Nintendo: How to Analyze Stocks, Part 1 (Video)

Part two is here.

Part three is here.

Scroll down past the video to see the full picture! Also, full script is below the picture. 🙂 – Ramon

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Nintendo Part 1

“Super Analyst Bros” (Ink and Watercolor)

Script:

Welcome to Art and Finance, the website that makes learning Business and Finance fun and engaging. Finance for non-Finance people

As some of you know, I’m an equities analyst, and I’m very passionate about my job. Some of  you might also recall that we recommend most individuals do not buy individual equities. However, we at Art and Finance believe that learning how to analyze stocks will be useful to our viewers and readers.

Not only do you learn about how businesses operate, but also how broader industry and economic trends may affect these businesses. So going forward, equity analysis is going to be a major feature of the Art and Finance vlog. In this video, we’ll begin laying the foundation for our analyses going forward, by learning the basics of equities analysis. And since this is Youtube, where gaming has a huge presence, what better way to start than with Nintendo as our case study?

In this and the next few episodes, we’ll learn about Nintendo the corporation – about its successes and challenges, and what the future might hold for the company – by performing equity analysis, which is both qualitative and quantitative.

(Stock Analysis and Investing: The Basics)

Let’s start at the beginning – what is equity? Equity, also known as stocks or shares (these three terms we’ll be using interchangeably going forward) represent an ownership interest of a company. The general public  (known as retail investors) normally buys stock that is publicly listed.  Also, institutional investors – professional investors that manage large amounts of money, such as asset management firms including mutual funds, hedge funds, and pension funds, buy stock as well.

Why would retail investors buy stock, and, conversely, why would firms issue stock to the public? As we’ve discussed previously, owning stock helps individuals’ personal finances beat inflation over the long run, as companies are able to pass on price increases to consumers. Individuals are able to benefit from this in the form of price appreciation of stocks (known as capital gains) and also from dividends that a company may decide to pay to shareholders.

Why would a company, such as Nintendo, issue shares to the public? Many times, it’s to help the company grow. If you’re a young and growing company, you may need funds that you can’t generate internally to grow. You could borrow money, but you want to avoid too much debt. After all, you’re legally obligated to pay interest on debt. If you don’t, you’re technically bankrupt and lenders could have a claim to your company’s assets. With stocks, you don’t always have to pay a dividend – you can instead reinvest your earnings for further growth. Therefore, issuing stock to the public provides another way for Nintendo to raise money.

Now, let’s get to our case study: Nintendo

(Nintendo – background information)

The Kyoto, Japan-based Nintendo corporation has been around for over a hundred and twenty-five years. They’ve tried their hands at various products, but found success with video games, especially with the launch in the early 80’s of the Nintendo entertainment system console.

The success of this hardware propelled Nintendo to be one of the most successful gaming companies through the ’80’s and mid-‘90’s.

Nintendo’s success was further bolstered by its first-party games and later consoles and handhelds, as well as Nintendo’s stable of iconic characters, a number of whom such as Mario, Link, and Donkey Kong, were created or co-created by legendary game designer Shigeru Miyamoto.

By the late 90’s and early 2000’s, however, Nintendo was facing tough competition. Sony and Microsoft, with their deep pockets, began producing high-powered consoles – the Playstation and Xbox, respectively.  What was Nintendo to do? Miyamoto and many of the creatives at Nintendo were geniuses, but the company needed someone to lead on the business end.

Enter Satoru Iwata, a talented programmer heavily involved with Nintendo’s success.  In 2002, Iwata became president of Nintendo.  Iwata’s key business insight was to not compete with Sony and Microsoft head-on, but instead to have Nintendo innovate its way to profit. 

Under Iwata, Nintendo began to follow a “blue ocean” strategy, where it would sell videogames to mainstream audiences, rather than the traditional “hardcore” gamers. It would execute this strategy by way of product differentiation, where each new console and handheld Nintendo produced would rely less on graphics and processing power, and more on delivering unique experiences. This strategy proved to be a success with the Nintendo DS and Wii, both of which debuted to initial skepticism, but became two of the best-selling game systems of all time.

(Nintendo: Financial Statement Analysis)

Now that we know the qualitative aspects of Nintendo, let’s dive into the quantitative aspects to further understand its strategy and success.

When a company goes public, it is required by law to provide the investors with financial reporting, in the form of financial statements it provides to the Securities and Exchange Commission. Nintendo is no exception. For investors to decide whether or not to invest in Nintendo by buying its stock, analysts perform several types of analysis, including financial statement analysis. Financial statement analysis involves manipulating the data found in these statements to get a better understanding of the company. This analysis also forms the base by which investors arrive at a valuation of a company’s stock, in other words, what the company is worth, to decide whether to buy, hold, or sell its stock.

