“Nostalgia – it’s delicate, but potent.” – Mad Men

Nintendo kindles warm childhood memories of playing Super Mario Bros. and Zelda with friends in the 1980s. Growing up, I was a certified Nintendo fanatic – I had the t-shirt, the cereal, the magazine, and even wrote to Nintendo suggesting games they might develop.

Despite my early passion for Nintendo, as an adult I never considered Nintendo investible because the business seemed too cyclical. Even when Nintendo landed a hit console, such as the Wii or DS, it would have a few good years and then the hardware would fade into obscurity. Developers would lose interest in the consoles and Nintendo would start over again.

Nintendo’s historical stock price chart reflects the boom-bust cycle.

Ultimately, Nintendo seemed unwilling or unable to steadily monetize its unique intellectual property. (We’ll get into the IP in just a moment.)

This opinion was challenged after reading Ryan O’Connor’s April 2019 Crossroads Capital investor letter. Over the course of nearly 70 pages, Ryan made the case for why this time is different at Nintendo. If nothing else, the letter led me to re-examine my assumptions and consider some new dynamics.

A key point to consider, for example, is that Nintendo owns some of the most valuable media – not just video game – franchises in the world. Pokémon (Nintendo owns the trademark and is part owner of The Pokémon Company) has generated more revenue (estimated $95 billion) between books, films, video games, merchandise, etc. than any other media franchise, including Mickey Mouse & Friends, Star Wars, and Winnie the Pooh.

Mario is also an elite franchise, with an estimated $38 billion in franchise sales. It also happens to be the best-selling video game franchise of all time.

Additionally, Nintendo’s Wii, Donkey Kong, and Zelda franchises have each generated more than $4 billion in revenue.

It’s clear that Nintendo has a lot of potential to leverage its valuable IP.

But as we’ve discussed in earlier posts, what’s important from an investment standpoint is product relevance, not just recognizability. It’s nice that Nintendo’s characters are globally recognizable, but unless Nintendo makes games that are relevant to today’s gamers, it won’t translate into profitable growth.

One reason we believe Nintendo will remain relevant for future generations is that its games are intrinsically family friendly and fun. PlayStation and Xbox – the two other major console makers – primarily feature intense, often violent, games with incredible graphics and audio. (If you’re a non-gamer, watch some gameplay of Grand Theft Auto or The Last of Us: Part II, and you’ll see what I mean.)

Think about how Pixar films thrive with family audiences. They aren’t winning Oscars for best picture every year – these are typically reserved for dramatic films created for adult audiences – but families adore Pixar films, which have had massive box office success. Both types of movies can thrive with different audiences.

Similarly, Nintendo doesn’t have to compete with PS and Xbox on graphics and audio – they just need to be technologically advanced enough to attract game developers and keep gamer interest. Instead, Nintendo is in a unique position to provide a fun gaming experience for families that is still fresh and enjoyable to play.

To illustrate, Nintendo’s 2017 release of Zelda: Breath of the Wild is considered one of the best video games of all time. It is visually stunning and has a dramatic narrative, but is also suitable for gamers aged 10 and up.

When I was a kid, adults thought video games were “rotting our brains,” and a general waste of time. This Far Side comic satire from 1990 captures this sentiment.

It turns out that the comic was just ahead of its time. Gamers are not only getting paid today, but parents are increasingly playing video games with their kids.

As the following chart shows, U.S. parents are increasingly playing games with their kids on a weekly basis – a trend that only began to accelerate in recent years.

Nintendo is in a prime position to own this trend.

Part of the reason for this trend is that the cohort that grew up with video games is now in prime household formation years and many of them are raising young children themselves.

Just like Boomers shared their favorite TV shows and movies with their children, Generation X and Millennial parents are sharing video games. It’s a trend we expect to get stronger with time. Mario and Zelda, like Mickey Mouse and Luke Skywalker before them, will get passed down through generations.

Nintendo had not been able to capitalize on its nostalgia advantages simply because not enough time had passed. In other words, it had passionate fans who were not old enough to pass down their love for Nintendo to the next generation.

