Nintendo

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Background History.

Nintendo’s history stretches back to 1889, when Fusajiro Yamauchi started a small business making Japanese playing cards, dubbed Hanafuda. The popularity of the cards sustained Nintendo through the next 6 decades, but when Fusajiro’s grandson—Hiroshi—visited the largest card manufacturer in the U.S. in 1956, he was struck by how tiny their offices were. With growth in the card business slowing after the introduction of a popular plastic deck of Hanafuda cards, Hiroshi started to think about new markets for growth. After penning a partnership with Disney to print their characters on cards, Nintendo went public in 1962 and invested in a variety of initiatives: instant rice, a taxi service, short-stay “love” hotels, and a remote-controlled vacuum cleaner. While none of these endeavors were very successful, Hiroshi stayed very involved with these efforts and frequently visited their factories. During one of these visits, he saw one of the workers, Gunpei Yokoi, playing with an “extended hand” device (seen below). Hiroshi learned that the employee had made the contraption out of boredom, and asked for permission to mass produce and launch the device as a toy. Nintendo sold over 1mn units of the “Ultra Hand,” and Gunpei Yokoi became the head of product development for Nintendo’s newly formed R&D Studio (and later video games) where he continued to develop and launch various products for the company.

Hanafuda playing cards on the left and Nintendo’s first toy, the “Extended Hand” on the right.

In line with their culture of experimentation, Nintendo soon began developing electronic toys. It wasn’t long before they had their first hit video game: Donkey Kong, which was initially released for the Atari 2600 and in arcades. Their first foray into gaming hardware came with the Game & Watch, a hand-held device modeled after a calculator that had a “game” and a “watch”. This was also an embodiment of their “lateral thinking with withered technology” strategy where they would use older (and thus cheaper) technology in new ways. Instead of competing by being on the cutting edge, they would optimize for novelty, utilizing older technology for new purposes. Another clear example of this philosophy comes in 1989 with the Gameboy. After a successful launch of the Nintendo Entertainment System—their first home console—Nintendo wanted to create a portable unit to follow it up. The Gameboy didn’t have anywhere near as advanced graphics as Sega’s and Atari’s devices, but instead only had 4 greyscale shades and was slower with laggy graphics. However, what Nintendo lacked on the hardware side they made up for with a more rugged device and far superior proprietary games likes Super Mario Land, The Final Fantasy Legend, Yoshi, Kirby’s Dream Land, and The Legend of Zelda.

Re-release of Nintendo’s Game & Watch for its 35th anniversary.

Over the next few decades, Nintendo would put out a new console out every 5-7 years and continue to prioritize their own slate of games. They launched the Nintendo 64 in 1996, their most successful console at the time, which still invokes nostalgia to this day. Its successor, the GameCube (launched 2001), had lackluster sales despite its dedicated fanbase. In 2006, Nintendo released the Wii console, which introduced novel forms of play with motion sensors and resulted in their largest blockbuster hit to date. Attempting to build off the Wii’s success, they released the Wii U, which turned out to be Nintendo’s worst selling console ever. Apart from its home consoles, Nintendo released a slew of handheld devices that went through similar ups and downs. This hardware cyclicality of “hits” and “misses” plagued Nintendo and would throw the company into periods of prolonged prosperity or privation. This level of volatility is more extreme than at other video game companies as the success of all of their games is closely tied to the success of their hardware, exacerbating business volatility. However, with the Nintendo Switch (released 2017), mobile gaming, and other IP monetization there could be a transformative shift underway that helps ameliorate the vicissitudes of Nintendo’s product launches. 

The Business.

Nintendo’s core business is fairly straightforward: they design and sell video game consoles and video games. Where they distinguish themselves is their closed system—they develop their own hardware and the majority of the games playable on that hardware. This is possible in part thanks to the large library of IP they have created over the years. While they do partner with some 3rd party game developers, Nintendo enforces strict standards and offers limited support. This means that Nintendo is the largest game developer for Nintendo consoles—they are the only console developer that has pursued this strategy. While the closed system breeds loyalty, there is a significant downside: if you sell fewer consoles, you’ll sell fewer games. The upside is that Nintendo gets to control the full gaming experience and can integrate their game development with hardware improvements. Additionally, the value prop of owning a Nintendo console expands beyond the immediate hardware and becomes the only way to play in the Nintendo Universe (more on this later). 

Some of the many characters in the Nintendo Universe.

While the Nintendo Universe is rich with IP, the hardware still needs to be compelling and the “hit-miss” nature of consumer products adds significant volatility to their business. Aside from it not being clear how a console will be received by consumers and what the upfront costs involved are, Nintendo’s business can quickly dry up on a poor console launch. Nintendo launches new consoles every ~5 years, usually in order to take advantage of improvements in technology that lead to better gaming experiences. Each time they launch a new console, like the GameCube, they are essentially “resetting” their install base. There were ~33mn consumers who owned Nintendo 64s that they could sell their games to, but when they moved on to the GameCube and started developing new games for that console, the number of consumers who could buy those games was reset to zero and Nintendo had to re-build their install base. If there is a bad console launch (like the Wii U), then Nintendo’s ability to sell games becomes limited.

As you can see in the lifetime console sales chart below, there is a lot of volatility in the consoles that dictate software sales (how they refer to video game sales). As Nintendo games are not sold on other consoles and are Nintendo’s main source of income, even a single product miss puts Nintendo in a precarious financial position.

