History:

With roots dating back to the 1920s but officially formed in the 1950s, Formula one has steadily grown to become one of the most popular motorsports around the world. Over the years, fans were drawn to technological innovation that F1 teams employed to achieve the fastest times around the grid.

Despite its long history, the sport only started to formalise under Bernie Ecclestone (originally an F1 team owner) in the 1970s. Original discussions around organising races were anything but organised; there were many separate negotiations with separate parties; F1 teams individually would have to negotiate with the regulators (FIA/FISA) as well as broadcasters, promoters, advertisers and sponsors leading up to a race. Frequent disagreement arose between the team around the size of the pay-out and who splits the bill. Ultimately, this led to several races being cancelled.

Things started to change when Bernie started to organise the F1 teams under one umbrella (now called the Formula One group). This enabled the teams to have more bargaining power in negotiations – whereas negotiations historically were every team for themselves, Bernie was able to organise them and settle negotiations as a collective. In the 80’s, the first Concorde agreement was signed with scheduled re-negotiations every couple of years - this guaranteed the split for each team from each race (from broadcasting revenue and price money) and in return, all teams would have to attend each race.

Over the years, stakes in the F1 group were sold in the private markets to PE firms such as CVC. Bernie still retained control over the company however, as characteristic of most PE investments, the resulting years of underinvestment and short-termism lead to the sport’s eventual decline in viewership numbers.

Enter Liberty:

In 2016, the sports franchise changed hands once again with John Malone (the widely known “Cable Cowboy” and former CEO of TCI) and Liberty Media purchasing the F1 parent company. As an aftermath of the transaction (and a common Malone strategy), Liberty issued a tracking stock that provided investors with exposure to the F1 franchise along with other eclectic mix of assets.

If anyone doesn’t know of Malone, I would recommend reading The Cable Cowboy (LINK). In short, Malone pioneered telecom investing through focusing on minimising tax leakage, maximising free cash flow per share and judicious reinvestment of free cash flow ultimately leading to the sale of his company TCI to AT&T for $48bn in 1998. Afterwards, he has dabbled with investing in the TMT space through his Liberty Media vehicle and generate outsized returns as a result. 

Whereas Malone typically invests across the TMT space, the similarity between all his investments is the ensuing complexity and structure that befuddle most investors. Despite this, I believe the story around FWONK is relatively clear – the company has historically been mismanaged under Bernie and PE firms leading to its stagnant financial performance and poor viewership metrics. New management (Chase Carey and now Stefano Domenicali) instilled by Malone and introduction of the right incentives should help steer the company to continued long term growth.

FWONK holds stakes in a number of public equity holdings such as the Liberty Braves and AT&T however the crown jewel is undoubtedly the F1 franchise itself.

The reason why FWONK is so interesting to me is that it is possibly the only opportunity for public market investors to invest into a sports franchise. Many other publicly listed companies provide exposure to a segment of certain sports franchises; however the performance of a team within their respective sport often influences the economics of the stock to a large degree and, in most instances, teams are run for emotional sentimental reasons rather than for financial ones. An example of this would be Manchester United’s flat performance since inception after the retirement of the legendary football manager Sir Alex Ferguson.

F1 controls the commercial IP rights of the sport through a lease agreement with the FIA (the motorsport regulator) lasting until 2110. As a result, F1 controls all programming, merchandising, licensing, advertising, and sponsorship rights as well as helping organise new F1 venues around the world.

The underlying economics of the business are phenomenal – revenue streams are predictable with locked in contracts spanning 3 -10 years in duration with built-in fee escalators. The franchise requires little capital expenditure costs resulting in high free cash flow conversion and margins. The company is structured in a way that maximises tax efficiency (a trademark of any John Malone investment) which has resulted in a relatively underfollowed opportunity outside of traditional indexes.

There is leverage in the company with roughly 5x net debt/EBITDA (this has fallen from 8x when Malone acquired the company). However, with vast majority of the debt maturing in 2023 and onwards, solvency risk is low. Vast majority of the cash flow will either be used for paying off the debt, making strategic acquisitions or reinvesting into organic growth.

