Nintendo: How Much is it Worth? (Part 3)
This is the third and final post on Nintendo:
At the current share price of $42/share, Nintendo’s market cap is roughly $40 Billion. Adjusted for approximately $9 Billion in net cash, short-term securities and zero debt, we get a value of about $31 Billion.
WHAT DOES $31 BILLION GET YOU?
Based on the below we have about $11 Billion of asset value.
Let’s look at Nintendo’s assets and do a back of the envelope valuation:
First, Nintendo owns a stake in “The Pokémon Company”. According to the Nintendo Enthusiast, The Pokémon Company generated $3 Billion in 2018 revenues and ranked 23rd on the list of top global licensors. (By comparison, the NBA and NFL made $3.2 and $3.5 Billion respectively.) This is an excellent business because it requires very little capital to run. The revenue, which is essentially royalty collection, is incredibly high margin. Therefore, if we assume the operating margins are anywhere from 50-75%, EBIT (Earnings Before Interest and Taxes) is roughly $1.5-$2.25 Billion. For simplicity let’s assume EBIT = Free Cash Flow (FCF). At a conservative 10 times FCF, The Pokémon Company is worth $15-22.5 Billion. This is a very conservative number. The royalty revenue could certainly grow over the next 5 or 10 years. Private transactions may even value the company at 20 times FCF. Lastly, Nintendo owns at a minimum half (it isn’t fully disclosed), so conservatively we have $7.5-11.25 Billion. Let’s call it $10 Billion (Margins are likely closer to 75% than 50%).
Second, Nintendo has an ownership stake in Niantic. Niantic was the spin off company responsible for the Pokemon Go Augmented Reality phenomenon a few years ago. This is a high growth Venture Capital asset. It could be worth a lot or absolutely nothing in the future. Although unclear how much Nintendo owns, at a recent $4 Billion valuation, if we assume a 10-20% ownership, Nintendo’s current stake is worth somewhere around half a billion dollars.
Third, Nintendo owns a stake in DeNA. DeNA is a public company worth $2.4 Billion. The value of Nintendo’s 10% equity stake is roughly $240 million.
Fourth, Nintendo happens to own 10% of the Seattle Mariners. According to Forbes, the Mariners are worth $1.6 Billion. Assuming this is in the right ballpark, that gets us $160 million.
$10+0.5+0.24+.16 Billion = ~$11 Billion
That leaves $20 Billion.
WHAT DOES THE REMAINING $20 BILLION GET YOU?
The remaining $20 Billion gets us Nintendo’s great library of Intellectual Property PLUS all future cash flows and profits from company operations, namely, from the Switch Console and Digital Sales, and from Mobile.
Profits from the Switch Console & Digital Sales
To determine how much the console business is worth, we need to estimate the following:
Number of consoles installed
Sales per console
If we assume that the console continues to sell well, the console should reach 100+ million installs by 2022 (by comparison, the Nintendo Wii had an installed base of ~101 million) so this is a reasonable estimate, especially considering the Switch is selling very well.
Current sales per console are shown below.
Today’s gross margins are around 42% but as the company continues to go digital, this should increase over the next few years. Let’s say they go up 15% to 48%.
Similarly, since the console business will become less cyclical, R&D spend should decrease from 9% of revenue to a much smaller number. Conservatively, let’s assume 6%.
Lastly, the company will experience more operating leverage and the G&A expense should decrease from the current ~11% to conservatively 7%.
This gives us a 13% margin improvement, resulting in operating income of about 26% (it is about 13% today). This is a massive increase.
Assuming 55,000 yen in sales per console in 2022, multiplied by a conservative 20 million consoles sold during 2022 gets us about $10 Billion USD in sales in 2022.
So, the $10 Billion in sales turns into $2.6 Billion in operating income. Assuming a 30% tax rate, we get $1.8 Billion in earnings.
Assuming a 15X earnings multiple since this is at least an above average business, the console and its digital sales business is worth $27 Billion.
We have ignored several pieces of value in the above “back of the envelope” calculation:
Increases in Sales per console over the next few years. This is a meaningful number as the company should be able to optimize its in-game digital sales.
Increases in subscription prices. Today prices are $20/year. These could easily increase 50% to $30/year and still be 50% cheaper than the annual subscription rates charged by Microsoft, Sony, and Apple Arcade.
We have ignored all profits/cash generated between now and 2022.
Based on the above, we are getting all future profits from Mobile for free! Similarly we are getting Nintendo’s complete library of intellectual property for free!
Profits from Mobile
Nintendo is already generating over $400 Million in high-quality revenue from its small number of mobile games (doesn’t include Mario Kart).
Considering the size of the market and the familiarity of the characters, mobile games could become a huge new profitable and fast growth vector for the company.
Why couldn’t this $400 Million in sales turn into a billion in a few years?
This would be significantly higher margin and higher growth than the console business. Why couldn’t this part of the business be worth $5-10 Billion ($1B revenue with 50% margins * 15-20X multiple) by itself a few years from now?
For our valuation purposes, let’s assume the midpoint at $7.5 Billion.
Intellectual Property
To estimate the value of Nintendo’s “core” IP, let’s do the following thought exercise: let’s take Pokemon Go for example. It reached $3B in lifetime revenue in just 3 years (2016-2019). At a steady state, this game likely has 50% margins. Using a 15X multiple gives us a $20B property!
And we haven’t even talked about other major IP like Mario or Zelda or Donkey Kong or Kirby, and the list goes on and on. All of these characters provide an evergreen future source of revenue.
