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Gaming Outlook & Nintendo Deep Dive

Gaming Outlook & Nintendo Deep Dive

Wedbush Analyst discusses Nintendo's focus on licensing.

Gaming Outlook & Nintendo Deep Dive
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Aired Apr 20, 2023
Kinsey Grant interviews Michael Patcher, a Research Analyst at Wedbush Securities, to explore the gaming industry and discuss Nintendo's pandemic success and future prospects.

Kinsey Grant: Hello, everybody and welcome to the Public Podcast. I'm Kinsey Grant, your host today and I am so excited to welcome on our fantastic guest. With us now is Michael Pachter, a research analyst at Wedbush Securities.  Michael, how are you today?

Michael Pachter: I'm good. Thank you, Kinsey. Thanks for having me. 

Kinsey Grant: Of course super excited to have this conversation. Today we are going to be talking about Nintendo, more specifically the outlook for Nintendo as we move ahead into the rest of the year into some big launches for the company. We're going to get your perspective on what comes next for Nintendo. So if you're ready, we can kick right off.

Michael Pachter: I'm ready. 

Kinsey Grant: Alright, sounds great. So Michael, can you give us a quick overview into Nintendo's business strategy, where it generates revenue, how it operates as a business. Tell me a little bit more about that 30,000 foot view. What is he big picture for Nintendo's business? 

Michael Pachter: Sure. They were founded in 1865, I think 1865 or 1869, I always get the year mixed up. And they were like a trading card company. And they kind of invented that in Japan, and you know, muddle along, made money and discovered video games in the 70s with arcade style games. So many people, I'm not sure very many of your viewers have actually ever played an arcade game in an arcade, but Donkey Kong was their first giant hit. And it was Mario running up a ramp and avoiding barrels being thrown by the gorilla who is Kong. So Donkey Kong was Mario trying to get past Kong, and get through all the levels and ultimately, free Princess Peach from being kidnapped. 

That allowed them to generate a lot of wealth, and they decided that they were going to bring the arcade experience to the home. So they're one of the early home console makers, Atari actually might have beat them to it. There's another company Colico, another company in television, all of them watch consoles around the same time in the 80s. And Nintendo’s was the most popular of the many consoles launched - the Nintendo Entertainment System in 1985. And I think that the reason that their console worked and the other guys didn't, is that Nintendo had content, that is, Mario to start. They kept expanding their content library, and they've launched consoles since 1990. The Super NES 1997 in ‘64. In 2001, the GameCube. In 2006 The Wii, which was enormously popular. Then they did the Wii U in 2013, which was terrible. And then the Switch in 2017, which has been very good. They've had a ton of handhelds. The Gameboy was the original, Gameboy Color, Gameboy Advance, Gameboy Advance SP, the DSX you know, and then the 3DS before the switch. If any of your viewers have watched the new Apple TV plus movie, Tetris, that's actually the story of how the Tetris Company was formed, and the key was getting on the Gameboy. So the Nintendo platform was so popular that these guys were minting money. But at the same time, they've developed about 30 different big brands on the Nintendo platform that they own. So among them Zelda and Kirby, and the Smash Brothers Mario Kart, and so Mario is the biggest one.

Their strategy has really not changed much in the last 40 years. They've been focused on the console and their strategy is to create proprietary software meaning software they own for their proprietary console, so the only way you can play their game is to buy their console. And the other guys aren't that way, Sony and Microsoft have consoles, their total sales of first party, their own IP are under 10% of their total revenue. So, you know, Nintendo is more like north of 50 - it has been as high as 80%. So Nintendo has a different strategy than the other guys. And the departure recently from that strategy, which is not meaningful, but it's interesting is that they really started to focus on licensing their IP, and getting opportunities elsewhere. So you start to see them on mobile a bit. They're not really good at it yet. But again, they only own 31% of Pokemon Company, Pokemon Go, it's been a giant mobile title. But the big, big change lately is this Mario Brothers movie. 

So the Super Mario movie is really driving a lot of awareness of the brand. And if you roll back, again, you're probably about 1. But back in 2000, there were surveys of the most recognizable brands of the 20th century. And you can look this up to this, this is findable on Google, the number one brand ahead of Coca Cola, you know ahead of anything else was Nintendo. So they are the most recognized brand on the planet. And yet, you know, their cumulative console sales, maybe have hit 250 million households, I don't think that could possibly be even close to a billion households. Yet, there are 3or 4 billion people on the planet who know what Nintendo is. 

