Nintendo – Our Next Value Long

Mr Bean here.

Nintendo (NTDOY) is off to the races, up over 14% after news broke claiming Tencent would be allowed to sell Nintendo’s Switch console on their platform. We’re initiating a position in NTDOY today and the thesis is simple: the market is pricing NTDOY as a stagnant, console-led gaming business with little growth and subject to boom and bust cycles. We believe the market isn’t pricing in Nintendo’s switch to a highly recurring revenue model and entrance into the smartphone market, which expands NTDOY’s TAM over 100x. The business currently trades at half the multiple of its peers with many levers to expand cash-flows and multiples over the next 5 years.

Upside Drivers
1. Switch to Subscription-Based model with monthly, recurring revenues — eliminating console risk/cyclicality.
2. Successful launch and sale of Nintendo Switch. On pace to out-sell PS4 and Xbox in 2019.
3. Entering Smartphone gaming market which will increase TAM by over 100x as almost everyone has a smartphone.
4. Current P/E (ex-cash) of 12.92 presents a substantial discount to peers and overall market (i.e., a great business at a great price).

Material Risks
1. Increased capital allocation towards hardware devices (read: screwing up with the Wii U all over again) instead of investing back into their platform subscription model.
2. Popularity of Fortnite-like games where freemium content rules, engagement matters and profitability isn’t the objective.
3. Margin volatility: historically speaking, NTDOY’s margins fluctuate along with the console gaming trends. This risk should be mitigated from the switch to online platform/subscription model.

Valuation
NTDOY generated $10.9B in revenue for TTM 2019 and is anticipating reaching $12B by 2020. Assuming the company grows at a modest 4% over the remaining three years we arrive at $13.5B in 2023 revenues. Given the company’s transition to online platform and subscription-based revenues, EBITDA margins should increase from their current >20% figure (we’ve assumed margin expansion to mid 30%). In 2023 we arrive at terminal EBITDA of $5.2B. Subtracting out cap-ex (~1.2% of revenues) and adding back D&A we get nearly $4B in terminal free cash flow and an Enterprise Value of $85B. Add $8B in cash and divide by the number of shares and we get a fair value range north of $90/share.

Additional comment: Alex here. Nintendo has a lot going for it. The company has a similar vantage point to Disney in its unique and globally recognized content IP; though obviously not to the same scale as the former. Like Disney, Nintendo is in the process of leveraging new tech-enabled distribution channels (SVOD for Disney and mobile phone gaming for Nintendo) to greatly expand its total addressable market (TAM) while also creating a full consumer ecosystem for the Nintendo experience (i.e., theme park, toys, movies etc..). These moves are a no-brainer, in my opinion, and should pay off well for shareholders.

Your Value Operator,

Mr Bean