As seen in their prospectus, F1 still is able to generate some of the highest viewership and attendance numbers out of any sport. Yet monetization of those viewers is still low. This is F1’s decision to handicap their reach through signing Pay-to-View broadcasting contracts rather than Free-to-view TV. However, Bernie’s scandals didn’t help F1’s family friendly image.

Revenue streams:

F1 revenue streams can be broken down into 4 segments:

• Race Promotion Fees – fees paid by venues to host the races.

• Broadcasting Fees – earned from licensing the right to broadcast the events on TV or Online

• Advertising Fees - paid by sponsors to advertise within the races.

• Other revenue – revenue generated from ancillary services, F2/3 as well as their OTT subscription service F1 TV.

Race Promotion fees are simple enough: the more F1 venues you organise per season, the more revenue you generate. Venues typically are arranged a couple years in advance and contracts between F1 and the racing venues last for 3 – 5 years with options to extend. Races have been gradually trending up over the past 15 years. 2020 season was originally scheduled to include 22 races however was cut to 17 as a result of COVID. Revenue per race has remained steady over the past 5 years at c.$30m per race and I expect this to continue as more races are added in future seasons (Formula 1 have recently announced a 23 race season for 2021) There is an agreement between FIA and F1 to place a soft-cap of 25 races within a season however I could see this being lifted in the foreseeable future given that both parties stand to benefit from more races (more fees for both parties!).

More venues mean more opportunities to attract local crowds and increase the geographical split of their revenue. Although the company does not disclose revenue split by geography, the majority of the F1 audience is situated within Europe (48% of the 2019 races and 76% of 2020 races were situated within Europe). Opportunities to expand viewership numbers within the US and China would provide a huge tailwind to future revenues.

“[The US is] under-viewed, under-monetised, under-everything… I don’t think that gets solved in a week but I think that’s an interesting long-term opportunity” Greg Maffei, Liberty Media CEO

Despite hosting grand prix in the US every year since 2012, Formula 1 is still the third most popular motorsport in the region (behind Indycar and NASCAR). US viewership numbers are showing promising growthover the past couple years. Clearly there is a lot of focus by Liberty Media to expand into the US globally and improving numbers will help with future sponsorship and broadcasting negotiation contracts. A current overhang to watch is F1’s renewal negotiations with Circuit of The Americas (where they host the US Grand Prix) in 2021 – securing the renewal will be pivotal in attracting a larger US fanbase.

Viewership numbers within emerging markets such as China and Brazil are also growing year on year (Nielsen estimates that China and Brazil have the largest F1 fan bases globally) however monetization in these regions is expected to be low.

Broadcasting fees have grown at 7% CAGR over the past five years through a combination of negotiated yearly fee increases (3-5% every year) and contract renewals with TV and online broadcasters. Contracts vary in duration depending on different regions; in any one year, there are always contracts to be renewed however the large step-up in revenue typically occurs every 3 years. The last 2 resign multiples occurred at 1.07x and 1.26x (compared to the previous contracts average annual payment).

When you compare resign multiples against other sports franchises, you will see that huge disparity between different sports. Upon further examination, we can see that US sports franchises typically resign broadcasting contracts at higher values than their previous contracts. Given that live sport is such a pivotal part of the cable’s value proposition vs. digital content providers, re-sign multiples should potentially increase for the foreseeable future as more TV stations try to differentiate themselves.

As F1 gains a larger dedicated following within the US, I could see broadcasting multiples converging to similar US franchises. Currently, Formula 1’s 1.26x resign multiple is at the lower end of this scale but should meaningfully increase to that of NASCAR’s as they continue to gain popularity within the US. This is despite NASCAR’s continuously falling viewership base over the last 20 years.

Advertising Revenue:

Soon after the acquisition, Liberty Media set about doubling the headcount of Formula 1 headquarters to 150; most of the hires were concentrated within their sponsorship team. Sponsorship metrics screen poorly against peers on most metrics and still require further investment and time to develop an attractive platform for advertisers.

