How Important Is Switch to Nintendo?

Nintendo's (NTDOY 0.66%) Switch gaming console has been one of the big hits of the holiday season. The innovative gaming system, which also works as a portable gaming device, promotes family gameplay and is more accessible than some of the systems offered by its rivals.

On this episode of Industry Focus: Tech, Dylan Lewis is joined by Motley Fool contributing writer Daniel Kline to talk about how the Switch fits into the company's business. They examine how the console works as well as the  stunning percentage of Switch-related sales that now comprise overall revenue.

In addition, the two break down exactly how Nintendo makes money on the Switch as well as what its future prospects look like. They also discuss how the success of Switch has caused a major swing in the company's earnings.

A full transcript follows the video.

This video was recorded on Dec. 1, 2017.

Dylan Lewis: Now that it's officially December 1st, I think we can start talking holiday stuff. I know that some folks over on the CG show already got into the spirit.

Dan Kline: It's very bizarre having it be December when, as you know, I live in West Palm Beach, so it's 82 degrees, yet somehow, it's almost Christmas.

Lewis: I'll say, even here in Washington D.C., it has been pretty mild. I'm not really feeling the December chill yet, so it's a little tough to get into the spirit of the season. We're going to try today, on the show, talking about some gift ideas. Before we get too far into some of this consumer tech stuff though, Dan, you have a teenage son. What is the hot item for him this year?

Kline: Mostly he's into telling me I'm wrong. He's 13, so that's kind of the age.

Lewis: You can't really package that.

Kline: He wants Star Wars Battlefront 2. He played, I would say, Battlefront was a good three months of endless gameplay, so he's excited about that. And he's getting an Amazon (AMZN -1.11%) Echo Dot, mostly because I'm tired of him talking to mine. It's going to be a tech heavy Christmas in my house, how about you?

Lewis: I take it that your son doesn't listen to the show, given that you just said what you're going to be giving him for Christmas. [laughs]

Kline: [laughs] I'm not sure my son knows what I do for a living. He did once tell his classmates that I work for The Monthly Fool.

Lewis: [laughs] Well, in some senses that's right, with our stock newsletter service. I have some snowboarding stuff on my wish list, I got into it last season thanks to a friend forcing me to get on the mountain, and I really liked it. So, I'm really looking forward to hopefully getting a couple of accessories for that. Man behind the glass, Austin Morgan, what's on your holiday wish list?

Austin Morgan: First of all, Dan Kline, Battlefield 2, I'm hearing it's a no-go, don't buy.

Kline: Really?

Morgan: Yeah. It sounds like you have to pay to be good at the game.

Kline: Yeah, that's one of my big complaints about a lot of these games. One of the things I saw in Battlefront 2 is that you can't be Darth Vader if you don't spend extra money. Darth Vader is a pretty core character in Star Wars.

Morgan: It sounds like you have to put in almost 200 hours to unlock Darth Vader -- or, My Heroes. Maybe not Darth Vader, but the heroes. Which is crazy.

Kline: Well, for a 13-year-old on Christmas break, that could happen.

Morgan: That's true, that's very true. My Christmas wish list is slightly different than it usually is. Usually I'm getting a new GoPro (GPRO -0.56%)or a stabilizer for a GoPro. But, this year, I just went to the Government Expo, and now my wish list is full of video gear that I can't afford. [laughs]

Lewis: So, Austin wants slightly different things than most people.

Morgan: A set of lights, maybe a new tripod so I can work that freelance.

Kline: I'm just glad you went last. You totally could have shamed us with saying how you were donating your holiday to charity or something that makes us look terrible.

Lewis: I'm going to bring this tangent around to what we're talking about today, and actually that Battlefront conversation was kind of a good queue up, because some of the things we're talking about are going to be relevant to the gaming space. One of the really big things on a lot of people's lists, and seeing the circulars being sent around by Best Buy (BBY 1.41%), Target (TGT 0.70%), things like that, is the Nintendo Switch. Dan, do you want to talk a little bit about this product and why so many people are interested in it?

Kline: I bought a Nintendo Switch right when it came out. It involves a lot of waiting in line, a lot of jumping onto websites. Basically, I'll call it a casual gaming console. It builds upon the original Nintendo Wii, and it's very interactive. Some of the games involve movement. I have a game called Arms where you actually move your arms to box, that's the game. It's more family friendly. It's a little bit cheaper for a new console at $299, which we'll talk about a little bit later. But it's really something that's meant to be for more casual game players. My wife might play Mario Kart. She's not going to play Battlefront 2.

