Nintendo short case

Tim Iordanov, December 2016 [email protected]

This document is for informational purposes only and not a recommendation to buy or sell securities

Short - Nintendo

Ticker – TYO:7974

Price – ¥29,400

Shares out – 120.1M

Market Cap – ¥3.6T

Net cash – ¥870.5B

EV – ¥2.73T

Price target – ¥14,000 As of December 12, 2016

Introduction

Nintendo shares have been on a tear this year, owing to the company’s announcement that it intends to

enter the mobile gaming market through a partnership with Japanese mobile developer DENA, and

subsequently due to the runaway success of Pokémon Go, for which Nintendo receives royalty through

its stake in the Pokémon Company. The excitement has recently accelerated with the announcement

that the company is bringing its most prized IP, Mario, to mobile.

On the face of it the argument is convincing and straight forward, Nintendo owns some of the most

successful brands in videogaming, and its characters from Mario to Pokémon to Zelda are well known by

children and adults alike. The only limiting component has been managements conservatism and

reluctance to come face to face with reality and ditch the confines of its proprietary hardware and

embrace the platforms that have been largely responsible for Nintendo’s decline.

I argue that all is not what it seems, and that investors have miscalculated Nintendo’s mobile

opportunity and have mispriced the stock accordingly.

In addition, with the recent reveal of its next console the Switch, Nintendo has doubled down on an

unsuccessful strategy of offering niche functionality for its hardware, and will be struggling against the

current in the coming years due to continued poor decision making and inflexibility in this area. As a

result, Nintendo’s core business is poised to continue declining.

Valuation

Nintendo’s stock price has returned nearly 150% since the beginning of 2015 (before their mobile

announcement) and EV has more than quadrupled. Nintendo’s operations are now valued about 30%

more than EA’s and comparable to that of Activision and the whole of Sony. To put this into perspective,

the most directly comparable division of Sony, games and network services brings in nearly 3x the

revenue and more than 3x the operating profit of Nintendo. While EA and Activision are similar on a

revenue basis, EA is 3x more profitable while ATVI is more than 4x.



$mm EV Sales EBIT EBIT margin EV/Sales EV/EBIT

ATVI 28123 6049 1448 24% 4.6 19.4

EA 19634 4547 1016 22% 4.3 19.3

Ubisoft 3600 1394 169 12% 2.6 21.3

SquareEnix 2210 1950 236 12% 1.1 9.4

Nintendo 25300 4464 290 6% 5.7 87.2

Sony IE* 37378 14059 995 7% 2.7 37.6

*In fact, if we take the corporate EV of Sony, and the revenues and operating profit of just its

PlayStation division (Sony Interactive Entertainment), it would still be cheaper than Nintendo!

Sony is the runaway leader in the console market and owns a collection of studios with prominent IP. In

addition, Sony Interactive Entertainment continues to grow reach and install base, culminating in steady

growth in both top line and operating margin. Guidance for the division is for operating income of ¥166B

on revenue of ¥1850B for FY2017. Compared with Nintendo’s of ¥30B operating income on revenue of

¥470B, with the impact of Pokémon Go fully accounted for in these numbers.

Sony Interactive Entertainment is a good comp for Nintendo, as it sells a mix of hardware, services and

software – all tied to Sony’s video game efforts. Sony owns a collection of game studios around the

world with a very solid collection of IP, such as Naughty Dog – developer of the Uncharted series and

Polyphony Digital, developer of the Gran Turismo series.

Activision Blizzard (ATVI) and Electronic Arts (EA) are both pure software companies, and do not sell

hardware – hence operating margins of 24% and 22% respectively. ATVI owns franchises such as the

long running World of Warcraft series (recently turned into a movie), the cash cow that is Call of Duty,

and it continues to successfully churn out new IP such as Overwatch. ATVI’s mobile efforts center

around King Digital and its Candy Crush series, the most profitable mobile franchise in history.

EA owns the Battlefield franchise, which this holiday season has eclipsed the comparable Call of Duty

game in popularity. In addition to The Sims, Star Wars, Mass Effect to name a few. EA also owns the

who’s who of sports IP, including Madden NFL, FIFA and NBA Live. EA’s mobile efforts focus on bringing

its staple of IP to the platform, as well as developing games that use known 3rd party IP.

So why exactly is Nintendo now valued at or near company’s in the same sector that are 3 to 4 times

more profitable, some with strong mobile businesses, and that for years have been showing stable or

improving fundamentals?



The answer, as with many things in the market, is expectations. When the stock was trading at multiyear

lows in the ¥11,500 range, Nintendo announced a partnership with Dena in March of 2015 whereby the

company would at long last enter the mobile games market. Development of the games would be

mainly handled by Nintendo, and Dena would be “primarily responsible for the service-oriented

operations”.

The stock shot past ¥24,000 in the ensuing months, only to level off when Nintendo took its time

divulging details of its mobile strategy and what specific games are on their way. The euphoria was

reignited with the runaway success of Pokémon Go, tapered by the realization that licensing fees would

be relatively muted, only to surge again after Shigeru Miyamoto took the stage of Apple’s iPhone 7

launch event to announce the release of its first Mario game on iOS. Talk about a rollercoaster!