The recent sponsorship deal with Saudi Aramco, announced this year, suggests that the F1 platform may be an attractive proposition for brand visibility in the emerging markets (especially given that the F1 audience skews more towards a wealthier demographic). With possible future growth in viewership, the sponsorship opportunities should growth commensurately along with revenue per sponsor.

Looking at the list of F1 sponsors, there is potential for sponsorships across a wide variety of industries such as Finance, Consumer staples to Telecommunications and Technology.

Other revenue sources:

Making up 18% of total revenue, there are a lot of activities bundled together under this segment. The company does not breakdown revenue sources within this segment which doesn’t exactly help with forecasting or analysis. Nonetheless, there are promising segments of growth to be aware of.

Greg Maffei has frequently alluded to increasing investment into digital value-add services. Whilst these ventures may never generate significant revenue to move the needle by themselves, they should increase the visibility of the sport worldwide.

A recent partnership with Netflix for their “Drive to Survive” series is already the 4th most popular documentary on Netflix. Whilst unlikely to be profitable, the venture will hopefully help attract a different audience base, from Netflix’s 195m viewer platform, to the sport. Given the success of the series, there are plans to create a 3rd season to the show.

The introduction of the E-sports E-series (the official F1 E-sports league) also provides an avenue for F1 to attract a younger audience (a headwind that is faced by many sports franchises worldwide). With nearly 80% of E-sports viewers under 34, there is a plausible chance that many of the viewers express an interest in F1 itself and convert into becoming an F1 viewer. The initial signs are encouraging; recent surveys performed on F1 fans have shown growth in fan base within the 16-24 age range.

F1 have also released their OTT service called F1 TV. For $26.99/year, the subscription service provides alternative angles, real time data analytics and archived footage of historical races which will likely attract the die-hard formula 1 fan. Frank Arthofer, F1’s Director of Digital and Licensing, estimates that there is a potential 5m addressable viewer base that will be attracted to this service. If those assumptions are correct, this could lead to $135m incremental revenue that will largely flow down to the bottom line. The introduction of the OTT service did throw a spanner in the works in broadcasting negotiations with NBC Sport resulting ESPN picking up F1 coverage for free. 

The introduction of this service likely scuppered many other broadcasting negotiations leading to a temporarily depressed resign multiple last year. Clearly management have confidence that F1 TV will improve the franchise in the long run. With current sell side estimates of 200k – 300k subscribers on the OTT service, the data however suggests otherwise.

What attracts viewers on the margin?

“If I was watching today [as a fan], I would most likely do the same and watch the highlights…” Lewis Hamilton, 7-time Formula 1 winner

Really, the heart of the debate around the future success of Formula 1 lies not in the financials of the business but in the intrinsic qualities of the sport itself; is the sport enjoyable to watch?

There have been frequent complaints of F1 by fans over the years over a wide variety of factors however bottom line is that the main limiting factor behind attracting new viewers is the lack of competitiveness within the sport. With only 3 different winning drivers and 2 different winning teams in the last 10 years, winners have gotten more predictable over the years. 

With greater and greater investment pumped in the R&D by the larger teams (used as a marketing branch by their corporate owners), the disparity between the winners and losers has widened over time. Couple this with the fact that most F1 teams are loss making or breakeven at best, being owned by a corporation seems to be a prerequisite for success on the grid.

Why have things changed?

With the Concorde agreement that has been signed this year, the overhang surrounding contract negotiations has been lifted providing greater visibility for the next 5 years (until the next Concorde agreement is scheduled to be negotiated). Whilst most of the terms of the new agreement have yet to publicly revealed, what can be gleaned from Maffei’s quotes suggest steps have been taken to make the sport more competitive and appealing to viewers.

• Unanimity is no longer required between the 10 F1 teams to push things through major amendments to the sport (they now only require the agreement of 8 teams). As a result, there is no longer the risk of a team blocking beneficial changes to the sport purely for self-interest.

• Formula 1 has followed the footsteps of the NBA/NHL/NFL through the introduction of budget caps. This spending cap only includes expenditure related improving car performance. With a $145m spending cap being introduced in 2021 and tapering down to $135m by 2023, future winning teams will determined by skill of the driver rather than the amount of money they put into R&D. Penalties, ranging from points deduction to exclusion from the World Champions, will deter any breaching of the rules.