Although not an apples to apples comparison, let’s also look at other IP transactions:
Disney bought Star Wars for $4 Billion
Disney bought Marvel for $4 Billion
Disney bought Pixar for $7.4 Billion (Toy Story/The Incredibles etc)
Comcast bought Dreamworks for ~$4B (Shrek/Kung Fu Panda etc)
Considering the above transactions, why can’t Nintendo’s characters be worth at least in the 10s of billions of dollars?
A CONSERVATIVE VALUATION
$9 Billion in Cash PLUS
$11 Billion in Assets PLUS
$27 Billion for the console and digital sales business PLUS
$7.5 Billion for the mobile business PLUS
$10-20 Billion in IP
EQUALS $65-$75 Billion
You’re getting this business, which has been around for 100+ years for $40 Billion today, at a 60-90% discount! The Valuation calculations above are also quite conservative so the discount may in fact be much higher.
AM I BUYING?
This situation is reminiscent of how in the early 2000s, Apple was going through a multiyear business model transformation that permanently improved its operations, and the quality of its revenue streams. This feels awfully similar to the position Nintendo is in today.
That said, I haven’t bought yet. Here are some of my concerns:
The company has executed poorly. They have been talking about Mobile and the “Apple approach” for a long time. I believe they first mentioned it publicly in 2014(?). Considering it’s been 5 years since, I would have expected a lot more progress, particularly with its Mobile presence. It’s unclear to me why it has taken so long for Nintendo to finally show up to the Mobile market.
Unlike the other two investments I have discussed earlier, KKR and Wells Fargo, investing in Nintendo would be a bet on a successful transformation. We would be betting on change. When investing in WFC & KKR, we were betting on the company to largely keep doing what it was already doing. Change is harder and less predictable.
Not being an avid gamer, I don’t feel I have as good an understanding of the nuances of the gaming industry as I would like. For example, how is e-sports impacting gaming? A game like Mario Kart seems like a perfect fit for a massively multi-player experience. But I don’t really see Nintendo talking about this much. Leveraging the e-sports phenomenon feels harder to pull off compared to Mobile, and clearly the company has struggled to move fast simply on Mobile.
That said, if you believe the company will indeed complete a successful transformation, Nintendo is pretty undervalued.
I don’t consider Nintendo is a “Dependable”. I don’t quite yet have the conviction to bet large on this company, unlike KKR and WFC. That said, Nintendo may still turn out to be a good investment. I may make a small/smaller more speculative purchase.
If I don’t invest, and the stock does do well, that’s ok. There are no called strikes in investing.
UPDATE:
Upon further reflection, I did end up buying Nintendo on Thursday Oct 31 at an average price of $46.07. However, by then, unfortunately, the price had gone up by almost 10%…. C’est la vie...
I bought Nintendo for the following reasons:
1) I don't think I lose money on this purchase
The margin of safety is high. The assets on the balance sheet provide downside protection. Also, at ~$44 Billion, we are getting all of Nintendo’s IP (which can be monetized for a long time to come) and the Mobile business (which has a lot of optionality) for free!
2) The upside is probably higher than I think.
Big stock returns come from revenue growth, margin expansion, and multiple expansion. Nintendo has the potential to benefit from all three. Revenues are going up (Switch is growing, they are expanding in China, and they are finally focused on Mobile). Margins are increasing via digital sales and subscriptions. Lastly, a higher multiple is warranted as the quality of the business improves (higher margin more sticky platform).
Plus, I tend to be rather conservative when it comes to valuation.
3) The Checklist
Is it virtually guaranteed that the company will be bigger 5+ years from now?
Yes, with the coming growth in Mobile and the Switch, I believe so.
However, if there is a recession during this time, Nintendo’s sales could be hurt. That said, the company has released the Switch Lite, a cheaper, portable-only console aimed at more “value conscious” buyers.
Does the company have a competitive advantage and is it growing?
It can be argued that Nintendo’s brand is not as strong as it used to be and it’s unclear whether that brand advantage is growing... But then again, I was just talking to a colleague of mine who graduated from undergrad this year. He said quote “everyone on campus had [a Switch],” so clearly (at least based on this anecdote) the Switch is resonating and the brand is alive and well.
This is one part of the checklist where I seem to be breaking the rules. Perhaps this is why my conviction level is lower compared to when I purchased KKR and WFC?
Will management be a good, trustworthy representative of my money?
I believe so. The CEO slashed his own salary by 50% earlier, when the Wii U bombed. That’s the type of selfless person I want representing my capital.
That said, as mentioned earlier, I do have some concerns about the company’s pace of execution. I plan to monitor closely.
Can I buy the business for meaningfully less than it’s worth?
Yes, we’ve talked a lot about this already.
4) A Divine Sign?
Thursday October 31 was Halloween. The person who sat next to me on my shuttle to work was wearing a Super Mario hat! Now, if that’s not a sign, I don’t know what is? :)
Apologies for the not so great picture...
On a More Serious Note
Nintendo surged ~7% last Friday Nov 1 after Nintendo said it shipped 4.8 million Switch consoles between July and September 2019, a year over year increase of approximately 50%! Its second-quarter operating profit also more than doubled amid strong sales for the recently launched Switch Lite.
Analysts at Morgan Stanley said Nintendo’s operating profit ratio of 24.6% for the second quarter was “well-above” levels seen in the same period a year ago at 14% as well as against the previous quarter’s 15.9%. Recall, I was forecasting 26%.
So, per the investment thesis, it looks like the revenue growth and margin expansion are indeed playing out... let’s see how the stock continues to perform.