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Nintendo sales/EBIT, millions yen



Investors took this as a sign that the company was finally taking mobile seriously and readying its heavy

hitters for an all-out assault on the market. Shares closed nearly 30% higher on the day of the Mario

announcement in September. No doubt the market didn’t assign a $9B higher value to the company

purely based on the Mario game, but instead valued Nintendo’s newfound mobile ambitions as a whole.

At first glance this all sounds somewhat reasonable, with the mobile games market valued at nearly

$40B and experiencing healthy growth. However, as we dig a little deeper and scrutinize Nintendo’s

plans, I’m afraid the bullish mobile thesis falls apart.

For the fiscal year ending March 2017, Nintendo plans to have a total of 4 mobile games on the market,

namely Miitomo, Super Mario Run, and mobile version on Animal Crossing and Fire Emblem. Miitomo

was released in March of this year, in Japan first – and was downloaded over a million times in the

country over a period of several days, leading to an 8% surge in the stock upon announcement of the

figures by Nintendo on Twitter. Miitomo faded quickly after attaining number 1 spots in app stores,

mostly due to its limited appeal as a social media app. This certainly wasn’t one of the company’s top

franchises, and we should have a much better indicator of Nintendo’s mobile future with the upcoming

release of Super Mario Run for iOS devices on December 15.

Frankly, the bull argument that the mobile market is x and Nintendo can gain y share at z margins is

somewhat simplistic, we need to delve deeper into the underling strategy and ecosystem to make a call

on the specifics. The market has already priced in the above-mentioned argument and if the future looks

any different, there will be an opportunity to generate alpha.

Mobile Market

Since Nintendo’s mobile ambitions were made clear in 2015, the equity value has increased by more

than the buyout values of King Digital and Supercell combined, the two runaway leaders in mobile

gaming.

King Digital – Acquired by Activison for $5.9B. Primary game is Candy Crush saga and various spinoffs.

Last full year figures right before the acquisition were $2B in revenue with profits of $517M. Leading to

an acquisition revenue multiple of roughly 3x and 11.5x on income.

Supercell – Tencent recently bought majority for a valuation of $10.2B. Maker of Clash of Clans. Last full

year revenues of $2.3B and profits of $964M, for 4.4x and 10.6x.

The market assigns a similar revenue multiple to both mobile and traditional game providers, but mobile

gaming deservedly gets half the income multiple due to the inherently more risky revenue streams

associated with mobile – often driven by one or two major titles.

Nintendo’s market cap has gone up by roughly $19B, but lets just focus on the $16B combined value of

King Digital and Supercell, and assign the other $3B to the Nintendo’s stake in Dena and Niantic. Let’s

work backwards from this number to ascertain what type of expectations the market is pricing in.



If we are to assign a generous 5x revenue multiple that leads us to $3.2B of revenue, at 40% operating

margin giving us $1.3B of operating income at a 12.5x multiple.

$mm Value assigned by market to mobile 16,000

Revenue @ 5x multiple 3200

EBIT @ 40% margin, 12.5x multiple 1280

The counter to these figures would be that this is a long-term revenue approximation and that it will

take years to get there. I will grant that, so let’s assume $1B of high growth revenue per year in the next

few years and ignore the sky-high multiple this would imply since it will be growing rapidly and with a

high ceiling.

$mm Value assigned by market to mobile 16,000

Revenue @ 16x multiple 1000

EBIT @ 40% margin, 40x multiple 400

The problem is that I see no real way Nintendo approaches $1B in mobile revenue with any real

visibility. In fact, Nintendo will have an uphill climb attaining even $500M/year in revenue from mobile

in the next few years, concluding that the priced-in expectations are overly optimistic indeed. This

combined with their declining core business (more on that later), leads the stock to be significantly

overvalued.

What is the main misconception behind the market’s misunderstanding of the story?

It is the belief that Nintendo has brand equity across the large majority of mobile game players for most

its IP. This is where I fundamentally disagree, the company’s immediate addressable market for the vast

majority of its’ IP – is the Nintendo fan base, past and present; with fairly limited cross over to most of

the ~1.5 billion people who play games on their smartphones. This is the key point. Not to say that

Nintendo can’t make a great game that will stand on its own merits with casual players, but for most of

the mobile gaming addressable market, their IP will not be the main selling point. Pokémon Go was a

mega hit due to the brands perfect fit for Niantic’s novel augmented reality technology. The Pokémon

brand provided the initial boost, and then it caught on with casual gamers because the game was a

fundamentally new and interesting concept, marrying the real and digital world. Pokémon Go was one

of those rare events formed from a perfect coalescence of factors and that is rarely repeated. However,

Nintendo is now priced as if Pokémon Go will be the norm rather than the exception.

The mobile game maker Kabam has partnerships with some of the most recognizable names in

entertainment, including Universal's Fast & Furious, Warner Bros.' The Hobbit, Lionsgate's Hunger

Games, and Disney's Marvel superheroes and Star Wars. These franchises are at least as familiar to the

casual mobile gamer as Mario, and probably more so.

