Nintendo: How to Analyze Stocks, Part 2 (Video)

Part one is here.

Part three is here.

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Music:
Jayson Litrio – The Legend of Zelda: A Link to the Past ‘The Goddess Appears (Trinity)’ http://ocremix.org/remix/OCR00454

Pumpkin King – The Legend of Zelda: Skyward Sword ‘Fragments of Time v.1’
http://ocremix.org/remix/OCR02928

Chris ~ Amaterasu, waltzforluma – The Legend of Zelda: Link’s Awakening ‘Dreams of Home’ http://ocremix.org/remix/OCR02608

Nostalvania – The Legend of Zelda: Ocarina of Time ‘The Guy from the Woods Is Back in Town’ http://ocremix.org/remix/OCR03071

“Skyward Sword Theme” https://www.youtube.com/watch?v=UsCPB…

Tim Sheehy – The Legend of Zelda: The Wind Waker ‘Forever Yours’ http://ocremix.org/remix/OCR02983

Script:

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

When we last left Iwata, Miyamoto, and the rest of the gang at Nintendo, the company was suffering from massive losses, following weaker-than-expected demand for its latest generation of gaming hardware, the 3DS and Wii U. What will Nintendo do to survive?

The most obvious way would be for Nintendo to exit the hardware business, as some critics have urged the company to do. After all, Nintendo’s iconic characters and games continue to be popular, plus the margins on videogames (which is software) are higher than those of game systems (known as hardware).

If you compare Nintendo’s overall sales to those of a third-party game publisher, in other words, a company that focuses on selling software and not hardware, the reason why Nintendo wants to stay in the console business becomes clearer. Here’s a chart comparing Nintendo’s revenue to that of Activision-Blizzard, one of the largest game publishers in the world and publisher of wildly popular franchises Call of Duty and Warcraft. In its Wii and DS heyday, Nintendo was clearly making money hand over fist, due to hardware sales. The takeaway here is that, if properly executed, selling hardware brings in the sales volume.

Sources: Company data, Art and Finance, Investing.com

Note: Different fiscal year-end periods; Sources: Company data, Art and Finance estimates, Investing.com

In fact, Nintendo has been adamant to stay in the gaming hardware business. Iwata’s insistence on maintaining Nintendo’s traditional “walled-garden” approach, where gamers have to buy Nintendo hardware to play Nintendo games, has left Nintendo between a rock and hard place in recent years, with Microsoft and Sony’s high-powered consoles maintaining their grip on hardcore gamers on one end, and casual gamers rushing toward smartphones and tablets on the other.

Nintendo’s stock has taken a nosedive since then, with investor sentiment not favorable to the company.

Source: Bloomberg

Source: Bloomberg

We already know that Nintendo’s sales and margins took a hit, but understanding the two other major components of financial statements, the balance sheet and statement of cash flows, and how they relate to the income statement and each other, shows how bad the situation is.

income statement

Nintendo’s balance sheet (also known as statement of financial position or statement of financial condition) paints a picture of the company’s health. It does so by disclosing Nintendo’s assets (what it controls), its liabilities (what it owes), and its shareholders’ equity (the amounts attributable to Nintendo’s shareholders). These three items are disclosed at a specific point in time, as opposed to the income statement, which records activity over a given period.

The equation that underlies the balance sheet is Assets – Liabilities = Shareholders’ Equity. In other words, shareholders get a claim on Nintendo’s assets once liabilities are netted out.

The reason why the balance sheet gives a snapshot of Nintendo’s health is because it shows its ability to meet its liabilities, including debt. Remember, as we previously discussed, debtholders get a higher priority claim on the firm’s assets than stockholders. Therefore, from a stockholder’s point of view, all other things equal it’s better for Nintendo to have assets exceed liabilities. 

Now, let’s take a look at Nintendo’s balance sheet as of fiscal 2015. Most companies provide further details to the balance sheet by subcategories within each of the three balance sheet components.

balance sheet =

Assets are often divided between current and noncurrent assets.  Current assets are those which are estimated to be consumed or converted into cash within a year. Examples include accounts receivable, short-term financial investments, and, of course, cash. Noncurrent assets are assets to be utilized over a period of time longer than one year. They include plant, property and equipment, as well as intangible assets, which we’ll talk about more later.

Liabilities are categorized in a similar fashion to assets, with current liabilities and noncurrent liabilities. Current liabilities can include accounts payable, as well as short-term debt to be paid within the year. Noncurrent liabilities are those which do not have to be settled within the year, such as long-term, multiyear debt.

