Wednesday, October 20, 2010

Nintendo's next console

David Radd wrote an article titled Why 'Wii HD' Just Won't Happen, which argues that

At the end of the day, I think there will be a successor to the Wii console, and yes it will have HD capabilities, but it probably won't come for at least a couple more years, and it will add far more than a simple bump in processing power and resolution.
I couldn't agree more. While it's far too early to make any solid guesses about what Nintendo will imagine for a Wii successor (the very ambitious 3DS will command their limited attention for the next year or so), we can speculate about it's incremental and sustaining improvements.

Judging from the 3DS rollout, the next Nintendo console will:

  1. Drop hardware GameCube compatibility
  2. Retain Wii compatibility
  3. Retain Virtual Console and WiiWare compatibility
  4. Support HD output
  5. Incrementally improve online functionality
  6. Incrementally improve anit-piracy measures
  7. Do something completely unexpected
Given those postulates, we can infer the new system will:
  1. Support the Wiimote and have a sensor bar
  2. Include a disk drive
  3. Support transfer of Virtual Console and WiiWare titles from the Wii
  4. Include HDMI and adequate processing power for HD graphics
  5. Continue to include built-in WiFi support
  6. Be a shock when first announced

What strikes me about the above conclusions is that the physical proximity between the system and the TV will be more important than the proximity between the system and the player. In fact, if there were no need for a disk drive and a sensor bar, the console could be completely hidden from the user. I could easily imagine digital distribution could allow Nintendo to eliminate the disk drive as Sony attempted with the PSP Go, though properly managing game transfers would be a challenge. With care, such a system could dramatically reduce piracy while also eliminating the annoyance of changing physical media.

Another clue about how the company operates comes from an interview with Miyamoto:

Miyamoto: If you think for yourself about what's wrong with your idea, and you understand the reasons why it's no good and get a handle on the problem, then you're sure to be able to use that idea sometime.

Itoi: That's right. It's a waste if you just say, "Oh, that idea's no good," and forget about it.

Miyamoto: That doesn't lead to anything. That's why, while I used to tell people to store up ideas in a drawer, I recently suggest putting ideas that were no good into a draw[sic] with the reason why they were no good affixed to them. Like writing the reason on a label.


Itoi: So you can toss an idea in storage, but it stays alive.

Miyamoto: Yes, while I stay hung up on the reason it won't work. Then one day I realize I can take off the label. When there's momentum to take off that label, I suddenly get so excited that I can take off other labels too. Things that used to appear little negative were offset and showed no real bad effect.

Among the ideas that Nintendo has resurrected are the Power Glove (the Wiimote captures the basic premise of the controller), the Power Pad (neatly replaced by the Wii Balance Board), and the Virtual Boy (the 3DS promises to correct most problems with stereoscopic 3D). But there are dozens of ideas that have either failed in the marketplace or could be updated for the modern gaming environment. For your consideration, I propose the next console will include an update to R.O.B.. I know it's crazy. We don't need another piece of plastic cluttering up our living rooms. On the other hand, it's just the sort of out-of-left-field idea that Nintendo has made to work over the last few years.

Wednesday, September 29, 2010

Why I bought Nintendo

I recently bought ADR shares of Nintendo at $35 a share. To be completely honest, I did almost no upfront valuation or analysis of the company. I just like their products. But looking back at the decision, it actually makes sense.

For starters, if you take the most recent annual dividend ($1.25 per ADR) and discount it at the current 2% you could get from a Japanese government 30-year bond, you get a fair value of $62.50. Against the more reasonable US Treasury 30-year (3.875%) the fair value is $32.26 assuming no growth. Given Nintendo closely ties it's dividends to earnings based on a formula and that Nintendo's earnings are likely to increase in the next 5 or so years, the dividend discount model suggests buying the stock. (As I write this, Nintendo has announced that earnings and therefore the dividend will be reduced for the fiscal year ending March 2011, but that could not have factored into my decision. I also think the announcement will prove irrelevant to long term value. More on this below.)

Understanding the company's past might help us glimpse the company's future. 92 years before Donkey Kong (1981) was released, Nintendo made traditional Japanese cards called Hanafuda. Until, 1963 the company manufactured playing cards (including western-style decks) at which time Nintendo branched out into other games, toys and novelties. It was a seminal moment that shifted the focus from pure industrial design and manufacturing to considerations of experience design. Having great looking and well-built decks enhances the experience of playing a card game, but the enjoyment of the game comes from the rules used to play it. A puzzle, like Ten Billion Barrel (1980), must be designed with the whole experience in mind: puzzle conception, design, manufacturing, packaging, cost, instructions, marketing and so on. Before 1963, Nintendo was a pure hardware company and afterward became a hybrid software/hardware company.

