C (4:27)

First I would say thank you for having me on. It's a genuine pleasure. You talk about nostalgia and it reminds me of a mutual friend, Eric Jorgensen, who coined the phrase weaponized nostalgia. And I think Nintendo fits that bill pretty well. But if I had to break it down in a very quick and dirty sense, I would frame Nintendo as a business that has in the last call it five to seven years transformed from a cyclical kind of hits driven business to what is now fast approaching a secular growth juggernaut defined by increasingly stable recurring revenue, expanding margins and declining capital intensity. And it's basically done this by getting away from having its earnings depend on the success or failure of each new console and instead it's basically transitioned to a very Apple like iterative hardware model where the net effect of all this is its installed base will continually grow and never reset to zero with each new system as it had in the past. This was basically the Achilles heel of the video game console business. As a result of that, the the company. This transformation basically ensures that its Switch family of devices will continue to benefit not just from the ongoing structural shift to higher margin digital distribution of its software, which I think you've seen across the entertainment space as a whole, but also from the ability to sell high margin software and its related online services to an ever growing installed base of active users. That should give it an overwhelming and endurable edge in a very high return industry where intellectual property is king and Nintendo has the best IP in the video game business by I would say several orders of magnitude. So that's the quick and dirty breakdown.

A (6:15)

I think the shift in business model in this industry is just so interesting to me and I think the core business itself with IP and video games and what is actually happening for the user is different but the monetization and how it's delivered, it's been something that we've talked about in various episodes. Nintendo just sitting at the crosshair and with some history and. And before we spend most of the conversation on the business model, I do want to touch upon the history because it's a Japanese business which makes it automatically interesting from a historical perspective and there's some unique dynamics here. So maybe you could just start us off with the earliest origins of Nintendo because I think it's interesting and bring us up to the launch of their first video game console and then we could take it from there.

C (6:59)

Yeah, where to begin? I guess very simplistically it is a 130ish year old company. I think it's September 23rd, 1889 was when Nintendo was originally incorporated. And the gist of its origin story is it sold playing cards ostensibly to Yakuza, which obviously creates a very interesting origin story considering I view Nintendo as the family friendly entertainment king these days. After it started with its cards, it basically embarked on a variety of enterprises over the next century until it basically eventually found its ways into toys and through that clear pathway to video games. One interesting dynamic, I'm sure I'm of the original Nintendo generation of kids, but the actual product that Nintendo made that really opened the door and made the rest of the Runway possible is believe it or not, the Dunk Hunt flashlight gun. One of the odd segues that brought Nintendo to its current place was it got into bowling alleys. Can't remember exactly if it was the 60s or 70s, but they had basically large versions of Buck Hunter for people to play. I think it was that was what started the relationship. It was either Mattel or Magnavox. That was the initial business decision that opened the door to the company that we know and love today. So they first started with arcade games particularly. That's where you see, I believe Mario was first named Jumpman as just a generic Plumber along with Donkey Kong. And that took arcades all over the US and elsewhere by storm. That's where the video game God Miyamoto first entered into its first alliances with the software space. But that is what brings us up to the early 80s with. Think of it as the imminent aftermath of the video game crash of 1983.

A (9:05)

It would be fascinating to know about the crash of 83. I think I'm familiar with crashes, Covid crashes, 2008, crash, 1987, Black Monday. These being more stock market related, but not as familiar with the video game crash. But would like to take a little history lesson here.

C (9:23)