The window of opportunity to capitalize on Nintendo’s nostalgia-driven IP is only just opening.

As the chart below illustrates, the peak of the Millennial generation turns 30 this year and since the cohort has deferred having children relative to past generations, the number of Millennial parents will rise significantly for years to come.

Evidence of Nintendo’s potential for family gaming was seen during quarantine, when due to a combination of limited supply and a spike in demand, there was a run on Nintendo Switch consoles. Switch was considered an essential for families during quarantine and units were being sold in the aftermarket for more than a 50% premium to the list prices of $199 for Switch Lite and $299 for Switch.

In addition, during quarantine educators used the hit game Animal Crossing: New Horizons to connect with young people around the world. Monterey Bay Aquarium in California and The Field Museum of Chicago, for example, put on virtual tours in Animal Crossing to teach viewers about science and natural history. This reinforced our belief that Switch is considered a “safe” video game platform through which families can engage in gaming and learning, and have wholesome interactions with others.

Here’s what The New York Times said in April about Animal Crossing:

“For children, being able to engage in adultlike chores, like building and decorating a house, gives them power often out of reach. For adults, especially millennials who have lived through the Great Recession and current coronavirus-induced economic stress, it offers the white picket fence often associated with the American dream that’s increasingly elusive.

Though the aesthetics of the game might lead some to believe it’s geared toward children, it’s found a dedicated audience with millennials, some of whom grew up with the franchise, and with younger audiences experiencing it for the first time.”

Importantly, Nintendo’s IP is supported by rich narratives that draw gamers back to each franchise iteration. This itself serves as a competitive advantage in an increasingly competitive video game space that includes not just consoles, but PC, and mobile games.

Thousands of games are published each year, but only a few are legitimate hits. Consider Amazon’s recent release of its first original game, Crucible. Despite the backing of one of the most valuable companies in the world with millions of Prime members, the game is by all accounts, a flop. At its launch peak, the game had just 10,600 participants.

By comparison, all Nintendo must do is release a Mario or Zelda-branded game and it instantly has millions of unit sales. The mobile game Mario Kart Tour, for instance, had 123.9 million downloads in the first month.

Put another way, Nintendo’s narrative advantage provides greater probability of success and gives its first-party developers more freedom to be creative without worrying about commercial disasters.

Further, Nintendo doesn’t have to aggressively market new first-party titles. Gamers know what to expect when they buy something made by Nintendo. In short: it will be fun and familiar.

On the hardware side, Switch has been a massive success. NPD Group’s Mat Piscatella recently noted that “with a time-aligned 39 months in market, the Switch unit installed base in the US trails only the Nintendo Wii and PlayStation 2.” It’s worth noting that Wii and PS2 were launched in 2006 and 2000, respectively – long before smartphones and mobile gaming were ubiquitous and competed with console gaming. This makes Switch’s success even more impressive.

Switch combines the best parts of Nintendo’s two most recent successful hardware products – Wii and DS – and allows users to enjoy video games in home, tabletop, or handheld mode.

Our take is that management does not view Switch as just another console product, but the ultimate Nintendo platform from which new iterations of hardware can be launched.

The 2019 launch of the Switch Lite suggests that this is the case. At a lower price point, Switch Lite is a handheld-only version of the Switch, and serves to bring more customers onto the platform who may have balked at the higher priced Switch.

We expect Nintendo to offer a “Pro” version of Switch next year to maintain third-party game developer interest after PlayStation and Xbox release their next generation products later this year.

Further, Nintendo is producing a single hardware platform for the first time since 1989 when it launched Game Boy alongside the NES. For almost 30 years, Nintendo was producing both handheld and home consoles simultaneously, which inevitably created some inefficiencies in marketing and development.

Iterating on the Switch hardware to higher and lower price points and maintaining a consistent software operating platform, much like Apple has done with the iPhone and iOS, strikes us as an intelligent break from the past boom-bust console cycle.