So the recent strategy shift has been to license the content to other media, like movies, to get even more awareness of the brand. I think you're going to start seeing, you know, Nintendo lunch pails, lunch boxes for the kids, Nintendo pajamas, you know, Nintendo plush toys. And I think that'll work. And ultimately, what that does is drive greater awareness and more interest in the brand, which will help them sell software and hardware. So they do great. They're making tons of money, the hardware sales spiked during COVID. And they've kind of pulled back lately, but we're talking about the difference between, you know, 21-22 million hardware units down to maybe 19, or 20. So it's not like they got cut in half - they just peaked. And now they've plateaued. I don't see a lead up anytime soon. They're due for product refresh. They haven't launched a new console in a while. So probably next year, there should be a Switch 2 or something, some upgraded Switch. And Nintendo has been pretty smart on the hardware side. They try to build their hardware and sell it at a profit so they tend to use commodity components rather than cutting edge technology. If you look at Sony and Microsoft, they both lose money on every console, Nintendo makes money on every console. So as a consequence, their consoles are less powerful than the other two. But their content is great so it doesn’t seem to matter to their fans. 

Kinsey: Yeah. And I think you bring up a really important point here, which is this idea that, you know, licensing IP, I think, for most of these companies that we're talking about, but not Nintendo specifically, I imagine the margins can be much higher on licensing IP than they can be on creating technology, creating software and hardware that require a lot of inputs that require a lot of very brilliant minds. And also a lot of parts to be made. You know that that is something that I don't want to discount here. 

But getting a little bit more into this idea of how important IP is for Nintendo as a company. Talk to me a little bit more about this. The Super Mario Brothers movie released in North America in early April pulled in around $380 million in its opening weekend, which is way I think out of you know, outperformed a lot of the expectations that were placed out there for this film. It was co-financed by Nintendo and Universal Pictures, how many more big, you know, major scaled projects like that, like a Super Mario Brothers movie do you see coming for Nintendo? You know, is this setting a new precedent for the company in terms of licensing IP or the project is going to be as big as you know, a major film release that blew expectations out of the water? Do you expect more of that?

Michael Pachter: The economics aren't clear, and I know that the companies announced that the film was co-financed, but my understanding is that Nintendo didn't put any money in. Instead, they contributed the intellectual property obviously, and they lent technical talent so they let their creative developers Miyamoto, who is the head of their studios, to the project to ensure that the characters had brand integrity that they did.

If you have Mario with five arms or or 10 fingers on each hand, and I think that it's likely that their net net profit on this will be something around, you know, 10% of the total film gross, which is still a big number, this film is going to do $2 billion, when they're all done, I mean, between box office and, and all the different DVD sales and pay per view and streaming service fees and licensing to broadcast TV. So they'll make a couple 100 million dollars, that's enough to get them interested in doing it. 

Again, this is one of the bigger projects for Universal. And this is the biggest animated film opening I think of all time. So Universal certainly is going to be interested in doing more and more of this. And for Universal, they make even more money, obviously, because they own the animation studio. So they're going to want to do more and more and more. And there'll be a balance, I think that Nintendo doesn't want to over saturate the market. And they certainly don't want to have any brand failures. But I would expect that you'll see another film within three years. I don't think it's going to be annual for a while.

It takes a lot to be like Disney and put out, you know, a Marvel film every three months, which they do. I don't think Nintendo is there yet. Could they get to one a year in the next 10 years? Sure. So it's a nice profit contributor, but the bigger impact of the film is just brand awareness that, you know, they end up having, say 500 million people see the film, you know, at most half of those people are Nintendo current customers and the other half are not. And ultimately they're going to win over a whole generation of people who are going to be interested. And it also opens up the opportunity for them to sell, you know, figurines.

As an example, when the Mandalorian came out, I bought my wife a couple of Growgu characters, and we hadn't seen the show yet. She's like, Why do I want these? And now she thinks they're super cute.

So if Disney's brilliant at Merchandising, and Nintendo has not been. And I expect that Nintendo will get brilliant at merchandising, I think that could open up another couple of 100 million a year of profit. So I can see this company really building on the success of the Super Mario movie, but I can't tell you that they'll do anything for the next two or three years.

