A Deep Dive into Nintendo's Business Model and Future

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1:27All right, folks, welcome to the Investing for Beginners podcast. Today, Brett and I are going to do a, I guess, company focus on a company called Nintendo. Might have heard of it. Brett is a shareholder. I am not. And so I'm going to kind of interview Brett about the company and try to learn as much about it as I can and pass that along to you guys. So Brett is our resident expert. He knows the company quite well. And if you've listened to a show, which if you haven't, after you're done here, go listen to a show. He and Ryan do a great job bringing Nintendo and many other companies down. So Brett, thanks for coming back again and talking to us about Nintendo today.

2:07Excited to discuss them. Yes, Nintendo company, I think almost every listener will have heard of. It's a Japanese company. You might think the Japanese stock market's been really bad. Let me just to entice the listeners in the last year Nintendo stock is up 63 % the US ADR it's been crushing the S &P Nasdaq indices even if even as those are soaring as well so don't think that this is just some boring Japanese stock that goes nowhere and I will say it's also going to be a fun lesson in a business case study and then looking at a stock and trying to analyze it analyze a business when it's at a i wouldn't call it a business model inflection but a huge turning point in their operations as we're right around the time of the launch of the switch two and their new console yeah yeah and so this is this is really good timing so let's let's maybe start with that like what is what is their business model how do they make money and we'll start there and then maybe we can talk about the transition or the turn not turnaround but the transition they're going through okay nintendo's business model has been at its core and this is back going back decades it's essentially been the same thing for a long while and it's the only business model like this in the gaming market and it's an integrated hardware and software business And when I say software, I just mean the video games that they sell.

3:41So they make gaming hardware. Right now they have the Switch, but historically people might know of the GameCube, the Wii, Super Nintendo. Sorry, I'm a little young. I don't know. I can't remember the names of the ones from the 90s as well. But then you had the handhelds, such as the Game Boy, the Nintendo DS. And that model has changed slightly because with the Switch, the reason it's called the switch is because you can switch from your home console to mobile with the same device and that just integrated those teams together but on the whole it's the same thing you they make the hardware and they sell the hardware because you can only play their first party titles on nintendo devices you have titles that they own such as mario and then all the characters associated with that you have, and these are the really popular ones, Pokemon, Animal Crossing, Splatoon, Zelda, that would probably be rounding out the top five of games that when they launch a flagship title, you can probably bet on at least 10 million unit sales and upwards of 20, 30 or 40 million, depending on how popular and how successful the game is.

4:56And when a game costs over$60 a pop, maybe pushing$80 now with some of the game inflation. Each 10 million units, that's$800 million in revenue. And given the incremental margins of the game business, especially without paying third-party fees to a PlayStation or an Xbox, you can have 90 % incremental margins in every game sale. So when Nintendo gets scale within their console business, they can generate a ton of cash but the downside is you got to make sure you create good hardware for people and you got to make sure you create games they want to play right now it seems like they're firing on all cylinders in both regards but as we can talk about that wasn't the case 10 years ago no it wasn't and that's one of the things that i noticed when i was looking at their financials on fiscal was that 10 years ago they were doing 6 % operating margins.

6:01Now they're in the 20s. And if you look at the revenue cycle, if you will, like the switch one came out in Kirkham if I'm wrong, 2017, 18, somewhere in that range. Okay. And so that year revenues were okay. the next year, boom, big time revenue growth. And the next two or three years after that, very big revenue growth. And then it started to kind of start to slide. And now you're starting to see with the new switch that's just come online recently, I expect that we're going to see a big upturn in revenues from that point. Yeah, we should. So far, it's been rock solid. Within the first four days, they sold 3.5 million switch twos.

6:48it seems like the wait lists have been quite strong and one of the reasons why and if you look at the chart you can kind of you need to look at the revenue chart but you can also look if we're talking about operating leverage which is as we mentioned i want to just define this again that is when you have the fixed cost which is all the money you invest into the hardware and then all the money you invest into the game development when you sell all of these software sales another million another 10 million of a mario card a new zelda game your margins can start expanding and expanding and expanding as your revenue grows.

