Nintendo Update: Uncertainty Creates Opportunity
Update on Nintendo, which I've owned for ~1 year. This post will look at the "Switch 2", console cycle, and changes in the gaming business which, together, create a great risk-adjusted bet.
I’ve owned Nintendo since early 2022; I’m up slightly since my purchase (I own the $NTDOY ADR). The stock trades ~12x NTM EV/Ebitda, with a market cap ~$55bln and an EV of ~$40bln. This is still a great risk-adjusted bet imo; I think we see earnings growth as the next gen console hits the market and Nintendo gets back to a normal cadence of software releases. They are also successfully monetizing their IP outside of gaming via movies & theme parks (additional high margin income streams). Link to original post.
This is a widely followed and popular stock on fintwit - Ryan O’Connor has an amazing deep dive as part of his 2021 investor letter and a couple of great podcasts with Bill Brewster and Andrew Walker. I’m going to focus on the console cycle for this update; simply put, if you can get comfortable with the console cycle risk for the “Switch 2”, the rest of the investment case makes itself. Historical revenue and operating profit are below.
The Bear Case
The key risk bears point to is the legacy console cycle; historically, every 5-10 years Nintendo releases a new console, their userbase resets, and they have to earn back every user with a quality console and hit games. It’s true Nintendo has a cult like following and some will buy regardless, but widespread popularity is required to sell >100mm consoles. The Switch has been a huge success, with ~117mm active users as of September 2023 (Switch was released in 2017), but the bears say there’s no guarantee the next console will be a Switch. It might be a Wii U...
The Wii U, released in 2012, sold ~14mm units and was a was an objective failure. It was poorly marketed, confused potential buyers, lacked any real 3rd party support, and got blown away by the PS4 and Xbox One.
I consider a Wii U scenario, where Nintendo earns basically nothing for 5 years, a very unlikely outcome (I’d go as far as saying 0% chance). There are a few reasons I feel confident in this prediction:
There’s hard evidence that the console cycle has changed.
Nintendo management has been clear the next console will build on current userbase.
Even if you don’t buy the backwards compatibility argument, the gaming industry has structurally changed over the last decade and is a better business. Some key changes: recurring online subscription revenue, digital sales, add-on content/increased monetization, and software-based game development.
I’m coming at this update post from 2 angles. If I can’t show that Nintendo will release a backwards compatible console that builds on the Switch userbase, I’m hoping I can prove that a Wii U scenario is impossible due to changes in the industry – even if we assume Nintendo releases a bad console that isn’t backwards compatible and markets it poorly, it still won’t result in Wii U style financial performance (the proxy being used by the market).
Let’s start with the console cycle.
Console Cycle
Above is Sony’s historical sales and operating income for their Game & Network Services Segment. The highlight is they earned record operating profit in the year they released the PS5 (2020). Historically, a console transition year resulted in a loss… So, what changed?
First, they offered backwards compatibility combined with a simple way to transfer your online profile over from your legacy console. Plug in your PS5, login to your PlayStation profile, and everything from your old console is waiting for you (think getting a new iPhone). This convenience, along with the ability to transfer games and saved data, dramatically increases switching costs and creates a smooth transition. Do you really want to lose all your legacy data and game library to switch to the Xbox?
The other key changes relate to more consistent and efficient monetization, as well as simplified game development (create smoother earnings throughout the cycle). We’ll dig into those a bit later, but let’s stick to backwards compatibility and the console transition for now.
Nintendo Transition
The bears would rightly push back on the previous section by saying something like, “this is only relevant if you assume Nintendo releases a console with backwards compatibility!” The bear case for Nintendo is they might not do this… Fair enough, let’s look at what has Nintendo management has said about the upcoming console transition?
“There are currently nearly 100 million annual playing users, and going forward, it is important to consider how we can maintain and expand on that number. This will also be essential when we consider our plan for the next hardware platform”
Looking back on past experiences of generational change such as the change from the Wii and Nintendo DS eras, we recognize that one of our tasks is ensuring the transition to future generations of hardware is as smooth as possible. To that end, we are focusing on building long-term relationships with our consumers (through Nintendo Accounts). While continuing to release new Nintendo Switch software for consumers to enjoy, we aim to maintain relationships across hardware generations through services that utilize Nintendo Accounts and by providing opportunities for them to experience our IP through other non-gaming channels.
November 2022 – Miyamoto quote:
"Previously, software development for dedicated video game systems was conducted in development environments dedicated to each hardware platform. This meant that those environments could not be brought forward when the hardware changed, and it would become impossible to play software released for previous hardware without making changes… However, the software development environments have recently been gradually integrated. So, generally speaking, it has become easier to implement an environment where software released for past hardware can be played on new hardware."
