After a lot of “backbreaking” research work, I am finally a proud shareholder of Nintendo!

Nintendo is a legendary Japanese video game company that has remained a mainstay in the industry for over 35 years, mostly because of its competence as a world-class game content creator. Nintendo owns the top 2 highest-grossing video game franchise of all time – Pokemon and Mario. Unlike most games that only last for less than 1 year, Nintendo’s most popular game franchises have exceptional longevity. For example, Nintendo’s current top 5 grossing games have been around for more than 10 years. I believe that Nintendo’s best days are ahead of it because its genius as a game maker will be amplified as Nintendo builds a direct and deep relationship with its gamer base. This new relationship with its gamer base will transform Nintendo’s cyclical revenue into a recurring one.

Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a cheap and effective medium to create all kind of problems for humans to solve. Nintendo’s genius lies in its ability to create problems (game contents) that are fun for the gamers to solve and to find the subtle balance between been too difficult and too easy. In short, Nintendo knows how to make games fun to play; or in Nintendo parlance, it “creates unique forms of play”.

Nintendo’s adopts the classic razor and razor blade business model. Gamers first purchase the Nintendo console, or more specifically Nintendo Switch which is the latest generation of Nintendo consoles, and separately buy the games to play on the console. Nintendo’s business model is to sell consoles at cost and make majority of the profit on the high gross margin game sales.

Traditionally, Nintendo is seen as a cyclical business because it is more reliant on the success of its console (hardware) rather than its true strength – games (software). Since new games released on the latest generation of console cannot be played on the previous generation of consoles (no backward compatibility), gamers might not upgrade to the latest generation of console which lead to limited incentives for game developers to develop new games for a console with small install base. This dynamic led to either huge successes or devastating failures. For Nintendo, Wii was a huge success but followed by Wii U which was a total commercial failure. But I believe this is changing as Nintendo’s relationship with its gamer is evolving to a more direct and continuous one which eventually lead to an almost recurring revenue stream.

Console games are evolving from distinct game worlds where gamers buy the game upfront with no further cost to persistent game worlds that gamers make ongoing payments. Many examples of very success persistent game worlds, such as World of Warcraft and League of Legends, have demonstrated incredible longevity and significantly higher revenue potential relative to distinct game worlds. As more gamers play more games with persistent game worlds, they are likely to play the console longer and more likely to upgrade to the new generation of console to enjoy better graphics.

Going forward, games’ backward compatibility is going to be a standard feature for the next-generation consoles. Without backward compatibility, each new generation of console resets the install base to zero, and the introduction of backward compatibility means that new console adds to the current generation console’s install base rather than a reset.

Nintendo builds a direct relationship with its gamer base through Nintendo Account which holds the entire library of games ever purchased by the gamers. This is a very powerful relationship as gamers could bring their games seamlessly onto the latest generation of console. Nintendo can also create new subscription products such as Online Membership which further improves revenue visibility.

Previously game developers found it very costly to develop for multiple gaming platforms (Nintendo, Sony, Xbox) as the underlying hardware architectures are different. Game engines such as Unreal and Unity provide a standard software development environment such that it is much easier for game developers to launch their games on multiple platforms. This dynamic amplifies Nintendo’s strength as a superior game developer relative to its competitors, who are primarily platform businesses with limited game development DNA, as gamers who previously buy Nintendo consoles just for the exclusive Nintendo games can now also get the games that are otherwise available on Sony and Xbox.

All of the four factors above – console games evolving from discreet to persistent game worlds, game’s backward compatibility, direct to gamer relationships and interoperability of gaming platforms – means that Nintendo’s strength as a world-class game maker is going to be the key driver for success going forward and the console’s cyclical risk is more muted.

Every time a big technology paradigm shift appears, there is always a risk that incumbents could somehow be disrupted. Cloud gaming is the latest technology paradigm shift. While it is still not clear to me how cloud gaming is going to change the industry, I am confident that Nintendo can thrive as long as they are able to apply their game development DNA to the cloud gaming environment. However, Nintendo might not be able to adapt to the cloud gaming world just as they still struggle to adapt to the mobile gaming environment.

Nintendo has failed to adapt to the mobile game environment because they do not have the operational capability to operate persistent game worlds that are live and requires a continuous content upgrade. Nintendo’s game production is more akin to making a movie rather than a talk show that requires new episodes every day.

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.

I believe that Nintendo can easily have 100m of gamers who would consistently spend USD 100 per year on Nintendo games almost on a recurring basis within 1-2 years. This translates into a USD 10bn revenue base. Assume they breakeven on hardware, Nintendo could generate USD 4bn of net profit. This implies 15x P/E which is very reasonable valuation for such a high-quality company.

By the way, I have never had so fun researching a company!