The Case Against Nintendo

The headlines made me raise an eyebrow — shares of Nintendo (Symbol: NTDOY) were down 10% after a poor showing at E3.  Which is terribly odd.  Usually these game companies keep their game release plans quiet all year, and then release them to big fanfare at E3, the big Electronic Entertainment Expo in Las Vegas this time of year.

Usually all that excitement is good for stock prices.  Shares tend to rise on optimism about the fall lineup, but in this case Nintendo found punishment.

Nintendo is (of course) one of the world’s big video game giants.  You’ve probably heard of them — they produce the Nintendo Switch (which is a very popular device right now) and many games involving an endless parade of bright colorful characters (Mario, Zelda, Metroid, etc).

They’ve been doing it for a long time — selling video games and video game systems since the 1980’s.  Generally their content is family friendly, and almost guaranteed to produce a decent amount of sales when new games are released.

So I was very curious as to why the shares might drop so suddenly.  When shares in companies with a solid reputation like Nintendo’s drop that quickly, there is usually a very good reason for it.

It could be a short term focused public.  They might be overly pessimistic about the company’s future prospects.  Or, maybe the pessimism is well deserved and the shares will drop even further.

So, I decided to take a closer look… digging into annual reports and trying to understand Nintendo’s past and what a potential future might look like for this prestigious company.

What I found, was interesting — I think it makes a surprisingly good case-study about a company that failed to compound.

Problem 1: No Compounding

On the surface, Nintendo seems like the kind of company that would make a great compounding investment — A very recognizable brand with well known characters.  Profitable.  A passionate customer base.  No debt.  Relatively low capital costs, and (at times) very nice profit margins.  Plenty of free cash flow.

Meanwhile, shares of Nintendo are richly priced at 33 times earnings.  Like a growth company.

So what’s the problem?

It’s not growing.  Nintendo hasn’t been able to consistently grow their earnings per share in decades.

Basically:  It’s not a compounder.

I reviewed the last couple decades worth of earnings reports, and found the company has a history of earning anywhere between -$500 million to $2.8 billion per year.  The numbers bounce around from year-to-year instead of consistently rising like you might expect from a compounder.

Meanwhile, the share count has remained essentially flat.

Revenue and earnings tend to rise when the company has a new “hit” game console and then fall a couple years later when the market is saturated.  Earnings per share generally “normalizes” to about $1 per share over the course of the video game system earnings cycle.

It’s been that way for decades…

Some years the company has losses, but these are largely balanced out by years when the company has a big hit on their hands (like 2008 when the Nintendo Wii hit its popularity peak).

Right now, Nintendo is on one of these regular upswings.  Sales of their latest Switch console look like it’s a big hit.  For the next couple of years I expect earnings will be good until the market for that game console gets saturated.

The company has largely followed this exact pattern of boom and bust for nearly 30 years.  Releasing a new game console every few years and then new versions of all their popular games.

It’s a business model that generates considerable profits… but what does the company do with all those profits?

Largely, Nintendo just piles-up cash and purchases marketable securities (stocks and bonds).  The company currently has over $12 billion dollars in cash and marketable securities.

Sadly, all that cash just sits there earning practically no return.  Interest income in 2017 was only $55 million — a return of roughly 0.4% on all that cash.

Problem 2: Poor Capital Allocation

Mostly I blame management here.  While Nintendo does pay a small dividend (company policy is 33% of operating profit), the vast majority of earnings are retained for “growth”.

Given current earnings and share prices, the dividend yield is about 1.28%

As investors, we’re taught that corporate management is suppose to to reinvest those retained earnings by doing something smart with it.  (Otherwise they should just distribute a larger dividend.)

That way, those earnings are being internally compounded and put to work for shareholders…

This is the general belief, but over and over again I find cases of companies like Nintendo — where retained earnings are simply wasted on foolish “investments” or just not reinvested at all.

Don’t get me wrong, I think Nintendo is an incredible company that produces high quality products, but as an investor that’s just not good enough.  I expect if all that cash is being retained it should be compounded.

Nintendo clearly isn’t doing that.

To give them a little credit, I think it’s fair to say they’ve tried to reinvest earnings, but with mixed results:

• They purchased majority ownership in the Seattle Mariners, but later sold the stake in 2016 to other investors when the baseball team performed poorly.
• Back in 1994, the company invested in a 55% stake of UK based Rare Studio’s Ltd, but later sold this studio and IP to Microsoft.
• In 1998, Nintendo formed a new game studio in Austin, Texas called Retro studios.  They produce the popular Metroid games today.
• In 2000, Nintendo co-founded 1-Up Studios and still operates this subsidiary today.
• In 2000, Nintendo co-founded Nd Cube, the game studio that largely makes the Mario Party and Animal Crossing series.  It still operates this subsidiary today.
• In 2007 Nintendo purchased a controlling stake in Monolith software.  This studio makes obscure JRPG games that hardly anyone buys.
• Super Mario Run was released for IOS and Android in 2016.  This mobile phone game largely underperformed expectations with lower than expected sales conversion rates (5%).
• Recent news stories indicated Nintendo is looking to create animated movies based on their intellectual property again.  They tried this back in the 1980’s, but it was a laughable failure.

Nintendo management is definitely trying, but their few successes are also mixed with significant failures.  These growth efforts have largely failed to take root for shareholders.

Would I Invest?

Am I being too harsh on Nintendo?  Honestly, I don’t think I am.  I believe the recent drop in share prices is largely deserved.

Yes, they have a hit on their hands right now, but investors have perhaps come to realize that Nintendo is not a growth company and doesn’t deserve to be priced like one.  Eventually sales of the latest switch console will slow down and earnings will normalize back to that $1 per share range.

That said, Nintendo is still a good company… just not one I would invest in at 33 times earnings.  After all, there’s no rule that says a company is required to grow.

No growth would be fine if the Company actually did something with all that cash — like buying back shares or paying a larger dividend.  Shareholders would benefit in that case.

Instead, the cash pile just sits there earning almost nothing.

In my opinion, Nintendo should be the equivalent of Disney in the video game space.  Disney is a great example of media company that’s been able to profitably reinvest and grow earnings.  Like Nintendo, Disney has had hits and misses over the years.  But unlike Nintendo, Disney was largely able to compound retained earnings for shareholders.

They’ve invested into live action movies, theme parks, television networks, and of course buying up the IP and characters of Pixar, Marvel, and Star Wars.  Today, Disney is a media powerhouse with earnings exceeding $10 billion per year.

What’s stopping Nintendo from do something similar?  Largely, I think it’s their inability to allocate capital well.  Until that changes, I don’t see any reason why Nintendo’s regular boom-bust cycle won’t continue to repeat.

What do you think — Is Nintendo a good investment?

[Image Credit: Flickr1, Flickr2]