Although revenue and cash flow growth are often the leading drivers of a stock's performance over the long run, few factors are more impactful in the short term than a stock's narrative.
Narrative -- the collective story market participants believe about a company's future -- has the ability to create huge discrepancies between a company's quoted stock price and its true value. For the Japanese gaming and entertainment giant Nintendo (NTDOY -1.25%), the narrative has soured.
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Why doesn't the market like Nintendo?
While it's always difficult to pin down the specific reasoning behind a stock's lack of positive investor sentiment, there are a few obvious culprits weighing down Nintendo. Here are three of them.
"Nintendo's a cyclical business"
Unlike many video game publishers, Nintendo develops not only games but also consoles. Since the console industry has seen decades of improvement and technological advances, it's been notoriously cyclical. Nintendo would spend years developing the next hit console for gamers, then spend the succeeding years building games for that particular piece of hardware. But when it came time to make the next popular console, it would be forced to restart from square one. Naturally, this process made investors skeptical about Nintendo's future earnings.
The perfect epitome of this boom and bust pattern in action was the Wii. After first debuting in 2006, Nintendo sold more than 100 million units of its Wii console, and it quickly became one of the best-selling video game consoles ever. However, in trying to build on this success, Nintendo followed up with the launch of the Wii U in 2012, which sold a measly 13.6 million units.
"The Switch is out of favor"
The most recent console that Nintendo has developed is the Nintendo Switch. After its launch in 2017, the Switch has been the best-selling console for 34 of the last 35 months. Despite this success, sales of the Switch for the first six months of this year were down 34% compared to the same period a year ago. This figure has helped investors make the seemingly logical assumption that the Switch is now falling out of favor with consumers.
"Management is too conservative"
Another knock that the company commonly gets is that its management team tends to play it too safe. Nintendo often keeps a large cash position on its balance sheet in case of a rainy day, and this time around seems to be no exception.
According to its latest quarterly report, Nintendo currently has about $15 billion in cash and investments on hand, which is equal to roughly 27% of its entire market cap. While this might be great for longevity, an unwillingness to return cash to shareholders or reinvest heavily can lead to poor stock performance. Additionally, Nintendo's management team has a history of giving incredibly conservative financial guidance. In fact, each of the last four years, Nintendo has beat its own game sales forecasts handily.
Why is the market wrong?
While it's pretty easy to see why the concerns from above might preclude investors from hopping on the Nintendo train, the company is beginning to put most of these worries to rest.
"Nintendo's a cyclical business"
There's one major structural change that should help the Switch platform have greater longevity than previous consoles. And it's just that. It's not a console, it's a platform.
Users are no longer tied to a specific piece of hardware but are instead linked to an online account. So customers can easily upgrade to new versions of the Switch, such as the Switch Lite or the Switch OLED model, without losing their progress or downloaded games.
This has, and should continue to, help smooth out the company's revenue growth while also making game development more lucrative since the number of active users continues to climb.
"The Switch is out of favor"
Despite selling fewer physical hardware units so far this year, user engagement for the Nintendo Switch platform is at an all-time high. In a recent investor presentation, Nintendo announced that it had 79 million playing users in the first six months of this year alone. That's just 9% lower than the ending count for the entire year prior.
As further evidence of this active user base, Nintendo's recent release of Pokémon Brilliant Diamond and Pokémon Shining Pearl quickly topped six million game sales in just the first week after its launch. That makes it one of the Switch's fastest-selling titles ever, despite it being a remake of an older Pokémon and not an original.
"Management is too conservative"
While Nintendo's management team will likely always err on the side of caution when issuing guidance, one thing has certainly changed. The company is no longer simply sitting on its cash pile.
Nintendo expects to pay a roughly 2.8% dividend yield for the year based on its current share price, and the management team also repurchased 1.4% of its total shares outstanding between Aug. 6 and Sept. 15 of this year. Additionally, beyond just returning cash to shareholders, management also stated that it will invest heavily in new entertainment strategies such as theme parks and movies.
All in all, the market seems awfully grim about Nintendo's future, and there's no better indicator of that than the company's valuation. Nintendo currently trades at an enterprise value (market cap minus net cash) to a trailing 12-month operating income ratio of roughly eight times -- well below its peers and the market average.
As the company steadily expands its user base and continues to produce hit games based on its timeless franchises like Mario, Zelda, and Pokémon, the market should begin to recognize Nintendo's staying power.