Basically, in the late 70s early 80s, Atari had become the undisputed king of home video games. Its VCS console, which I think was later renamed the 2600, was basically crushing all of the rival entries from, say, Mattel and Magnavox that I had mentioned before. But as it came out originally, only Atari made games for the vcs. But that's where the birth of the industry we know today comes. Because in 1979, some of the disgrunted software developers from Atari basically left and started Activision, which was essentially the world's first third party developer of video games for home consoles. Activision games were for a long time praised widely for their quality. But their success in carving itself off from Atari essentially inspired other companies to get started and jump on the third party software developer bandwagon. 2 Fast forward to 1983. The market had become smothered by a glut of copycat game developers for the Atari vcs. They had atrocious graphics, even for the time, and arguably even worse gameplay. And to add insult to injury, by that point even Atari's games had nose dived in quality severely. By that point, it basically had started to rush out big titles to meet sales projections. I think most famously, Atari basically did a shockingly dull adaption of the hit movie E.T. and it ended up selling so poorly that Atari, because it didn't know what to do with all of these excess copies, buried thousands of the unsold games in a New Mexico landfill. Sum that all up, you had a scenario where games and the quality of the entries had just gotten worse, worse and worse, and angry consumers eventually closed their wallets and a lot of these fly by night. Companies that had come in in the wake of Activision dashed out of the industry as quickly as they had piled in. And by the end of 83, things had gotten so bad that Atari was sold off by Warner Communications, its parent company. And for all Intents and purposes, it looks like the video game era was dead. And your classic fad, for lack of a better term.

A (11:44)

It's a fascinating moment in time to think about the collapse and thinking that there was not going to continue to be some life in that market. And great documentary that I've seen on that ET and the New Mexico landfill. I think it's one of the mythbusters type things which turned out to be true, which was quite impressive, but also interesting that Nintendo then launches something right at this time. So what were they going to do that was different than the rest of the market in that period when they first launched in that market?

C (12:17)

It's very important actually to set the stage for really where the company stands today in a around the world and back again type way. So in the wake of the crash of 83, the US home gaming industry, the console which had become quite robust, had basically been dead for almost two years. And so it was into that void that Nintendo launched the Nintendo Entertainment System, or the NES for short, as we would have called it in 1985. And this was essentially a remodeled version of Nintendo's Famicom, which stands for family computer that debuted in Japan. I think in 83. The NES ended up becoming a massive hit, as we all know. If you want to think about to circle back to the point, there was three points that I think are critical to what pushed video games in general, and Nintendo in particular, back into center stage, if you will, and basically single handedly revived the entire industry. The first is that with the NES you had several features that would later come to be seen as hallmarks of the company and its hardware. And that's basically it drew people in with unusual hardware. The original NES are hard to find now, but they were initially shipped with a user controlled robot that could move spinning tops around to affect action in certain games. And then of course the light sensitive gun that could be used to shoot on screen targets. And others, most famously via Duck Hunt. While neither of those two particular gimmicky hardware aspects ended up enjoying long lasting success, they did offer differentiated gameplay experiences that basically were a big part of attracting that first wave of consumers to the system. In that sense, I think they're important. Second, broad bullet point that made a big difference in terms of adoption is that the NES emphasized ergonomics. The NES was basically the first home console to feature the cross pad, or as we would call it now, the D pad for controlling on screen action. The button. Think of it, it's basically shaped like a plus sign. Let Players move objects on screen in various directions simply by rolling their thumbs over it in a way that was ergonomically easy. And then that freed up the player's right hand to press buttons on the controller to open up gameplay and what you could do on the screen, such as jumping or shooting. This might seem like a stretch, but if you realize that the previous consoles by Atari and their peers, it was like a rogues gallery of who could create the most uncomfortable, awkward and just plain hard to use controller. So with the D Pad, Nintendo basically from that point on you had basically thumb operated controls. And the D Pad has basically been a piece of every home console and portable device made by all game companies ever since. It was much more comfortable. And then finally the third bullet point, and I think this is far and away the most important, is that with the NES, given kind of the historical context we just quickly went through, for the first time ever, its games were subject to quality control. So if you're familiar, if you can remember that gold Nintendo seal of quality that really changed the game here, not only with the NES did Nintendo were you the first time the company had started to apply its gift for creating great gameplay with its own in house titles, Super Mario, Legend of Zelda, Metroid and the like. But it strictly controlled third party game developers and essentially required them to submit titles for evaluation and licensing in order to earn that Nintendo seal of quality. The gold starburst logo that was prominently displayed on each game's packaging. And one last point I would make on the seal of approval or seal of quality is that this was essentially the world's first app store. Given that Nintendo charged these third party developers a 30% fee for access to its hardware, obviously a model that Apple would go on to leverage to somewhat mind boggling success a few decades later. Those are I think the three core differentiators that allowed Nintendo to single handedly revive the industry and create the industry as we know it today.