Nintendo’s most successful console to date is the Wii, which sold 102mn hardware units and 923mn software units for a Tie ratio (software sales/ hardware units sold) of 9x. For every console they sold, Nintendo was able to sell 9 video games. Following their best-selling console ever was their worst: the Wii U sold a woeful 14mn hardware units and 104mn software units (Tie ratio of ~7.5x). If a product misses, then Nintendo suffers the double whammy of worse hardware sales and weaker software sales. To get a sense of the magnitude of this effect, compare the first full year of Wii sales (2007) and the first full year of Wii U sales (2013). In 2007, Nintendo generated ¥1.7tn ($15.5bn) in revenue and ¥487bn ($4.4bn) of operating profit versus 2013 where sales were 66% lower at ¥0.6tn ($5.5bn) and Nintendo recorded an operating loss of -¥46bn (-$420mn). This cyclicality is why investors have never placed a premium on the business, although new revenue streams and turning to a “continuous iterative hardware” model could stamp out volatility. But before we get to that, we will further explore how Nintendo differentiates itself from its competitors to get a better sense of their gaming proposition to consumers.

As we alluded to earlier, Nintendo is a closed system which not only helps make their brand synonymous with their family-friendly characters like Mario, Donkey Kong, Zelda, but also puts Nintendo in a universe of its own versus the Sony’s PlayStation and Microsoft’s Xbox line-ups (the two other most popular console devices for those unfamiliar). The benefits of having their own closed system supported by their own IP is that they have a unique value prop that differentiates them from competitors: if you want to play Super Smash Bros (a popular cross-over fighting game) you must own a Nintendo console. In fact, ~80% of games sold for Nintendo are their own creations (dubbed 1P games), which are not sold for other hardware consoles. This contrasts with the PlayStation and Xbox, where almost all games are sold for each device. This is because unlike Nintendo, Sony and Microsoft prioritize selling consoles given their limited monetizable content. This is why they decided to make exclusive to their devices the few hit games they did each produce (Microsoft has “Halo” & “Gears of War”, Sony has “Uncharted” and “God of War” among a few others). The game development business for Sony and Microsoft was meant to make their hardware more attractive by having device-exclusive games to sway over consumers who would likely only own one of the two. Nintendo maintains exclusivity to the extreme with all of their games restricted to just their devices. This tying of game and console is done for several reasons: 1) to ensure they always have a console consumers would buy and thus Nintendo wouldn’t be relegated to 3rd party developer status on someone else’s platform, 2) protect their family-friendly brand by not having Mario games on the same device that can play the latest Grand Theft Auto, 3) to innovate with hardware that can change the gameplaying experience (think of the motion-sensors in the Wii that allow you to play Wii Tennis). Given this game exclusivity, the Nintendo universe is a totally distinct gaming proposition from what a consumer would get with an Xbox or PlayStation. It is for these reasons that Nintendo doesn’t directly compete against Xbox or PlayStation (other than for time), and consumers who own two consoles usually own a Nintendo along with one of the other two.

Nintendo reports their revenue in three segments: 1) Dedicated Video Game Platform, 2) Mobile, IP related income, etc., and 3) Playing Cards. The Dedicated Video Game Platform’s segment houses hardware and software sales (including Nintendo Online, more on this later), which constitutes ~97% of their revenues. The Mobile and IP related segment is still small now, but could be an important source of earnings growth. Their Playing Card segment is broken out separately for historical reasons (a long time ago it was materially all of their sales), but it is so small today that you cannot even see it in the pie chart above. In the bar chart below, we break out Dedicated Video Game Platform further into Hardware sales and Software sales. Revenue mix has stayed fairly steady the past few years with hardware contributing slightly more than software and the Mobile/ IP segment actually falling as a percentage of total revenues.

Dedicated Video Game Platform.

This segment has several sources of revenue: 1) hardware consoles, 2) packaged software (physical video games sold in retail stores), 3) digital software (digital versions of games of the same games sold physically), 4) Additional in-game content (think expansion packs and other purchasable in-game items), and 5) Nintendo Switch Online (a subscription service that lets gamers play online with others and access a catalog of older games).

Hardware.

As mentioned before, Nintendo’s ability to create a compelling hardware console is instrumental to their business, absent of which Nintendo’s ecosystem quickly deteriorates. In the last generation of their hardware, they combined their home console and portable lines into one with the Switch. As the name implies, the Switch lets a user Switch between portable play and full screen play. Every Switch game works across both forms of play. Merging the two separate lines of hardware is smart because it allows them to focus on only one hardware product while eliminating the need for separate developer and sales teams. Furthermore, since the install base is higher, there are more consumers Nintendo can sell games to.  

The Nintendo Switch: for fun at home or on the go.

Switch sales have been strong and are on pace to to eclipse the Wii. Nintendo has been expanding their Switch line-up with the Switch Light—a lower priced option that is strictly mobile—and the OLED version—which comes with an OLED screen, better audio, and a slightly larger screen. There are also rumors of a “Pro” version being in the works (although Nintendo management has publicly denied having any additional Switch models in their pipeline). Nintendo’s current strategy of only offering one console, but in different formats, expands the Nintendo ecosystem and increases developers’ consumer base without any real compromise. But the real question is whether the Switch will be a platform that they continue to iterate on or if Nintendo will eventually reset the hardware cycle with something entirely new. While we know they are developing new hardware, the critical question is whether future games that are developed for the next generation of consoles will be forward compatible.

Forward compatibility means that the current version of the Switch will be able to play the next generation of games—for example, if you could play PS4 games on a PS3. If that sounds odd, that’s because it is. Historically, the improvements in hardware were large enough that new developers would want to take advantage of the better technological capabilities of the new system and optimize development to the latest hardware. In order to benefit from markedly better graphics and performance, Nintendo has redesigned each new console from scratch. This has meant that new games couldn’t be backward compatible with prior consoles, making Nintendo’s ability to sell video games entirely dependent on successfully re-building their install base with each console launch. In the carousel below, we show gameplay photos from different Mario games from the Nintendo 64, the GameCube, the Wii, and the Switch. You’ll see the jump in quality of graphics from the Nintendo 64 to the GameCube is a much more significant increase than from the Wii to the Switch (note that not all aspects of gaming improvement can be captured in a still frame).