Kabam’s most successful game to date, Marvel: Contest of Champions is a fighting game featuring

marvel superheroes that has taken off in China. The game has done over $300M in revenue over 18

months since its launch in 2015. Marvel movies come out on a yearly basis and everyone knows their



superheroes. Let me ask you this: If the most prolific franchises in entertainment, backed up by good

underlying games, were not able to make a dent in the leadership of Clash of Clans or Candy Crush, what

is the probability that Mario and Zelda are just going to overtake them all? Because that’s what the

market is pricing in.

Kabam is doing about $400M in annual revenues on a company wide basis, with all of those IP

partnerships. Remember when everyone was playing Angry Birds? Rovio, the maker of Angry Birds

earned $216M in revenue at its height in 2013. With 30% of that coming from licensed merchandise

sales.

Similar to the upcoming Mario Run, Sega released an autorunner based on its very popular and nostalgic

Sonic Series, it attained 100 million downloads in under 3 years, as a free to play title. Now Sonic is

certainly not Mario, but is Mario that much more popular? Or is the sheer force of marketing from Apple

and Nintendo going to entice people to pay more times for Mario than what Sonic did in total

downloads as a free app?

So what kind of numbers can Mario Run actually do?

Mario Run is a type of game known as an autorunner, where the main character automatically runs

forward and the player just needs to tap the screen to make him jump over obstacles. The most

successful auto runner to date is Temple Run, which managed 1 billion downloads over 3 years across

multiple versions, including a partnership with Disney for its Brave IP. The game is free to play.

If we think Mario can do 600 million downloads in a year (higher than Temple run in any one year), with

a 5% user pay rate (more than double the average). We can get Mario Run to bring in $300M in gross

revenue at the $10 price Nintendo plans to charge. Take off the 30% fee to Apple and Google to host the

game on their platforms and we have $210M in net revenue from Mario Run, in the most optimistic

case.

These numbers highly optimistic for a reason. All successful auto runner games have been free to play.

Nintendo is charging a premium price for a mobile game and the game itself is a fundamentally different

and more limited concept. It is a level based auto runner, rather than an infinite runner that one can

play ad nauseum such as Temple Run or Sonic. When you pass all of the Mario levels – there will be a

limited appeal to return. This is the more traditional game model that Nintendo is used to but that

doesn’t parallel the addictive high replay value type games that have been successful in the genre. And

certainly not comparable to games such as Clash of Clans, Candy Crush, Game of War, Mobile strike and

virtually all the top grossing games which by design offer continuous and unlimited replayability, often

married to a free to play but pay to win model that keeps the revenue flowing. The Mario IP is simply

not well suited to this lucrative revenue model.

Which of Nintendo’s properties can reliably generate the type of figures responsible for King Digital’s

and Supercell’s top line? How can Nintendo create a game with its existing IP that caters to the reality of

todays mobile marketplace, where half of mobile game revenues are generated from only .19% of the

players, the so called “whales”. People who spend hundreds of dollars on in game purchases. The

answers to these questions are complex, and the market seems to be giving Nintendo way more credit

than it deserves. Where is all of this confidence coming from? Sure, Nintendo has great IP, but IP



licensing and partnerships are a staple of mobile gaming, characters from movies, videogames and

books grace the small screen, many comparable to and surpassing Nintendo’s best in popularity.

In addition to Mario Run, Animal Crossing and Fire emblem are coming out next year. These are niche

names that the vast majority of people who play games on their phone have never heard of. The only

rational way to price these two properties is to use Miitomo as the parallel, until proven otherwise.

Miitomo is now nowhere to be found on the app charts. Animal Crossing is like Miitomo in the sense

that it’s a “community game”. Fire Emblem is a role playing franchise, and there is no indication yet as to

how Nintendo plans to adopt it for mobile.

One obvious possibility is for Nintendo to release a version of Mario Cart for mobile. The maker of the

most successful mobile racing series is Gameloft with its Asphalt series. EA is in 2nd spot with its Need for

Speed series. Gameloft does about $250M across all its franchises while releasing between 10 and 20

games per year.

Let’s say Nintendo does $200M for Mario Cart properties, $400M for action/runners, $250M for

something like a Zelda RPG or Firefox game and throw $150 on top for that for misc games like Fire

emblem.

These numbers are all extremely unrealistic and represent significantly higher download and pay rates

than the most successful games in their respective genres. The only way you can possibly square the

valuation is to essentially hope that Nintendo innovates in some unknown way. The majority of

Nintendo’s market cap at present is just that – hope.

I cannot think of a single plausible scenario that gets Nintendo to $1B in mobile revenue in the medium

term. And for the near term, they are poised to do significantly less than $500M. And yet the market

(assuming reasonable multiples) is pricing in near $3B! This over-valuation is the most irrational thing I

have seen in a while.

They can theoretically release another Pokémon game where they are entitled to a much larger share of

revenues and profits, possibly jointly developed by Game Freak and Dena. But I assume at least for the

next few years – Niantic will try to keep improving Pokémon Go. How many Pokémon games can the

market handle at the same time? Will the market eventually accept a more traditional Pokémon game

on mobile, a concept currently associated with the Nintendo DS handheld line, such as Pokémon Sun

and Moon? That possibility is some ways away and it remains to be seen if the traditional Pokémon

game concept on mobile can gain traction outside of the 16M or so gamers that can be counted on

buying each Pokémon installment. Nintendo will also need to accept a lower price for such a mobile

Pokémon game than the $40 it currently charges for the 3DS versions.

