Should Investors Bet on Nintendo to Successfully Re-Enter the Gaming Hardware Race?

Image source: Nintendo.

Nintendo (NTDOY 0.66%) stock has exploded in 2016, more than doubling by July and up 80% as of Sept. 12, thanks to the performance of its breakout Pokemon Go and the recent announcement of Super Mario Run for iOS. The push into mobile is exciting and has triggered a reappraisal of the value of the company's properties, but console and handheld hardware and software remain the core part of its business, accounting for more than half of revenue in the past fiscal year.

The company's mysterious upcoming platform, dubbed "NX" for the time being, represents a chance to recapture a larger segment of the gaming hardware market and create a healthy ecosystem for the company's non-mobile software. But Nintendo is facing an uphill battle in this endeavor, and counting on success in the company's traditional sphere is a risky proposition. How much faith should investors put in Nintendo's ability to compete with Sony (SONY -1.68%) and Microsoft (MSFT -0.66%) and counteract the negative effects that mobile gaming has had on its handheld business?

NX facts, rumors, and speculation

The NX is expected to be unveiled in October and is on track for a 2017 release. Comments from Nintendo management indicate that its next hardware move is to create a unified platform that combines elements of the handheld and home console. Reports from The Wall Street Journal and Engadget suggest that the new hardware will double as both a portable device and a home console, and rumors that the device will support cartridges rather than optical discs  seem to point in this direction.

Creating a console-handheld hybrid would enable Nintendo to concentrate its development resources rather than having to support disparate hardware. Nintendo's description of NX as a platform rather than a console might also point to iterative hardware updates that fall under the same ecosystem, a shift that would be in line with recent moves from Sony and Microsoft to release upgraded versions of their respective consoles that run the same software.

Nintendo's new platform will solve a core problem but still faces big challenges

The 3DS and, to a much greater extent, the Wii U were hurt by having long windows between major software releases, as both systems relied on Nintendo for their biggest games. The move to a unified platform should lessen the time between major Nintendo releases and mitigate software droughts because it will allow the company to focus its resources instead of needing to develop different games to support a home console and a handheld, but the NX will have limited prospects if it can't attract strong third-party support. Publishers including Activision Blizzard (ATVI) and Electronic Arts (EA -0.19%) canceled major support for the Wii U early in the system's lifecycle and saw diminishing returns from releasing software on the 3DS handheld, as mobile gaming ate into the popularity of dedicated handhelds.

Nintendo's software output has been stronger than Microsoft's and Sony's in recent years, and it's reasonable to expect that this will continue to be the case. But the company's games have tended to attract a different audience from those of its console competitors, and that audience has not been very receptive to non-Nintendo games. For example, early reporting of Activision's 2013 release Call of Duty: Ghosts showed that the Wii U version accounted for just 0.33% of the game's sales, and EA stopped releasing games for the system less than a year after the system's release. Even with a massive installed base on the Wii, third parties often saw anemic sales on the console.

Some of the poor receptivity for third-party titles can be attributed to better versions being available on rival platforms. This often stemmed from Nintendo consoles having weaker hardware, and there's a danger that similar scenarios will play out with the NX. Both the Wii and the Wii U were relatively under-powered compared to their generational competition, which meant that games looked and performed better on other platforms and that developers were unable to easily transfer engines or assets to them. If Nintendo's upcoming NX platform really does double as a portable and home console, it's probable that the system will fall short of the graphical capabilities of Sony's and Microsoft's consoles, and that technical constraints will put off developers.   

Nintendo will also need to more fully embrace online play if the NX is to be a hit in the current climate. Some progress on this front is to be expected, but the company's quiet track record in the online sphere makes it difficult to anticipate the type of huge jump that might be needed. 

For well over a decade, Nintendo's consoles have had less robust online support than the competition, and they have more recently required a relatively cumbersome process to add players to online friends lists and lacked features including cross-game voice chat. With the Wii U, the company's decision not to emphasize online play as a major selling point and frequently bare-bones functionality in its own games contributed to an ecosystem that had relatively low online engagement, a condition which EA Chief Competition Officer Peter Moore pointed to as a contributing factor in his company's decision to abandon the system. Online play can be a big factor in driving revenue after the initial sale of a game, and unless Nintendo can establish the NX as a thriving platform for connected play, third parties are likely to be discouraged.  

Nintendo's experimentation is exciting, but hardware is still key to its business

Hardware sales accounted for more than half of Nintendo's revenue in the past fiscal year, and controlling its own platform probably gives the company better margins on its software than mobile releases will, as well as licensing fees from third-party publishers. Initiatives including mobile development, the upcoming Pokemon film produced through a partnership with Legendary Pictures, and the incorporation of Nintendo characters at Comcast's Universal parks have big potential, but the recent excitement reflected in the company's valuation boom won't hold up if Nintendo hardware continues on its current trajectory.

Sales of the company's Wii U console sit at roughly 13 million units -- down from over 101 million units for its predecessor, the Wii. The company's 3DS handheld has sold roughly 60 million units worldwide -- down from roughly 154 million units for the DS handheld that released in 2005. For now, there's good reason to be skeptical about Nintendo's ability to deliver a turnaround hit with the NX.