Nintendo reported, in my view, excellent results for the Fiscal Year (FY) 2021 and it is a real pleasure to be a business owner (and customer) in this fantastic business.

My core investment thesis for Nintendo remains the same: Nintendo Switch is a sustainable gaming platform because it is anchored by Nintendo’s world-class games and supported by a mix of long life-cycle games and new games by both Nintendo and third-party game developers. Nintendo Switch is in a positive feedback loop now where its large install base is attracting more third-party game developers which in turn attract more Switch buyers. If my assumption that the Switch gaming platform would defy the previous console lifecycle of peaking in year 5 and ending in year 7, then I assess Nintendo’s intrinsic value with the following factors: 1) Switch install base, 2) software revenue per install base, and 3) gamer engagement with Switch platform.

Switch Install Base

Gamers are buying more units of Nintendo Switch and software for the three months ended Mar 2021 (4.72m) versus the same period in 2020 (3.28). This is very impressive because there were no mega game releases such as Animal Crossing in 2021 and yet Switch is still selling very well. It is hard to assess the impact of the pandemic on sales trends.

As of Mar 2021, the install base for Nintendo Switch is 84.6m. Nintendo is guiding to 25.5m units of Switch sales in FY 2022. Let’s stick with Nintendo’s famously conservative guidance for a second here. This implies that the install base could reach 110m by Mar 2022. If I have to guess, I think Nintendo would probably have a good chance to beat its own conservative guidance. Of course, there is the rumored Switch Pro (an updated Switch with better performance) which could help to grow the install base even further.

Anyhow, I think we are safe to assume that the Switch install base could reach 110m by end of 2022.

Software Revenue Per Install Base

Instead of using the industry average of tie-ratio (units of software sales per install base), I prefer to use software revenue per install base which is simply taking total software revenue (a dollar amount) and divide by the total install base. This metric was first introduced by Nintendo CEO, Mr. Shuntaro Furukawa, and he argued that as online membership revenue and in-game item sales increase, it is less effective to use software units to understand the software performance. And I agree with Mr. Shuntaro Furukawa.

Software revenue per device declined 11% YoY from JPY 10,749 to JPY 9506 in FY 2021. This decline in FY 2021 is smaller versus the decline in FY 2020. If my thesis that Switch is a sustainable gaming platform is correct, then I expect the software revenue per install base should at least stabilize if not increase further from here.

There are quite a few dynamics that impacts the software revenue per install base and I will try to call out a few big ones here:

  • The most hardcore Nintendo fans will buy Switch first and they have the highest revenue per install base. As the less fanatic gamers join the Switch platform, they pull down the average software revenue per install base because the casual fans outweigh the most hardcore Nintendo fans
  • Ramp up of a new gamer – it takes time for a new gamer to ramp their spending on the platform as they slowly discover the games that really appeal to them. Generally speaking, new gamers might discover one or two games that they really like, and then, voila, the spending would increase dramatically
  • There are two kinds of game revenue on Nintendo Switch – the one-off revenue that comes from single-game releases and the “recurring” revenue that comes from free-to-play games. Most of Nintendo’s game revenue derives from one-off game sales. The “recurring revenue” includes 1) online membership, 2) sales of in-game items, and 3) season passes for games like Fortnite. For more details on this topic see here.
  • Not all free to play games will be long lifecycle games, but as the number of free to play games increases on Switch, there will inevitably be more long lifecycle ones
  • As the number of long lifecycle games increases, the “recurring” revenue per install base should start to increase slowly. This impact is less observable due to low base and obstructed by the lumpy new game release schedules.

Again if my thesis is right, then the “recurring” revenue from long lifecycle games, such as Fortnite and Tetris, should form the bedrock of Nintendo’s software revenue. And new games releases’ contribution to total software revenue would be volatile in nature.

Taking the various factors into consideration, I assume that software revenue per install base would continue to decline by 10% in FY 2022 and reach JPY 8555

Gamer engagement with the Switch platform

Healthy gamer engagement is critical to the long-term health of the Switch platform. Ideally, you want gamers to play Switch every day even if they only buy one-off game products such as The Witcher 3. Because as long as gamers are coming to Switch on a regular basis, then there is always a  chance to sell a new game to the gamer.

