Nintendo: Is This Time Different?

Resolving some key points in the bull vs. bear debate

Those following me on Twitter know that I am bullish on Nintendo. I have been a Nintendo gamer/fan since I was a child and shareholder since late 2019. While there are plenty of Nintendo bulls on Twitter, it is apparent that markets do not share our rosy vision for the stock yet. Recently, there was a healthy & heated debate on Twitter between Ryan O’Connor (Founder/PM, Crossroads Capital, @AboveAvgOdds) and Atul Goyal (MD, Jefferies Equity Research, @agoyal00) over the future of Nintendo. The debate clearly synthesized several key points of contention between bulls and holds/bears. I will try to address each point to the best of my ability here below, as well as objectively (as much as I can as a bull) answer the question: Is This Time Different for Nintendo?

Before we jump to answer the question, we need to answer a few key subquestions:

1.       Will the Switch hardware cycle extend past its predecessors (Wii/DS)?

2.       Will an extended hardware cycle support an extended earnings cycle?

3.       What impact will an extended earnings cycle have on key line items (revenue, EBIT)?

Now, I’ll answer these questions line-by-line:

1.       Will the Switch hardware cycle extend past its predecessors (Wii/DS)?

Fellow bulls and I have staked most of our pitches on the foundation of the Switch being a precedent-breaking hit and extending the console cycle. For our evidence, we have pointed towards Nintendo merging its home & handheld console departments back in 2013, management hinting towards making the Switch family an Apple-like platform to support steady, sustainable software sales, and the complementary success of the Switch Lite. We have also sleuthed around to find out that a higher-spec Switch (Switch Pro/Super Switch) is set to launch this calendar year most likely. This evidence compiles to create a powerful narrative – that management has woken up to see the merits of Apples hardware/software approach and is betting big on making an iterative Switch family that mimics the iterative lines of iPhones/Pads/etc.

This narrative, however strong it may be, must be rooted in reality now that we are in the 4th year of the Switch cycle. Data points that support this narrative are both anecdotal and statistical. Many have noted the Switch being sold out at Amazon, Target, Best Buy, etc., and red-hot sales of system-selling games like Animal Crossing: New Horizons drawing in more and more incremental buyers over 2020. Additionally, several read-throughs from Switch supplier 2020 quarterly earnings transcripts indicated that the only thing holding back demand throughout 2020 was supply chain issues. Anecdotes and readthroughs certainly indicate that to this day, Switch demand is largely meeting or outpacing supply in several periods. Taking a statistical look at Switch sales also supports this conclusion of steadily strong Switch demand in the now 4th year of the console’s cycle, which is said by many to be the first hump in the downcycle.

As Nintendo’s most popular home console, the Wii is used most often as the Switch’s comp for its hardware cycle. The Switch’s sales trajectory, however, is vastly different and better than the Wii’s. Take a look below at the Switch and Wii’s rolling 4-quarter sales trajectory since inception.

While the Wii started out red hot compared to the Switch, it also fell quickly. The Switch overtook the Wii in the 11th 4-Q period from 12/31/2019 to 9/30/2020. It has also continued to rise after it overtook the Wii, which peaked in its 7th 4-Q period just 1.5 years after release. The Wii’s rolling 4-Q sales trajectory continued to fall without much resistance after this period, while the Switch has done anything but that. Taking this all into consideration, using the Wii as a comp for projecting the Switch’s console cycle is misguided at best and intellectually dishonest at worst. Taylor Henderson (Voss Capital, @taylor_hndrson) also provided this analysis on Twitter, saying that, “While the Wii got off to a hot start, it's highest sales in any 52-week period came just 2.3 years after release, in February 2009. Conversely, Switch sales have steadily accelerated for almost 4 years now.”

Taylor’s analysis corroborates mine and reinforces the conclusion of the Switch’s relative strength compared to the Wii.

Now, to be intellectually honest, I’ll compare the Switch to the DS due to both consoles’ iterative nature. The Wii did not have a major iteration, so bears may point out that I am making the Wii a straw man to justify my bullishness on the Switch. Below is a graph comparing the rolling 4-Q sales trajectory of the Switch and the DS.

As seen, the DS outperforms the Switch after an initial period of lower sales. While bears may use this as evidence to model the Switch console installed base in line or below the DS’ trajectory, I think this graph is conversely bullish for the Switch. If you takes a look at the DS’ competitive positioning vs. the Switch, the DS was the dominant handheld/portable gaming console on the market, sold with Nintendo’s dominant, kid-friendly gaming IP. The PS Vita and other competitors did not sell close to the DS and offered much worse value propositions. The Switch, on the other hand, was released after the infamous failure of the WiiU, halfway through the console cycles of the XboxOne and the PS4. While competing against these two in the midpoint of their cycles is not the same as competition during peak periods, the Switch faced much more formidable competition than the DS.

Additionally, the Switch remains on a more upwards sloping trajectory at this point in its cycle, with the Super Switch/Switch Pro’s release set to continue this upwards slope for 1-2 more FYs. Based on these two graphs and the iterative characteristics of both the DS and the Switch, it is fair to model the Switch’s installed base growing similarly to the DS’ in the near-to-medium term, while Nintendo’s singularly dedicated approach to the Switch justifies the Switch installed base growing to above the DS’ 127.84mm installed base in the long term. Here below are my projections based on this rationale:

While my projections and thoughts are my own, they do get close to Ryan O’Connor’s assertion of, “the Switch installed base balancing out in steady state at 150m units 3 to 4 years from now…” with my installed base hitting ~164mm units by 3/31/2024. In my view, the Switch can achieve this installed base trajectory due to its positive, accelerating sales momentum, Nintendo’s dedicated approach to releasing hardware iterations every 2-3 years for the Switch, and the release of more 1st party/3rd party games on the Switch than any other previous console.