November 2023 Financial results briefing slide:
I think it’s pretty clear from management’s comments that the new console will take advantage of the Switch userbase and leverage Nintendo Accounts to transfer data across console generations. They’ve done everything except outright say it.
There is some recent reporting that the “Switch 2” will have two versions, one with backwards compatibility and one without. The article goes on to point out, however, as I have above, that management has made it clear they understand keeping the userbase is key. Additionally, Nick Shpeshal, who reported the rumor, caveats that his source only knew this was a potential plan and wasn’t sure if Nintendo followed through (i.e., the source is not currently close to Nintendo). I don’t put much weight behind this rumor/reporting…
I could see a scenario where Nintendo has two consoles at launch, with a digital only version (no cartridge slot, similar to PlayStation and Xbox); this would help continue the transition to digital, without shutting out players with physical Switch libraries. However, it makes very little sense to have one console with digital backwards compatibility, and one without. If Nintendo has done the work for digital backwards compatibility, it makes no sense to then limit it to one console type (no significant additional cost to have on 2 console types vs 1). This would also be in direct conflict with 3 years of management communication...
Gaming Industry Changes
Let’s say you just can’t get there on the backwards compatibility argument until it’s officially announced, what if I told you gaming is just a structurally better business than a decade ago? Some structural changes over the last decade:
Rise of online subscriptions (e.g., Nintendo Switch Online).
Growth of digital sales and add on content.
Simplification of game development (removal of hardware considerations when developing games).
Nintendo Switch Online
Launched in 2018, users pay ~$20-50 a year (two tiers) for access to online multiplayer and other benefits like legacy Nintendo games; they currently have ~38mm subscribers. Reports from 2021 have Switch Online revenues ~$1bln. Given they’ve grown subs ~20% since 2021, an estimate for current revenue would be ~$1.2bln in high margin recurring revenue; this is very conservative given the ARPU bump from Expansion Pack+, which launched in late 2021 (their $50 offering).
Bears are effectively saying that Nintendo will give up >$1.2bln in recurring revenue when they launch their new console? I will happily take the other side of that bet.
Even if we assume Nintendo starts from scratch, NSO has amazing growth potential. First, NSO penetration was low for the Switch as they were slower to rollout the online features (33% for Nintendo vs ~45% penetration for PlayStation). I expect the next generation to have higher penetration, regardless of whether they start from 0 or 117mm users…
Second, they’re using older IP and add-on content to drive NSO, such as rereleasing legacy games as part of an NSO subscription. Games include classics like Mario Kart 64, GoldenEye 007, and The Legend of Zelda: Ocarina of Time. These are huge draws that offer value for old-school Nintendo fans. Additionally, they’ve tied add-on content for top selling Switch games like Mario Kart 8 Deluxe and Animal Crossing, to an NSO subscription. The value provided by NSO is only going to increase as they add more legacy games and increase the amount of add-on content for their popular Switch titles (regardless of console transition method).
Again, I find it very difficult to imagine a situation where Nintendo gives up >$1.2bln of high margin recurring revenue. However, let’s say “Nintendo is gonna to Nintendo”, and they announce NSO is shutting down the day they release the Switch 2, and they’ve launched a new online subscription “NSO 2”. NSO 2 would also be a high margin recurring revenue stream… this wasn’t the case with the Wii U transition.
Digital sales
As I pointed to in my original post, cutting out the middleman (retailer) is a significant margin enhancer for Nintendo. On a $60 game, a brick-and-mortar retailer traditionally takes ~20-25% ($12), and distribution costs are ~$4. So, on a $60 game, Nintendo might only see ~$40.
Digital stores have allowed console providers to keep this additional margin for themselves (assuming selling price stays at $60). Sure, there’s costs to running the store, accepting payments etc., but it isn’t $20 a game! Digital stores are also a great DTC product that adds value for the customer (some DTC models are starting to find the middleman was more valuable than they realized…); it’s more convenient, if you want the game, you just download it (don’t have to drive into town), you can redownload games onto another console from your online account, and there’s no need to look after a physical disk or cartridge.
Nintendo continues to increase digital penetration but there’s still plenty of room for growth. First, increased NSO sign-ups helps push increased digital penetration – an NSO customer is more likely to purchase digital games via the Nintendo Store (already in Nintendo’s online ecosystem). Nintendo still lags others in the industry, with other developers ~85% digital penetration (EA, TTI, etc.). Catching up any time soon is unrealistic, but with the likely end point a fully digital experience, I’d expect Nintendo to continue increasing penetration and margins.