A (16:45)

And can you get into a little bit more detail just in terms of how they controlled third party games and the quality control that went into those early years or in the 80s, just keeping the quality of titles high as it relates to third party developers?

C (17:01)

Sure.

D (17:02)

This is obviously a key piece of how they single handedly revived the industry. Essentially what happened was, was when the NES was released in the United States in 85, they created what are called lockout chips. So for third party licensing fees. And how that worked, practically speaking, was only Nintendo could make the cartridges for third party games. This is important because with that lockout chip. It made creating the glut of low quality games that had sunk the industry in the US in particular, essentially impossible because without that chip, unlicensed games simply.

C (17:42)

Would not work on Nintendo's hardware.

D (17:44)

And then another interesting side segue here is that Nintendo was very wise in the way it structured its contracts with 3P software developers in two ways. First was they limited the number of games they could release on the NES to five games per year, which also had that quality control dynamic. It basically prevented other devs like say Activision from flooding the system with second rate crap games, for lack of a better term. And then also, and this is the second point is, while they wouldn't know how important this would become by say 1990, all their third party software devs that created games for the system essentially could not create a game for another console for essentially two years when the Sega Genesis came and whatnot. That actually ended up becoming a very key component, if you will, to how by the early 90s they had essentially 90% market share dominance in the same way that Microsoft is dominant with Excel and Word. And the rest those two things together, the lockout chip, the licensing agreement, all of that kind of came together to ensure that the Nintendo seal of approval actually meant something. And slowly but surely people started to come back when they realized not only were the games good, and maybe this is an important point that I didn't bring up earlier, which is by the time the NES came out, it was not only five years ahead of the competition in terms of graphics and gameplay and all the incredible software that the team created, but it was actually far cheaper than the current console systems at the time from Atari, you kind of bring all that stuff together and you have the beginning of the Nintendo we have today.

A (19:29)

When you lay out this idea of the third party ecosystem really coming to life again, and it's tapping into the earlier roots of the business. Can you just put some context around where that stands today? Whether you're actually seeing some movement in that segment of the business or that strategy, anything that you can help bring the story to life.

D (19:48)

Quick and dirty summary of the broad thesis here. You have the improving digital software mix that's going to bolster margins. You have investments around Nintendo's 3P ecosystem and Switch to hardware which should drive incremental margin. And then I'm sure we'll get into this later. Better monetization of digital software and other forms of ip. Think movies and theme parks and IP merchandise licensing that come together to create a flywheel effect that will improve brand recognition and customer mind share, while also like the first two, driving meaningful increases in revenue and profit along the way. In terms of the eShop as the next app store like platform, there are a couple key things that Nintendo has done this time around, very reminiscent of history that have made all of this possible. So one of the biggest I would mention is in the past Nintendo has created its own games for its own hardware and really didn't spend much attention at all post 1990 thinking about third party software developers. Its hardware was built for its games and they were for the most part pretty insular in that way. As Nintendo has invested billions in state of the art networked online infrastructure, they have dedicated servers and the online gameplay this time around will be every bit as good as what you would expect from your typical Sony and Microsoft platform games. It is Nintendo really turning around and spending a lot of time to strengthen its relationships with 3P developers and incentivize them to bring games to the platform and in not exactly the same ways, but in I would argue, key ways by doing things like establishing a Nintendo development portal. And this is important because it helps all types of developers access the tools and resources and support needed for creating great Switch games. Another key change was they had started to support numerous middleware and engine support for Unity and Unreal game engines. And this is important because it makes cross platform development easier. And then finally they have gone out of their way to make their development kits. These are the kits that they will send software developers so they can have an idea of what the hardware will be to make games for the platform much more affordable. Don't quote me on this, but I believe they brought it down to something like 500 or 1000 bucks in the grand scheme of things. All of those elements have come together in a way that make working or creating games for Nintendo a much more attractive proposition. And this is even on top of the fact that they have the largest active player base and therefore the biggest profit pool to go after. Unlike with the original Switch at launch, it makes all the sense in the world for these third party developers in these big AAA third party games to be, if not available day and date with the Switch 2, certainly 2, they really can't afford not to make games for the Switch, given the way the industry has evolved. And then I guess the last thing I would touch on is the 3P app store ecosystem that Apple has gone on to generate tens of billions in profits a year from by taking a tax of every third party game sold on the system and through these last five to seven years with the original Switch, Nintendo's kind of been hard at work bringing together the secret ingredients if you will, of course, a third party app store ecosystem success, for lack of a better term. And so you have the largest annual active player base in the industry. That has compounded, I believe at 30% a year since 2017. The increase in recurring revenue streams. I think the most notable here is obviously Nintendo Switch Online. Membership at Nintendo Switch Online is compounded at 25% a year. Strong digital distribution, currently approximately 50% of software sales, but moving closer towards 85% ish at maturity. By the way, Digital software sales I think have compounded at roughly 50% over this time period as well. Digital only content, this is expansion packs. Nintendo music is something that they've recently added to strengthen the value proposition of your online subscriptions at NSO. And then finally strong 3P engagement. I believe right now there's something like 11,000 titles on the Switch ecosystem and that 3P titles have compounded at 40% a year. The big thing to keep in mind here though is that as much as the Switch has already been a success with third parties, that success has primarily been in what are called indie games or single A or AA games that are much less expensive and much more involved. And that's part of bringing the power back to the system and developing the networked online infrastructure and all of the other stuff was to make those AAA games the biggest and best. As I said, Call of Duty or Madden. The new hardware basically allows for the first time in 20 some odd years Nintendo to offer these best third party AAA games in kind of true fidelity to the way they were intended to be played. And it's been a long time since we've had non dumbed down versions of these games. And so to have actual apples to apples equivalent gameplay in these games I think is going to drive a big step change increase and not just continued growth in single and double A third party games, but most importantly the big tentpole franchises that are the bread and butter of Sony and Microsoft's systems. That's basically the quick and dirty.