Activision Blizzard has solid properties too, but they had to fork out $6B for King Digital to enter mobile,

while King and Supercell, Machine Zone, and many of the other successful mobile developers didn’t

have prior well known IP. EA has great IP and a solid mobile business ($500M revenue at 35-40% EBITDA

margins) they’ve been at it for a while and release many games per year. Gameloft, for example –

releases about 20 games per year. Nintendo won’t be releasing 20 mobile games per year any time

soon, if ever. The mobile market is complex and success is determined by many different factors, but

mostly by the game itself.



Nintendo has proven it can design good games for consoles, but mobile is a different animal and what

worked in one environment is not automatically going to work in another. In a recent interview, Shigeru

Miyamoto bragged that the Mario Run team did not look at any other mobile runner games for

inspiration. This is not a good thing, and Nintendo may get caught up in its own hubris when it realizes

that traditional concepts aren’t a sure bet on mobile. Shockingly, it was announced that Mario Run will

need a constant internet connection to be playable. How are casual players supposed to switch from

Candy Crush to Mario Run when they won’t even be able to play the game on their commute to work?

Nintendo gives the impression that they expect to be entitled to success in mobile simply because of

their IP, which runs contrary to the history of the mobile gaming market thus far.

The problem of the core business:

Nintendo’s core business has been pressured both from mobile games and poor strategy in their home

entertainment business.

Until now, the company’s games have been exclusively released on their own hardware, which means

that as hardware sales decline, software sales follow suit. Nintendo’s handheld consoles, namely the DS

and 3DS line, have been steadily declining due to mobile gaming, which is what has precipitated the

need to develop games for Android and iOS platforms. While the company’s most recent effort at a

home console, the Wii U, has been a major disappointment in terms of sales. Since it did not offer the

novel functionality of the previously successful Wii, but remained underpowered relative to competitors

from Sony and Microsoft and therefore lacked any 3rd party developer support.

Source: Nintendo



The Wii U did 13M in sales vs the Wii at over 100M units, while software sales for the Wii U were a tenth

of the Wii’s numbers. The 3DS has done less than half the sales of the DS, with less than a third of the

software sales.

Source: Statista

As you can see, most of Nintendo’s revenue is tied to their proprietary hardware platforms, including

the “other” category which includes Amiibo figures and cards that can interact with games on

Nintendo’s consoles through and NFC (Near Field Communication) interface. The company’s hardware

strategy therefore remains the most critical factor in the success of the firm.

When Nintendo shares were trading at all time highs around ¥67,000 in 2007, its Wii platform was

setting the world on fire and handily beating out PlayStation and Xbox competitors due to its emphasis

on motion controls and novel way to enjoy video games for the casual demographic. High margin

software sales followed and things looked great until the Wii proved to be a fad with limited staying

power.

Enter the Nintendo Switch

Releasing in March of 2017, The Nintendo Switch will be the company’s attempt at an answer to what

ails its hardware division. It will be a portable gaming tablet like device and will come with the ability to

dock to a stand and become a traditional home console.

The Switch will have very little chance of changing Nintendo’s dismal trajectory in hardware, and by

extension will not turn around their core business. They are targeting a niche market that straddles two

different segments, without really appealing to either. The switch has a 6.2-inch screen and will be less

portable than the DS line, with less battery life. It will be significantly less powerful than competing

home consoles, thus limiting user experience and once again stifling potential 3rd party support. In

addition, it won’t be backwards compatible with either DS or Wii games.



Both the Wii and Wii U were backwards compatible with previous versions of Nintendo’s home

consoles, meaning that they could play a player’s old library of games. The same goes for the DS and 3DS

line, where backwards compatibility was always built in to newer hardware. The switch does away with

this history and isn’t compatible with either DS/3DS or Wii/Wii U games.

This is quite the oversight, and is especially important when it comes to DS games. Gamers might have

their old Wii lying around their house if they want to play older titles, but how are they supposed to play

their old library of DS games without having to carry around a second device? Especially considering the

Switches mediocre launch line up.

Nintendo’s whole philosophy behind the Switch is somewhat perplexing. The main factor behind the Wii

U’s disappointing sales was the total lack of 3rd party support from the major studios. The hardware was

underpowered and unsuitable to the big budget games from the likes of Activision, EA, Ubisoft and

others. Nintendo refuses to address this major downside. The Switch will use a powerful mobile Nvidia

CPU/GPU, but it will still be about half as powerful as the chips in the Xbox and PlayStation. In addition

to using totally different architectures (ARM vs x86) and with half the memory (4GB), making porting

games even more challenging than it already would have been. It was easier to port games from Xbox

360 and PlayStation 3 to the Wii U, and that console got just a few major ports. Moving games from

Xbox One/PS4 to the Switch will be too challenging to bother with, thus there is every reason to expect

3rd party support to be as weak or weaker than what happened with the Wii U. This is unfortunate, as

the main selling points for todays home consoles are major 3rd party games such as Call of Duty,

Battlefield, and Mass Effect. In fact, the PlayStation 4 was able to take a commanding lead in this

generation’s hardware cycle simply because it was marginally more powerful and able to offer a

marginally better 3rd party game experience, with better framerates and higher resolution than the

competing Xbox One.