The gameplay screenshots are from (in order): 1) Mario 64 released on the Nintendo 64, 2) Super Mario Sunshine released on the GameCube, 3) Super Mario Galaxy released on the Wii, and 4) Super Mario Odyssey released on the Switch. While graphics have improved on each new game, the changes seem to be more incremental as of late.

There has been enthusiastic speculation in the investor community that Nintendo may move to a “continuous hardware iteration” model where future hardware is similar enough that a simple software adjustment will allow old devices to play new games. This would be akin to the iPhone model where apps work across multiple generations of phones, and apps developed today still work with much older models. Furthermore, since games could be downloaded and tied to a user’s profile, a consumer could buy the newest game without buying the newest console, then bring it with them should they upgrade later. This would have huge implications for the sustainability and quality of Nintendo’s business if they follow this strategy. However, on the last earnings call, Nintendo President Furukawa said that the “Nintendo Switch has entered the middle of its lifecycle,” alluding to the fact that they are planning to release a new console around 2025. That said, this doesn’t necessarily mean that future games will not be able to be played on the current Switch platform. (Games would only need to be forward compatible for a generation or two and similar to the iPhone upgrade cycle, consumers won’t always want the latest one, but will usually upgrade once the changes become compelling enough. This will depend on the current version of the hardware they have, so instead of the install base abruptly dropping off, it slowly rolls off. Once a piece of hardware gets especially old, new software is no longer supported on it—you cannot get most apps today to function on the iPhone 4, but most still work with the iPhone 6, a phone that is six generations old. So new games Nintendo makes in the future will not always be workable on the current version of the Switch, but allowing this transition to roll over a few generations means the base still slowly grows because new hardware adds are greater than obsolete hardware that can no longer play new games.)

However, the other factor, and perhaps more critical, to the lack of forward compatibility is that Nintendo likes to innovate on the form of gameplay. Something that sets Nintendo apart from PlayStation and Xbox is that Nintendo believes their ability to sell new consoles is predicated on creating a new and novel experience for consumers. This is in stark contrast to Sony and Microsoft, who focus more on the specs of their hardware, their developer ecosystem, and getting proprietary content. In fact, as we mentioned in the introduction, Nintendo’s historical focus on “lateral thinking with withered technology” means that it is a cultural feature that Nintendo continues to innovate on the hardware front. When Nintendo entered video gaming, the games were secondary to the hardware. That’s not to say they didn’t have some of the best and highest quality games, because they did and the games were often far more popular than their competitors’, but the games were created to fit the form of their hardware. Along that vein, Nintendo never releases their games on 3rd party hardware.

A visual representation of Nintendo’s philosophy of “lateral thinking with withered technology.”

The decision to tie their games to their hardware wasn’t a mistake, especially not when the video game industry was in its nascency. In the early years there was a deluge of low-quality games and Nintendo set itself apart by consistently releasing high-quality games. This allowed consumers to extend trust to the Nintendo brand, which would increase gamers’ willingness to try their new titles. Furthermore, creating the hardware allowed for advancements in video gameplay—Nintendo is responsible for the d-pad, analog stick, popularizing the ability to save a game, and the rumble pack. However, gameplay has become more standardize and innovations do seem to be more secondary in the last few decades. The biggest innovation in gameplay change in recent history was Nintendo’s motion control capabilities introduced with the Wii, but with the exception of the very popular Wii Sports, it is a fairly trivial component for most games. The lack of big gaming innovations in recent history weakens the rationale for Nintendo coupling their hardware and games.

We will pick up later on what management has said around their plans for this console cycle and whether there is evidence of a new paradigm shift. As mentioned before though, the Switch has sold well and still has good momentum. While prior to Covid sales were good, the lockdowns swelled Switch demand and console shortages were widespread with them selling for 50%+ premiums in the secondary market. As seen below, Switch consoles hit an all-time high last year at 29mn and while Switch demand is strong, it is a bit softer than last year. They reported 4.5mn in sales last quarter versus 5.7mn for the prior period, but Covid could have, of course, distorted traditional seasonality. Nevertheless, at this pace it will be the best-selling console in their history. 

The top left graph shows Switch console sales and the top right is Wii unit sales. The bottom graph shows handheld unit sales.

As alluded to in the graph above, Switch sales should arguably be stronger since it combines both their handheld and home devices into one. However, the Switch did launch in an “off-cycle” (usually consoles are launched every 5-7 years, but since the Wii U flopped they moved up the schedule), which can explain part of the lower unit sales when looking at the past hardware lines on a combined basis. But it also seems likely that smartphone gaming has absorbed a lot of the demand for a portable gaming device (ie the 3DS was met with muted demand compared to the DS). As smartphones continue to advance with incredible quality graphics and fast performance, it seems unlikely that Nintendo will launch a stand-alone portable gaming unit again (not to mention all of the dis-synergies from doing so), as President Furukawa previously noted that “being able to focus our software development resources on a single platform has the advantage of creating an environment that lets us create even more unique entertainment than past platforms.”

Below you can see that hardware sales have been growing at a strong clip, reaching ~¥900bn ($8.2bn), almost entirely driven by unit growth and slightly offset by lower ASPs from the Switch Lite. The Switch Lite is about $100 cheaper than the regular Switch at $299, which means for just $200 a consumer can enter the Nintendo ecosystem, a much lower price point than the $500 Microsoft and Sony charge for their respective units. The lower price point is why many consumers own multiple Nintendo devices for different members in the house or because they also wanted a more portable Switch Lite. Hardware revenue is growing ~50% y/y, but the volatility of sales means you cannot draw much from this. Gross margins are also much lower for hardware sales than software, so it is also a lower quality revenue stream. We will dive more into gross margins in the software segment.

Software.