Lastly, shareholders’ equity includes share capital, which is the initial amount Nintendo earns from selling shares to the public, minority interests, which represent ownership interest of subsidiaries not wholly owned by Nintendo, and the accumulated retained earnings that have not been paid out as dividends on the income statement.

Now that we’ve gone over the specifics of the balance sheet, the equation Assets-Liabilities = Shareholders’ Equity, or, conversely, Assets = Liabilities+Shareholders’ Equity, makes more sense. lenders and Shareholders use a variety of methods to finance Nintendo’s assets, which Nintendo uses to do business and make money, paying off lenders and providing shareholders’ a return on their investment. 

One striking feature is that Nintendo has historically held zero debt. A look at their balance sheet reveals various payables, but no actual debt.

Source: Company data

Source: Company data

On the other hand, Nintendo has historically held high levels of cash, which is the single biggest line item in the “assets” section of its balance sheet. This might be the sign of a conservative company avoiding debt and holding on to cash just in case of massive losses. Whatever the reason, in hindsight it was a good thing Nintendo structured their balance sheet in this way, given what has occurred in recent years.

There was, however, a noticeable drop in cash and deposits in fiscal 2012, close to 50%, perhaps unsurprisingly, given that this was the same period when sales plunged, margins went negative, and Nintendo was forced to cut the price of its 3DS hardware.

Sources: Company data, Art and Finance estimates

Sources: Company data, Art and Finance estimates

We already know that the income statement is connected to the balance sheet via retained earnings, but these charts hint at another link between the two, via cash. Here is where the statement of cash flows’ role becomes apparent.

3 statements detail b

The net income, also known as net profit or earnings, found at the bottom of the income statement is not necessarily all cash. This is because financial statement preparation involves accrual accounting. What this means is that Nintendo’s cash revenues and cash expenses are not necessarily recognized in the income statement the moment cash changes hands.

Isn’t that confusing? Why would we use accrual accounting? The reason is the timing difference between accounting recognition and exchange of cash.  Take for example accounts payable, which are essentially IOUs Nintendo owes to suppliers in a year. Between fiscal 2011 and 2012, accounts payable, which are recorded in the “liabilities” section of the balance sheet, plunged, meaning that Nintendo paid in 2012 what it owed its suppliers in 2011. The expense, however, was recorded in the income statement in 2011, as purchasing items from suppliers is part of Nintendo’s regular operating activities and therefore must be recorded during the year the purchase agreement, not necessarily the exchange of cash, was made.

The statement of cash flows, on the other hand, records this and other cash transactions the moment cash is exchanged. Thus, the decrease in accounts payable in fiscal 2012 can be found in that year’s statement of cash flows.  To get a better idea of how much cash Nintendo earned or lost during this period, Nintendo’s net income is adjusted for these internal cash movements – the end result is the net change in cash, which is then applied to the “cash” item in the balance sheet.

Essentially, then, the statement of cash flows links net income from the income statement to the cash item found in the “assets” section of the balance sheet. There are three subcategories within the statement of cash flows: cash flow from operating activities (which are the cash transactions from normal company operations), investing activities (such as purchase of plant, property, and equipment), and financing activities (such as paying interest or dividends).

A popular method of presentation in financial statements is to have net income adjusted for cash flow from operating activities, which means adding and subtracting from net income, as per our accounts payable example. The resulting operating cash flow is combined with investing cash flow and financing cash flow to give us the net change in cash.

The results of the net change in cash can be volatile, given that it’s based on a company’s internal movement of cash. However, cash flow changes including the large cash outflow to pay accounts payable, combined with the losses Nintendo incurred in fiscal 2012, resulted in a large drop in Nintendo’s cash holdings by nearly 50%.

The implication is that Nintendo could not keep incurring major losses like it did in fiscal 2012. How much cash would it continue to burn? Iwata had to make some tough decisions.

Iwata’s short-term solution was to cut costs. In May of 2014, Iwata vowed for Nintendo to return to operating profit by the end of the fiscal year, by way of focusing on profitability instead of sales expansion via price cut. Initiatives involved salary cuts (Iwata himself imposed a 50% cut on his own salary, while Miyamoto and other executives received a 20-30% cut), and lower advertising expenses. Despite investor skepticism given that Nintendo had missed targets before, the company was able to eke out a profit in fiscal 2015.

Some might argue that Nintendo should have cut the price of the WiiU to stimulate demand, similar to what it did with the 3DS, but, given our analysis of what that price cut did to Nintendo’s balance sheet, perhaps cost cutting was the right way to go in this case! By the way: it’s interesting to note that throughout the turmoil of the past few years and recent cash burn, Nintendo continued to pay a dividend – how’s that for focusing on shareholder returns?

