Stomping over the competition?

Nintendo has had something of a rollercoaster year as far as its share price is concerned. Speculation surrounding the NX as well as the expectation (and subsequent delay) of the company's first smartphone app Miitomo have resulted in value of its shares dropping and rising quite alarmingly.

While such an occurrence might - to the outside observer, at least - indicate that Nintendo is in trouble, Joshua Kennedy of Sonian Capital Management feels that it's not telling the full picture.

Speaking to SumZero - a social network for professional investors - Kennedy was quick to point out that the market doesn't necessarily understand Nintendo, and that has resulting in the value of its stock being "mispriced":

There is a confluence of factors that has led to Nintendo getting mispriced in the past, and I think it is a pattern we're seeing again today.

The first factor is the cyclicality of their hardware business; sales are very strong when they have a hit console or handheld. Software sales are procyclical, so it is a real peak-and-valley sales pattern.

The second factor is the company is extremely circumspect about sharing its plans for new products, so it leaves investors, competitors, and fans to speculate about what's coming next for Nintendo, particularly when sales are at a trough because the old cycle has ended.

As a value investor, Nintendo is an attractive example of a protected downside, because of the balance sheet and the intangible assets, plus an earnings engine that potentially can drive the stock much higher. It might not work, they might screw it up, and lots of things can happen. But the combination of risk and reward is positively skewed almost regardless of how low a probability you place on Nintendo's continued vibrancy in the video game space.

Still with us? Good.

Kennedy also touched upon the question of another company swooping in and purchasing Nintendo, or Nintendo buying other companies. In short, he doesn't think either scenario is likely:

Nintendo will not be acquired, I think that much is certain.

Although Nintendo has the capital to easily swallow some listed Japanese game makers like Capcom or Square Enix, both of which are further along in adapting their game franchises to mobile than Nintendo, I don't see that happening either. Nintendo is pretty independent and prefers to develop its own IP.

Predictably, NX came up later in the discussion. Kennedy says that if the console does unite Nintendo's handheld and home markets as many expect it to, it could be a "win" for the firm:

The current hardware platforms – the Wii U console and 3DS handheld – were both really problematic. The Wii U in particular was a marketing blunder and management has acknowledged that. But really, it was a bomb and barely sold 10m units. NX can improve on that.

Finally, and this is something that may in fact be overlooked because it is hard to measure, the NX is likely to replace both Wii U and DS at the same time. There has been considerable speculation that the controller will be a standalone handheld device that you can take with you on the go. Think for a moment how problematic and inefficient it has been for Nintendo to have two different hardware platforms for the last several years. They have to develop separate games for both, third-party developers are reluctant to develop because the audience is split in two, plus there are two hardware teams, two support teams, etc. Simply by consolidating into one platform, which management has said in the past is a desirable goal, could be a win for Nintendo.

On another note, look at sales of the PS4. It is the best-selling Playstation yet. I don't think that's consistent with the end of the console era, I think there's a place for console gaming and a place for Nintendo. Additionally, it certainly appears Sony is exiting the handheld business, which would leave Nintendo with the only dedicated handheld gaming device on the market.

The topic of the Chinese games market was next. Kennedy stresses that the size of this market - plus the considerable fame of Nintendo's IP in the region - could equal handsome financial rewards for the company. He also says that he has heard DeNA is building up its presence in China, presumably in preparation for Nintendo's first wave of smartphone titles:

Nintendo's IP is well-known and recognized in China, and I suspect this is a driver behind Nintendo's reversal on smartphone games. Distributing anything physically in China is challenging, but digital distribution is world-class. I have heard anecdotally that DeNA has been aggressively building its team in China.

Kennedy was also pushed on Nintendo's future. He points out that it's very much a no-lose situation for investors right now; if things go according to plan and the NX and smartphone apps hit their targets, Nintendo will be back to generating bumper profits. However, even if NX flops that doesn't mean those who have invested now will lose out - the company would presumably then throw more resource at mobile, which is almost certain to create a lot of cash:

The risk is that Nintendo fails to execute, either on the NX or on mobile, and as a result, earnings don't recover robustly over the next 3-5 years. This is a "value trap" type of risk.

But to me, the largest cause of value traps is a deteriorating competitive advantage, and I don't see that here. If the NX flops because the end of consoles really is here, that will ultimately push Nintendo further into mobile or onto other platforms. The characters and their universes are valuable, and Nintendo has a lot of experience monetizing them. It's rare to see a stock this cheap that has the advantages Nintendo has.

Imagine just for a moment what the individual franchises would sell for in a private market transaction. Activision paid $6 billion for King Digital, which had one asset: Candy Crush. What would they pay for Mario and Luigi? That franchise alone is worth multiples of Candy Crush, in my mind.

Indeed, the topic of Nintendo going "software only" was also mentioned. When quizzed about how Nintendo is currently harnessing its catalogue of brands, Kennedy pointed out that although the company has been signing quite a few cross-promotional deals of late, video games remain the most effective way of generating revenue from IP:

They are certainly showing a more open mind than in the past. For example, last year Nintendo announced a collaboration with Universal Resorts in which its characters will be used as the basis for theme park attractions. They also experimented with having Mercedes-Benz vehicles available in Mario Kart, so there may be some advertising angles to explore, particularly in mobile. And amiibo – the character figurines that work with certain games – are by far the most significant move into toys Nintendo has made.

But in reality, there are not many ways to monetize your IP better than video games, and that is Nintendo's wheelhouse. A lot of investors would just like Nintendo to become a pure software game maker and focus on churning out Mario, Zelda and Starfox for whatever hardware is available. If they announced tomorrow that was their plan, the stock would double.

What do you make of these comments? Let us know by investing some time in the comments section below.

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