Joshua Kennedy of Sonian Capital Management has earned an impressive 25% avg. total return across 14 ideas on SumZero. His latest thesis, a long on struggling game giant Nintendo (7974:JP), quickly captured a 98% peer-rating, and focuses on a market where Kennedy has demonstrated consistent analytical prowess: Japan. SumZero sat down with Mr. Kennedy to discuss the details of the high-uncertainty, low-risk Nintendo situation, and how the company could be poised to take mobile by storm with its classic characters.
A summary of the following pitch was featured on Yahoo! Finance.
SumZero: What about Nintendo initially caught your attention as a value investor What is the market missing?
Joshua Kennedy, Sonian Capital Management: 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.
SumZero: Does the company indicate any desire to capitalize on their immense IP strength in new ways aside from mobile?
Joshua Kennedy, Sonian Capital Management: 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 MarioKart, 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. It has many of the hallmarks of a really exceptional business. 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.
SumZero: Is there any possibility that Nintendo acquire/be acquired by a competitor that can put Nintendo’s IP to use in the smartphone world more effectively?
Joshua Kennedy, Sonian Capital Management: Nintendo will not be acquired, I think that much is certain.
In terms of deals they could do that would help them in smartphones, they took an obvious first step with their partnership with DeNA, which is a mobile gaming specialist in Japan. That partnership included a share swap, so Nintendo owns 10% of DeNA. We don’t necessarily know the details of DeNA’s role, but if they are jointly successful in mobile games, Nintendo could begin to account for a significant portion of DeNA’s profit stream. In Japan, this type of progressively deepening relationship can be a predecessor to M&A.
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.
SumZero: Part of the long thesis is in Nintendo's impressive balance sheet. Does Nintendo manage its immense cash pile intelligently? What plans have they made for it publicly, if any?
Joshua Kennedy, Sonian Capital Management: “Intelligent” might be a stretch. Some portion of the cash is really like the fat a bear puts on as winter approaches. Nintendo knows there may be long stretches between cycles, so they eschew debt, and they never want to be in a position where they cannot invest in their business, or market new products properly, or anything else that may injure the long-term value of the business. As a shareholder, I like this, but it certainly does not meet the standard of the “efficient” balance sheet from a Western, CAPM-oriented perspective.
That having been said, they are good stewards of capital. The dividend policy is a payout ratio – which is hardly universal in Japan – so dividends ebb and flow with earnings. They have bought back stock opportunistically, once in 2006 shortly before the DS and Wii both became big hits, and more recently (and more aggressively) in 2014, when the stock was trading barely above net cash. They subsequently used some of those shares in the DeNA share swap in 2015, and today the company has 15% of shares outstanding in treasury.
Kimishima-san was CFO when they did that buy-back, and he is CEO today, so there may yet be hope for a slimming down of the balance sheet.
SumZero: Given Nintendo's hardware/software business model, what is the best way to value it when competitors like Activision (ATVI:US) and EA (EA:US) are pure software plays?
Joshua Kennedy, Sonian Capital Management: There are not really good comparisons, per se. A hybrid comp is essentially Sony’s Playstation business combined with Activision and EA’s business, weighted for sales exposure. The problem is that Nintendo’s software and hardware are tightly intertwined historically. My approach in valuing Nintendo was to try to come up with a range of values for the smartphone opportunity, which is truly massive compared to Nintendo’s traditional reach. If Nintendo can capture meaningful market share of the smartphone space, say 5%, that component of Nintendo’s business certainly deserves to be valued like a healthy game software company with strong IP.
SumZero: How do you think Nintendo’s new console (the Nintendo NX) will be received? It’s widely speculated that the 8th generation of consoles will be the last, especially for casual gaming.
Joshua Kennedy, Sonian Capital Management: Honestly, I don’t know. My investment thesis is not predicated on being able to predict demand for the NX. Of course, I hope it’s good.
Here is what I will say about the NX, though. First, I don’t think expectations are particularly high due to leaked production figures from Hon Hai and other sources of scuttlebutt. There is a certain population of Nintendo fans who are going to buy it no matter what, so I don’t think it will fall flat.
Second, the current hardware platforms – the WiiU console and 3DS handheld – were both really problematic. The WiiU 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, but NX is likely to replace both WiiU 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.
SumZero: When was the last time Nintendo launched a successful new franchise? How long can the company stand of the shoulders of Super Smash Bros?
Joshua Kennedy, Sonian Capital Management: Nintendo’s continued ability to create compelling new games has been obscured in recent years by the limited reach of their platform. Splatoon is a perfect example. Splatoon, which is a kind of team-oriented, family-friendly, third-person shooter game, was an entirely new game in 2015, not based on existing IP. It was a hit, and won all kinds of awards, but sales were ultimately limited by the reach of WiiU. This game, which is multiplayer in nature, would be perfect for mobile and will undoubtedly be the basis of a new franchise. Super Smash Bros is important, particularly to amiibo toy sales, but my belief is that Nintendo is actually less reliant on a single franchise than most other software makers because its IP is diverse. The problem is the limits of the hardware platform, which is why mobile is both essential and, in my view, inevitable.