When we refer to software we are including their packaged video games, their digitally offered games, in-game purchases/ other downloadable content (DLC), and their Nintendo Switch Online Subscription. Software is ~45% of revenues, but ~70% of total gross profits, and that mix-shift will likely grow over time, especially if the hardware cycle is extended. (President Furukawa has stated on a previous earnings call that “we want to further extend the platform’s lifecycle.”) We do not have a granular breakdown of different software services, but Nintendo does provide some figures across time. As shown in the table above, the Digital portion of sales has been growing from just 15% of software revenues to 43% in 2021. The shift from packaged software to more digital sales will directly increase their gross margins.

A fan’s collection of Nintendo Switch games. These are all examples of packaged software.

There have been two strong drivers to gross margin: 1) shift from physical sales to digital sales with mix-shift increasing ~30 points in favor of digital sales since 2017, 2) absolute software sales have been strong on the back of multiple hit games. As shown below, these two factors have translated to gross margins of 55% in 2021, up 1400bps from 2017.

Going forward, there is still room for gross margins to improve. Digital sales are still only 43% of total software sales and could lift total margins another ~5 points if they ever converge to 100% of sales (57% of software sales get a ~20 point margin boost and software is ~half of total) and even more if hardware falls as a % of total revenues. We estimate Nintendo’s software margins (explained below) to be ~80% currently, but that figure is a mix of all their different software offerings (physical games, digital games, in-game purchases, NSO).

The exhibit below makes some assumptions that could be wrong, but bigger picture we want to approximately capture the magnitude of how much more lucrative software is than hardware. There are a few different factors we used to try to triangulate margins: 1) incremental revenues by segment, 2) incremental total gross profits, 3) total gross margin trajectory since 2016. We lock into the fact that hardware sales are almost exactly the same in 2018 as they were in 2020 to support the assumption that gross profits are unchanged from this time period. This could be a fallacious assumption, but adding or taking away several points of hardware gross margin won’t change the overall conclusion. This assumption allows us to assume the full increase of gross profits from the 2018-2020 period can be attributed to their software and mobile/IP segments. This implies an incremental margin of 90%, which seems high, but since it appears they put game development costs in Research & Development and there was a positive mix-shift towards more digital sales, it’s not totally implausible as there are very little costs to digitally deliver a game. Since hardware margins are presumably flat and company gross margins have expanded, incremental margins must be higher than current software margins. We assume a software and mobile/IP segment margin of 75% for 2020, which comes from triangulating a few different factors (method detailed below). Taking that 75% software and mobile/IP segment gross margin, we can impute gross margins, which come out to 23% for 2020.

The next step of our analysis is to apply the 2020 estimates to 2021 to see what they imply for margins. There is a bit of a circularity here because the output of the 2021 numbers informed whether our input—the 75%—was too high or too low. We are trying to triangulate between hardware margins for 2020 and software margins for 2021. When doing so, we needed to adjust 2021 hardware margins upwards otherwise the implied software margin expansion in 2021 looked too large. We then cross-checked the output against what that implies margins were several years ago. The result is that in 2018 gross margins were in the high 60s and grew to 81% by 2021, which is what drove the majority of the ~17% company gross margin expansion. The exhibit below shows actual margins and calculated margins (which is a check to show they match). Essentially, this is all a dressed-up way to say we made it up, but it is all internally consistent and we nevertheless think it is directionally close enough to not materially change the investment thesis.

A savvy reader may catch that we are implying physical software sales are delivering mid-60s margins, which is higher than we observed at peers when they were mostly selling physical discs (although it is hard to make a total like-to-like comparison given limited info on cost comparability). We do not have enough itemized cost info or disclosures on Nintendo’s cost of revenue line item to really gauge if this is inaccurate.  Additionally, hardware gross profit margins of 30% may seem higher than many estimate (we have seen various reports that their hardware is near loss-making), but this is what our math is showing and adjusting hardware margins down mathematically means software margins must go up more, which seems incorrect. Not to lose the forest for the trees, the purpose of all of this was just to hone our margin assumptions to have an approximate base to build off of for our gross profit build, which will come later on. (Don’t worry, we will not rehash this margin discussion again). More important than their margins on their games though, is their ability to create compelling content that gamers love and franchises that continue to keep them engaged.

A scene from The Legend of Zelda Breath of the Wild, one of the most critically acclaimed installments in the beloved Legend of Zelda franchise.

Nintendo has many of the all-time top games—26 of the top 50 to best sellers to be exact. There is no dispute that the quality of their games is high and are consistently received well by consumers. Their IP is wide-ranging from Mario and Zelda to Final Fantasy and Pokémon (1/3rd ownership), which allows them to continue to make hit games with a built-in fan base. Furthermore, Nintendo has a very strong history of creating new characters and new story lines that keep their games fresh. This is even more the case when they couple that with new hardware that adds different vectors to play-form. However, the innovation and desire to continually “reinvent the wheel” has come at a cost of game production velocity.

List of the best-selling video games of all time. Nintendo has developed/published 6 of the top 10 and 26 of the top 50.

Pictured below are all the games from the Super Smash Bros series, one of their most beloved games. Since 1999, they have only released 6 games versus Activision’s Call of Duty which has launched 24 games since 2003. Where other game developers release a new game for a series every year or two, Nintendo releases a new game every console. To be clear, we do not want to insist they should simply saturate the market with their IP. There is something to be said about building up the hype for the next title in a series, but we would like Nintendo to move away from the mindset that their game releases need to go in sync with their console launches, especially if console cycles will be longer (or forward compatible). Nevertheless, strictly from a business perspective, which is perhaps not the best way to judge creative works, we would want to see a more consistent title schedule for their hit games. Or, conversely, if they continue to launch only one title in a series per console, they should add more DLC (downloadable content separate from the main game) to keep gamers engaged across the life of the game and provide more opportunities to monetize. As games have become enabled by the internet, there is an ability to constantly update the game to keep it fresh, but it also provides ample opportunity to sell the consumer various in-game items with small charges.

The first Super Smash Bros. was launched in 1999, but they have only created 6 games in total for the extraordinarily popular franchise.