In the latest result call, Mr. Furukawa said the following on Switch’s active user base:

“After the release of Animal Crossing: New Horizons, there was a substantial increase in the number of consumers playing Nintendo Switch. There was a gradual decrease afterward, but there was another considerable increase during the year-end holiday season last year, which reached the highest number of active users since the release of Nintendo Switch. Although the number slightly decreased after the beginning of this calendar year, a lot of consumers are playing Nintendo Switch with the recent March release of Capcom’s Monster Hunter Rise, so we don’t think that the momentum is fading. Many new software titles will be released this fiscal year, starting in the first quarter, which we think will help continuously expand the range of consumers who play Nintendo Switch to include those who haven’t played Nintendo Switch in a while or are completely new users.”

It sounds like the active user base is growing which is a very healthy signal. I would love to know how the active user base as % of the total install base is trending. But I guess we would never quite know that.

Previously I wrote that:

“I view Nintendo’s lack of game operation competence as the single biggest concern now. If I see evidence that Nintendo has developed a strong game operation competence, then I will increase our investment in Nintendo meaningfully.”

For the last 12 months, I see evidence that Nintendo is beginning to understand the importance of live game operations. For example, Nintendo has been continuously providing new content for Animal Crossing and introducing online gameplay to Super Mario Party. With stronger live game operation capabilities, Nintendo will be able to maintain a strong engagement with its gamer base.

And as long as gamer engagement is high, the revenue will follow.

Nintendo’s operating profit margin

Given that Nintendo’s hardware revenue is break-even at best, I like to define operating profit margin as total operating profit divide by software revenue. Hence both hardware and software R&D is expensed through the software revenue line which is consistent with the razor and blade business model.

In my definition, Nintendo’s operating profit margin expanded from 24% in 2017 to 80% in 2021.

There are a few key drivers for the operating profit margin expansion.

1. The increase in the proportion of total software sales sold through the digital channel (42.9% in FY 2020) has been increasing steadily over the last 5 years. Digital sales carry a much higher margin than offline retail channels because 1) there is no cost to produce physical copy and 2) Nintendo earn the full retail price instead of the wholesale price.

Mr. Furukawa gave us an update on the purchasing behavior of gamers which gave me confidence that digital sales % can only increase from here albeit more slowly from here:

“And in terms of digital sales, consumers who purchased hardware during the year-end holiday season are relatively inclined to purchase their next game digitally, leading to a tendency for the ratio of digital sales in the fourth quarter to be higher than the third quarter. But even so, the fourth-quarter digital sales in the previous fiscal year were comparable to those in the third quarter, which indicates that purchasing software digitally has become quite widespread as an option for our consumers.”

Also as the “recurring” revenue from online membership, in-game items sales, and DLC sales should also help to grow the digital sales percentage.

2. Another driver for operating margin expansion has been the growth of third-party games on the Switch platform.

Nintendo charges an estimated 30% take rate on sales of third-party games on its Switch platform. Since this revenue stream carries close to 100% margin, the growing percentage of the third-party games will drive the overall operating margin. Nintendo recognizes first-party games at gross revenue and third-party games at net revenue (i.e. only the 30% take rate revenue). If I try to compare first-party and third-party games on a comparable gross revenue basis, then third-party games would have accounted for ~46% of total gross revenue on the Switch platform.

This indicates a very healthy 3rd party developer ecosystem on Switch. I think Switch has a lot of work to do in terms of improving the discoverability of games on Switch.

I assume that they would need to incur more R&D spend on both hardware and software and hence I assume a 70% adjusted operating margin in 2022.

Nintendo’s earnings base

Taking the above factors together, we have:

  1. 110m of install base in 2022
  2. JPY 8555 software sales per install base in 2022
  3. Apply 75% adjusted operating margin on total software sales for conservative sake

Then we arrive at JPY 703bn of operating profit in 2022. Apply a 36% corporate tax rate, Nintendo’s net earnings is JPY 450bn.

This implies a P/E of 16x based on my 2022 estimated earnings.

If we look out 3 years to 2024, I assume that Switch install base could reach 140m and software sales only drop another 10% over the next 3 years, JPY 7700. Assuming that operating margin would remain at 75% as the higher incremental margin is reinvested back into the business. Then I arrive at JPY 690bn.

This implies a P/E 10x based on 2024 earnings.

Now I could be way too optimistic in estimation. There are still many risks – cloud gaming could commoditize hardware, Nintendo launching another weird console just like they did with Wii U, iPad becoming a stronger console platform. And most importantly, Nintendo fails to fully embrace gaming as a service. On balance, I think Nintendo’s risk-reward feels very good here to justify the high portfolio weight.

Investment action: keep holding