Lewis: And it's a little bit more of a hybrid device. It blends the categories between consoles and handheld gaming.

Kline: That's the really cool part. It's actually a tablet. If you want to play on your TV, you can sit it in a little cradle and it comes up on your TV. And if, mid-game, you want to switch and move with it, you just grab it, slide the little controller things into the side, and it becomes a really cool tablet gaming experience, pretty much seamless.

Lewis: You mentioned that price of $299. One of the things we wanted to do with today's show is look at, this is a popular device, what does it actually mean for the company that sells it and their financials. Earlier this year, this tech firm, Fomalhaut Techno Solutions, did a teardown of the Nintendo Switch, and they ballpark that the build costs roughly $257. That leaves them some margin to grab, but not a ton.

Kline: Except most of them are being sold through retailers, and while there's very little retail markup, they have to be making something to cover their handlings. My guess is, Nintendo sells the device at a loss. But, what's very important on the Switch, and this will come up again and again with other consoles, is that when you get the Switch, you really only have what you need for limited gameplay. You pretty much need to buy a second controller, the two controllers that come with it are mini controllers and they slide into something to make a full controller. So, really, you're looking at another $100 worth of accessories. I bought a carrying case, I bought some additional memory. Those items do have margin. And I would say the vast majority of people, even before they buy a game, and it does not come with a game, do have to buy some additional accessories that are probably at somewhere between 30-50% margin, given retail traditions.

Lewis: And looking at what that mean specifically for Nintendo, you go back over the past six months, the Switch segment produced 65% of the company's revenue and led Nintendo to produce 165% year over year growth for the first six months of 2017. That's incredible!

Kline: And what's more important about it is, it's great to sell all these consoles, but if they're selling them and people are just setting them aside, which I think is going to be the case with some other one-off technology, but they're really building a user base. And this is going to be a viable platform for 10 years, maybe even 15 years. It's very adaptable, you can have new software, and because it's not meant to be cutting edge in terms of graphic capability, it's not that important if it feels a bit dated. You can still buy Wii games at GameStop (GME -0.68%), it's really just ending its life cycle. So, this kind of revitalized Nintendo's business in terms of a platform to sell software off of.

Lewis: Granted, I cited that very gaudy growth rate, they were coming off of a period where they had really disappointing sales of previous devices. So, in some ways, they were going up against some really easy comps. But, something that was pretty encouraging for me in looking at Nintendo's results is, they also post units as one of their main measurements, so they give you the idea of how many units of the Switch they're selling, but they also talk about the number of software titles they're selling per device, and it works out to about five games for every Switch they've sold. So, that's a testament to how much people enjoy using the device and are buying things to use on it.

Kline: And they've made it really easy. Obviously, there's an online marketplace for every game console. But in addition to being able to buy the top-tier $60 Switch titles, there's also a library of older Nintendo titles. If you want to buy Street Fighter from, I'm going to guess the year, 1994, maybe it's $6.99 and you can get two or three days of play out of that. So, while they haven't turned on all the social features that could eventually be enabled in the game, they kind of made it so that you can make your major purchases when you're excited about, my son really wanted Splatoon, that came out and it was worth $60, but if it's a rainy day and we're just looking for something to play, there's much lower price games that you could download at home relatively easily.

Lewis: And one more point on their financials where I think that has borne out, you look over at what they were doing in the first half of 2016, they posted operating losses of around $50 million. And there's some adjustments there because they report in a different currency. Fast forward to the first six months of 2017, they posted operating income of $350 million. A lot of that is on the back of these software sales because they're higher margin.

Kline: It's been an absolute game-changer for them. Nintendo was at the point that, while they had some of the handheld market, they were teasing, if this didn't work, they would have to just license their content, their intellectual property, to other platforms. And there's certainly a market for Super Mario and Zelda and all their other top-tier content. But the second you start doing, you become one step removed from the sale, so there's margin to be paid out elsewhere. This really insulates their business and protects their IP for a long time to come.

Lewis: All of this is to say, if you see Nintendo Switches flying off the shelves, and you see a lot of reports about really strong Nintendo Switch sales, that's going to bode very well for Nintendo's stock, right?

Kline: Absolutely. This is really strong news for Nintendo's stock and really for the company. Look at everything they're trying to do -- licensing to Universal for theme park rides -- it's all built off this infrastructure of games. And this gives new life. Right now, they're riding Super Mario Odyssey, and I don't know what number Mario title that is, but the X entry in that game, and that's just things they can build off of without having to rely on Apple (AAPL -0.81%) or Microsoft (MSFT -0.66%)or whoever else it might be who would distribute it for them.