Why would EA bother with a Nintendo system if their sales on the platforms look like this:

The mobility aspect of the Switch will not be a selling point for most consumers. The type of games that

are played on home consoles and on mobile are totally different and do not intersect. Home consoles

offer big budget highly immersive experiences with high resolution graphics designed to be played on a

big screen.



Is it possible that the Switch gains traction like the original Wii? Simply put, no. It has no such “killer

feature” to warrant such optimism. The Switch will likely outdo the Wii U in lifetime sales, but that will

be because it’s targeting both Nintendo’s home and handheld businesses (although it is officially

marketed as a home console first and foremost). Leading to aggregate hardware sales continuing to

decline in the coming years, with software sales following. The Switch can’t even be used as a Blu ray

player, one of the most basic use cases of home consoles.

Pricing is rumoured at around $250. A level that both competing consoles have hit this holiday season.

Who except Nintendo’s hardcore fans are going to buy a niche system with a limited number launch

games and no real 3rd party support and forego much more powerful and versatile (more storage for

media, ability to DVD/Blu Ray playback) systems with a much deeper catalogue of games.

So, Nintendo’s attempt at console relevance centers around a system that will:

Likely have very little 3rd party support

Exist somewhere between a home and handheld consoles, while excelling at neither.

Not be backwards compatible with either of Nintendo’s current systems.

Nintendo might have some good 1st party games in store for the Switch, such as Zelda and Mario – but

those were not enough to save the Wii U, so why would this time be any different?

Summary

For the current fiscal year ending March 2017, Nintendo projects operating income of ¥30B, down from

an earlier projection of ¥45B made 6 months prior. This downgraded forecast for the current fiscal year

was made despite the Pokémon Go phenomenon contributing to the bottom line in the form of income

in equity affiliates (through Nintendo’s 31% stake in the Pokémon Company). Pokémon Go had the best

start of any mobile game in history from a downloads and revenue standpoint, and in 3 months on the

market, contributed ¥12B or ~$115M to Nintendo’s operating income (not all of that was from Pokémon

GO, but safe to say the majority was). That is a third of current full year guidance straight to the bottom

line, even though Pokémon Go had been out for only 3 months at the time of Nintendo’s September

2016 earnings.

Pokémon Go will be out for a total of 9 months when Nintendo’s current fiscal year ends. And yet, they

lowered operating income guidance for the full year! They issued a statement at the height of the

Pokémon Go craze that stated something along the lines of “Pokémon Go is already in our projections”.

This can only mean one thing, Nintendo would have missed their own guidance by a country mile if not

for being saved by a lighting bolt out of the blue in the form of Niantic. If it takes the most popular

mobile game in history to somewhat save Nintendo’s year, their business is in pretty rough shape.

So, what is the market expecting with the recent run up in stock price? Several more (wholly owned)

Pokémon Go’s? We’ve just examined how unlikely that is. A resurgence of the core business? Just as

unlikely. There is nothing left to do but position for the hype to dissipate.

Risks

Nintendo’s mobile efforts could bear substantial fruit. Nintendo’s core business may see an uplift from

the release of the Switch, over and above what I predict. The company may enter other business

lines/partnerships that may improve financial fundamentals.



Update 12/16/16

Sensor Tower, a mobile analytics company predicted that Mario Run will gross $71M in revenue in its

first month, becoming the 3rd highest grossing game after 30 days trailing only Pokemon Go ($143M)

and Clash Royale ($107M). Despite being an iOS exclusive release. It’s usually best to avoid calls on

specifics when it comes to these things, especially when the thesis itself isn’t really predicated on one

data point. That being said, I can’t help myself and will call this $71M gross figure highly unrealistic. This

would mean that they reach roughly Pokemon Go’s download rate in the first 30 days (100M) and

convert to paying users at an extremely high 7% to get to $71M. I think Mario will garner a lot of

downloads, but my issue is with the conversion rate being so high. The industry has gone free to play for

a reason, expecting such a high pay rate for a game that has a higher price tag than 99% of the games in

the app store is questionable.

Jefferies thinks that $71M in the first month is conservative:

"We believe SMR revenues would exceed market expectations (of c. $70m in first month) potentially by

100%. Additional drivers are – incremental upside from Switch; weaker ¥, Nintendo’s willingness to

bring IP treasure to mobile." They say $500 million in revenue by Q3 2017 from just Super Mario

Run... That's insanely optimistic

And then you have this: https://www.bloomberg.com/news/articles/2016-12-16/super-mario-run-

debuts-at-no-1-as-nintendo-embraces-smartphones

Not sure if he actually meant to say $7B of revenue to Nintendo? Either way my jaw dropped

Update 12/19/16

The website digital foundry has updated the rumoured technical specs of the upcoming Nintendo Switch

console:

https://www.youtube.com/watch?v=PzS4LbH5nmA

Essentially we are looking at a system that should be marginally more powerful than the Wii U in

handheld (undocked mode) and over twice that when docked to the TV. This means we are likely to see

Wii U like games in handheld 720p resolution, which then can be upscaled to 1080p or close when in

docked mode.

While not confirmed, theses specs or anything close to them, ensure a near total lack of support from

3rd party studios. Meaning that the Switch will be relegated to a niche market like the Wii U was.

