Nintendo (NTDOY -0.67%) delivered robust growth in sales and profits during the pandemic, and that has sent the stock to multiyear highs. A combination of shelter-in-place dynamics and new game releases was a perfect storm for the classic gaming brand. While the Sony PlayStation 5 and Microsoft Xbox Series X will present serious competition this holiday season, there are three reasons Nintendo stock still has upside for investors both near term and in the years ahead.
1. Digital sales fueling growth in profits
Stock prices can do anything in the short term, but long term, there is a tight correlation between share performance and earnings growth. Not only did Nintendo's net sales more than double year over year in the fiscal first quarter (ended June 30), but net profit per share surged 541% year over year, bringing Nintendo's trailing 12-month net profits to 348.5 billion yen ($3.2 billion).
The robust growth on the bottom line was due to more Switch owners buying games digitally, which generates higher margins than sales of game cartridges. Digital software sales comprised 55.6% of total software sales last quarter. That's up from 38.3% in the year-ago quarter.
Obviously, sheltering in place pushed gamers to buy more games directly from the Nintendo eShop on their Switch devices, but the shift to digital sales has been a major trend across the video game industry in recent years. In fiscal 2020 (which ended in March), Nintendo's digital sales increased 71.8%.
Nintendo's digital sales growth may moderate as retailers reopen, and the holiday quarter could see a shift to sales of physical copies as games are purchased as gifts. But Nintendo should continue to see the portion of digital sales to total sales continue to increase over the next few years, driving faster growth in profits and supporting a higher stock price.
2. This key supplier is hinting at continued strong demand
NVIDIA is a key Nintendo supplier, providing custom Tegra system-on-a-chip modules for the Switch console. During its recent quarterly conference call, NVIDIA provided investors a clue that Nintendo's momentum is for real.
The graphics specialist guided for continued growth in its gaming segment through the next quarter with shipments for console products contributing to that growth. NVIDIA CFO Colette Kress said console shipments are expected to be up "strongly quarter over quarter." This is likely due to Nintendo ramping up production for strong demand this holiday season.
During the call, NVIDIA CEO Jensen Huang expressed his optimism for the success of Nintendo: "They're on their way to make Switch the most successful gaming platform of all time. And so, I'm super excited for them."
3. Nintendo may deserve a higher valuation
The final and most important reason why there is still upside in the stock is its valuation. Nintendo stock currently trades at about 20 times its trailing earnings, lower than its video game peers. This doesn't seem to justify the momentum in the business and the prospects for growth, especially the opportunity to continue growing higher-margin digital sales.
On one hand, Nintendo may deserve to trade at a lower valuation than a company like Activision Blizzard, since Nintendo generates around half of its sales from hardware, which presents an extra element of risk and capital investment that Nintendo has to manage in its business.
Still, it's difficult to make the case that Nintendo stock is expensive, even after its 35% climb year to date.
Nintendo has a roster of exclusive game franchises, including Zelda, Mario Bros., and Animal Crossing. The latest Animal Crossing release sold more than 20 million copies since March, driven partly by demand from new players to the franchise. One of Nintendo's biggest advantages is the ability to create unique gaming experiences with these exclusive titles that players can't find anywhere else.
The company has plenty of opportunities to reach new gaming audiences, which is management's stated mission in the growing interactive entertainment industry. Nintendo stock still looks like a buy at these elevated levels.