Whether Nintendo can achieve this variant installed base is anyone’s guess, but I think my educated guess is more on the money than the market currently. Next, I’ll examine the implications of this extended hardware cycle/variant installed base on Nintendo’s earnings cycle.

2.       Will an extended hardware cycle support an extended earnings cycle?

On a $NTDOY Twitter conversation between Atul Goyal and I, he commented that, “For Nintendo, extension of Switch life cycle is not the same as extension of earnings cycle.” I replied, “life = / = earnings, but life & sustained tie ratio = earnings cycle extension,” a thought which I will expand upon here.

Atul is right in his statement – just because a company manages to sell units of its console over a longer period of time (in Nintendo’s case, a few years longer than its 9-10 yr. average lifetime), doesn’t mean it will extend its earnings over that same period. In fact, it’s very common for companies to experience significant drops in YoY top-line in the last couple of years in their console cycle due to their transition to the next console and resulting dearth of major titles for the incumbent console (ex: PS4).

For Atul’s statement to be right on Nintendo, however, it means that management would need to have medium-term intentions of transitioning soon away from the Switch and to a new console & discontinuing new game development for the Switch. Management, to be clear, has displayed no such intentions and furthermore, do not have a reason to. They know they have a hit in the Switch, as seen in the installed base evolution so far, and have just recently begun expanding Switch sales in China.

Atul’s statement could still stand, however, if management has all the intentions to make the Switch a mainstay but fail to maintain a sufficient tie ratio with the Switch. The counter to this argument is simple – Nintendo have gone all-in on the Switch for their dedicated video game platform segment. After sales of the 3DS dropped to zero in the past CY, the Switch is now their only significant source of revenue for the segment and has been the sole subject of attention of Nintendo’s merged console department since 2013. To support their sole console platform, Nintendo has released and has plans to release more 1st party key IP and 3rd party games for the Switch than any of its predecessors. While Nintendo stayed away from releasing more than one game in its key franchises for each console (only released one of LoZ, Smash, etc. for predecessors) it has broken this principle for the Switch with its plans to release a system-selling sequel to the original system-selling Legend of Zelda: Breath of the Wild (BoTW). BoTW 2 will certainly become a system-selling game (>200mm units) like ACNH, Super Smash Bros., and will lead Nintendo’s other games (Donkey Kong anniversary, Metroid, etc.) in maintaining a high tie ratio in the medium-term and likely for the long-term as well (game line-ups will need to be confirmed on an ongoing basis, however). Additionally, Nintendo has recently worked to reverse its reputation as a poor platform for 3rd party publishers – with the quote below from the publisher of Monster Hunter serving as recent evidence. 3rd party IP has proliferated on the Switch compared to previous Nintendo consoles, and will be an important secondary driver of a sustained, strong tie ratio.

Nintendo’s singular dedication to the Switch and its long-term lineup of 1P/3P games will maintain a strong tie ratio that matches and beats the DS’ tie ratio of 6.6 in steady-state. The impact of this strong tie ratio, combined with the Switch’s extended life cycle, will prove to be a powerful earnings driver. The magnitude of this earnings driver, as well as how it stacks up against current consensus numbers, will be expanded upon in the next section.

3.       What impact will an extended earnings cycle have on key line items (revenue, operating profit)?

The narrative created by an extended hardware cycle and high tie ratio is strong and simple. Since consensus underestimates the number of Switch units sold and the number of games sold with each unit, they underestimate Nintendo’s medium-term top-line growth. This underestimation creates an opportunity for investors to buy NTDOY today and hold until such variance is eliminated over time.

Investors, however, do not have to just rely on revenue variance as a reason to buy NTDOY today. Consensus also underappreciates the digitization driver that is present within Nintendo’s Switch platform today, and their EBIT/EBIT margin estimates consequently fail to capture how Nintendo Switch Online recurring revenue, DLC/eShop royalty revenue, and increasing digital distribution of Switch games will dramatically expand EBIT margins and de-cyclify long-term earnings power.

One of my PMs last summer said it best when she said that, “the best pitches can be summarized with one graph.” If I had to pick one graph to represent my Nintendo pitch, I would pick the one below from Taylor Henderson.

As displayed, digital revenue, by taking an increasing proportion of total revenue, has been driving Nintendo’s operating margins up rapidly in the past 16 quarters. Additionally, digitization’s positive impact on margins is not unique to Nintendo. In fact, the company is playing catch up to peers like EA, ATVI, TTWO, and UBI who have all achieved this digital-led margin expansion in the past decade.

This margin expansion via digitization playbook, despite being well-known and understood, is not properly accounted for in consensus estimates today. Consensus estimates have operating margins in FY 3/21-23E staying in the 34-36% range, which do not price in the strong likelihood that the recent margin expansion trend will continue. Either due to shortsightedness or an over-appreciation of hardware cycle risks (additionally, Nintendo sells Switches for profit unlike loss-incurring SNE/MSFT), sell-side is completely missing this digitization earnings driver.

To put everything together, current consensus estimates undershoot top-line growth by missing the Switch’s extended lifetime and undershoot operating profit by missing the digitization earnings driver. Until consensus and investors wake up to correct these two mispricings, Nintendo will continue to be cheap on medium-term (next 2-3 FY) earnings power.

Here below are some variance tables comparing my estimates to consensus and Jefferies’. You can take a look for yourself how much variance could exist today.

So yes, this time is indeed different for Nintendo. The Switch’s extended hardware cycle and digitization-led margin expansion will enable to have an acyclical earnings structure that will beat medium-term consensus estimates.

4.       Sensitivity Analysis