This is a shift from the traditional video game transaction, which is essentially completed at purchase of the game, to making the consumer relationship on-going. As you are probably familiar, Fortnite is the extreme of this example where it is free-to-play (F2P), but they monetize on microtransactions of various in-game items. This strategy works because there is only a small portion of users who will spend prodigiously on a video game (maybe 2-4%) and finding these users is very important. We have seen some games where these ultra-enthusiastic buyers can constitute half of the game’s total revenue (this rule seems to generally hold up for other services too, like brokerage trading). By making the games free, more consumers can enter the funnel and the developer has a better chance of capturing these power-spenders. Charging upfront for the game ($50-$60) usually means most gamers expect the rest of the game to be free and can create apprehension if the developer tries to put anything behind the paywall beyond something like skins (different colors/ costumes for a character).

To Nintendo’s credit, they have been adding more DLC content to their games especially with Super Smash Bros. They have introduced over 10 different character packs, charging $5-6 per character, which felt high for some consumers but has generally been received well. The ability to keep monetizing a pre-existing game will help Nintendo generate more consistent revenues. By and large, management seems to be making the right moves, just very slowly. But as we detailed in the hardware section, this still all hinges on them not resetting the install base with a new console (and non-backward compatible games). Adding more monetizable DLC content may make software sales more consistent within a hardware cycle, but it does nothing for the stability of their overall business between hardware cycles.

This is an example of DLC content where a user can buy new characters for Super Smash Bros.

The other factor to consider when thinking about their monetization strategy is how having a closed ecosystem can affect the development (and monetization of their games). Users can only play with other users who also have a Nintendo, so if you want to play your friends Super Smash Bros. online and they are willing to buy the game, but not a whole console, then you are out of luck. This limits the network effects a game can have to those who already have a Nintendo console which is very TAM limiting. We are not talking about the actual monetization limitations of tying software to their Nintendo consoles, which we already mentioned, but we are talking about how the gameplay is limited by being on a smaller network. This is evident with a game like Mario Maker, where users design their own levels and can share them with friends. It was originally launched on the Wii U and quickly floundered despite being a fun game because the network was too small: the value prop of building a game to share it quickly falters when there is no one to share it with on the platform. They relaunched it on the Switch and it has done better, but many of the most popular games today have social aspects to them and Nintendo is limiting themselves here by not making their games available across different platforms. Roblox for example is playable on all devices (including Nintendo) because the value is in the network and the interplay between what users create and consume. Of course, Nintendo doesn’t have to do everything, but the hardware exclusivity probably precludes them from ever being a strong contender to create a metaverse-like game (unless they move to a continuous iteration hardware model and build up their install base).

Mario Maker allows users to design their own games. Perhaps allowing sharing across platform could have convinced more users to invest time into creating levels. Sharing is limited to those with a Nintendo Switch and a Nintendo Switch Online subscription.

Along the lines of a closed system, Nintendo heavily guards what games can be played on their console, historically by utilizing cartridges that had built-in security features so no 3rd party could easily make a game playable on a Nintendo system without the proprietary cartridges Nintendo dished out only on game approval. This was to ensure only quality games would be allowed on the Nintendo, but also to limit violence and overly sexual content they didn’t want their brand associated with. This closed ecosystem was unfriendly to developers because of the cost associated with Nintendo’s proprietary hardware, which meant developing a game for Nintendo had lower margins. Although this was a more muted factor in recent years as games moved to discs, the history of not doing much to support 3rd party developers continued and ~90% of game sales were Nintendo created title just 5 years ago. However, they have moved to support developers more in recent years with things like the Nintendo Developer Portal, affordable dev kits (they cost just $450), and the Nintendo eShop, where people can self-publish their titles. 3P sales have gone from 13% in 2017 to 21% in 2021, which is important as it helps give Nintendo gamers more game options and also is higher margin for Nintendo as there are no development costs associated with 3P games. Ultimately though, we still believe Nintendo will continue to produce the most compelling content available on their systems, but it is good that they have supplementary content.

Nintendo Switch Online.

Nintendo Switch Online (NSO) is a subscription product (similar to Xbox Live) that 1) lets users play with others online, 2) access a library of old NES and Super NES games to play, 3) save data to the cloud, and 4) access a smartphone app that facilitates voice chat. A 12-month member ship is $20, which makes it seem like a very fair value. Nevertheless, online play tends to be a much smaller value add for Nintendo games (which are primarily played by yourself or with people in the same room), but it is important for games like Animal Crossing. It is encouraging to see they kept the price point low as their install base is already smaller versus peers and the non-cross platform compatibility already restricts network effects (which are important for a game like Animal Crossing). They do not disclose NSO subscribers regularly, but they had over 26mn in 2020 and we estimate they are around ~35mn today. This is a high-margin, recurring stream of revenue for Nintendo of over >$700mn. Over time, as more games have an online component and they add more games to the subscription they will have the ability to take prices up (Xbox Live is $60).

Perhaps, overtime, Nintendo could move all of their games to the subscription, essentially creating a gaming subscription similar to Xbox’s current Game Pass, which is $15 a month. The average Nintendo gamer only buys ~2 games a year ($100-120), so this wouldn’t be as cannibalistic as it may appear. Having a gaming streaming service also lowers the initial cost to joining the Nintendo community as a gamer has all games available to them right off the bat for a small monthly fee. We will speculate more later on what the future of gaming could look like.

As a reminder, everything we just went through from the hardware to NSO is housed in the same “Dedicated Video Game Platform” segment and we will now move to the mobile/ IP segment.

Mobile and IP-related.

As you can see below, Mobile and IP revenues are still a tiny portion of total revenues, but it represents the largest untapped opportunity. They do not break out mobile game revenues vs IP-related income, but together they represent just ~$500mn of revenues, up only $150mn from 2018.