  

• A new committee (named “The Working Group”) was created to identify and prevent exploitation of loopholes that may occur after introduction of the new rules. Historically, there have been multiple occurrences of F1 teams exploiting these loopholes to gain an aerodynamic edge within the race (Brawn GP famously won the 2009 World Championship through these practices).

• Race weekends will be more condensed from four days to three days providing a better viewing experience.

I’m unsure how the new Concorde agreement will affect F1 teams take rate from FWONK (historically, teams have received around 65% of pre-team EBITDA but this has gradually increased the company have been bought). The most pressing issue affecting FWONK’s margins is whether the take rate will increase in the future.  At a first glance, the negotiations seem to negatively impact the F1 teams however the changes should be conducive in attracting new fans to the sport. Over time, this should result in higher broadcasting, promotional and advertising revenue for Formula 1 and flow down the competing teams. The elephant in the room is would the F1 teams be willing to take a smaller chunk of a growing pie or a large chunk of a potentially shrinking pie. My money would be on the former.

Recent Events:

With the recent interparty transaction (outlined below), some of the complexity around the FWONK structure (the Live Entertainment Stake, Convertible debt etc) has been removed play on Formula 1.

I won’t dig down too deep into the weeds, but Liberty Formula One essentially sold some out-of-the-money naked calls on Liberty Sirius Shares. The calls became in-the-money during COVID so Malone and Co. had to undergo this transaction to cover those calls. Some of the assets within Liberty Media have been rejigged to cover the call options.

Recently, on the 2020 Liberty Investor Meeting, the company has also announced that they were launching a SPAC (ticker: LMACU). The company will acquire $250m stake (out of an expected $500m raise) and attribute it under the FWONK vehicle. The SPAC is expected to target private TMT mid-caps; valuations in that space are high which could create some difficulty but there is some additional upside optionality here provided they make a good transaction.

In terms of potential targets, I believe the Indycar franchise would make sense from Malone’s point of view – there are potential synergies around building up their OTT value proposition (and hopefully pricing power) and it would provide greater power when it comes to contract negotiations with US broadcasters. Liberty’s expertise in ex-US broadcasting will help extend the appeal of Indycar overseas.

"People who have done a great job, like WWE, have a huge amount of content which isn't available on a linear feed so you have more tonnage to put on the Over The Top product… We are never going to have that breadth so that inherently limits some of our upside.” Greg Maffei

Liberty have been making minority investments in Indycar so there clearly is some interest there. However, given the likely size of the transaction, Liberty would only be able to take a minority stake in the franchise. NASCAR has been floated before as an option with Liberty clearly open to owning a stake.

For Liberty Media and FWONK investors, the SPAC will provide a ton of optionality that has yet to be properly valued by the market. All eyes will be on what they will likely buy.

Valuation:

Now let’s see how the valuation stacks up to the story:

Promotion revenue is driven by number of races per season and revenue generated per race. I project revenue per race to stay constant for the next 5 years (I have no conviction that revenue per race will meaningfully move in either direction). 17 and 23 races are scheduled for this year and next year respectively. I suspect races will increase to 25 by 2024 (the upper limit before Formula One needs to get authorization from the FIA).

For Broadcasting revenue, I assume an annual fee escalator of 2% ever year (this is less than the 3-5% stated by management). I believe resign multiple will increase when major negotiations take place in 2022 – this is because there is no longer the overhang of the F1 OTT release negatively affecting discussions. As such, my projected resign multiple is on par with NASCAR’s historical multiples.

Advertising revenue should meaningfully increase as more sponsors join the F1 platform and there is moderate increase in revenue/sponsor. Hopefully, the changes in the Concorde agreement should increase the competitiveness of the sport and attract a larger fanbase. With growth in viewers, this will encourage more advertisers to partner with F1 as well as an increase in revenue per sponsor.

Since management do not breakdown Other Revenue in more detail, it is hard to project what it will be in the future. I believe that F1 OTT will attract up to 2m viewers by 2024 creating an incremental revenue increase of $47m. This is still below F1 management’s projections of 5m subscribers.

