There may not be a company that is loved so much by consumers but disliked by the investment community more than Nintendo (NTDOY 3.03%). Fans of Mario, Zelda, and other characters eagerly anticipate every Nintendo product announcement, a level of enthusiasm only perhaps matched by Apple's faithful customer base.
And yet, even with this valuable intellectual property (IP) and rabid fans, Nintendo shares have historically traded at an earnings multiple below the market average. Today, its price-to-earnings (P/E) ratio is 14.5, while the S&P 500 trades at a P/E of 25. Disney -- the most comparable entertainment company to Nintendo -- trades at a nosebleed P/E of 39.
Why does Nintendo have such a cheap earnings ratio? Does that make the stock a buy at these prices? Let's investigate.
NTDOY P/E Ratio data by YCharts.
Cyclical worries, no new hardware (yet)
While Nintendo has been beloved by the video game community for decades, it has gone through periods of profit cyclicality. Fifteen years ago, it launched the motion-controlled Wii gaming console, which surged in popularity for a few years. Along with the launch of the Wii, Nintendo's profits soared to an annual rate of over $5 billion. Then, a few years later, the company followed up the Wii with the Wii U, which was a total flop and led to a multiyear period of negative earnings. Today, Nintendo is riding high again with the successful handheld/console-hybrid gaming device called the Nintendo Switch, which has sold over 125 million units in the six years since its launch. Profits -- as you might expect -- have risen along with the success of the new product.
NTDOY Operating Income (TTM) data by YCharts.
This is the key reason why investors are putting a discount on Nintendo shares today. They are worried Nintendo will head into another cyclical downturn if its next-generation gaming hardware after the first Switch is a flop like the Wii U or Game Cube.
But the question is: Do these worries have merit?
Why investor concerns are misguided
Nintendo is a unique company that thinks for the ultra-long term, which can frustrate shareholders. The company has a history of making bold, experimental bets with new products that sometimes pay off handsomely (like with the Wii) but other times flop horrendously (like with the Wii U). There is always a small risk this could occur with whatever new device Nintendo comes out with as a successor to the first Switch.
But there are signs management has learned its lesson from the poor market performance of the Wii U. For one, it now has customers sign up for a holistic online Nintendo account, which should help them spur demand for this new hardware launch as player data can now be easily transferred digitally. Second, it now has recurring revenue with its growing Nintendo Switch Online (NSO) subscription service. An estimated 40 million gamers now subscribe to NSO for access to legacy game libraries, online playing capabilities, and free add-on content. This should stabilize earnings as Nintendo transitions to its next hardware product, whenever it gets released.
Lastly, we should remember that Nintendo is making major expansions to diversify away from its gaming business. It just released the Super Mario Bros animated movie in conjunction with Illumination Entertainment, which recently became the second-best-selling animated movie at the box office, grossing $1.33 billion. It is opening up four theme parks across the world, which have gotten rave reviews from customers. We do not have formal guidance on what Nintendo's long-term plans are for its movie and theme park businesses, but if the segments continue to grow, it will help Nintendo de-risk from a potential gaming hardware flop.
Add all this up, and it looks like investors are overplaying Nintendo's earnings cyclicality as the company is much more immune from this risk than it was even just 10 years ago.
Will the stock do well over the next decade?
Today, Nintendo trades at a market cap of $51.5 billion. The company has a famously conservative balance sheet, with over $15 billion worth of cash, securities, and investments, along with zero debt as of the end of last quarter. Subtracting this number out from that market cap and Nintendo's current enterprise value (EV) is $36.5 billion.
Over the last 12 months, Nintendo generated $3.5 billion in net income for shareholders. This has been depressed due to the rising value of the U.S. dollar vs. the Japanese yen and euro over the last two years, something that is out of Nintendo's control and likely won't go on forever. Combining this with the NSO recurring revenue stream, new initiatives outside of gaming, and management's strategy to mitigate the chance its next hardware device is a flop, it looks likely that Nintendo's annual profits will be close to the same or higher for this decade.
If this happens, Nintendo will be capable of generating total free cash flows close to its entire enterprise value within 10 years -- a significant feat that suggests the stock could perform exceedingly well from a total return perspective. From my seat, this makes Nintendo stock an easy buy at these prices, especially compared to the market, which trades at a historic nosebleed P/E of 25.