7:20If we look from, say, the March 2017, you know, 6 % margin really low. During the peak in 2021, when we saw the peak of the original Switch, profit margins hit 36%. And it's trailed off since then, as we've seen the Switch, the original Switch mature. It had a really long lifespan of going, I think, about eight years until the Switch 2 was released. And that I don't think should be a concern or it's not a concern for me. It's just part of the business model. But what I would note, and we can talk about some of the changes to their business model that's happened over the last 10 years, the lesson they learned from their failures 10 to 15 years ago with the Wii U.

8:05If we're at, say, the trough of the cycle right before the new hardware launches, you know, financially, when we look at the income statement with a switch to over the last 12 months, according to Fiscal.ai, their operating margin was 24 % compared to six. So there has been a business model change where we're seeing, even though you're not going to eliminate all cyclicality with a video game business, especially one with integrated hardware and software model, they made some improvements that have helped steady the business and combined with a very conservative balance sheet, it's not, I would say, a very risky stock down.

8:47Yeah. So those are all great points. And I guess some questions that kind of pop up to my mind, I want to get to the business model kind of evolution. But I'm curious about two things. Number one, is the time between hardware devices, between Switch 1 and Switch 2, is that normal in the industry? And is that normal for them? And then I guess the second part of that is how often do they update the games themselves? So you mentioned Zelda. I never played it, don't know anything about it. But is that something that they update regularly or is it more of a legacy game that generation after generation just falls in love with and keeps playing?

9:32Okay, so on the hardware side, this one was a little bit in an extended cycle. Typically, from what I've read, the gaming hardware, you know, could be Xbox, PlayStation, Nintendo, or any of the other smaller players. You upgraded about a five to seven year time horizon. Now, Nintendo, they did upgrade their screen halfway through with what was called the OLED model or OLED model. And that was a little bit of a change, but the actual processing power, you know, the computer chip was the same. The underlying hardware was the same. So, eight years was a little bit long and people were anticipating an announcement from the notoriously secretive company for many years, or at least two to three years.

10:14So, it was a little bit longer. And then when we're talking about the games themselves, one of the key, I guess the first thing I'll mention is when they have the integrated hardware and software, Whereas you probably noticed if you shop for holiday shopping for, you know, Christmas gifts for kids, they'll have the bundle because you can't get a gaming hardware and then have no games to play. You got to buy at least one game. It would be very crazy not to do that and spend all that money. They'll integrate, say, Mario Kart as their flagship game. And that'll consistently sell year after quarter after quarter after quarter because they bundle it together.

10:52Now, I think it was almost 10 years in between the last Mario Kart and the one that just came out. So, sometimes that can last a long time, but they will and what they've changed, this is part of the change of their business model, is every couple of years or maybe on a, you know, they'll roll it out every quarter or half year or some sort of cadence, they'll do add-on software that will be a small fee, say 10 to 20 bucks, that you can buy to enhance the game, which is important for the online functionality they've built and just you know new games and stuff like that now if we look at a zelda game those are usually longer life cycles those are the most what i would call premium games or games for adults that nintendo builds and that might have a five to seven year development cycle but something like pokemon which they don't develop mostly themselves i'm maybe getting some of this wrong but it's not necessarily important that there's a separate pokemon company that they partially own and they have a long-standing relationship with those come out more frequently but it just kind of depends on on what gaming franchise you're looking at okay all right that makes a lot of sense so let's now i guess kind of dive into the business model change we've kind of teased that a little bit here so what what exactly is going on like what are they what how are they changing what what are they changing from and how are they changing so the they're changing from i think they were stuck maybe 10 to 15 years behind compared to Xbox and PlayStation when it comes to the consumer value proposition.

12:23The first thing I think they wanted to do was bring their model to the 21st century. This includes things like an integrated Nintendo account, online play, software downloads, essentially making it so it's easier to play for a modern person. You can, I guess, have all that functionality, play with your friends, download this game online without going to a store and just making it much better for software updates as opposed to, you know, the old model before we could have internet connectivity. So, that was part of the value proposition that they've continued to build and continue to invest in.

13:06Now, the business model change, first, they added on, for anyone that doesn't know, they have these online subscriptions that, you know, let you play online with friends, but also have for Nintendo specifically what they try to play on is the nostalgia of families that own a Nintendo Switch which has become more important as the people that they were the original players of Nintendo games in the 90s early 2000s are getting into the age of their 30s 40s and 50s when they're going to have families themselves and they'll probably want to buy Nintendo hardware for their kids you know it's family friendly you don't you're not gonna be having your eight-year-old kid be playing call of duty i hope no judgments if they are but you with the nintendo switch online which or nso which has i think 35 or 40 million subscribers you can get say a bunch of cloud streaming games from past cycles i forget all these names but think an old mario game from the 90s that you wish you could play or an old Pokemon game, stuff like that.