I expect a good portion of launch titles to be ports from the Wii U. Which begs the question of who

exactly will be lining up for this system. If most of the launch games, and even the upcoming hit Zelda:

Breath of the Wild, will be available on Nintendo’s last generation device, this disincentivises Nintendo

fans from purchasing the new system, since they most likely already own those games. I don’t see how

gamers would be willing pay up for a new console and then have to repurchase the same games they

already own just for a modest graphics bump. Everyone else who isn’t a die hard Nintendo fan will have

as much reason to purchase the Switch as they had with the Wii U, which sold very poorly.

https://www.bloomberg.com/news/articles/2016-12-16/super-mario-run-debuts-at-no-1-as-nintendo-embraces-smartphones

https://www.bloomberg.com/news/articles/2016-12-16/super-mario-run-debuts-at-no-1-as-nintendo-embraces-smartphones

https://www.youtube.com/watch?v=PzS4LbH5nmA



As for the portability aspect – the Switch will be a good deal less portable than the Nintendo 3DS system

that, for the time being, will continue to be sold. The Switch won’t be a true mobile device as a phone or

the 3DS is, since it generally won’t fit into pockets. You’d need to carry around a bag to bring your

Switch with you. It’s closer in size to a standard tablet.

It’s very difficult to envision a scenario where Nintendo’s next console gains real traction with

consumers.

Mario Run Update:

SensorTower is sticking with it’s projections of $71M of revenue in the first month of release:

https://sensortower.com/blog/super-mario-run-first-day

I still think those numbers are overly optimistic, as Mario Run will probably have an unusually strong

download start due to the unprecedented prominence of the launch, including being feature at an Apple

event, placements on the App Store prior to release, sign up lists, etc… Apple went all out with the

promotion to seal the exclusivity deal for Mario Run with Nintendo, so expect downloads to be skewed

to the launch date more so than many other hit games, which gain in popularity over a longer time

horizon.

Other research firms have started to downgrade revenue expectations for Super Mario Run:

http://www.gamespot.com/articles/super-mario-run-earnings-projections-downgraded-si/1100-

6446280/

I think these types of expectation adjustments are what’s driving the stock lower. As per my article, the

value ascribed to Nintendo’s mobile ambitions is astronomical. Even if Mario Run is very successful,

which it will be by any sane measure – its just very difficult to see how the numbers square with the

valuation.

Update 12/19/16

Nintendo held an event on January 13th to discuss the details of their upcoming console, the Switch. The

stock decline 6% on the day of announcement and a further 2% on Monday. The market seemed to be

disappointed primarily with two things: the higher than expected price ($299) and slim pickings when it

comes to the games launching for the system.

Surprisingly, the $299 price point does not include a bundled game, making the Switch more expensive

than both competing consoles - which can be found for around the $250 mark with a bundled game. So

to buy the Switch on launch day with a game you’re looking at a ~$360 outlay which is out of impulse

purchase territory.

The launch lineup is only 5 games, most of which are ports of previously available titles, or generic tech

demos for the console’s functionality that are definitely not system sellers. The launch lineup of 5 games

compares poorly to the Wii U’s launch lineup of 32 games, some of which included 3rd party triple A

titles such as Mass Effect and the Batman Arkham franchise.

http://www.gamespot.com/articles/super-mario-run-earnings-projections-downgraded-si/1100-6446280/

http://www.gamespot.com/articles/super-mario-run-earnings-projections-downgraded-si/1100-6446280/



The one bright spot for Nintendo as far as launch games are concerned is that the new Legend of Zelda

game will indeed be available to buy for the Switch on day one. This is one of Nintendo’s core franchises

and may draw players to the system. I say may, because the Legend of Zelda will also be available for the

Wii U on the same day. The game itself will be identical on both systems except for a higher resolution

rendering on the new Switch console. Since a portion of Nintendo’s fan base already owns the Wii U, I

see many opting to buy the game for the older console instead of shelling out the $360 needed to buy

the game and the Switch console.

There will be a trickle of Nintendo and third party titles through 2017, but many of these will simply be

enhanced ports of Wii U games. Mario Cart Delux and Splatoon 2 are two examples. Most of Nintendo’s

fan base already owns these games for their Wii U – so they are less likely to pay the full $60 retail price

for slightly enhanced versions of games they already own, in addition to the aforementioned $300 dollar

price point of the system. The bullish argument here is that since the Switch doubles as a portable

console, the core fan base will be willing to buy the new system and enhanced versions of the games in

order to be able to play these games on the go. This is plausible and will certainly drive a portion of

Switch sales – But to a much more limited degree than some expect, for reasons explained below.

I talk about Nintendo’s core fan base for a reason, since I firmly believe now more than ever, that the

Switch will only appeal to them and is dead on arrival when it comes to the much larger console market.

I’ve spent the past couple of days scouring forums and reading/watching reactions to the Switch reveal

among core console gamers and the consensus is a very clear negative. It’s overpriced, underpowered

and will lack major 3rdparty developer support.