A (25:32)

You mentioned this generational dynamic here and I know there are major fans as you mentioned in the 30 to 50 year old customer base. Do you have any sense and just in terms of how that transitions down to the next generation? I know you laid out some of the things that they're trying, but does that show up in any way to get a sense on whether there's actual adoption happening for Nintendo with the younger Generations.

D (25:58)

This is another, I think critical question and something that is very much worthy of putting your head in to understand. But first thing I would say is at this point you mentioned the average age of gamers these days is I believe it's something like 34, 35. There's a huge percentage of the modern video game industry that is driven by people from say 30 to 50 that grew up with these games and continued to play.

C (26:28)

And if you look at what Sony.

D (26:30)

And Microsoft have done, for example, all of their focus has been on retained on that customer. And I think the reasons why are somewhat intuitive and common sense. This is much like the Millennials are the highest spending cohort to buy new homes in America. By far the highest spending players are those with income that are say 30 to 50 years old. The issue with that though is that while that might make a very interesting short term or medium term strategic game plan, it's disastrous in the long run because essentially what you've seen is two of the three big players in console hardware have essentially conceded the kids market to Nintendo. And this is just based upon the nature of the games they make. I would say one of the ways Nintendo is digging where its peers are zagging is that it has invested a considerable amount in making younger kids games. The Yoshi games are a great example of that. Also there was a Princess Peach game that was just made. But going through Nintendo's catalog, it's very clear. Super Mario Wonder, which was the big hit last year, the first 2D Mario in something like 10 or 11 years. Nintendo is clearly making a very focused effort to create the same type of wonderful games and simple gameplay that is intuitive, that kind of got us all.

C (27:56)

Hooked in the 80s.

D (27:57)

And they remember the big picture is always keenly in Nintendo's mind. So ensuring that next generation gets handed the baton has always been a very big focus for them. More concretely, outside of just focusing and putting development money and R and D into younger kids games, you also have the flywheel effect. From all their investments in movies and theme parks, IPV merchandise, licensing, for example, you can go buy a Nintendo LEGO set. And that has had a huge impact. You've seen it in the numbers. I think something like over 170 million people saw the Super Mario Brothers movie. And more to the point, I'll just give you one of variety examples. There was obviously the Bowser Peaches song that took the kids recitals across the country by storm. And you really couldn't get on X or anywhere without seeing kids going wild at kids singing the song I was driving home.