Of course, there’s a chicken and the egg issue with game consoles. Gamers go where there’s software and software developers go where there’s gamers. As such, Nintendo must feature compelling games to maintain an active user base to attract developers. Historically, Nintendo has relied on first-party franchises like Mario and Zelda to drive console sales, leaving third-party developers on the outside of the Nintendo ecosystem.

That has not been the case with Switch and is another sign to us that management is breaking from tradition and understanding the power of Switch as a platform rather than a product. Third-party developers are taking note of Switch’s massive installed base of gamers. Notably, in a recent conference call, game publisher Electronic Arts promised to “deliver more for Nintendo fans,” with more EA games slated for the Switch platform this year.

As the chart below shows, momentum for third-party developer sales on the Switch platform has been strong in recent years.

Thus far, we’ve provided a backdrop as to why we think Nintendo is set up for success. Here’s what we think that should look like.

First, despite progress on making Switch a platform rather than a product, Nintendo is still way behind other gaming platforms when it comes to multiplayer and the digital experience. For example, adding friends on Switch is clunky. We think the success of Animal Crossing during quarantine should prove to management the power of social gaming and encourage more development to this end.

Second, Nintendo has lagged other gaming platforms in digital game sales. Digital delivery of games carries much higher gross margins than physical game sales because Nintendo does not have to give the retailer a cut. The more software sales Nintendo can push through its Switch Online store, the greater the lift to gross margins.

The most recent quarter’s results showed the gross margin expansion potential. During quarantine, Nintendo saw a spike in digital downloads. For the quarter, 49% of software sales were digital and we estimate that it was between 70-80% during the last few weeks of March. Due in part to the shift toward digital, gross margins expanded from 41.7% in fiscal 2019 to 49% in fiscal 2020. A digital-only version of Switch – one that does not use physical cartridges – might also accelerate digital sales.

Third, Nintendo should offer access to all its legacy first-party titles through a more robust Switch Online offering. Currently, Switch Online costs $34.99 a year, or less than $3 per month, and offers a library of about 70 classic Super NES and NES games including Tecmo Bowl, Super Mario Kart, and The Legend of Zelda.

We think if Nintendo added access to all its legacy first-party games and made them online and multiplayer capable, they could easily charge Netflix-like subscription rates of $9-15 per month.

Nintendo is the only video game family where there’s massive demand for games that are 10, 20, or 30 years old and they should capitalize on this advantage. Few gamers want to play the original Call of Duty or Grand Theft Auto when the current generation is so much more technologically advanced, but gamers will fall over themselves playing the original 8-bit Super Mario Bros. The reason is nostalgia. Old Nintendo games are simple, but they bring back happy memories, whether they are realized consciously or unconsciously.

Fourth, Nintendo should continue to build on the surge of third party game demand to illustrate to game developers that there is a large, new addressable market in the form of parents and families – not just children and younger men, who have traditionally been the sole audience for video games.

A platform enables other things to be built on top of it. While Switch is an excellent platform for Nintendo to iterate on for years to come, they can unleash the full power of a platform business model through continuing to enable third party games to thrive on Switch, while ensuring that any and all games available on Switch are family friendly.

All four of these strategies are doable and, if successfully implemented, would improve Nintendo’s cash flow quality and reduce the view that Nintendo is a cyclical company. The result would not only be improved earnings growth, but also likely multiple expansion as investor confidence builds.

There remains, however, many skeptical investors who expect Nintendo to fall back into its ways of scrapping the old and starting something new. This remains a distinct possibility. Nintendo management has a track record of unforced errors and head-scratching decisions from a business model perspective, despite continuing to delight customers with its products.

As such, our investment in Nintendo is considered an “emerging moat” position, which is assigned a lower portfolio weight relative to our core holdings. We consider Nintendo’s IP to be a dormant moat and the “emerging” part is the business model and the potential for monetizing the IP. If we continue to see management making wise decisions, it could quickly become a core holding.

With a healthy net cash balance sheet, Nintendo can afford to be more aggressive with these strategies. There’s little downside and a lot of upside potential. Now’s the time for Nintendo to capitalize on its unique nostalgia-drenched IP.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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