The question is therefore how many Nintendo fans will buy the system in the first few months of

availability, and the answer doesn’t look very positive for Nintendo. I’ve seen many reactions from the

Nintendo fan base that advocate for a wait and see approach, i.e. seeking a price drop or a game bundle,

and more games to be released. The first year of a new console is very important, as that is when

reputation is built up with potential customers and just as importantly, with potential 3rd party

developers who want to gauge a systems’ install base before committing time and money to develop

games for it.

I’ve read sell side estimates of the Switch selling 10m units in its first year, where the Wii U sold ~5m. I

think these estimates will need to come down by a few million. The bulls may argue that since the

Switch is a hybrid home/handheld console, and the Nintendo’s handheld business is relatively healthier

than its’ home consoles business – then the Switch will sell a lot more than the Wii U. My come back to

this argument is that when the current generation Nintendo handheld system launched for $250 five

years ago – it didn’t sell. Nintendo had to cut its’ price by more than 30% to $170 for sales to get going.

And the 3DS was able to play a gamers old library of Nintendo DS games. The Switch has no backwards

compatibility and therefore will not be able to play DS or 3DS games. There is very little chance that the

young audience that typically buys Nintendo handhelds will line up for the much more expensive Switch,

with more expensive games, and a very slim picking of those games to play.

Current Xbox or PlayStation owners will not buy the Switch either, for reasons mentioned earlier. This

leaves Nintendo with an ever shrinking pie of potential customers for their new console. I believe the

Switch will outsell the Wii U, but not markedly so, and any sales above and beyond that of the Wii U will

more than likely cannibalize 3DS sales. We are thus likely to see Nintendo’s hardware and associated

software revenues continue their downward trajectory in the coming years.



Answers to a few questions I’ve received

Q - I thought this was a fascinating note but a little bit difficult to understand. So a few questions:

1) Can you split out where Nintendo earns revenues from (hardware, games, etc...) and explain the

differences in the segments? Can you also explain how Nintendo earns revenues - ie. from Pokemon?

2) Can you compare how EA and Activision earn revenues (segments) and explain the differences in

segments.

3) Is there a difference to the Balance Sheets? ACTI I think is heavily levered post the M&A wheras I don't

think EA is and I have no clue about Nintendo?

4) What are the biggest expenses at Nintendo? Making the games? making the software? how have the

expenses tracked over the years?

5) If you're short Nintendo who would you be long - or would you be short the entire sector?

A – 1) Here is Nintendo's FY16 Revenue composition:

Handheld Hardware - 22%

Home console Hardware - 20%

Handheld software - 22%

Home console software - 18%

Other - 17%

Total revenue of 504,457m Yen

Nintendo earns revenues primarily from its hardware systems and game sales. Handheld hardware

includes the various versions of the company's 3DS systems. Handheld software includes games sold for

the 3DS systems, and fees from 3rd part publishers that sell games for the 3DS systems. Home hardware

is primarily the company's Wii U home console. Home software consists of Nintendo's and 3rd party

games sold for the Wii U system. Other revenue comes from products such as Amibo figures – these are

similar to action figures you find at toy stores, but they have the ability to interact with Nintendo

console hardware and give the player in game benefits when an Amiibo is detected. Nintendo also earns

various licensing fees also lumped into the other category, such as from the recently announced deal

with Universal’s theme park in Japan, in addition to licensing fees from sales of merchandise using

Nintendo’s IP. Nintendo has until recently only released its in house developed games on its own

hardware. This has led to Software sales following hardware sales on a downward trajectory, since the

addressable market (people who own Nintendo systems) has been declining. Part of the bull thesis for

Nintendo going mobile is that it increases the addressable market for Nintendo’s still very strong IP and

games by leaps and bounds, since they will no longer be tied to Nintendo’s increasingly out of favor

hardware devices. Pokémon is a tricky case, since the brand is technically not wholly owned by

Nintendo, and Nintendo has been the publisher but not the developer of the hit Pokémon games on the

Gameboy/DS/3DS handheld systems. The Pokémon Company owns the rights to the franchise, and is

jointly owned by Nintendo, Creatures Inc, and Game Freak. Game Freak is the developer behind all

Pokémon games on Nintendo systems. There is probably cross ownership of some sort here as well.

Although the whole thing is somewhat convoluted and Nintendo does not disclose the specifics of the



revenue/profit split for the Pokémon franchise except for the fact that it owns 31% of the Pokémon

Company, which is accounted for using the equity method and therefore bypasses revenue and goes

straight to the bottom line. Maybe someone more knowledgeable on the subject can provide some

more insight, but the confusion in Pokémon’s ownership was on display earlier in the year during

Pokémon Go’s release. Nintendo provides little clarity on the matter.

