NTDOF - Nintendo: Still Happy To Wait For Better Longer-Term Visibility

2023-03-21 09:23:29 ET

Summary

• The recent trading activity looks relatively subdued at Nintendo, following the lowered company guidance for FY3/2023.
• The Switch software pipeline looks satisfactory but not overwhelmingly so, and limited evidence of the new Switch upgrade lowers earnings visibility.
• Valuations are not demanding on consensus PER FY3/2024 16.4x, but we are happy to wait for more news on the next 'hit' product cycle.

Investment thesis

We reiterate our Neutral rating on Nintendo ( OTCPK:NTDOY ). We believe there are no positive catalysts in the short term, given the lowered company guidance for FY3/2023, and limited visibility over a new product cycle that can generate sustainably high returns for the medium to long term. We are happy to wait until there is more evidence of a new 'hit' product cycle.

Quick primer

Nintendo is a leading franchise in electronic entertainment. The Switch game console has reached over 149.1 million hardware unit sales in Q3 FY3/2023 - the bestselling console for the company to date since the Wii which sold 103.51 million units.

Key financials with consensus forecasts

Our objectives

Q1-3 FY3/2023 results were disappointing, with the company announcing a downward revision to FY3/2023 earnings guidance as well as dividends. We note that consensus forecasts remain optimistic, with net income remaining at JPY404.6 billion versus the new guidance of JPY370 billion. In this piece we want to investigate:

• whether recent trading is strong to warrant outperformance.
• outlook into FY3/2024.

Limited upside in the short term

Putting aside current forex fluctuations, we do not see any major software releases (either first or third-party) that will move the needle significantly for the company to beat forecasts in the current quarter. The company will be reliant on repeat sales post the Christmas season which itself was not as active as anticipated. The latest 'Zelda' appears to be a major winner with strong Japanese pre-orders, unfortunately, this will not mean much for Q4 FY3/2023 with a release date of May 12th, 2023.

Other events appear to have limited impact - the opening of SUPER NINTENDO WORLD at Universal Studios Hollywood in February 2023, or continued sell-thru demand for the latest major titles Pokémon Scarlet and Pokémon Violet. The Head of Nintendo of America Doug Bowser has commented that supply chain problems for the hardware now appear to have subsided, and we do not see indications of pent-up demand at retail.

Revised company guidance implies Q4 FY3/2023 operating profit to be just under JPY70 billion, which is a major decline of 40% YoY. Such as result would be a negative optic, and highlight that the Switch cycle had peaked in FY3/2021. The key question is whether there are potential events that could re-energize the franchise in the medium term.

Not exactly a seven-year itch

The Switch has entered its seventh-year post-release, and the official company line appears to be 'no update' as yet. The first-party software line-up is said to remain robust, and there appears to be no hurry to come up with a next-generation platform. We see the risk of a positive surprise in the short term to be low, given that the company will not be attending the E3 conference this year which is usually a showcase event for major announcements. This is not to say that Nintendo is not preparing for a new product, but the timing does not coincide with their plans. However, the company is aware that it is in unchartered territory, running one platform into its seventh anniversary.

In-house software launches will always be the key to success, but unfortunately for now the market remains in the dark about top-tier launches to come. CY2023 should see 'Pikmin 4', and we know that shooter 'Metroid Prime 4' is in the works. However, there is a distinct lack of marquee 'Mario' titles which could mean that a new platform could be planned for launch in late 2024. Whatever the plan may be, we believe it is unlikely that management wants to stop catering to a user base of nearly 150 million Switch units - this is a cash cow, and any transition to another platform will be high risk and need to be done with utmost care.

We believe the likely scenario is that the Switch will continue as the core business into H1 FY3/2025, and then a new product launch will start to place investor emphasis on growth. Until then, there appear to be limited opportunities for the company to outperform.

Valuation

On current consensus forecasts, the shares are trading on PER FY3/2024 16.4x and a dividend yield of 3.0%. Nintendo has no direct comparative being a pure-play game business (unlike Sony ( SONY ) and Microsoft ( MSFT ) with multiple business lines) which makes peer analysis difficult. However, with the 5-year historical PER at 18.1x, the current PER multiple suggests fair value to us given the negative growth outlook.

Risks

Upside risk comes from a newly unveiled slate of software in H2 FY3/2024 that would drive earnings much more strongly than currently anticipated. FY3/2024 company guidance could also be high to reflect this renewed level of activity on the Switch platform.

A major weakness in the Japanese yen versus the US dollar will help both transaction and translation when reporting the financials.

Downside risk comes from weak guidance for FY3/2024, despite the release of 'Zelda' and 'Pikmin'.

The company may seek to lengthen the life of the Switch platform past FY3/2025, which may prove to be too long as gamer interest wanes considerably as the platform enters its ninth year.

Conclusion

The market already knows about Nintendo's core strengths in intellectual property, historically stable cash flow generation, and large cash pile. We believe what the market needs to see is a new product that will be able to successfully generate sustainable earnings at the record-high levels currently being witnessed by the Switch. This is both a tall order but also vital with respect to maintaining the company's market valuation. Until we see greater evidence of the next 'hit' product cycle, we reiterate our neutral rating.

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