C (28:52)

I don't know, maybe it was about.

D (28:53)

A year ago, it was well after the movie had left theaters and there was a Catholic grade school right across.

C (28:59)

The street from where we live and.

D (29:01)

They had the entire school out at night with a giant projection screen watching Super Mario Brothers. I think the movies and the way in which they are better monetizing their kind of world class IP specifically with the kids in mind is having a profound and intended effect that I personally see everywhere. You saw it with Halloween this year, I probably saw 10 to 15% of the kids walking around our neighborhood stressed in some type of Nintendo ip.

C (29:31)

So you have that I think in.

D (29:32)

Terms of new ways in which they are going to are actively in the process of building on this is there was the Nintendo Play Test that was limited To I think 10,000 users last month and was basically while it wasn't technically an NDA, it was a very kind of under the covers type thing where I believe users that were accepted did have to sign something.

C (29:59)

Shots of that leaked or at least.

D (30:01)

The game that this Play test was used for, pictures of it were leaked. And pretty quickly we got an idea of what it is that they were testing. And by all intents and purposes it looks to be a Roblox Minecraft killer MMO type life service game. And without getting into the details, Roblox has taken the younger kids market by storm. Minecraft is also hugely popular in Japan as well. Not a lot of people I think fully appreciate that. It's probably the only thing Microsoft has ever done successfully in Japan after a long list of unforced errors and losses in that key market. But this game is essentially tailor made for not only what Nintendo's best at, but I would say if one of the big competitive threats in the younger cohort space. I almost jumped out of my chair when I saw the gameplay because I think that will be a wonderful way to draw younger kids in and keep them engaged with the wonderful world of Nintendo, its IP and its characters from an early age. So we don't know the hard details there, but I think that's clearly what they're aiming for and I think that will serve those end goals remarkably well. And then finally I would just add one of the big differences between call it the strategic vision of your Microsoft and Sony's of the world versus Nintendo is laser focused on what I would call intergenerational nostalgia. They make games that are intended for the most part for all ages with fun gameplay loops. And unlike where Sony and Microsoft get this feeling that you're withdrawn from the world, stuck in someone's basement, playing Call of Duty all day. Community and getting out into the world and playing Nintendo games has always been core to who they are. Nintendo, for example, this Christmas is offering an intergenerational lifeline between parents and grandparents. Much like, I don't know, muscle cars from the 60s or collecting baseball cards. A parent that is, say my age very much wants to share the experiences they have had growing up playing video games with their kids. And it's just a wonderfully nostalgic way to bring families together and for families across generations to relate to each other in a way that I think really shows the short sightedness of Sony and Microsoft's approach. You take all those things together and I think that Nintendo will continue to acquire customers in the age groups of say 4 to 12 in a way that its peers can't possibly replicate. And that's a very important and very exciting thing. Looking out like we do over 10 years and beyond and bodes well for the future.

A (32:51)

Certainly it's fascinating to think about what differentiated them in terms of the quality control, but at the same time the IP that they then built and then curated and developed over those years with some of the titles that you mentioned, it's what I associate Nintendo with, Mario with Zelda with some of these other games. And can you just bring us up to date in terms of when was the shift? Because you had this model which you described which was a console sale and then a game sale and these were essentially one time events. There was nothing reoccurring in nature beyond that they were going to release a new console and new games in the future. When did you start to see that shift to what you were describing at the top of the episode and a little bit more around that and maybe some of the modern day themes.