2) EA and Activision are direct competitors. They develop and publish games, and do not sell any

proprietary hardware. Their games are played on home consoles, PC and smartphone/tablet. Both EA

and Activision are known as 3rd party publishers, which means they sell games but do not own the

underlying hardware that the games are played on. Nintendo would be classified as a 1st party publisher

when it releases a Mario game on it’s Wii U game system, for example – since it owns the hardware and

publishes the game. Industry revenue is categorized in a few different ways, depending on what one

wants to emphasize. EA has two revenue segments, traditional (in store physical discs) and through its

growing digital distribution channel. The digital distribution channel has higher gross margins and is

growing faster than the traditional channel. Out of $4.4B revenue in EA’s last full fiscal year, $2.41B was

digital. $548M of that $2.41B digital revenue was tied to EA’s mobile game efforts. I understand that all

mobile revenue is earned through digital channels. Activision differentiates revenue in a couple of ways,

reportable segments derive from previously acquired entities Blizzard and King, as well Activision. Both

Blizzard and Activision segments overlap in that they serve PC and home console markets, while King

represents ATVI’s mobile offering. On a TTM basis the Activision segment is 43% of revenues, Blizzard is

38% and King is 19%. Like EA, Activision also breaks down sales in terms of distribution channels, with

Digital distribution representing 69% of sales, boosted by the King acquisition where $2B in annual

revenues are all earned digitally. Nintendo doesn’t break down digital and traditional channel sales. I

understand that they have been lagging in building out a digital distribution platform.

3) You’re right that ATVI has taken on some debt for the King Digital acquisition, $2.3B to be exact. The

rest was funded with offshore cash (King is based in Sweden). ATVI’s net debt is $2.37B (6.44-4.07 cash).

Roughly 1x unlevered FCF. Definitely not heavily levered though. EA has a $1.3B net cash position. While

Nintendo is flush with cash, ¥870B (~$7.6B), no debt.

4) In terms of expenses, their cost of sales have come down markedly as they sell less hardware, since

most of cost of sales is related to the lower margin hardware side of the business. In the past couple of

years, gross margins have actually gone up due to the improving mix between software/hardware sales.

Software sales tend to peak around mid/end of a hardware cycle, since the games can go after a larger

install base of hardware (which incidentally presents another issue as Nintendo transitions to new

hardware in 2017) SG&A has remained flattish relative to cost of sales over the past decade, since they

still need to do R&D, market and release games on a regular basis. The cost to develop these games

would mostly be contained in the R&D and general expenses. It’s easy to see why people want Nintendo

to completely ditch hardware, but those high margin software sales are at the moment tied up to the

low margin hardware business, and even going completely 3rd party is going to require a very real

adjustment from the company. It’s easy to sell their games on Nintendo systems since there is little 3rd

party competition on Nintendo’s own systems. Going 3rd party will be like stepping into a shark tank

with the likes of ATVI, EA, UBiSoft, Sony, THQ, Square Enix, Capcom etc… Far from an easy task.

5) My call is based on challenges specific to Nintendo, but the industry as a whole is actually very

healthy. This home console cycle has been significantly stronger than the previous one, with the install



base of the Xbox one and Playstation 4 at over 80M units only 3 years in. This is reflected in the

performance of ATVI and EA stock prices, for example. Mobile gaming is growing at a healthy clip as

well. ATVI has had a bit of a dip lately with the latest Call of Duty underperforming vs past installments.

Really don’t have a long pick as I would need some specific insights vs the market, which I don’t believe I

have at the moment.

Q - In terms of hardware do you know market share vs Xbox and Playstation? And I assume at this point

they kind of compete for different customer segments, correct?

A - Regarding market share, the Wii U has sold about 13M units, the Playstation 4 is probably over 55M

and Xbox is somewhere in the mid 30M range. So call it about 13% for Nintendo, mid-high 50's for Sony

and low 30's for Microsoft. The Wii U has been out for a year longer than both those consoles, so sales

trajectories have actually been worse than those numbers indicate. In terms of the handheld console

market - Sony recently exited and ceased producing their handheld Playstation Vita, leaving Nintendo as

the only game in town with their 3DS systems. But the handheld market has been pressured by the rise

of smartphones, so that part of Nintendo's hardware business is also in decline. I'm not really sure what

customer segments Nintendo is targeting with their current consoles. People say they target the

"casual" demographic. I really don't know what that means tbh and think the reality of the matter is that

Nintendo at this point is targeting their "core" fan base, or people who really like Nintendo games like

Mario and Zelda. This core fan base usually has one of the other competing consoles in order to play the

popular 3rd party games, meaning Nintendo often gets relegated to 2nd console status even among its

core base.

Q - What do you think the catalyst could be for the market to realize the Nintendo story is full of air? Bad

quarter? Little success of the Switch?

A - I think it will be a combination of factors, ultimately culminating in the financial results. First on the

list would be the deflation of the premium attached to their mobile efforts, as the market realizes that

gaining traction in the space is going to be a lot more difficult than it first appeared. I think we're seeing

that already Then it will be sales of the Switch - although I would expect it to sell well in the beginning to

the hardcore Nintendo fan base, a clearer picture of sales should emerge in 2H17.

Q - How do you handicap the risk that they announce a new Zelda/Donkey Kong/Mario Kart/etc. game

and the stock pops 10%+?

A – That type of single day move is certainly possible, but less likely given recent context. I don't think

the market will be surprised by them announcing more of their top IP coming to mobile (I assume you

meant announce those titles for mobile). Management has already indicated that they are focusing on

mobile gaming and want that to be a 3rd revenue stream, releasing 2-3 games per year. The sort of

excitement that we saw when Mario Run was announced (25%+) is out of the question, in my opinion. A

move of ~10% is possible, but that comes with the territory and no real way of avoiding that risk. With

proper position sizing it shouldn't be an issue.

Date post:	13-Apr-2017
Category:	Data & Analytics
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Nintendo short case

Data & Analytics