’s assume that during the holiday season we will see the bump in sales numbers and the company reaches its 10 million mark, there are still a lot of uncertainties about the console’s lifecycle and the guarantee that its sales will grow in the consecutive fiscal years.

Two weeks ago, Nintendo announced that it will ramp up production of Switch to guarantee steady rate of supply for the holiday season. While at first it seems like a smart move, the expansion of the production line is an expensive move that could have negative impact on the company’s financials, if the investment doesn’t justify itself. In addition, despite the great demand for the console in the first months of its launch, the management of Nintendo decided not to increase its full-year guidance for the number of consoles that are expected to be sold and left it at 10 million mark. This could hint us that the company doesn’t want to overcommit to releasing too much of its product and later be left with the stockpiles of unused devices. Unlike a great number of Nintendo shareholders, the management itself doesn’t want to get overexcited about Switch and tries to be conservative about its future. We respect such a thinking from the company’s top executives, but we don’t believe that this will help Nintendo to establish a stronger presence in the gaming industry, primarily due to the strong competition from the companies such as Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE) and the growing effects of AR and VR technologies that will revolutionize the gaming business and make the current generation of consoles useless in the upcoming years.

With all that in mind, we decided to create a DCF model, where our revenue forecast for the next three years is in line with the Capital IQ predictions, the WACC is 7% and the tax rate is 30.9%.

Source: Capital IQ, Own estimates

Before we move forward with the valuation process, we need to clarify that Nintendo could be traded either on Tokyo Stock Exchange under the ticker 7974.TSE or on the OTC market via the tickers NTDOF and NTDOY. Our DCF model includes the Japanese ticker from the Tokyo exchange and the NTDOF ticker from the over-the-counter market.

Continuing with the valuation process, we calculated that Nintendo’s stock trades at ~28% premium from its fair value.

Source: Own estimates

We decided not to stop at the DCF model and concluded an additional peer analysis, which confirmed that Nintendo’s stock is overvalued at the moment and trades at ~25% premium from its fair value.

Source: Capital IQ, Own estimates

In the end, we combined both of our analysis and came to a conclusion that Nintendo’s stock trades at ~27% premium from its fair value. The table below shows our target for Nintendo’s stock for each of the tickers:

Source: Own estimates

Conclusion

We don’t believe that Switch is a game changer for Nintendo. Despite strong launch, it’s unlikely that the console will continue to show great performance in the upcoming quarters, as the gaming industry becomes more diversified and there is a strong competition in each sector of the business that will make it harder for Nintendo to succeed. As stated in the beginning of this article, we continue to hold short position in Nintendo, primarily through OTC market via ticker NTDOY, since it’s more liquid than NTDOF, and believe that the company will struggle to assure growth in the long run.

Disclosure: I am/we are short 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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Tagged: , Electronic Equipment, Japan
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