Why the Nintendo crash could be a massive opportunity to own world class IP

Down over 50% amidst memory worries

This is a free post going over some more or less structured thoughts. It’s not a perfect resemblance of my paid content, but it shows my line of thinking. I also typically write about smaller companies and Nintendo is a pretty well covered business. Consider subscribing to help me continue to product content for you.

We are all familiar with Nintendo, one of the greatest treasure troves of IP in the world! Everybody at least has heard of Super Mario or Pokémon before. After Disney, Nintendo in my opinion has the most valuable IP no the planet. The business is however stuck in a cyclical industry, or let’s say a hit-based industry.

In the stock chart we can definitely see when the company had strong selling consoles (The Wii launched in 2006, the Switch launched in 2017) and when consoles flopped (The Wii U launched in 2012). The Switch 2 has been released just last year and the stock is down 50% since. This won’t be a deep dive, but I’ll dive into a few topics that crossed my mind with Nintendo, why I think it’s a very compelling opportunity right now and how I’m struggling to find a good valuation approach here.

I have compiled a few questions and will go through them with as much detail as I have in mind:

• Can Switch 2 (SW2) outsell Switch 1 (SW1)?

• What was the real impact of the pandemic for video game demand? Is the SW1 cycle a good comparison?

• What’s the damage of memory prices? How well was Nintendo hedged?

• Will people buy as many games going forward?

• What’s the attach rate for Nintendo Online?

• Will management finally distribute its cash pile?

• How will future IP monetization work?

Can Switch 2 outsell Switch 1?

So far the Switch 2 has massively outsold the Switch 1, but the SW1 launch also had some availability issues. Nintendo has learned from this issue and stocked up on materials and components beforehand. Of course, it’s tough to plan a launch and after the disaster that was the Wii U (selling less than 15 million consoles in its lifetime) Nintendo wanted to approach the SW1 launch with more flexibility.

The SW2 is an extension of the SW1 ecosystem and has backwards compatibility. That means SW2 users can play all the SW1 games on the new system. That means Nintendo can leverage the 129 million annual players from the SW1 system, unlike with previous consoles where you basically start from 0 to build the player base. This massively reduces execution risk.

The big question, which I cannot answer yet, is if they are just having a very strong early adapter movement or if this is sustainable demand for the console cycle. Die hard Nintendo fans often just buy the new console once it comes out. More casual players might not upgrade to the SW2 though. It needs new games (SW2 exclusives) to drive them to upgrade, and that is still a very important unknown. Overall I’m optimistic that the SW2 can exceed the 155 million units the SW1 sold in its lifetime (the SW1 is still being sold and will likely sell many more millions before it is sunset).

What was the real impact of the pandemic for video game demand? Is the SW1 cycle a good comparison?

During Covid, the Switch was at one of its strongest points having already gained a massive base in its first years of selling and a strong set of games available. With everybody stuck at home there were massive tailwinds for a while, until the world reopened in 2022. Is the SW1 cycle a good comparison or were there strong distortions? I’d say the impact wasn’t strong enough to distort a ~8 year cycle enough to matter.

What’s the damage of memory prices? How well was Nintendo hedged?

The big bear case right now are memory prices. Since the launch of the console prices have skyrocketed and many expect them to rise further. This is the most prominent bear case around. We must consider how Nintendo makes money:

• Hardware sales: Around 10-20% gross margin historically. Unlike competitors, Nintendo aims to have positive gross margins and not be a full cost leader for its consoles.

• Software 1P: Games developed by Nintendo have strong gross margins, around 80%. Digital sales have higher margins than physical sales, which take a cut from distributors.

• Software 3P: Games from third party developers sold on the Nintendo eShop or as physical copies (100% gross margin in both cases). This is purely leveraging the Switch platform and taking a toll road comission.

• Subscriptions: Nintendo Online services are monthly/annually recurring and run at >80% gross margins as well.

Considering all this, memory prices might lead to price increases for the console, making it less affordable. Nintendo also have long term agreements with suppliers, which at least should cushion the impact. They also built inventory ahead of the launch of SW2.

So we might see negative gross margins and short term headwinds from memory prices, but this likely isn’t a structural issue. Memory chips are a highly cyclical industry and right now a lot of capacity is being spent to satisfy AI infrastructure demand. This won’t last forever and eventually we will have enough supply or the AI capex will slow down. A downturn in component prices will follow.

Historically, an average Nintendo home console sale led to ~10 software titles purchased (SW1 sold 155 million consoles and over 1.5 billion software units. So even if you lose some money on a console, you’ll make a lot of cash over the customer lifetime. Memory is a short term headwind, but doesn’t change the thesis.

Will people buy as many games going forward?

We can rely on history (around 10 software titles per console), but that’s an important assumption to make. AI is a bear case, as it will be much easier to create games…but unlike normal development studies, Nintendo is a toll road business (at least partially). The SW2 platform will also cater to more hardcore gamers than the SW1, because it has much better specs, so game franchises that weren’t ported to SW1 can now also be distributed on the large SW2 platform. More supply thus should be a tailwind for the 3P business.

The other bearish take is that AI developed games will take share from Nintendo’s IP. I don’t buy this, because they have strong IP and decades of marketing and mindshare with people globally. We don’t want to watch a random guy jumping over some turtles, we want to play Super Mario. Nintendo again could leverage new technology to increase development speed and reduce costs to make this 1P games, making the SW2 platform more desirable.