Currently, FWONK trades at c.24x FYE21 EBITDA. The only remotely comparable public company is World Wrestling Entertainment (WWE) which has historically traded at around 20x EV/EBITDA over the past 5 years. I would argue that Formula 1 should trade at a premium to WWE due to greater reach, higher EBITDA margins and better management (someday I will write about Vince McMahon’s mismanagement of WWE). However, due to conservativism, I will stick to 20x EV/EBITDA. Applying a 20x multiple of my estimates of FYE24 EBITDA provides me an estimate of FWONK’s valuation in five years’ time.

* For the value of the LYV call spread, I have assumed it will return the maximum amount (which occurs if LYV shares trade over $47.74).

Adding all my stakes together and subtracting away net debt, the upside on the company doesn’t look particularly attractive. All in all, even looking forward five years, FWONK looks to be fairly valued. There have been rumours that Liberty are looking to sell the asset on – I think it would be unlikely right now but given the amount of interest from PE firms on sports asset and the valuations these deals are occurring at, it wouldn’t surprise me if Malone & Liberty sold it off at the right price.

Although FWONK is unlikely to generate attractive returns over the next five years, given the active involvement by private investors, I will likely be keeping an eye out on this space…

Potential Risks to look out for:

-        US grand prix negotiations in 2021

-        Resign multiples of broadcasting contracts for other sports. NHL and NFL both have broadcasting rights deal that expire in 2021 so it will be interesting to see what resign multiple are assigned to their new contracts. Any potential signs of a downward re-rating could affect F1’s future broadcasting revenues.

-        Number of races to announced for the 2022 season.

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Switching it up

“Apple and Nintendo have similar philosophies” Miyamoto, 2016

From the release of the Gameboy creating the portable gaming segment to the Wii utilising motion controls, Nintendo has a rich history of pushing boundaries with each console release. The Switch release is no exception – the console provides gamers with the best of both worlds; playing your favourite titles in the comfort of your home and continuing your progress while on the go. Unlike previous Nintendo consoles that operated solely within either the home console or portable console segment, the Switch operates within both and appeals to gamers that prefer either segment and addresses a larger market than previous Nintendo consoles.

Meanwhile, with COVID and working-from-home, Switch adoption has accelerated with the consoles flying off the shelves. And whilst many people mistakenly perceive Xbox (owned by Microsoft) and PS series (owned by Sony) as competitors, the NPD group survey states that over 70% of switch owners actually own an Xbox, PS4 or both. Due to its unique appeal, the Switch attracts a different segment of gamers; Switch owner demographics skew 50% female which is higher than 42% for the Xbox One and PS4.

However the big issue within the console market is that product life cycles typically last between 5-10 years. Hardware revenue streams are highly variable through the cycle; sales peak after a couple of years and start to taper down as the product starts to show its age. Software sales typically mirror the performance of its hardware. The success of each new cycle depends on the launch of each new product and its customer reception.

Consoles are typically sold at a loss/breakeven to maximise the number of installed base and profits are instead made from software sales. Software sales experience extremely high operating however its success is dependent on the size of the installed base (i.e. if the consoles release flops, then software sales will likely flop). Whilst this has proven to be fruitful when a console release is a success (such as the Wii in 2011 and the DS in 2012), this has the opposite effect when reception is poor (e.g. Wii U). Historically, games aren’t backwards or forwards compatible (cannot be played on future or past consoles) which further exacerbated the cyclicality. Due to this cyclicality, the market has historically punished Nintendo with a discounted valuation against other game publishers.

With the release of the Switch and the online cloud membership (Nintendo Switch Online/Nintendo Account), the company is further pivoting their business model from releasing hit driven consoles into building an online software platform with regular iterative hardware releases.

With shorter product life cycles between each new console release and game releases being backwards compatible, Nintendo’s business model is becoming more like that of Apple’s. Customers can play the same Nintendo games across different Switch products and new console demand will be less cyclical as it will be driven by replacement demand (i.e. I want better performance, graphics, and battery life) rather than creating demand for a completely new console. With less cyclical revenue streams, Nintendo should get a multiple rerating more akin to comparative game publishers.