14:13So they're bundling this all together there, including the online functionality. And you get, I think the cost is, and again, it's not really relevant for the podcast, but either 25 bucks or 50 bucks a year, fairly reasonable price, but you're at 40 million subscribers around the globe. That can add up to some really strong recurring revenue that will have high margins. Now, the second thing they changed with their business model is one that also relates to the consumer value proposition, which is software downloads. Now, instead of having a physical game, which costs money for them to make, and then paying your cut to the physical retailer, such as a Target, Best Buy, or Walmart, or Amazon, if you're buying it online, you can purchase directly from the Nintendo eShop.

15:00And that's going to have better profit margins for Nintendo. And they're actually way behind PlayStation and Xbox in this regard. So, they have plenty of room to keep expanding their margins, as I would assume 90 % plus to maybe even 100 % plus. Eventually, you know, we get rid of physical games just because it's much easier, more economical for everyone. I know there's some hardcore gamers out there that want to have the physical package. Maybe they'll keep it around for them, but it'll probably be more expensive. Third thing they did is the add-on content that I mentioned. So, previously, you'd buy a game, the physical game and maybe you didn't buy another one for five years within that franchise you'd play the same one you give nintendo sixty dollars and then boom you have nothing left now they're doing these things called and again i i the names escape me i you can tell i'm not a gamer but let's say you play mario kart okay they add 12 new courses that you now play online with your friends or they add some sort of new pack.

16:07I think they call them expansion packs. That's 25 bucks. That's another revenue stream that you can add in three or four years later and it'll keep people playing more. You know, it helps them find more enjoyment. It makes the game even better and it's another revenue stream for Nintendo. I think there might be some others that I'm mentioning but that is the core thing. They're trying to build more recurring revenue, add-on revenue and just keep more consistent software sales as opposed to selling the hardware selling you a few games when you buy the hardware and then hoping you buy another one eight years later right so what prompted them to start making this change like you mentioned earlier that they were kind of behind in some of these cycles.

16:56So if a company had some success in one style, what made them want to change? Are you saying from the hardware perspective or just the whole business model? More for the hardware, I guess. I think it was the key catalyst was the flop of the Wii U. I think it was their worst gaming hardware ever was the follow-up to the fairly successful Wii. but I think the Wii gets overhyped because it was that novel game plan it didn't actually have that much staying power for true gamers you had kids playing you know that that was when I was a kid you'd play things like Wii Sports and Mario Kart and you'd play it all day but were you really a good customer quote-unquote for that business not as much as you would be on a Switch customer base so they they had the first Wii and then they came out the Wii U Wii U was a total flop just from the hardware perspective, they had antiquated, you know, the electronic shop, online play was either non-existent or terrible.

17:56It was just coming at the same time that Xbox and PlayStation had, you know, the Xbox Live, the online stores, and they were just with a superior model there. And even though Nintendo still had these great gaming franchises, the Wii U is such a bad hardware that no one is buying it. If no one's buying it, no one's going to buy the game. So, it really ruins your business model. This inspired them to say, look, we got to modernize. They merged the mobile team and the at-home console team together. They formed the Switch. It became an innovative model that has been a roaring success ever since where you can take the hardware that you play at home and it has a detachable handheld console and you can play the same games on the go.

18:44I think some companies have tried to copy them, but given the fact that they've actually built modern functionality, they seem to be in a much better place. And they're not going to have ever, you know, compared to the PC gaming, especially, or the PlayStations or the Xboxes of the world, from a graphical processing or the actual computing power, however you want to define it, of the gaming hardware. It's probably never going to be as good on Nintendo. That doesn't really matter. But the fact that you just don't have the pain points of saying, you know, this feels like it's in 2005, instead of 2025, that's helped them a ton.

19:23And it's seemed to make their customers quite happy because we can look at and I hopefully I can find this chart quick because they post it on every annual report. If we go back to 2018 2019, they have this annual playing users chart which is essentially I think anyone that's logged in and played a game they had 36 million that has grown and this is remember at the end of the switch uh life cycle so this is right before the switch 2 has come out that has grown to 128 million and that's about the same as it was in 2023 and 2024 but we've seen a huge expansion of their annual playing users and hopefully can grow once the Switch 2 starts selling through.