Kinsey Grant: Totally, totally. And to your point, you know, the pace with which a company like Disney can put out movies in a franchise like Marvel is astounding. And you know, every single actor in Hollywood these days is somehow tied to the Marvel Cinematic Universe, which is wild. But with that in mind, it brings to I think, this conversation the the concept of going back to things that work versus creating a new idea or following some sort of new potential concept idea, or content idea or content concept, you know, when we think about Super Mario Brothers has been around to your point where it's being introduced to a new generation, but it was around for my generation, for the younger people in the generation ahead of me, you know that this not really a new franchise. 

And the same goes with Zelda. I know that there's a big release in the Zelda franchise happening next month that a lot of gaming creators are really excited for. But how important is it for Nintendo to come up with the next Mario or the next Zelda? Is that something that you think companies like Nintendo or even Nintendo itself are considering? Or are they really doubling down on returning to what they know works and adding new elements to those franchises that do work versus trying to come up with, you know, totally brand new ideas - blank white sheet of paper trying to figure out what's next? 

Michael Pachter: You know, it's a great question. I don't see Nintendo innovating on their existing brands, you will see them create new brands like Animal Crossing, but new that probably is 10 years old. So it's not like that. That's something they did this past year, in the last 20 years. I doubt that they've done more than two big new brands. They have, I counted not for this interview I counted for another reason, there are 30 brands at Nintendo that have sold multiple millions of units of games. So they have 30 established franchises. I promise you Marvel doesn't have 30. I mean, we think that they have 4000 characters, but they don't have 30 brands. And, you know, Disney's managed to do something with that. DC doesn't have 30. You know, but the difficulty in exploiting those brands is, you know, that you have to create a fun, compelling story around them. And I think with 30 brands, Nintendo's got plenty to continue to pump out, you know, three or four big games a year, movies.

It's interesting because some brands are really great movies like Guardians of the Galaxy, where the brand itself as a comic book wasn't that big a deal. I mean, it was popular but I don't think anybody in this room, I'd say fewer than 10% of the people who are aware of the Guardians of the Galaxy brand will ever have seen the comic book. They learned about the brand from the movie. And that's the right way to build brands, you know that you don't have to build the brand on the comic book.

So an Animal Crossing movie might be good, or a Yoshi Island movie might be good. But we'll definitely get another Animal Crossing game. And we'll definitely get another Yoshi’s Island game. And as I said, there's so many of them that, you know, I don't think Nintendo has to worry about new IP anytime soon.

Kinsey Grant: Totally - and Animal Crossing. I can't help but ask your perspective on the impact of the COVID 19 pandemic on Nintendo as a business and how Animal Crossing became enormous. People were stuck at home, everybody wanted a Nintendo Switch, they were actually incredibly difficult to get for a time. 

I'm curious about how the you know, coming out of the the thick of the COVID 19 pandemic might impact how Nintendo moves forward knowing that they did have this this significant moment in the sun, I would say especially with the switch, which I believe is in its seventh fiscal year next, year heading into its seventh fiscal year next year. So it's not a brand new product, you mentioned that you're expecting some sort of a refurbish or a refresh. 

How do you think Nintendo is going to rise to the occasion to make sure that you know now that everybody is kind of going back to their regular lives, not really at home quite as much, what is Nintendo going to do to make sure that those people want to buy the next generation of a switch?

Michael Patcher: Yeah, I mean, one of the things Nintendo has pioneered and yet failed to exploit adequately is the concept of user generated content. So they've created these Super Mario Maker software packages that allow you to create your own characters and do your own thing. Animal Crossing, let you do that, you can customize your character. And so when I say they pioneered it and failed to exploit, there were brands that were building things inside Animal Crossing. So you could literally wear Burberry, Burberry sweater, or carry a Louis Vuitton bag. And yet, Nintendo failed to exploit that. 

So they didn't create a storefront and let you know, only allow the brand to create the Burberry sweater and then let the brand sell you the sweater. And can you imagine if you could buy a Burberry sweater in the game for $1? You know, Burberry would have made 20 million bucks. And why not? Like how does that hurt them? You know, it has 20 million people, you know, wearing their sweater, it helps us. So I think Nintendo is smart. I think their management team is smart. I like the current CEO a lot.

He'll get that right in the next iteration. So that'll be fun. I think that again, who knows what they're going to do with that next generation switch. But if they allow more creator tools, and they allow you more interoperability, so maybe create something and broadcast that TikTok video or Twitch video through your console, which Sony allows you to do now, I think you get a lot more creative talents. And if you open up the opportunity to create to everybody, you end up enriching the world because you end up with something like America's Got Talent or American Idol, where you get these amateurs who are really talented, and they turn into superstars, you know, so Carrie Underwood, came out came off of a farm in Oklahoma and is a star. And it's hard to know that she would have been discovered but for the opportunity for amateurs to compete, you know, in public.

