NTDOF - The Nintendo Thesis Is Materializing

2023-11-28 05:03:26 ET

Summary

• Nintendo reported strong H1 numbers, but investor focus should not be on the numbers.
• Many things point to a strategic shift, which will be key for the Nintendo investment thesis.
• Slowly but steadily, the company is building a significant portion of recurring revenue. We got updated NSO numbers.
• Guidance was tweaked but needs context.

Introduction

Nintendo ( NTDOY ) reported its H1 earnings a couple of weeks ago, and these were solid. Don’t expect anything crazy from the numbers, but it was a positive quarter. Last quarter, we discussed this in our earnings digest , and we think that as quarters go by, we continue to see how the strategy shift is now a reality more than a plan.

We also believe the market is waking up (albeit slowly) to this fact, with Nintendo significantly up in Japan this year. The continued weakness of the Yen has eroded the ADR’s performance:

Seeing the market finally waking up to the company’s potential is nice, but we don’t think YTD returns are relevant to the thesis. If Nintendo successfully performs its strategic shift, it will probably be worth much more in the future. We often get the question: ‘What’s Nintendo worth?’ This question requires a fairly long explanation (we discussed it in a webinar with subs), but there’s a shortcut.

Microsoft (MSFT) recently acquired Activision ( ATVI ) for close to $70 billion, and we believe Nintendo is worth considerably more than Activision, while it's currently trading for a market cap of $57 billion market cap with around $10 billion in cash. Our rationale is that Nintendo is better managed and has significantly more optionality to monetize and leverage its IP. Anyway, let’s get on with the earnings release.

The numbers

The headline numbers

Nintendo’s sales clearly decelerated in Q2, normal considering that most of the impact of the Super Mario Bros movie and the Zelda game was felt in Q1. During the first six months, sales grew 21.2% to $3.12 billion compared to 50% year-over-year growth in Q1:

This means that Q2 sales actually dropped 4.2% year-over-year. This drop might seem worrying, but we don’t think the Nintendo thesis currently relies on growing sales but on the assurance that management will make the strategic shift to monetizing its IP. This said, if you were to ask any analyst who followed Nintendo a year ago what their expectations were for the first 6 months of 2024, we are sure they would’ve guided for a substantial drop in sales, not a 21.2% increase. We should not forget that the Switch is now entering its seventh year, unprecedented territory for any Nintendo hardware.

Operating profit expanded 27% during the first six months to $1.89 billion but dropped significantly year over year in Q2. Nintendo’s Q2 operating profit dropped 20%, which makes sense considering the surge we saw in Q1 caused by high-margin revenue like the movie and sales of Zelda.

Until Nintendo releases its new system, hopefully an iteration of the Switch, and confirms its new recurring model aspirations, it’s normal to see volatile financials. In the meantime, these will be heavily skewed toward 1P activities like the Mario movie or certain software releases. This is “bad” because it introduces volatility, but also good because it demonstrates how powerful the company’s IP is. It's pretty outstanding that a movie and a single game can be so impactful to a device's 7th-year performance.

Digging deeper into the top line

Nintendo reports in three operating segments: dedicated video game platform, mobile, IP-related income, and playing cards. All grew year over year during the first 6 months, but all of them decelerated significantly in Q2:

It is worth noting that the yen's depreciation over the first 6 months has also positively impacted sales:

The depreciation of the Yen benefits Nintendo because a good portion of its costs are incurred in yen (development), so the company makes more Yen after a devaluation but does not see a comparable increase in expenses in its domestic operations. Out of the 139.2 billion yen increase in sales, almost 37 billion came from foreign exchange. This means that constant currency sales grew 16% year over year during the first 6 months:

Nothing was worrying in what relates to sales, but we think the following stat should not be taken lightly:

Sales in the first half of the fiscal year were the largest since the launch of the Nintendo Switch.

We don’t think many investors expected to be reading this stat in the seventh year of the Switch cycle, which makes it even more impressive. Again, this demonstrates that the Nintendo thesis does not lie in its hardware specifications but rather in its development expertise and IP. This might seem unimportant, but it takes away much of the company’s disruption risk.

Looking at other operational data, we can see some interesting things. For starters, it’s logical to see the proportion of 1P sales increase dramatically during the first 6 months due to the Zelda game and the sales related to the Mario franchise (brought partly by the movie). What’s starting to worry us slightly is the stagnant proportion of digital sales:

Nintendo’s proportion of digital sales has increased significantly throughout the Switch cycle but seems to be stagnating now:

Many people have argued that this percentage would gradually increase to that of Sony (around 70%), but the reality is that this objective seems far away and probably unattainable. This might stem from the nature of Nintendo’s software, which is more prone to physical sales (as holiday/birthday presents and due to their nostalgic feel). We don’t think this is a “blow” to the thesis (not even close), but we do believe management should find a way to improve this number, especially considering the substantially higher margins digital sales enjoy.

During the first 6 months, Nintendo slightly increased both its hardware and software sales, although a good portion of these were in Q1 (for reasons already discussed). Q3 (holiday season) is Nintendo’s most important quarter, so we’ll see how that develops, especially with Super Mario Wonder enjoying such great performance:

Both hardware and software unit sales dropped sequentially but remained pretty resilient compared to Q4 FY 2023.

It’s outstanding that Nintendo has sold almost 20 million copies of Zelda and more than 3 million copies of Mario Kart 8 Deluxe in 6 months, especially since the former was launched more than 6 years ago!