20:11Yeah, yeah. So do they have any expectations for the Switch 2? Or have they stated anything? Funny you say that. They do have guidance. But if, say, you're a listener to this and you're someone that likes to look at a bunch of, you know, financial statements yourself, look at IR investor relations pages, just know that Nintendo is sometimes shockingly conservative in how many, I don't know, in all of their guidance. They never want to miss to the downside. They try to be conservative. It's just kind of in their company culture. It's why they have a really conservative balance sheet. And this kind of stems from that Wii U disaster where they just disappointed the whole investor community, disappointed their fan bases, and they just don't want to have that happen again.

20:57That being said, their current fiscal year forecast, and remember I already mentioned that they sold three and a half million units in four days and we still have a holiday quarter in this fiscal year they believe they're going to sell only 15 million Nintendo Switch 2s this year and 45 million software units and software units includes full party games Nintendo Switch Online subscriptions add-on content anything that's a purchase that's you know software related so i think both of those are highly likely to get surpassed yeah typically for anyone that doesn't know they do they did about 200 million plus in software unit sales at the peak of the switch two during co but i think they sold in between 20 and 30 million switch ones a year and that was when people were still getting how should i say associated with that brand.

21:50I was coming from scratch and people were still learning how to, what the device even was. And now we're starting at a higher base. Everyone knows the switch. You have 128 million people who already love the switch. I think we're going to hit 20 to 30 million units this year fairly easily. I'm not going to lie. Running a small business has been stressful lately, swamped in paperwork, different state agencies, and got all these expenses to track and everything. And it's hard to have visibility on these things. But I've stumbled on a better solution, kind of like a one-stop shop for my bookkeeping, my expenses, my P &L, my banking, my contractor payments, all of the messy pieces.

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24:33I use Function and you should too. Check your health the way I do. Function provides 160 plus lab tests for$1 a day and member pricing on advanced imaging. Join at functionhealth.com slash beginners and use gift code beginners25. What's the best way to get started in the market? Download my ebook for free at stockmarketpdf.com. I was reading a little bit about the company in preparation for today. and somebody mentioned that they felt like Nintendo was kind of like the Disney of gaming that they you know that they have been able to create an IP around the brand name and having you know movies and TV shows and all these things that are super popular kind of alongside the games I don't remember the numbers around the the Mario movie 1.3 billion or something in revenue from the movie and I think that correlated to increased sales for the company.

25:31And so I guess what are your thoughts on that idea that they're kind of like the Disney of gaming? They're trying to do that for sure, expand outside of just video games. I think most importantly, they started out from the base of we are a trusted family-friendly content for whatever category you know disney for whatever their issues right now have that for movies where nintendo has that for video games and i would argue that nintendo's been much better at not overly what i would call juicing their ip or putting out multiple stuff each year that dilutes it and they'll have a game come out once every five years where disney might put out what 10 might be a bit much but a couple things each year for a single franchise that's more of a business strategy thing but i think the analogy does play if we look at their what is it the growth the the movies it's one of the top grossing animated movies ever i think on this list i'm looking at now it's fourth either way it could be it's top five there was some movie i hadn't recognized down there 1.36 billion dollars at the box office this is the first one they've done so i think it is a good testament to their creative skills they partner with illumination which is a is a strong animation studio yeah i i think it's it's going quite quite well i think they're going to have a pace of about one per year once they start consistently making these movies They have plans for another Mario one in that universe and then another Zelda one coming.

27:12I think one per year can be helpful for them. But as you mentioned, it's not necessarily going to be the box office revenue. Given that the video game industry is so profitable, they'll probably make more money by turning someone who sees the Mario movie or a kid that watches the Mario movie five times on Netflix into a gaming customer. because think about the transaction. What does a movie ticket cost? 20 bucks. Nintendo keeps a slice of that. Now, if you get someone to buy a Switch 2, that's a$500 purchase. If you get them to buy Mario Kart, that's an$80 purchase with the vast majority of that$80 going to Nintendo.