I think Nintendo exploits that type of concept, and let's amateurs create within the switch to universe. I think they'll come up with really great content, and I think there's an opportunity to make money. 

Kinsey Grant: Yeah, incredibly interesting. Who's the Carrie Underwood for Nintendo is a fun question to ponder here. 

So Michael, I want to talk for a second here about risks and sort of the future, we’ll future cast just a little bit here. You have an outperform rating for Nintendo shares said in a recent report that the stock presents a favorable risk reward profile. I would love to hear you explain that just a little bit and talk to me a little about the risks that might materialize for Nintendo in the medium and long term.

Michael Patcher: They're a pretty dependable company. So they're pretty easy to forecast. Their hardware sales, as I said, don't vary by more than 10% either way. So the odds of them forecasting 20 million switch sales coming in at 10, that's pretty close to zero. They forecast 20 that comes in at 18, they're not going to be thrown from profit to loss, they're going to make a little less money. And it's just as likely that it goes from 20 million to 22. They still have the tool in their pocket of price cuts, and they haven't cut the price much if at all. They've introduced three now three models of the switch, they have the switch light, the regular switch, and the switch OLED.  I could see them cutting the price of each of those by 50 bucks, and suddenly you would see sales go up. And they'll still make money because the cost of manufacture and shipping has gone way down as the supply chain has gotten more normal. 

So I really say low, low low risk on hardware. Software is more a function of release schedule. So you know, if they release a new game, every three months, they're fine. If they miss one, and it takes six months, they might not make as much profit as we forecast. And if they missed two or three, and we go a year or two without, without a new software title, that's a problem. But they've been pretty dependable since the Switch launch that I've seen them really miss anything. You know, delaying Zelda, a few months doesn't matter. That's time value of three months of cash, it's not that big a deal. 

So I'd say risks are very, very low. The reward opportunity, you know, the upside is that when they cut price, they surprise us with a better lineup. And we get more software sales. You know, Zelda is not the best selling game of all time, you know, Mario Kart is, the big surprise for upside would be that there's a Mario Kart 9. You know, which the last Mario Kart I think came out in 2014. It's been a long, long time. So they're really due for something like that. That could be huge. And I would guess that that's their next movie. And so I would guess that you're going get Mario Kart game and Mario Kart movie kind of at the same time. And, and that's where I think they surprise the upside. So I, there's more opportunity for them to beat than there is for them to miss. 

Kinsey Grant: Right. All right. So Michael, this has been wonderful. I have one last question for you for the road. Before we wrap things up here. Just while I have you, Roblox. I would love to get your perspective. Your take on Roblox recently reported monthly key metrics for March that perhaps fell a bit short of expectations. I know you have a neutral rating and a $37 price target for that stock. What are your general thoughts just quickly on Roblox as a company right now,

Michael Patcher: They, you know, they don't disclose their monthly active users, but the number is around 300 million. And that's not even close to saturation. I mean, they could get to a billion users. But the way to do that is to expand the product offering to appeal to people older than 20. And I don't mean to suggest that their content isn’t good, it is. It's just that as you age, you're much more interested in shooter games like Call of Duty, or, you know, role playing games like World of Warcraft.

And so the way to get that type of content is to expand the platform. And the way to expand the platform is to rev share at a higher rate for recognizable content. I think they can. And I actually like their management. And I think that they know that they need to do this, but they haven't done it yet. So I don't see this company getting to the growth implied by its share price until they shift the business model, share more of the revenue with developers and attract games that appeal to older people. And you know, they have a couple of quarters of stagnant growth. That's really what's going on there. The growth is okay, but not as good as people expected. If they have a couple of quarters, stagnant growth, I expect that they'll make a shift. So I'm waiting until it happens. I guess I could forecast the exact date it will happen, but I don't know. If we see an indication that they're going to change them, then we obviously will look at them more favorably, but I haven't seen that yet. 

Kinsey Grant: Right. All right. Well, we'll just have to check back in at a later date. Michael, this has been so wonderful. Thank you so much for your time and all of your incredible insights. I've really enjoyed this conversation.

Michael Patcher: Thank you, Kinsey. My pleasure.

Kinsey: And that was Michael Pachter, Research Analyst at Wedbush Securities. Thank you to everybody out there listening. Once again. I'm Kinsey Grant, and I hope you have a fantastic rest of your day.

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