Let’s focus on three major components of financial statements – the income statement, the balance sheet, and the statement of cash flows. Here, we’ve taken the data from Nintendo’s statements and placed them in excel, performed an analysis, and developed a valuation of Nintendo’s stock. This is what’s known in the Finance industry as “modeling” – basically, you develop a quantitative model of Nintendo’s business to help you understand the company and create a valuation. Sounds intimidating, doesn’t it? Well, it shouldn’t be – this model is all about addition, subtraction, multiplication, and division. The hard part, as we’ll learn later on, is deciding whether to buy, hold, or sell.

(Nintendo: The Income Statement)

Let’s start with the income statement, also known as the statement of operations, or profit and loss statement.  Nintendo’s income statement presents the financial results of its business activities in a given period. Here we’re looking at their annual results, which follow Nintendo’s fiscal calendar, which is the 12-month period ending in March. By the way, this is an example where a company’s fiscal year doesn’t match with the calendar year; important to keep in mind.

The basic equation that underlies the income statement is pretty simple:

Revenue – Expenses = Net Income.  Revenue, also known as sales, are the amounts charged for the firm providing a good and/or service. In Nintendo’s case, that is the sale of video games and related merchandise and services. Expenses are, of course, the costs that Nintendo incurs while doing business. Net income is what’s left after subtracting expenses from revenue, and is either retained by Nintendo for reinvestment, or paid to shareholders as dividends.

Of course, the income statement is a bit more detailed than that. As analysts, we seek more detail into Nintendo’s operations, and as such, most income statements are further sectioned to help us gain some insight. Most income statements follow this format:

Revenue - COGS h

You have revenues, then you subtract the costs of the actual goods sold – these costs include manufacturing costs and costs of materials. This gives you gross profit.

Next, we look at operating expenses – basically the ongoing costs that Nintendo incurs every year in its normal course of business, regardless of how many goods are sold. In recent years, Nintendo has provided a breakdown of the types of costs that make up operating expenses. These include advertising, research and development, and salaries, among others. Subtracting operating expenses from gross profit gives us Nintendo’s operating profit.

Next, we account for non-operating gains and expenses. These are items that are not directly related to Nintendo’s operations – for example, interest income from Nintendo’s investments (a gain) and foreign exchange translation losses (a loss; remember that Nintendo is based in Japan but sells its products around the world). Adding non-operating gains and subtracting non-operating expenses from operating profit yields pre-tax profit.

Finally, subtracting taxes paid, as well as income that flows to private shareholders, gives us net income available to common shareholders.

Dividing the income statement this way allows us the do more detailed analysis on Nintendo. We can now look at how profitable Nintendo is on several levels, by looking at its margins. For example, operating profit as a percentage of revenue gives us Nintendo’s operating profit margin. All other things equal, the more profitable Nintendo is, the larger this margin will be – meaning, for example, that it is generating more revenue while keeping a lid on operating costs. Besides the operating profit margin, analysts look at other margins as well, such as gross profit margin, pre-tax profit margin, and net profit margin.

Now, let’s look at how Nintendo’s been doing with regards to its income statement. Here, we’ve graphed Nintendo’s revenues, from fiscal 2001 to fiscal 2015, Nintendo’s latest filing period. Things looked pretty good throughout the mid-2000’s, with revenues rising AND margins expanding, meaning Nintendo was becoming more profitable EVEN while it was growing.

Growth Revenue and OPM

Sources: Company data, Art and Finance estimates

By the early 2010’s, however, things took a turn for the worse. What happened?

Loss Revenue and OPM

Sources: Company data, Art and Finance estimates

Recall in Ilusion Chapter 2, that the consumer technology industry tends to follow product cycles, and, having to keep up with improving technology and changing consumer tastes, the video game industry is no different,. Following the success of the Wii and DS systems, Nintendo released the handheld 3DS in 2011, followed by the WiiU console in 2012. Demand for the 3DS was weaker than expected to say the least, as Nintendo was forced to make a price cut soon after its debut. The result of the cut was reflected with the 36% drop in revenue in fiscal 2012.

Since then, Nintendo has not meaningfully recovered, as demand for its new console, the WiiU, remains weak, despite stronger sales of the 3DS.

Recover Revenue and OPM

Sources: Company data, Art and Finance estimates

There are several reasons for current weakness, but the main issue appears to be that casual gamers have moved from Nintendo’s products to smartphones and tablets, which debuted in the years between the Wii’s launch and the introduction of the 3DS.

So what does Nintendo plan to do next? Find out in our next episode!

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Art and Finance

Sources:

CFA Curriculum Level I, 2009, volume 3, pp. 6-7, 10-11

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