Nintendo entered mobile after much trepidation, given it was the first time their IP would be on hardware they didn’t own (outside of some poorly done PC games several decades ago) and they possibly wouldn’t have entered at all if the Wii U wasn’t selling so poorly. And their hesitation shows: the first game they launched on mobile was “Miitomo” a social quiz game that was met with decent initial interest (10 million downloads), but engagement quickly fell off and they pulled it from the app store just two years after it launched. Following Miitomo was Super Mario Run 9 months later, which showed a willingness to employ their top-tier IP, however they fumbled mobile-gaming etiquette by only allowing users to play a short demo before requiring $10 for the full game versus the more standardized F2P (free to play and monetize via microtransactions) methods other game developers utilize. Nintendo never released official financial figures for Super Mario Run, but 3rd parties estimate they made ~$80mn in revenue against over 300mn downloads, which translates to just a ~3% paid player penetration, far lower than the typical ~10%+ seen among peers. They launched several other games, but Nintendo’s most successful so far is Fire Emblem Heroes. Notably, Fire Emblem Heroes adopts the common F2P mobile format and has far outperformed their other games with an estimated $600mn+ in lifetime revenues as of 2020. Disappointingly though, they added a $9.49 subscription tier to the game that put behind a paywall many features fans were clamoring for, which was was met with a lot of player frustration. Xbox’s Game Pass is $15 a month for their whole library of games and Nintendo is charging 2/3rds of that to access premium features for a single mobile game, which seems a bit tone deaf. 

Fire Emblem Heroes mobile gameplay.

However, despite Fire Emblems Heroes’ aggressive monetization, Nintendo’s mobile success so far has been underwhelming given the breadth of their IP and gaming expertise. They do not have a knock out success like Arena of Valor, Candy Crush, Fate/Grand Order, Free Fire, Clash of Clans, or many others. You may be wondering about Pokémon Go, given it was one of the most popular mobile games ever and  generates over $1bn+ a year, but Nintendo had no material role in developing it. Niantic, the AR-focused gaming company that spun out of Google in 2015, was the main developer on the game. But fortunately Nintendo and Niantic have announced a partnership in March of this year to work on more games, starting with the Pikmin franchise (Nintendo owns ~1/3rd of the Pokémon company and has an undisclosed stake in Niantic). A single hit game could be equivalent to 15-20% of total annual software revenues, but also add much needed stability to their earnings. While Nintendo’s gaming success has been limited to just Fire Emblems Heroes so far, there is hope with new partnerships they can eventually have a few other hit games. Nevertheless, their commitment to mobile seems more ancillary to their console business, when in reality it is equally (or more) important given the 2bn+ install base of smart phones vs. ~90mn for the Switch today. In our revenue build we will show what it could look like if they have more success with mobile, but a conservative investor may not want to assume outsized execution here.  

The picture from the Niantic/Nintendo press release announcing a partnership and the development of a Pikmin game.

Intellectual Property and the “Nintendo Universe”.

The second piece to this segment is their IP-related revenues. This includes licensing for toys, Amiibo, & other merchandise, and will also include revenues from their new initiatives like the Super Mario Bros. film and the Super Nintendo World experience at Universal Studios theme parks. The renewed focus on merchandise as well as new focus on media and parks naturally makes some investors want to draw a parallel to Disney.

Part of the Nintendo toy section in a toy store.
The Amiibo section in a toy store. The figurines can be used to unlock different features in many games.

The Disney flywheel allows all of their IP to interact with consumers through multiple touch points that act together to reinforce engagement between properties. Disney’s virtuous cycle effectively allows them to amortize CAC across multiple different business lines. But it is often even more powerful than that: what would be standalone acquisition costs for one business are actually profit pools for another. The well-known Walt Disney diagram on how all of these different forms of engagement interact with and reinforce each other is pictured below.

Every creative effort supports each other one, lifting the Disney Kingdom up in lock-step.

There are a few recent developments that support the spirit of this thesis: 1) Nintendo is opening up a theme park in partnership with Universal Studios dubbed Super Nintendo World, 2) a Super Mario movie is slated for release in 2022 in partnership with Illumination Entertainment and Nintendo has stated that they are interested in expanding their IP out more (albeit cautiously) 3) Nintendo has been growing their toy licensing operations, notably with Super Mario Legos. While it is an attractive thesis and we would love to see Nintendo execute along this path, it seems unlikely given Nintendo’s culture, involvement, and priorities.

Super Nintendo World at Universal Studios Japan.

Nintendo has always had hardware at the center of their universe with the belief that innovating that hardware is critical to their continued success. While that could have been true at some point, in the past ~15 years we have seen the Xbox and PlayStation consoles continue to dominant the video game space with no notable hardware innovation (beyond improving graphics and performance). While Nintendo hardware innovation may be critical to stand out in the hardware space, it is not critical or even necessary to support their gaming and IP anymore. They could easily make their games compatible across all platforms and even get out of the hardware business entirely. It seems today Nintendo is optimizing for the wrong thing given their massive library of well-known IP that many more consumers would happily engage with regularly if there were more touch points. In some sense, this is reminiscent of the Steve Ballmer era at Microsoft where all of the best products and services like Office and Azure were tied to Windows as a way of differentiating and supporting the operating system and justifying increasing licensing fees. But in doing so, Microsoft was missing the far bigger opportunity to sell many more copies of Office across different platforms (like on Macs) and expand Azure use cases by running non-window software (Azure did eventually run Linux under Ballmer, but the point stands). While we think this is too extreme of an analogy for Nintendo, it captures the essence of what will hold Nintendo back from being the next Disney: the prioritization of growing their hardware business will always limit the potential of the “Nintendo Universe” compared to what it could be if it was more platform agnostic. The virtuous cycle of each business supporting the others doesn’t work if one business stands above all others. For instance, the theme parks and movies don’t accrue equivalent benefits to the Nintendo ecosystem compared to a hit hardware console. Said another way, if they had a hit movie out and the parks were running at the time the Wii U was launched, it is unlikely it would have been the difference between making the console a success. This asymmetry in business lines is why Nintendo outsources development of all of their new initiatives and continues to be laser-focused on the hardware business. Simply said, nothing can wreck their business as quickly as having a bad hardware cycle, and as long as they insist on prioritizing hardware over the whole “Nintendo Universe,” they will always be a cyclical gaming company subject to the vagaries of their hardware R&D department.