C (33:38)

I guess we have to fast forward to right around 2015 and this was on the cusp of the disastrous follow up to the massively successful Wii with its Wii U. They basically, I think they sold 13 and a half million over the life of the console. And there was a variety of issues with this. People weren't sure if it was like an iteration of the Wii, if it was an entirely new system. There were marketing issues. Basically everything that could have gone wrong did go wrong. And so when I started noticing this was I was going back and reviewing a lot of the statements that Iwata and Miyamoto had made, but some they were reflecting on Apple and how Apple's devices are Basically it's called the iterative hardware model. In the past, during the pre Switch era, Nintendo's near to medium term earnings have always depended on the success of its game systems. So investors would, I think, rightfully remain wary due to the cyclicality and the inherent unpredictability that's par for the course of any hits driven business in general. But what Nintendo did by studying Apple and seeing the brilliance of that model, was created a console platform that for all intensive purposes can last effectively for forever. And in doing so, that meant that Nintendo's most valuable asset, so the installed base of console users, it would build up with each new system again, never needed to reset to zero, as it had in every five to six years in the past. But when the Switch launched in 2017, its games looked pretty much the same as those of its immediate predecessor. And you basically have them in various ways, hinting that they were in fact moving towards what I would determine as the Apple model. And for what it's worth, both Sony and Microsoft starting around 2014 shifted to a similar transition where you had the ability to play not only backwards compatibility, but they'd start to create a software based ecosystem across their console generations where you could play not just past games, but they would start to release games from the new model on the older system. So not only did all video game console makers and software publishers become structurally more profitable, but the inherent cyclicality was pulled out. So this broad level change, I'd say between 2013 and 2017 when the switch was released, created basically a new world where all video game consoles in a sense would last forever. So where does that get us starting in call it 2017, but they'd started developing it a couple years prior. You had a new kind of video game console where old consoles could indeed play games related to the distant future. You can see proof of this by looking at another game playing device, the smartphone, the iPhone in particular. They've been around for almost two decades now, but the improvement in their basic design have been incremental, so not necessarily revolutionary. There's a much bigger difference between say a 2006 Nokia flip phone and the original 2007 iPhone than there is between a 2007 iPhone and today's iPhone 16. And while more recent apps on that phone might take better advantage of say, the iPhone 16, or I forget, the current number we're on right now, which has obviously much better hardware, higher specs, greater capabilities. But even if your iPhone is several generations old, you can still use it to interact and play newer apps that have come out years since. And this gets back to what I was saying. The whole magic of, say, the iPhone's longevity is the fact that today's models run on essentially the same operating system, In Apple's case, iOS, as the older versions. There have been continuous updates to that iOS, but it hasn't been replaced wholesale with an entirely different operating system. I'd say there are two factors here to really zero in on the increasingly modest size of technological advances, and that is kind of the law of diminishing returns. If you play a PlayStation 4 game versus a PlayStation 5 game, does the PlayStation 5 game look better? Yes. Does it really matter at this point? Not really. Not in the way it did between, say, a Nintendo, the first Mario games, and, I don't know, the Mario on N64, the first 3D one. That was night and day. And that kind of leads us to the second point, which is the longevity of the operating systems, which has meant that whether it's Apple or Nintendo or Sony or Microsoft, hasn't had to build a new user base from scratch every time they roll out a new piece of hardware. Those two things together basically massively reduced their company's revenue volatility, not only from the hardware themselves, but also from the countless products and services related to them. And this is what allowed Apple to go from basically a standing start in 2007 to, I don't know what it is today, 1.5 billion, as far as their installed base of network devices. And they did that approximately in 10 years. That's what laid the groundwork for the App Store, which is arguably one of, if not the greatest businesses to come into being in the last 20 years by, I'd say, several orders of magnitude. And I think you have started to see that same basic dynamic play out with consoles and video games in general.

A (39:34)

And with the Switch and the console itself. Can you just talk through the actual revenue model there? I think you described it. And if I picture an iPhone, I spend X amount of dollars up front, and then I'm spending X amount of dollars on my various apps. I might have a monthly subscription to this app. Apple takes a 30% cut. Can you walk through that and just what that looks like for the customer, just to zero in on it from a customer standpoint.

