Why Nintendo is in no hurry for Wii2

Nintendo has three functions in the video game business of which most journalists and analysts seem to focus on just one. Today I'd like to look at the health of the Wii platform in reference to those three areas.

Hardware manufacture

Most Nintendo observers focus on it's hardware business. While Nintendo hardware has blown away the competition in recent years, so far this year the Wii platform seems to be falling behind.

Worldwide Hardware 2011 (YTD)
Console Yearly    Total
------- ------    -----
PS3     1,817,179  48,163,035
DS      1,743,582 145,707,365
X360    1,677,025  52,065,666
Wii     1,676,899  85,336,683
PSP     1,046,947  66,433,522
PS2       474,050 142,132,409
3DS       374,164     374,164
Total   8,809,846  

(All charts taken from VGChartz.)

Considering that the DS, in its various forms, has been the best selling game machine since 2006, Nintendo did well to shift to the 3DS, which seems to be off to a fast start. Meanwhile, the Wii maintains a large lead in total consoles sold among current systems, but is clearly losing momentum at an alarming rate. Since this is the number most people focus on, Nintendo seems to be in trouble. By 2010 the handwriting was on the wall for both of Nintendo's platforms:

Worldwide Hardware 2010
Console Yearly     (change) Total
------- ------     -------- -----
DS      21,445,632 (-25%)  143,963,783
Wii     18,345,329 (-15%)   83,659,784
PS3     14,443,529 (+11%)   46,345,856
X360    13,606,638 (+34%)   50,388,641
PSP      9,298,210 (-11%)   65,386,575
PS2      4,591,780 (-24%)  141,942,000
Total   81,731,118 (-9%)  

It's important to know that historically Sony and Microsoft lose money on each console sold and Nintendo makes a moderate profit. This late in the console cycle, it's likely that all three consoles are making money, but Nintendo has always profited from Wii sales. In addition, the Wii's already large install base makes selling new consoles harder.

Software publishing

Nintendo's second role in the industry is as game publisher. In this case, Nintendo's DS and Wii game sales far exceed all competitors with the possible exception of EA.

Worldwide Publisher Totals 2011 (YTD)
Pos     Publisher                    Yearly
---     ---------                    ------
1       Nintendo                    10,901,624
2       Electronic Arts              9,019,470
3       Activision                   6,813,847
4       Ubisoft                      6,694,007
5       Sony Computer Entertainment  4,922,930
6       Microsoft                    3,724,148
7       THQ                          3,303,488
8       Sega                         2,674,190
9       Capcom                       2,568,090
10      Namco Bandai                 2,540,164

While Nintendo has a big lead over EA in terms of unit sales, that seems to include games packed with hardware and does not include downloadable content. So while it's conceivable that EA and Activision have been more successful, by no means is Nintendo failing as a publisher.

Most publishers rely on a hit game system which results in huge sales in the months following a game's launch after which they move to the next title. Nintendo, which has been the leading publisher for years, has been able to create and market "evergreen" titles that sell well for several years. Along with Microsoft and Sony, Nintendo has the advantage that each software release increases the value of their hardware business. Nintendo re-releases titles from their back catalog more successfully than any other competitor. Each of these strategies minimize development costs and increase profits both for DS and Wii games.

Platform licencing

Finally, Nintendo takes a cut of every title sold for one of its platforms. When it comes to evaluating launching a new platform, total software sales has to be a primary consideration. A new console is a huge expense and risk for the manufacturer, consumer and game publishers. The only people who benefit with certainty from a console launch are the journalists who cover the story. As long as games are still selling on a hardware system, there's just no reason to replace it.

Worldwide Software Totals 2011 (YTD)
Console Yearly     Total       (tie ratio)
------- ------     -----       -----------
Wii     22,696,263 637,024,525 (7.46)
PS3     18,246,636 349,149,161 (7.25)
X360    18,227,812 476,688,453 (9.16)
DS      13,323,937 650,342,875 (4.46)
PSP      6,130,249 195,271,066 (2.94)
PS2      1,773,060     n/a
PC       1,349,242     n/a
3DS        344,446     n/a
Total 82,091,645

By game sales, the Wii is still the most successful console due in part to its massive install base. Notice that a console, such as the PS2, can enjoy a very long software life after production ends. A critical statistic for a console is the tie ratio, which compares the total games per console sold. The average Xbox owner has a library of 9 or so games while average Wii and PS libraries hold just over 7 titles. Since people continue to buy software after they buy the console, the number will tend to increase over the life of a system, which is why the oldest system has the highest number. Handheld tie ratios will naturally be lower if only because some households will buy multiple systems and share a software library. Tie ratios matter to the consumer because the more games they own and enjoy, the better value they wring from the console. They matter just as much to a hardware manufacturer because they represent incremental profit on top of the original hardware sale.