Many investors see numerous parallels between Nintendo and Disney, but more importantly, they see a supposed easy roadmap for expansion and monetization.

But that’s not to say Nintendo’s IP monetization efforts are misled. On the contrary, they are a high-margin revenue stream that is not reliant on console sales, but we are stopping short of saying it is an accelerant to the building of a whole “Nintendo Universe” and rather think of the benefit as being more muted. These IP efforts will likely drive more sales and engagement to their properties, but overall a dedicated section at a few theme parks and a movie is a far cry from a Nintendo Flywheel. Perhaps they are only testing the waters and will in the future have much more content that is released on a regular basis, but if you think back to the culture of Nintendo—the company that launches just one of their franchise games on each console every 5-7 years—it seems unlikely the culture is built for that rapid speed of production. We don’t want to give the impression that we think Nintendo is doing anything wrong necessarily, it is just that it is not what investors would want. It’s important to remember that what makes a good video game developer isn’t what makes a good business. Nintendo wants to make unique forms of entertainment and produce video games in line with the Nintendo ethos, not to just make recurring revenue (we do not mean to imply a value judgement here, this is just how we believe management thinks and will act accordingly). Remember, the Disney flywheel wasn’t stumbled upon just from an overflow of IP, it was the express business plan Walt Disney laid out for the company and Nintendo has made no claims they intend to follow it. The ambitions to become the next Disney are not seeded from Nintendo management, but rather investors looking for a story.

Estimating out revenues is very tricky as it is impossible to estimate the potential for a movie franchise that hasn’t been launched yet, but a hit movie on the level of Marvel or Harry Potter can make ~$1bn. If they have multiple franchises that are successful there is potential for a hit movie every year. As far as the parks revenues go, a Universal Studios ticket is ~$100 and they receive ~11mn visitors annually, which with Nintendo’s estimated ~9% split of revenues equates to ~$100mn per park. They have plans to enter 4 parks in total which would equate to ~$400mn. Adding two annual hit movies and parks could be another ~$2.5bn of annual revenues. If there are knock-on effects to merchandising and other games, the lift could be much more. We won’t be so bold as to put all of this into our revenue build below, but there is upside if they do lean more on their movie production schedule and it is well received.

New Initiatives.

Nintendo has started to already foray into Virtual Reality with Nintendo LABO. These different cardboard kits allow for novel game experiences. Interestingly, they incorporate the existing Switch controllers, which is a data point that Nintendo can continue to innovate on the form of gameplay without having to actually change the hardware platform (we still aren’t so sure). These carboard kits are DIY assembly and run from $30-50 each.

There are 4 kits in total today. Below is their vehicle kit to simulate a driving experience. Consumers have expressed delight at how smart and easy these kits are to build, despite looking complicated to assemble.

Other new initiatives include their partnership with Tencent to develop a Pokémon game and distribute the Switch. China had a 15 year video game console ban that expired and they are allowing limited devices to be sold within China. Around 1mn Switch units have been sold through Tencent in China, but there is an estimated 3m+ that were acquired through the grey market. There seems to be high demand for Nintendo’s console, with high secondary prices, despite very few games having been approved and distributed in China.

Management.

Despite its 130+ year history, Nintendo only had six presidents. Incredibly from 1889 to 2002 the Yamauchi family, descendants of the original Hanafuda card company founder, ran the company. Perhaps even more incredibly though, after 113 years of family control they passed on the reins to an outsider, Satoru Iwata, who was just 42 years old. As the final Yamauchi to lead (Hiroshi) was stepping out, he told Iwata one request: “that Nintendo give birth to wholly new ideas and create hardware which reflects that ideal”, showing how embedded hardware innovation is in the DNA of the company. Iwata described Yamauchi’s guiding principles as “originality” or “surprise” and said he had limited patience for “Kaizen,” the management philosophy that advocated for inch-by-inch product improvement. The worst answer you could give him, Iwata said, was “it’s not different, but it’s better.” Iwata followed those guiding principles with the Wii launched under his leadership, but he tragically died young in 2015 leading to a 3-year transitional President, Tatsumi Kimishima. It wasn’t until 2018 they found a more permanent (and the current) President, Shuntaro Furukawa. This means that Furukawa took over right at the time of the Switch’s success was apparent and after Nintendo had already experimented with mobile games. Furukawa worked closely with Kimishima during these developments though, as a Head of Corporate Planning. In fact, he was partly chosen because he had already mapped out the future of Nintendo and his prior accounting role in Germany gave him a global perspective that allowed him to inclusively convey that future to an increasingly decentralized workforce. As far as the future of Nintendo goes, it would seem that it would still embody the ideals of Hiroshi Yamauchi who promoted hardware as core to creating unique gaming experiences, but as Furukawa has said “as the times have changed, some parts of our philosophy must change too.” Supporting Furukawa is Creative Fellow Shigeru Miyamoto, who joined the company in 1977 and is best known for creating the Mario and Zelda franchises.

Current President Shuntaro Furukawa (right) and Creative Fellow Shigeru Miyamoto (left).

Revenue Build.

When we try to build out revenues, immediately we run into an issue because of the uncertainty of their hardware cycle and whether they do indeed move to a more continuous iterative hardware model. We do not believe there is much evidence to support the continuous iterative hardware model thesis, but it is impossible to try to guess what revenues would be in 5 years from a console that has yet to be released. Since the Nintendo 64, Nintendo has not had two consistently popular consoles so it is quite possible the next console “misses” and their install base is lowered which means far fewer software sales and potentially incurring losses. The issue with the Nintendo investment thesis has nothing to do with how the company is currently being run, but the future ambiguity that new product launches with uncertain consumer reception brings. Management committing to making the Switch their permanent platform and allowing new games to be playable on old devices would be a dramatic improvement in the quality of their business.

