Nintendo: There’s A Glitch – Case Study by Joshua Kennedy, Sonian Capital Management

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Executive Summary:

NINTENDO (Japan: 7974) is a global leader in the booming video game industry, with a long history of innovation in both hardware and software in what has become a mainstream, arguably dominant entertainment category. Today, as with other moments in Nintendo’s storied history, the company stands at a pivotal crossroads. Only 8 years removed from the peak of its biggest-ever hardware hit product, Nintendo is contemplating a future in which its core business model: selling software made excusively for its own hardware, may be a thing of the past. In this context, Nintendo carries a balance sheet with half its market cap in net cash and investments, and owns the most valuable intellectual property in the video game business. With 2.5 billion smartphone users in the world, the greatest video game maker of all is about to enter an arena an order of magnitude larger than any in which it has ever played. Why then is Nintendo valued as if it has no future?

Nintendo: There's A Glitch - Case StudyThis handsome fella here is Carl Gustav Jacob Jacobi.

Mr. Jacobi was a German mathematician of exceptional brilliance who is known by practitioners of that field (of which I am not one) for his work on elliptic functions, theta functions and differential equations. Also, the Jacobi crater on the moon is named after him, which is a pretty nifty calling card.

He is remembered by stock market investors primarily due to the efforts of Charlie Munger, Vice-Chairman of Berkshire Hathaway. Charlie exhorts investors to “Invert, always invert,” by which he means when confronted with a challenging puzzle, flip it over and try working backwards to gain a new perspective.

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Munger is, in fact, promoting Jacobi’s insight: Man Mass Immer Umkehren. Here is Jacobi translated into English:

“Many hard problems are best solved when they are addressed backward.”

Here is Charlie, taking it one step further:

“Indeed, many problems can’t be solved forward.”

According to the Wikipedia entry on differential equations: “in pure mathematics, differential equations are studied from several different perspectives, mostly concerned with their solutions – the set of functions that satisfy the equation.” I don’t know if Jacobi’s insight about inversion helped him contribute to differential equations, or the other way around, but it totally makes sense.

Normally an investment writeup like this would start with a description of the company, what they do, competitive dynamics in the industry, etc. We all know the drill. We’d do some valuation work, come up with a range of prices, compare them to the market price, and try to conclude that it is a buy or sell, or whether there is a sufficient margin of safety, and so forth.

Nintendo (7974 JP), the Japanese video game giant, is a difficult company to value at the current moment in time. There is an extraordinarily high level of uncertainty about essential features of the company’s near-term future. This makes it kind of a puzzle.

If we invert the problem, however, it becomes pretty clear. If you take the market price – “the solution” – and interpret what that implies about the future of the company, an investment case becomes evident. This is a situation where a high degree of uncertainty is being confused with a high level of risk.

But in fact, the risk of permanent capital loss is very low. Even in a dire scenario, Nintendo can’t really be worth much less than today’s price. And it’s quite possible it is worth much more, possibly multiples of what you can buy it for today.

Nintendo's Long History

Mr. Jacobi passed away in 1851. Only a few decades later a card-playing frenzy was gripping Japan, and Nintendo was established to manufacture playing cards in 1889. The company bounced around from one form of entertainment to another for the next 80 years before embarking on video games in the 1970’s.

Nintendo essentially created the home console video gaming business, and has by turns survived and thrived in the three decades since. It’s fortunes have been closely tied to the popularity of each generation of hardware console. Through the rise and fall of massive hits like the Gameboy and duds like WiiU, however, Nintendo has succeeded in building a massive fan base for the company’s products and in particular, its stable of video game characters like the Super Mario Bros.

Console WarsNintendo is an exceptionally well-known company with a long and storied history that, for the sake of brevity, does not need to be re-hashed here. For those interested in a deeper dive, I recommend Blake Harris’ Console Wars.

Instead I will just highlight a couple of salient points that I think any potential investors should draw from studying Nintendo’s past.

1) Business model: Nintendo is relatively unique today (although not historically) in that they make hardware and software. Microsoft and Sony currently make consoles and are involved in a few gaming studios, but are not fundamentally in the video game software business. Activision, Electronic Arts and other game developers make games and strategically prepare them for different platforms, but do not have their own platforms. Smartphones have disrupted this, which will be discussed at length below.

The first important point is that Nintendo is the most successful game developer of all time in no small part because they develop their games exclusively for their own platforms. Company management views this as an elemental component of their competitive advantage: Nintendo develops games for specific, unique hardware. The second key product of this business model is the operating leverage: the success of a Nintendo game is inextricably linked to the success of the current Nintendo hardware platform. So if a console launch is a hit like Wii, Nintendo sells a lot of, say, Wii Sports. If a console is a dud, like WiiU, then there is a cap on how many copies of, say, Super Mario Maker Nintendo can sell.

2) Trendspotting: Since the success of the NES in the ‘80’s, every Nintendo platform has been developed in secret, highly anticipated and hotly debated. And the company has produced both heroes and goats. The essential point, however, is this: Nintendo has repeatedly been criticized for having lost the plot of what gamers want, only to deliver something extraordinary. The best example of this was prior to the launch of the Wii, when it became clear Nintendo’s console would not support high-def, though Xbox and Playstation would. Investors and fans were apoplectic. It’s happening again today: a recent Forbes.com commentary on the company was entitled “Why I’m Angry At Nintendo.”

3) By developing both handheld gaming devices and home consoles, Nintendo has inadvertently ended up with two different gaming platforms that don’t really work together. This is problematic for Nintendo’s game developers, as management has to choose which games go where. But it is also problematic for third-party game developers, and in somes cases inhibits them from preparing their best games for one platform or the other.

Nintendo

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