This has been a business model that Nintendo management have repeatedly alluded to in the past.

• “We want to have flexible hardware cycles where the launch of new hardware sets off the development of the next hardware that will respond to consumer trends” Tatsumi Kimishima, former Nintendo CEO, 2017 Investor Call

• “Up until now, the hardware cycle has trended at around five or six years, but it would be very interesting if we could prolong that life cycle, and I think you should be looking forward to that” Shigeru Miyamoto, 2018 Investor call

Also for £18/year subscription to Switch Online, the cloud service will allow you to save your game files online and enable game progression across platforms (e.g. between new Switch consoles). From a pricing perspective, subscription costs are extremely competitive versus the equivalent services provided by Microsoft and Sony (£50/year for Xbox Live Gold and £49.99/year for PS Plus).

So far, the subscription has been highly successful; 6 months after release, 28% of all switch users have a subscription. As of H1 FY21, there are over 26 million subscriptions accounting for over 38% of installed user base. Recurring revenue is making up an increasingly larger proportion of total revenue.

Currently, Nintendo has released 2 new iterations of the Switch aimed at attracting different segment consumers with a 3rd new iteration (expected to be called the Switch Pro) scheduled to be released in 2021. Each new release is still similar to the original Switch in terms of functionality however hardware specifications and price will differ depending on the consumer segment it is targeting.

The Nintendo Account also will allow the company to get direct insight into consumer data allowing them to introduce greater value add services onto the platform. This should increase consumer retention and could unlock further potential pricing power for their subscription services (for Switch Online). The company has already introduced a catalogue of 60 legacy NES games onto the platform.

Digitisation and Direct to Consumer

In tandem with the Switch release, Nintendo has also been increasing their digital sales to consumers. Digital sales lag considerably relative to peer game publishers but the difference should lower in time as the benefits are clear: greater convenience to consumers, no wait times etc.

For Nintendo, the economics behind going direct to consumer make a lot of sense: the company can increase margins through skipping out the middle man (brick and mortar retail) and can increase revenue by capturing the retail price for itself. However, the effects are more pronounced depending on the type of game sold.

For first party (Nintendo owns the IP and sell to consumers), there is potential for greater margin expansion as the company bears the costs of manufacturing and distribution itself. For third party games (where external publisher pays a license fee to Nintendo to publish their games on Nintendo consoles), Nintendo only receives the benefit of a higher ASP.  Given that over 80% of games sold on Nintendo are first party games, I expect there to be a substantial margin expansion opportunity as Nintendo focuses their efforts on increasing digital sales.

High Quality IP

One of the most distinctive lessons that has come out of the streaming and entertainment wars is the primacy of high quality original IP. With many entertainment and technology companies trying to capture your attention and differentiate their value proposition to consumers, this will become more important as time goes on.

Over its lifetime, Nintendo has cultivated and owns some of the most valuable entertainment IP. Pokémon, Nintendo’s golden goose, is the highest grossing media franchise globally along with other multi-billion dollar IP such as Mario, Donkey Kong and Legend of Zelda. In an iconic 1990s US survey, Mario was more recognisable to American children than Mickey Mouse!

With the exception of Pokémon, the vast majority of these sales have come from the sale of video games. However, as we have seen many times across Disney’s history, great IP translates well across other mediums as long as the execution is good.

In fact, this was so pivotal to Disney’s business model that, in 1957, Walt Disney visually outlines the economic moat of their business. The picture below depicts Disney films as the pivotal attraction for new customers upon which they would interact with other segments of the Disney universe generating greater value for the consumer and strengthening the brand itself. Nintendo is currently attempting to do the same thing with video games at the centre of its moat.

Recent partnerships with Comcast to open three Nintendo-based theme parks by 2022, a collaboration with Illumination Entertainment (makers of the Despicable and Minions franchise) to make a Mario movie as well as efforts to expand the merchandising revenue are all attempts are creating a virtuous flywheel for their IP.