Worldwide Software Totals 2010
Console Yearly      (change) Total       (tie ratio)
------- ------      -------- -----       -----------
Wii     182,616,765 (+2%)    614,328,262 (7.34)
X360    141,041,533 (+24%)   458,460,641 (9.10)
PS3     126,996,359 (+38%)   330,902,525 (7.14)
DS      119,157,411 (-17%)   637,018,938 (4.42)
PSP      40,577,954 (+9%)    189,140,817 (2.89)
PS2      15,938,237 (-42%)       n/a
PC       10,153,009 (-)          n/a
Total   636,481,268 (+7%) 

This chart shows the 2010 sales by platform and reveals that Wii software actually increased year-over-year, though not nearly as much as its rivals. The DS, meanwhile, entered the decline portion of its life-cycle, which pushed the introduction of the 3DS. Since the company will not be able to support two simultaneous console launches, a Wii sequel wasn't in the cards for 2011. But if Wii sales slow this year, Nintendo may need to announce its next console soon.

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.

Mono-linked chains

Warren Buffett just released his annual letter to shareholders, which explained the results of Berkshire Hathaway in 2004. He commented on a $579 million loss in a zinc mining loss:

Our failure here illustrates the importance of a guideline — ­ stay with simple propositions —­ that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for —­ if you'll excuse an oxymoron —­ mono-linked chains.

This is such a good analogy. I also think it reflects an investment philosophy I didn't know I held until now. My first (and one of my favorite) investments was Oracle. Over the years, it has taken some huge, bet-the-company risks. But in every case (at least from what I remember reading Softwar) the risks have involved one, key variable. For instance, each of the complete software rewrites (which are very risky) pivoted on having a better product at the end of the processes and little else. Time and again Larry Ellison bet Oracle the company on Oracle the database. Buying PeopleSoft, in fact, will have been a successful risk if Oracle manages to move a wide variety of applications onto a single database schema.

Select Comfort is also a one-link chain: the adjustable airbed. Like Oracle, the company has focused on one, big idea — the hedgehog approach. Since Sleep Number beds can fold into a handful of boxes, they are shipped directly to the customer. Since most people aren't familiar with the idea, Select Comfort stores, commercials, QVC shows, and the website are geared toward showing how the beds improve a person's quality of life. Since the beds are made to order, customers have a range of choices about which controls, mattress covers, air pumps, pillow tops, sizes (including the Grand King (80" x 98") designed for 6'11" Kevin Garnett), and foundations. There are any number of things that can go wrong, but as long as it's possible to sell high-quality air mattresses, Select Comfort is probably going to do alright.

Raytheon is moving in the direction of being a single link. It used to sell everything from microwave ovens to Patriot missiles. At some point, this made sense — microwaves used to be high-technology. Lately, Raytheon has been selling off or ending businesses that don't fit into the government contracts umbrella. Increased dependence on one customer might seem foolish except that the customer is schizophrenic. It still has too many links, but at least management has learned its lesson from the diversification adventure.

I have a harder time justifying Canon on the "one-link" criteria. I'm tempted to say optics excellence, but one of Canon's biggest revenue streams is printer ink. Fujio Mitarai, Canon's CEO, says, " Canon was built on the foundation of original innovative technology." But I think Canon's success is due to a uniquely Japanese ability to mold thousands of employees to a single philosophy. Many of Canon's investor relations documents describe the idea of "kyosei", which is translated "living and working together for the common good". If so, the risk is that this bubbly optimism might fail to produce new and better products at a reasonable expense.

Maybe it's naive to think that Canon has really implanted kyosei into its culture. But look at this quote in a press release of the death of Sony's founder:

"Mr. Ibuka has been at the heart of Sony's philosophy. He has sowed the seeds of deep conviction that our products must bring joy and fun to users. Mr. Ibuka always asked himself what was at the core of 'making things,' and thought in broad terms of how these products could enhance people's lives and cultures.

Or this quote from the Toyota Forklift division:

At Toyota facilities around the globe, "kaizen" is a word mentioned frequently. The word means "continuous improvement" and is a key factor in Toyota quality. Kaizen has been incorporated into the Toyota Production System driving our engineering and manufacturing teams to constantly improve our lift trucks. It also drives our service personnel.

Coming full circle, Berkshire Hathaway is a horrendously complicated company rivaled only by GE. Any attempt to evaluate the company would require intimate and detailed knowledge of a company that sells everything from candy to catastrophic re-insurance. Ultimately, Berkshire investors are risking their investment on the philosophy described in the Berkshire "Owner's Manual".