All early video game companies (Atari, Magnavox, Philips, RCA, Coleco, Midway, Milton Bradley, Mattel, VTech, Commodore, etc.) were hybrid companies out of necessity—true game platforms had not yet been created. Most of these companies either dropped out of the video game industry or shifted focus to either hardware or software. Nintendo alone survived the primordial era with a complete gaming ecosystem under it's control. In fact, Nintendo is the only company that manages two major platforms outside of Japan with it's handheld and home console lines. Much of their early success must be attributed to designers such as Gumpei Yokoi and his protégé Shigeru Miyamoto who began their careers designing physical toys and games.

Nintendo has always taken advantage of Moore's Law by releasing electronics that are behind the leading edge of technology. For instance, the Game Boy handheld was less capable that either the Atari Lynx or the Sega Game Gear, but was also both cheaper and more profitable. Since the chips became less expensive over the life of the system, the retail price dropped further and Nintendo continued to make a good profit on the device. As it became clear to game developers that the platform was the most popular handheld system on the market, they produced more games which increased the hardware's value to the consumer. This same virtuous pattern has cropped up in the DS and the various consoles Nintendo has released.

Along the way, Nintendo has also excelled at producing high quality game franchises. Mario, Metroid and Zelda games are among the highest-rated games of all time. Not coincidently, Nintendo also boasts many of the best-selling franchises in video games, including Pokémon. Since the Philips CD-i debacle, Nintendo franchises are available exclusively on Nintendo hardware creating a sort of killer app for each hardware generation. Software, as always, sells hardware and not the other way around.

Nintendo's future path is fairly well laid out at this point: release new games, new hardware to facilitate those games and further exploit licencing opportunities. Recent history shows that more and more people take up gaming as time goes on, so Nintendo must continue to find new ways to get people into their games. Which is to say, they must continue doing what they are doing.

No game platform lasts forever as players need constant new experiences to stay interested and engaged. Both the DS and Wii platforms have also sold into nearly their entire market at this point. Therefore, Nintendo has already announced their next handheld device called the 3DS. A replacement for the Wii is certainly in the works and ought to be released in the next few years. In my opinion, there are a number of keys to a successful launch:

  1. Backward comparability—Allowing new platforms to play games designed for current systems both gives consumers a better value (at minimal cost) when they upgrade and extends the current system's viability for developers. Given Nintendo's massive current install base, there will likely a market for Wii and DS games for years after replacement machines go on sale. We've seen this happen for Game Boy Advance and PS2 software.
  2. Improved functionality—On the other hand, a new system must offer something substantially different than what is already available for consumers to risk an upgrade. More than any other company, Nintendo stakes it's reputation on delivering novel gaming hardware. From the D-pad to 3D technology, new hardware always adds some significant gameplay improvement over the previous platform. (As an aside, simply upgrading the Wii's visuals to HD would do little to change gameplay. A more radical update will be required.)
  3. Strong first-party launch titles—A critical factor for Nintendo especially. A single Mario or Zelda title can make the difference between buy and wait for many consumers. The Wii broke sales records last holiday season on the back of a throwback Super Mario Bros. sequel.
  4. Third-party developer buy-in—Conversely, Nintendo rarely needs third parties to help sell hardware. Still, third party games at launch suggest to the consumer that there will be plenty of new experiences to be had once you've beaten Bowser for the umpteenth time. For the 3DS, which carries the stigma of Nintendo's previous foray into stereoscopic 3D (the Virtual Boy), having so many developers building software for the system could make all the difference.
  5. Priced to give better value than competitors—For much of Nintendo's history, it's hardware sold for less than all competitors. A massive exception to the rule has to be the North American release of the original Nintendo Entertainment System bundle in 1985. But given the incredible value of the NES throughout its life in terms of better games, graphics, sound and peripherals, the machine was priced to be the best selling system of its era. Ultimately, the better Nintendo does on the first four points, the higher price they can set on hardware while remaining competitive.
  6. Available—Sometimes you hear that Nintendo purposely held back supplies of the Wii or DS to whip up demand with artificial scarcity. But while companies (especially hardware manufacturers) love to see inventory flying off the shelves, they don't like seeing their products resold for twice or thrice the retail price on eBay the week following a system launch. Frothy demand on day one that leads early adopters to sleep over night on the street turns into mocking dismissal a year later. Worse, a successful long-term platform requires those early adopters to evangelize their friends and relatives, but not having enough systems to sell cripples the process.
Technology adoption life cycle

From the above list, Nintendo seems to be handling the 3DS perfectly. Delaying the launch in Japan, while missing an important buying season, will not hurt the system in the long run if it improves availability and eliminates bugs. It's not hard to picture Mario fan-boys and tech-nerds rushing out to get their hands on the world's first stereoscopic 3D device that doesn't make you look like a dweeb, but the public at large will need to be sold on the system's value before it will shell out console cash for a handheld. That remains true whether the system is released before or after Christmas.