This, once again, demonstrates the timelessness of Nintendo’s IP and the impact of the Mario Bros movie:

Is the Mario movie the best investment in Nintendo’s history? Food for thought…

Another example is the new release of the Mario saga. Super Mario Wonder is a return to the original Mario games (it had been more than a decade since a similar game was launched), and it sold more than 4 million copies in two weeks. This is the biggest release for any Super Mario title, so it's not something investors should sleep on.

This timelessness is also evident in the lifecycle of Nintendo’s software sales. Most 1P titles tend to generate the majority of their sales after the 13th month, so we’ll probably see the successful title remain that way for a long time:

We also got an update on Nintendo’s subscription offering: Nintendo Switch Online or NSO. Management claimed that NSO had reached the 38 million subscriber milestone. This translates into subscriber growth of 6% year-over-year:

This is not great, but it gives Nintendo quite a bit of annual recurring revenue. Assuming an average yearly price of $35 (the midpoint between both subscription offerings), we get to $1.3 billion in Annual Recurring Revenue, not bad at all.

Another thing to note is that we should be realistic with the potential here. Nintendo disclosed 117 million annual playing users this quarter, but we must not forget that many of these users are sporadic players who might get periodically engaged with the release of a Zelda or Pokemon game, for example. These players might not see a compelling value proposition in the NSO subscription, meaning we should expect the gap between annual playing users and NSO subscribers to remain wide. This said, we also believe that the value of the NSO subscription to recurring players is significantly higher than $35/year, which gives Nintendo quite a bit of pricing power.

All in all, nothing unexpected from a revenue standpoint. Sales will be more important next quarter due to the holiday season, so let’s see how that goes.

Profitability - Deleveraging after a very strong quarter

We’ve already seen a glimpse of what happened to profitability. After a surge in profitability in Q1, it dropped significantly in Q2. Let’s briefly analyze it.

First, the gross profit margin was slightly down over the first 6 months and significantly down from Q2 to Q1:

This is completely normal considering that revenue from the movie and the Zelda game (both high-margin products) were absent this quarter. Also, Nintendo is now selling more of the OLED model, which carries a lower gross profit margin.

To this, we have to add that Nintendo will not slow down operating expenses, especially as we go into the holiday season and the company supposedly prepares to launch a new hardware model. Advertising and R&D expenses were both up double digits during the first 6 months:

Unlike the company’s gross profit margin, its operating margin remained somewhat resilient during the first 6 months. It was actually up, but that’s something normal considering the operating leverage Nintendo enjoyed in Q1. This is what we wrote in our latest earnings digest :

The operating margin expanded by 710 basis points, 630 of which came from SG&A leverage and 90 of which came from gross margin expansion. They don’t add up to 710 due to slight currency headwinds.

Note that there are several things included in SG&A, but we only get disclosure on S&M and R&D. R&D marched significantly higher than S&M, demonstrating that a good portion of the sales surge was achieved thanks to passive advertising from the movie and the release of the New Zelda game which of course doesn’t need too much advertising due to its loyal fan base.

This is very important when considering the potential of the monetization of IP. As we always say, not many companies get paid to advertise, but Nintendo is one of the few that do! There are few evidences, by the way, that Nintendo will stop these ventures:

We are utilizing our characters to continue expansion into a broad range of areas . We aim to continually create points of contact with consumers, broaden our fan base, and deepen their fondness for Nintendo IP.

As the accumulation of software assets is important for our long-term business strategy, we will be leveraging our cash on hand over the long term with initiatives in fields like visual content that have a high affinity with our dedicated video game platform business.

Source: Shuntaro Furukawa, Nintendo’s President

Do you want more?

Going forward, we are determined to work even harder in our visual content business .

Source: Shigeru Miyamoto

Nintendo announced the production of a live-action movie in the Zelda franchise:

Regarding the balance between maximizing IP value and the risk of causing devaluation, it is important to continue developing projects one by one, being careful to prevent excessive exposure to the IP .

Source: Shigeru Miyamoto

Guidance

For some quarters, we have said that Nintendo’s guidance seemed pretty conservative, considering the movie’s success and what it had done to the overall business. This quarter, Nintendo presented updated guidance figures, although they need context:

We see substantial increases across the board, but there are not many changes really. The only meaningful change comes from an almost 3% higher software sales expectation. This is precisely the area where we have claimed that Nintendo was being extremely conservative. The new guidance also seems quite conservative, considering the company has sold 97.1 million software units in the first two quarters (around 53% of what’s guided) and that Q3 should come in pretty strong because it includes the holiday season and a resounding success in Super Mario Bros Wonder.

The hardware guidance does not seem too conservative, considering Nintendo has sold around 6.83 million Switch (45% of what’s guided); it needs a strong holiday season.

The rest of the increases stem from a modified exchange rate forecast. The company has now increased the USD/YEN exchange rate by almost 8% and the EUR/YEN exchange rate by 10%, which obviously benefits the company’s sales and profitability.

The guidance still looks conservative on the software side and pretty demanding on the hardware side, but not much changes regarding the business's underlying performance.

Conclusion

Nintendo reported good earnings, but we must not forget that the financials are not the most important thing right now. The potential in Nintendo lies in its strategic shift to a more recurring model and the monetization of its intellectual property.

In the meantime, keep growing!

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