The reality is that the SW2 doesn’t really compete with Playstation, Xbox or Steam. People buy it for the IP, because from a technological perspective the other systems are better. Sony nowadays also licenses more of its previously exclusive IP, like the God of War or Uncharted series, which has been listed on Steam for a while. Nintendo has a unique differentiator to others. An interesting fact is also that Nintendo rarely discounts its games, while on other platforms games typically fall by 50-90% in price after just a few years during sales (it’s a digital good without incremental costs after all). This shows the strong pricing power Nintendo has with its IP.

What’s the attach rate for Nintendo Online?

Not a strong point, but a bull case usually involves an increasing adoption of Nintendo Switch online subscription, so we want a higher percentage of users to pay the subscription. We could argue that compared to peers the subscription price is low and Nintendo could use pricing power. I guess modeling an increasing rate (especially as they’ll put online voice chat behind the paywall soon) makes sense, but it’s another unknown.

Will management finally distribute its cash pile?

One of the biggest question from a financial perspective is the cash pile. With a market cap of $55 billion, Nintendo has $14.6 billion in cash without any debt. We can see that they always had a large cash pile over the last 20 years. This was understandable when the company was highly dependent on hit consoles. The Wii U era had Nintendo reporting losses, so the cash pile helped them to stay focused on turning the ship around, instead of fending off creditors.

Now we have a different situation: The business is becoming less cyclical (higher recurring revenue and continuation of the SW1 user base) and we are starting the SW2 cycle with already ~$14 billion in net cash. FCF peaked at $5 billion in 2021 and Nintendo pays out around 50% of earnings as dividends. The big question is if they’ll finally feel comfortable enough to pay out higher dividends or use buybacks to return capital to shareholders. Otherwise, we’ll likely see the cash pile going toward $25 billion+ over the SW2 cycle.

Japanese management teams are notorious for bad capital allocation, but the government is trying to get companies to return more capital. We’ll see if Nintendo joins in, but in light of history I don’t feel comfortable using the full cash pile in valuing Nintendo, rather a 50% discount makes sense to stay conservative. I also won’t use their stakes in businesses as assets towards EV. They should have around $5~ billion if we’d value their stakes in the Pokémon company, Niantic (Pokémon Go developer) and some others.

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How will future IP monetization work?

For a long time the Nintendo pitch includes monetization of IP. I hope they’ll never gut their IP like Disney does, but they could try to leverage it a bit more. The Super Mario movie and the sequel which is currently in theaters are a great first step. They also have theme parks in collaboration with Universal. Most of their IP monetization is license-based, so low risk for Nintendo. I wouldn’t really rely on IP to drive earnings growth, more so I’d see it as a marketing flywheel. Instead of spending money on advertising their Super Mario franchise, Nintendo gives its IP to Illumination to develop a movie. That way they increase awareness, while getting some royalty payments leading to a negative customer acquisition cost.

Concluding thoughts and valuation

Valuing a cyclical business is tough. A console cycle typically peaks around years 3-5 or so (consoles are still selling fast and you have a large user base that is buying new games annually) and historically Nintendo achieved EBIT margins around 30-35% in good years and 21% EBIT margin on average over the last 20 years (this includes 7 years of Wii U ranging between 16% and -8%, dragging averages down). One could argue that this cycle top could approach 40% EBIT margins, as Nintendo Online becomes more relevant and the SW1 platform continues to contribute high margin earnings.

Looking at the chart below we see that analysts have aggressively cut back EBIT estimates for the coming years, around $1 billion of reduction for most years. Beyond the memory issue I don’t really see reasons for that, especially looking at the momentum of the console sales. If we look at sales estimates, analysts hardly lowered targets and in some cases raised them. I’d conclude that they mainly see the memory drag as a factor for lower profitability, creating an opportunity. The SW2 is off to a great start and the possibility of a flop console is off the cards.

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If we now compute all of these estimates, we see that the EBIT margin ranges from 14% to 25% over the next 4 years between low and high estimates. That’s in sharp contrast to the historical margins Nintendo achieved during the good periods of the cycle.

I ran those analyst sales estimates through EBIT margins more in line with historical good times for Nintendo (25%, 30% and 35% EBIT). Keep in mind that this is just a thought experiment. The FY26 margins certainly won’t come in at 25-35%, but over the medium term they should be able to achieve these margins again in my opinion as software takes over. We get a distribution between 14.4x and 5.7x EBIT (again using just 50% of cash in EV calculation) across those scenarios. That looks very cheap in my opinion for a business of this quality, even if it’s a cyclical, with lots of optionality. Nintendo has set up the SW2 well to benefit from great game releases in the critical years 2 and 3 (you really want a strong IP catalogue here to grow the user base fast).

I struggle to find a good valuation using an IRR model. Historical EV/EBIT multiples are at a median of 12x, but this is of course distorted by the cycle and the 7 years of Wii U underperformance. In good times, Nintendo often traded at 30x forward EBIT, and arguably we are in good times. Just under a year ago it traded at 37x forward EBIT. We now have lower estimates and a much lower multiple. Analysts (even after cutting estimates sharply) see shares at single digit EBIT multiples in a few years for one of the best IP catalogues on the planet (these EV/EBIT multiples use the full cash pile though). The memory fears have completely crushed the EBIT estimates for Nintendo, which I believe is a distortion creating a compelling opportunity. I haven’t fully decided yet, but this looks like a set up for me to start a position. While I don’t have a good model to price Nintendo, it looks just too cheap at these levels and estimates way too bearish. I’ll likely initiate a position in the coming days.

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