SumZero: Demographically speaking, how do you see the gaming population evolving? Are gamers getting older as a broader group, and thus naturally gravitating toward more mature offerings? Is there adequate replacement of younger players and families going on at the top of the funnel?
Joshua Kennedy, Sonian Capital Management: I grew up playing video games, starting with the Atari 2600 and then NES and Sega Genesis. I played a lot of Tecmo Bowl, and a lot of NHLPA Hockey ’93 and ‘94. The demographic of gamers is getting older because video games used to be for kids, but the kids who grew up with video games are still playing as adults. But their kids are playing too.
The stereotypes of the gaming demographic are really breaking down. It is not just teenagers in hoodies playing Call of Duty. Adult women are the largest demographic now, followed by adult men. The whole thing is spreading out, gaming is now an entertainment medium for every part of the population. But the demographic is not aging, kids are as interested in the pastime as ever, at least if my kids and their friends are any indication. 29% of the gaming population is under 18. If you go to Japan, every single kid you see has a DS of some generation, you’d think they issued them in school.
SumZero: How huge of an opportunity is the newly opened market of China?
Joshua Kennedy, Sonian Capital Management: China is actually already the world’s largest gaming market, and companies like Tencent and Netease are making prodigious profits there on games. That market has developed in a substantially different way, and none of the traditional players from the West or Japan have a meaningful presence there because since 2000 there has been a complete ban on video game consoles. As a result the industry there is split between PC and mobile.
The video game console ban, which was purely cultural in nature and put in place for all the same reasons video games have sometimes been criticized in the West, was just lifted in 2015. This represents both an opportunity and a threat for the console makers. It is a huge market that I have little doubt will consume huge numbers of consoles from Microsoft, Sony and Nintendo. But the ban has also kept the lid on competitors that might have otherwise emerged. The game makers in China are also top-notch, and they will increasingly look to compete in markets outside China.
However 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.
SumZero: What were the biggest risks associated with the trade in your view?
Joshua Kennedy, Sonian Capital Management: I think there is very little “permanent capital loss”-type risk here. The company will still be in business, selling the unique Nintendo gaming experience in some form or another many years down the road. 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.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Joshua Kennedy, Sonian Capital Management: Before the metrics change much, we are going to get a lot of news flow in 2016, which I think is going to reduce a lot of the uncertainty surrounding Nintendo. New mobile games are going to be announced, the details of the NX will be revealed, Pokemon will have a big year because it is the 20th anniversary.
Here is one thing to watch: in Japan, highly anticipated apps and games will often have a pre-registration period. Miitomo – Nintendo’s first mobile app which has a kind of a chat/avatar functionality, will start taking pre-registrations later this month. That will be an early indication of the enthusiasm from Nintendo fans for the mobile rollout. Those will be people signing up even though they have no idea what the games will be. For mobile to be a success, Nintendo needs at least a couple hundred million MAU’s. Miitomo pre-registration will be the first indicator of demand.
SumZero: You presented this thesis on Nintendo as a high-uncertainty/low-risk situation. Why is such a thing good for investors?
Joshua Kennedy, Sonian Capital Management: I’ve never met Mohnish Pabrai, but I have taken a lot from his insights, so if you’re reading this Mohnish, I will buy you dinner in Boston!
One of his great insights is that investors sometimes get two things confused: uncertainty and risk. But, obviously, they are not the same thing. If there is no uncertainty, there is not likely to be a mispricing. If everything is relatively clear, then you discount your cashflows and you get an estimate of the value. But the problem is everybody can do this, so the price is likely to be about right for that business. That’s what is appealing about uncertainty to me, prices are more likely to be wrong. If you can find uncertainty that is devoid of a considerable risk of a loss of capital, that’s interesting.
SumZero: What are your thoughts on the Japanese market apart from Nintendo? Any other favorite names right now that are good buys?
Joshua Kennedy, Sonian Capital Management: I don’t have any insight into what is going to happen in the Japanese market overall. There are lots of cheap stocks, but the country has significant challenges, and it may be that a lot of those companies deserve to be cheap. I’ve been investing in Japan for a long time now and here’s what I think is most often overlooked: it is the home to an extraordinary number of world-class companies. Outside of the United States, I would assert there are more exceptional companies with durable competitive advantages in Japan than any other place. You only need a handful of those, so Japan is a good place to search. Plus, the food is great.
I have a few things on my buy list right now that seem to get cheaper every day, but I am not going to disclose those because we’re still buying them. One great company, though, that we have owned for a long time and has sold off sharply is Asics, which makes running sneakers. They make a fantastic product and their customers are very loyal. They specialize in long-distance running and unlike their global competitors, such as Nike and Adidas, they don’t use celebrity endorsements, so their A&P spend is much lower. Instead, they sponsor hundreds of marathons globally and their reps attend every one, talking to runners about the products. This allows them to generate good margins despite competing against much larger peers. Asics is an excellent brand, and the company has a long runway of growth not just in running, which is growing structurally, but by moving horizontally into apparel and footwear for other sports. They have had some growing pains this year as they work to become a company that can really compete on a global scale, so the stock has come down to an attractive price.