In these licensing agreements, Nintendo shoulders none of the capital expenditure/development costs which limit any downside that could occur. On the upside, they will receive performance based license fees which scale depending on the success of each partnership. Although the details of these partnership agreements are unlikely to disclosed, royalty revenue is extremely high margin and is consistent over time.

Whilst Nintendo has tried to license out its IP in the past (the Legend of Zelda tv series and 1993 Mario movie flops come to mind), the company was hesitant to exert creative control over the contents. Miyamoto (maker of Mario) has talked about this in the past – “the movie may have tried to get a little too close to what the Mario Bros. video games were. And in that sense, it became a movie that was about a video game, rather than an entertaining movie in and of itself”.

Nintendo has likely learnt from these mistakes and are taking a more active approach with their partnership. With Miyamoto now the producer of the new Mario movie, there’s greater chance that Nintendo can successfully expand their IP beyond just video games.

Changing of the guard

After the terrible performance of the Wii U launch, Nintendo set about reorganizing its senior executives. From this, there have been a few beneficial changes to their corporate governance approach.

Performance based compensation has been introduced that is based upon consolidated operating profits and is capped at ¥800m ($7m) for 2020. I would personally like to see more disclosure around company cross holdings as it may be beneficial to unlocking any hidden asset value within the company’s balance sheet– the company has taken steps to simplify its cross holding structure somewhat with its majority stake sale of the Seattle Mariners in 2016 (it still, however, retains a 10% stake).

Transparency has been improving but is still lacking in my eyes - the company still doesn’t disclose private company stakes amounting to less than 20%. New senior management are still all Nintendo-lifers; I fear they may lack the fresh perspective an outside hire could provide to bring about lasting change in the company. A positive sign is the involvement of activist hedge fund, Valueact, with their 2% stake in the company.

Management clearly do care a lot of the company. When sales of Wii U and 3DS plummeted, the CEO and senior executives cut their salary by 50% rather than deciding to cut their workforce. This shows that there is alignment of incentives between shareholders and senior executives as they share in both the upside and the downside.

In terms of capital allocation, the company has retained a large amount of cash on the balance sheet in case of an extended downturn in the console cycle.

Given the structural changes that Nintendo are undergoing, management have started to realise that there is no longer a need to hold such a larger amount of cash on the balance sheet. Over the past ten years, management have been steadily lowering cash levels and returning it back to shareholders in the form of rising dividends and opportunistic share buybacks. I assume that cash levels to continue to trend down in the future (in my model I assume cash and short term investments fall to 52% over the next 5 years with the surplus cash being used to buy back shares).I still expect a large proportion of the cash to be retained on the balance sheet – this is still a Japanese company after all!

Exploring New Markets

Despite Nintendo’s experience within the video game market, there are still plenty of opportunities to expand their revenue geographically. Sales from China (included in Other) account for a very small sliver of total revenues. This has been due to 15 year game console ban that was only lifted in 2015. Since then, the company has slowly become more receptive about venturing into new markets such as China. Efforts increasing China sales have been lacklustre due to lack of experience marketing within the region. Any potential success attracting the 640 million Chinese gamers onto the Nintendo platform will have a significant impact on finances.

In 2019, they partnered with Tencent to sell the Switch console in China. Only 3 titles have been authorised for sale by the Chinese government so far. Although uptake in China is likely to be slow in the initial years, this marks a significant step by Nintendo in accessing the largest gaming region (c. 30% market share). Tencent’s Wechat platform and historical success of tapping into the Chinese gaming market should extend towards this partnership. Releases of future game titles will further enhance the Switch game library, encouraging growth in hardware sales in the region.

In 2015, Nintendo has started to dip its toes into the fastest growing segment of the gaming market; mobile games. The market potential for Nintendo is huge; there are approximately 1.4bn mobile gamers worldwide and, according to Newzoo, the market is expected to grow at 9.9% until 2023.

The aim is to release 1 or 2 titles for mobile every year. Monetization rates have underperformed relative to other mobile publishers and currently, mobile accounts for c.4% of total sales. However, mobile margins are high and, with more experience under their belts, monetization should meaningfully improve with future releases.