We adjust our ROIC calculation by capitalizing R&D for 6 years and amortizing it under the straight-line method. The idea behind this is to better capture the investment Nintendo makes in hardware development.

As we show above, ROIC the last few years has been very strong and if Nintendo could just continue doing what they are doing with the Switch, making it a platform, they would have an incredible business on their hands. To understand the power of this transformation, we run our revenue build assuming they do go to a continuous iterative hardware model to see how powerful of a transition that would be for them financially. The exhibit below runs through our revenue build assuming the install base doesn’t reset and they have fairly good success in mobile and their other IP initiatives (but not quite the knock-out success of them “becoming the next Disney”).

As seen, above a shift to iterative hardware means much more software sales overtime. Below we estimate NOPAT based off of the revenue build above.

We complete this analysis by showing what those earnings capitalized at 15-25x NOPAT would imply in terms of a investor return. At 20x, which is a very fair price to pay for a company with a strong competitive position stemming from proprietary IP and would likely still be growing at least high single digits in 10 years’ time, would be a 20%+ compounded return. However, as we have said throughout, we do not think they are likely to move to this model and if they launch a new console in a few years time, all bets are off.

It is very easy to rationalize buying Nintendo today given it trades at 12x ex-cash earnings with many call options for future earnings to be much better and downside risk protection from their large library of IP, cash and investment stakes (notably 1/3rd of the Pokémon Company). However, it is far from inconceivable they launch a new console that is a “miss” in a few years to replace the Switch and Nintendo treads water for four years as they try to come up with the next iteration of hardware. In the meantime, they will draw down cash and software sales will dry up as they cannot sell games for a console no one owns. They can experience markedly lower earnings or incur losses again. In fact, they actually specifically mention their high cash balances as insurance against creating something no one wants and to buy time to start over. Their fortified balance sheet of ¥1.2tn (~$11bn) in cash isn’t just typical Japanese conservatism, it is expressly to cushion a loss. As CEO Furukawa said just this last March, “we need cash holdings not only for ordinary working capital, but also to withstand a number of unsuccessful projects.” As attractive as their model could become, we must not lose sight of the downside inherent in a console transition. Perhaps an investor can have more confidence than us that this transition to a continuous iterative hardware model will happen or an investor could place higher weight in their Mobile & IP efforts which will give Nintendo an earnings stream that is uncorrelated to their hardware consoles. 

The Future of Gaming.

It is also worth mentioning that the future of gaming is more unsure of now than ever before. Microsoft and Sony are preparing for a world where there is no regular hardware cycle with the invent of game streaming. Microsoft has gone so far as to not only offer a gaming subscription, but also a console subscription that bundles the two together for just $25/month. Other players like Google with Stadia, Nvidia with GeForce now, and even Amazon with Luna allow a consumer to play eligible games across platforms including PC or tablet where a user can simply plug in a controller. All of these services are driving the commoditization of hardware as the cloud allows more workloads to be done on the server side, decreasing the need for regular home console improvements. The lack of differentiation between different hardware means these services will only be able to differentiate themselves through content, which is why Microsoft bought ZeniMax Media for $7.5bn, the parent company that owns the studios responsible for Fall Out and Doom, among others. This is all a positive for Nintendo, the owners of one of the largest libraries of games with some of the best IP, but it still is the case that making their games allowed cross-platform would effectively kill their hardware business and as we mentioned before, that seems culturally untenable. In fact, on the last earnings call, President Furukawa said that they had “no plans for cross-platform play for Nintendo titles.”

To speculate, it seems plausible that Nintendo will eventually be forced to ditch their hardware if game streaming becomes a service that is as easily accessible as TV streaming is today with $30 Fire sticks. Under such a scenario Nintendo could still create unique controllers that plug into the streaming device, but if they the utilized common hardware (the same controllers used for other games) then they could access a much larger player base. Instead of licensing their games to a game subscription service like Xbox’s Game Pass, Nintendo could have enough content to justify creating their own “Nintendo World Pass” that grants subscribers’ full access to their library of games. If they are successful with their media efforts and end up launching tv shows and movies, all of this could be included in the subscription price as well. We are entirely unsure of what the gaming dynamic will look like a decade from now, but we are sure Nintendo will have some place in it. But remember, what makes a good video game developer doesn’t necessarily make a good business. While we have confidence in Nintendo having a top place in the video game realm in the future, we have no confidence in what their earnings will look like. A platform transition can be painful and may necessitate many years of low or no earnings. This is before mentioning all of the ambiguity that AR/VR gaming brings, which at one extreme could render their hardware outdated (with no cheap “withered technology” to utilize) and require prodigious investment to produce quality AR/VR content.

If there are any clear management indications that Nintendo is moving to a more continuous iterative hardware model or there is outsized success with more stable revenue streams like mobile, then we would be more constructive on them. Our valuation isn’t the problem, it’s the lack of confidence in the assumptions. Perhaps an investor who is better at reading the tea leaves then us can see the future with more clarity than we can.

Summary Model.

As usual our summary model below isn’t meant to match with other exhibit assumptions but present a picture of how different items flow through. Of course, Members Plus will be able to change the assumptions for the below model and have full access to the underlying excel behind all other exhibits.

Conclusion.

Thank you for reading! Please feel free to drop in any questions or discuss with other members in our Discord group!

*Disclaimer: People who have helped craft this analysis may individually (or through funds they work at) have a position in the company. Absolutely nothing in this report is investment advice nor should it be construed as such. We make no claims to the veracity of all facts and figures presented in this report. Certain figures could be stated erroneously and certain analysis could be incorrect. Please see the full disclaimer linked above.

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