27:53So, it's not necessarily the money they're going to make from the movies, but how it can drive more fans to those franchises. And when you have an eight-year-old kid that say, I love Mario. My friend plays Mario Kart. We got to get a Switch 2. Or how do I play Mario? They probably don't know what a Switch 2, but how do I play Mario? Well, the parent's going to go, okay, well, I think we're going to buy a Switch 2 this holiday season. Yeah. Yeah, I could definitely see that. And I think it's a smart marketing ploy or play to kind of help further deepening the recognition of the brand and the acknowledgement meant that, hey, we will help entertain your family, either in the movie or via the games.

28:43So I guess I'm curious about the subscription part of the business versus the hardware part of the business. Does Fiscal break out the percentages of what that is and how is that changing? And I'll get to my point here in just a second. So my question is, I think that there's probably a gap between the amount of people that have bought the hardware versus subscribing to the online subscription services. Do you think that that's going to merge at some point or get closer? Or do you feel like the hardware is going to be the dominant play and the other one will be not necessarily a minor play, but maybe a lesser part of the business going forward?

29:28or is that just on the upswing? So we don't, they don't break out hardware revenue versus software revenue, I don't think. And they don't break out the subscription revenue. You have to kind of backfill it yourself. If we look at the ones they have on fiscal, they'll have Nintendo Switch revenue and then mobile and IP revenue, which is the movies, theme parks and other. And the vast majority of their overall revenue is going to be from video game platform sales, which includes hardware and software. But if we look at, and this is how I think about it, they sell the Switch 2 or their gaming hardware at low margin.

30:06I don't think, unlike the PlayStation or the Xbox, I don't think they sell them at like zero or negative margins. But they do sell them at a low margin and most of the profits not going to come from the games. but the majority of the profit is going to come from the or sorry the gaming harder the majority of the profit is going to come from the game sales and the add-on subscriptions if we look at i'm just trying to do the math in my head if you have 10 million people free every 10 million nintendo switch online subscribers that pay 50 million a year or sorry 50 a year that would be 500 million in annual recurring revenue that is really high margin revenue so every new subscriber you add to that that's going to have high incremental margins if we look at their latest quarterly earnings this is right before the new Mario Kart came out on the Switch 2 they still sold let me find the number for you in fiscal year 2025 which is what ended in March They still sold 6 million Mario Kart 8 Deluxe units.

31:16And this game was, I think, 10 years old. It was even on the Wii U to start. And each one is, I think,$60. So do the math on that. They're not putting any new development costs into that. Every single new sale on that may have close to 80%, 90 % margins. I could be exaggerating. But even though the revenue from software might be slightly lower than hardware, and it probably will still be because you need them to sell hardware, the majority of the profits are going to come from game sales. So one of the most important things I like to track is if their flagship titles, Zelda, Mario, Animal Crossing, Splatoon, Pokemon, and maybe a couple others, if their flagship titles within those franchises are selling well, because that's going to be where the profit shows up.

32:08yeah yeah that makes a lot of sense so i guess one of the i guess concerns that i would have about this company would be the cycle that we kind of talked about a little bit earlier like if four or five years for the switch one if you project a similar scenario for switch two well you know like like everything else what's next like what are you going to do for me after that so do you feel like maybe if you're looking at this company as a long-term investment are you banking on them coming up with another hardware device or a switch three or something else that can continue to carry them forward or are you banking more on the the games and the the online subscription part of the business so first thing i'll say is i think we're de-risked from that i know it's a long ways away so yeah take that take that for what it's worth if you asked me that question two years ago i would have said there's much more near-term risk that has become de-risked in the last year and that's why the stock's up 60 is that they seem to have executed fairly flawlessly with the switch to and pleased most of their customers and just basically taking the same concept and improved on it four to five years from now or essentially in perpetuity if you're going to be a permanent shareholder, you have to understand that there is a little bit of a cyclicality risk.

33:42I guess if you're doing your valuation work, you know, don't take the peak profits from 2021 and say, that's going to happen forever. You're probably going to be upset with the returns what leads me to like the company is just their culture of excellence around game development and yeah they might take some risks and eventually maybe if the there's new developments in hardware around gaming which include you know ar augmented reality virtual reality any sort of new innovation within gaming that they are going to have to take advantage of this could be five ten years from now if there is the virtual reality and that's what becomes the main way that people play they're probably going to have to add that on there could be like eye tracking stuff there could be any sort of new innovations within video games they're going to have to innovate on that and make something that delights their customer now they've had a long culture of doing that.