In order to target the Chinese mobile gaming segment (which occupies c.65% of Chinese market), Nintendo is partnering with Timi Studios (Tencent’s in-house gaming studios) to create Pokémon Unite. The freemium game will be cross compatible between mobile and the Switch and hopes the leverage the Pokémon IP to encourage Chinese consumer onto the Nintendo ecosystem.

Tencent have been extremely successful at monetizing Honour of Kings with an estimated player spending of $15/download since launch. If Pokémon Unite can attract 20% of total downloads of Honour of Kings (60m) and improve their monetization to $5/download, the game will generate around $300m revenue (which would be a huge success compared to Nintendo’s other mobile game releases).

Pokémon Unite is scheduled to be release late 2020/early 2021 and I also expect the cross compatibility feature to bring a meaningful uplift in sales of the Switch going forward.

Hidden Asset Value

As is customary with Japanese companies, Nintendo holds stakes in many different companies and due to the vagaries of Japanese financial reporting, these aren’t explicitly revealed in the balance sheet. Their largest asset is their 32% ownership of the Pokémon Company, consolidated under the equity method of accounting, and is jointly owned by Game Freak and Creatures. Nintendo has effective control over distribution of Pokémon games whilst paying a small license fee to TPC. There are suggestions that Nintendo own stakes in Creatures and Game Freak, which should increase their ownership stake in TPC. However, as Nintendo refuses to disclose their stakes in private companies, I am only attributing value to the 32% stake. This article (LINK) goes into this in more detail.

Not to mention their 10% stake in the Seattle Mariners, 10% stake in DeNa, 1.75% stake in Bandai Namco and 13% stake in Niantic (maker of top selling augmented reality app Pokémon Go), these basket of assets account for roughly 1500 JPY/Share. Cash on the balance sheet also accounts for over 15% of the current market value.

Valuation:

Given that Nintendo owns an eclectic combination of assets, Sum of the Parts valuation seems to be the most viable option here.

Regarding differentiation from consensus, I believe I differ in 2 ways:

1.       Use of total sales/hardware unit sold vs. attach rate (no. of software units/hardware units sold)

Traditionally the sell side uses attach rate (software units / hardware units) and software price as drivers for the business. However, this fails to take into account the higher software revenue per unit generated as digital and recurring sales making up a larger proportion of software sales. A more appropriate driver to value the company would be total sales/hardware units.

2. Assuming that revenue per software unit sold doesn’t increase:

Sell side fail to take into account that Nintendo generates higher revenue per unit of software sold (they internally capture the mark-up that brick and mortar stores would traditionally get) as they typically assume a constant software price.

Factoring this in, my base case scenario assumes:

-          Total installed base of switch players reach to c. 145 million (below that of the DS console).

o   This is higher than the Wii due to its appeal across portable and home console players and penetration into the Chinese player base.

-          Switch online member increases from 33.4% in H1 FY20 to 50% of total installed player base by FY25. Switch online membership price stays constant.

-          Digital sales increase 47.2% to 70% by 2025.

-          Mobile and IP revenue increases by 52% CAGR until 2025.

- EBIT margin expansion by 14% due to higher sales mix from digital software, switch online subscription member and mobile revenue.

-          Company uses c.13% of its cash balance to buy back shares every year.

Based on my base case thesis, I assume a slight EV/EBITDA multiple expansion from 12x to 14x given that revenue streams will become less cyclical going forward. This is still significantly below US game publisher’s (ATVI, EA, UBI, and TTWO) historical average of 20x. The end result is still a roughly 40% margin of safety on my base case.

On a probability weighted basis (factoring my own three valuation scenarios), I get a 13.7% 5 year IRR which includes the 2.99% dividend yield offered at the current price.

Risks

-          Potential further delays to Theme Park Openings

-          Poor execution risk around Mario Movie

-          Death of Shigeru Miyamoto – can Nintendo survive the death of its creative director and the maker of Mario, Legend of Zelda and Donkey Kong franchise?

Catalysts:

-          Switch Pro Release

-          Pokémon Unite Release

-          Sales of stakes in other companies

-          Value realisation of private company stakes (Niantic IPO)

-          Theme Park Openings

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