Anyway, Nintendo dropped an even bigger bombshell on March 17, 2015.  Iwata announced that Nintendo would partner with mobile developer DeNA to develop a gaming platform for smart devices. This partnership also involved both parties buying an ownership stake in each other.  Perhaps unsurprisingly, Nintendo’s stock rallied after the announcement, gaining over 30%.

But this is Nintendo, a company that has successfully reinvented itself for over a century. It did not stop at just that.

In May, it announced yet another partnership, this time with Universal, to produce Nintendo-themed attractions in Universal’s parks, reportedly to create ” spectacular, dedicated experiences based on Nintendo’s wildly popular games, characters and worlds.”

Perhaps in an even more surprising move, Nintendo announced in June that it would take a “more active approach” to merchandising, and what they referred to as “visual content production” – essentially, TV and cinema.

Does that mean that Nintendo will be getting back into TV and movies, more than 20 years after the infamous Super Mario Bros. movie of 1993? (rest in peace Bob Hoskins) According to Miyamoto:

“As we look more broadly at what is Nintendo’s role as an entertainment company, we’re starting to think more and more about how movies can fit in with that—and we’ll potentially be looking at things like movies in the future,”

News like this shows that Nintendo is evolving – perhaps it has to. Similar to its competitive environment over a decade ago, the current consumer tech landscape is causing Nintendo to innovate once more, hopefully to profit.

Perhaps expanding Nintendo’s library of iconic characters, its intellectual property, into other media is a good idea. We’re already seeing new combinations of technology, media, and content creation, so why not?

Personally, I could see Mario being made into a kid-friendly cartoon (it’s been done before). Given Nintendo’s previous success in kids’ shows with the Pokemon franchise, it might not be too much of a stretch to do the same with Mario.

Nintendo has the additional benefit that an entire generation, the Millenials, grew up playing their games. That increases the total addressable market for Nintendo’s media and merchandise efforts to encompass not just children, but adults as well.

The question is, of course, whether or not such media will be critically successful. Some amount of quality is needed for a film to be commercially successful, especially for adults. We don’t want a repeat of the last time Nintendo ventured into film, not to mention the string of *critically-acclaimed* masterpieces based on videogames in the years that followed the live-action Mario movie.

Some argue that due to player-determined storyline, videogames are inherently not adaptable to TV and cinema. We beg to differ, because more has been made from even less. Like this:

(The Lego Movie)

The fact that a movie literally about bricks was such a commercial and critical success is testament to the power of good storytelling. What might work for Nintendo is to partner up with established content creators. We could easily see Nintendo working with Disney to develop children’s entertainment. In fact, Nintendo recently partnered up with Disney for a Mario Kart event (with Youtubers, no less), so a Disney-developed Nintendo film, for example, wouldn’t be a stretch of the imagination.

What about more mature content for teens and adults? Mario and Pokemon may not fit the bill, but we know one popular Nintendo franchise that just might:

(The Legend of Zelda)

The beloved Legend of Zelda franchise could be key to winning over lapsed fans (including myself) who grew up playing Nintendo but moved on to other things.  The series has already experimented with darker themes and look. Given the crossover success of the fantasy genre, first with the Lord of Rings trilogy and more recently with HBO’s Game of Thrones, a Zelda media product, whether on film or TV, could win over older audiences.

Not only that, it could pave the way for Nintendo’s lesser known franchises. For example, given the success of Marvel and Netflix’s Jessica Jones, the Metroid franchise, which follows the adventures of female space bounty hunter Samus Aran, could have potential as a show. Assuming Nintendo partners up and executes its media offerings well, with less of this, and more of this, the sky’s the limit.

 However, before we get all excited about where Nintendo could go with its IP, we have to take into consideration one important fact. Back in March, in conjunction with its announcement of the mobile partnership with DeNa, Nintendo also disclosed that it is developing a new console, codenamed the NX. What – another console? And judging by the fact that Nintendo’s R&D expenses have increased in recent years, despite all the recent cost-cutting in other areas, it looks like Iwata, Miyamoto, and the rest of Nintendo are going all in on this console.

Sources: Company data, Art and Finance estimates

Sources: Company data, Art and Finance estimates

What’s going on? What’s Nintendo’s game plan? Find out, in our next video, as we conclude our case study on Nintendo.

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Art and Finance

Sources:

CFA Curriculum Level I, 2009, volume 3, pp. 38, 63, 220-1, 267-8

Investopedia Balance Sheet Basics

Investopedia Share Capital Definition

Minority Interest (About.com)

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