Add on content
Consoles and developers have also increased the efficiency with which they monetize the consumer. Add-on content has allowed for increased monetization per game sold. A game used to be $60, but that was it, there was no way to continue monetizing a hit game. No matter how good the game was, you’d need to convince a customer to buy another new game for additional revenue.
Now, consoles release additional downloadable content for popular games like Skyrim or Mario Kart 8 Deluxe. Downloadable add-on content is extremely high margin. You already know the game is popular (original game sold well), which means solid attach rates, and the incremental work is minimal compared to developing a whole new game. This is another win-win for the gamer and developer.
Nintendo doesn’t use microtransactions for the Switch, so I’m not going to spend much time here. They tried it briefly with Mobile, but the backlash was swift. I don’t mind microtransactions in some instances, like for skins that provide no benefit to gameplay (which is what Nintendo tried), but developers like EA have made some game modes unplayable unless you spend cash on in games benefits (e.g., FIFA Ultimate Team). I don’t expect Nintendo to pursue/push microtransactions (focused on protecting their brand and image).
To hammer the point home, below are two charts of Sony’s PS4 and PS5 release, it shows the revenue breakdown and game spend per device. Since 2013 (PS4 release), Sony’s revenue has gone from ~50/50 software vs hardware, to ~80/20. Add-on content has increased from ~10-15% of software revenue to ~35-40%!
Game Development
Game development is another area that has changed significantly over the last decade. Historically, each console used their own development engine, making it difficult to create a game for multiple consoles; hardware was a key input. This meant adapting a PlayStation game for a Nintendo console required a significant amount of incremental development work; Nintendo’s business model of building hardware to sell their own software, exacerbated this dynamic as it created little incentive for 3rd party developers to adapt games for their consoles.
Nintendo’s platform was also less powerful than PlayStation and Xbox, making the work even more challenging. It wasn’t uncommon for a home to have a PlayStation/Xbox, and a Nintendo, specially for their first party games (Zelda, Mario, Pokémon etc.); so, Nintendo’s revenue from 3rd party was a small part of their business, the economics just didn’t make sense for developers and even if they did, they wouldn’t run as well on Nintendo’s console.
The rise of development engines like Unity means games are now created with less emphasis on the platform/console (the hardware layer is stripped away); development requires a lot less hardware specific considerations. This is great for Nintendo, as they were often overlooked by other developers; now the numbers make sense, the cost of adapting a game have decreased significantly. Nintendo console owners still buy less 3rd party games compared to PlayStation/Xbox, but this is a growing stream of low effort revenue that falls straight to Nintendo’s bottom line. 3rd party games have increased from ~25% to ~50% of software unit sales since 2018.
It’s worth noting that Nintendo’s commissions from 3rd party developers are recorded net on the financial statements (disclosed in their explanatory material – footnote at the bottom of page 13). So, while Nintendo discloses ~80% of their revenue comes from first party software sales, if we compare apples to apples, it’s closer to 50/50 on a units basis (see slide above for a better comparison).
This tailwind should continue for Nintendo’s next console and might even strengthen if we get the expected jump in console performance - a lot of 3rd party AAA games have to run on lower quality settings to account for Switch’s lower performance. So, even if the next console is a Wii U level dud, it will still make sense for developers to release games on the console. This was not previously the case.
Summary
I think a lot of the discussion on Nintendo gets wrapped up in whether the next console will be backwards compatible. This makes sense, it will be huge news when it’s announced (stock will likely jump or dive on the announcement). What I hope I’ve shown above is 2 things. First, management been pretty clear the next console will take advantage of the current Switch userbase. Second, even if you aren’t sure on the backwards compatibility question, gaming is just structurally a better business than a decade ago, and the Wii U is not a relevant comparison for estimating the financial performance of a Nintendo console flop.
I’m going to save the IP value and Japanese culture discussions for another day (they’re definitely important, but the console issue is key); the success of the theme parks and movies has added another consistent revenue stream for the business, and the expected changes in Japanese corporate management should be a tailwind over the next decade.
Bottom line, Nintendo is still priced like a legacy console business, with the stock pricing in the risk of a dud Switch 2 and half a decade of poor financial performance. Others have shown the console cycle has changed, and that gaming is now a high margin software business with a smoother earnings profile. Add in Nintendo’s new-found willingness to monetize their IP, and I think we have a great risk adjusted bet, I plan on holding long-term.