C (40:03)

So not only say you buy a Switch and you have bought a couple games a year for any number of years, with, say, the incoming release of the Switch 2, all of your old games that you've bought and purchased are going to be playable on the new hardware that would not have been possible in the past. Even cooler. And I think this isn't talked about nearly enough with the Switch 2. You have Nvidia's DLSS AI built into this hardware. And practically speaking, what that is going to do is when you buy a new Switch 2 and you download all your old games that you had bought on your original Switch, they are actually going to be dramatically upgraded. And what I mean by that is thanks to Nvidia's very impressive continuously iterated AI features, you're going to basically have not only a substantial graphical upgrade with your old games day one, which I think is frankly incredible, but the frame rates and the smoothness of these games, the playability will be dramatically upgraded as well. So this time around, not only when you buy a new console or the successor to the original Switch, not only can you play your old games, this time around, all those old games are going to be almost like new, as if they'd been remastered with better graphics, smoother frame rates and the like. Pretty much day one. So I think that's quite special.

A (41:38)

Do I have to subscribe to the game or do I actually outright own the game? Asked differently, you make a one time payment for the game, it is not a monthly payment.

C (41:48)

Correct. That's the first key change. The second key change is Nintendo Switch Online. And simplistically the way you could look at that is as a Netflix of video games. Microsoft has gone and Sony have very much gone this direction with their own titles. But for the most part there's a huge difference here in the models themselves. With say Microsoft you have Game Pass, which is a dramatically more expensive service where you get, call it contemporary, up to date games playable via subscription pretty much day one. Now with their release and with Nintendo, they've I think very wisely done it very differently where one element of them being the king of video game IP. And if you were to look at the top 100 selling games of all time, you'll be astounded by how many of them are basically Nintendo classics up through the current generation. What Nintendo Switch Online was, we talked earlier about weaponized nostalgia is Nintendo had built this software and expensed it through their income statement in some cases decades ago. And so what the consumer gets in lieu of a subscription is not not only online play, play with friends and online multiplayer and things like that that are quote unquote hot ways to play video games today. But you get a basically all of the retro consoles and vintage call it evergreen game classics that Nintendo had put in the past out on prior systems available to you via various apps, you have a constant release of. Originally there was, I don't know, 20 NES games and then more games get out over time and they added Super Nintendo games and then they've continued to add more games since then they've added the Game Boy advance, even ironically enough the Sega Genesis and Most recently the N64. As time goes on, I think you're especially with this next console changeover with the Switch 2 which will be Nintendo's first major iterative hardware upgrade. I think you're going to get GameCube games and Wii games, but you basically get the best of all of Nintendo's historical classic evergreen consoles and video games for a monthly subscription fee, plus unique new games. With Nintendo Switch Online you get the best of their old games, you get a continuous stream of new Nintendo built games and I think in the future some very cool live service games that will be very good for the business and the model. So you have two things. You have your classic evergreen franchises, the latest Mario and Zelda.

D (44:37)

You're going to pay for those.

C (44:38)

It's going to be a, for the most part a one off purchase. And then Nintendo also has Nintendo Switch Online which not only for a monthly fee can you play online with friends, but you get this entire back catalog of the best that Nintendo has created in the past, plus iterative new battle royale games and a ton of other bells and whistles that I think will be continuously improved over time to make the experience and drive more engagement with players relative to the way they have in the past.

A (45:12)

And can you bring us to current date some snapshot of the business through numbers, whether that's revenue, titles, however you think is best to frame it. What are you looking at when you look at Nintendo the business?

C (45:26)

Okay, that is a great question and can basically be broken out into various earnings engines if you will. Obviously the primary driver of Nintendo's business is its software sales, particularly its first party software sales.

A (45:44)

You say software sales. Should I think of that as the purchase of a title, an in game purchase? Bring software to me because when I think of software I think I'm buying an Excel subscription.

C (45:56)

So that's a long question. You should think of video games. There's also Nintendo Switch Online in game monetization. Think of it as buying a new skin or suit for your character, downloadable content. In the past it would be Nintendo would release say the new Mario or the new Zelda for each system and that would be it. Now they can release their big evergreen franchises and then call it maybe a year or two later add in a new downloadable piece of content that will increase the amount of levels. Or it basically extends the durable life of these games and keeps players engaged. Not just when they first buy the game, beat it and then they just set it down and move on to something else. It provides a reason for fans to come back and DLC in game monetization where instead of it being just a simple one off purchase, it creates recurring revenue and more consistent durable revenue and profits over time. Instead of it being just a one off purchase where beat the game and then set it down. So this has obviously rather profound implications for its business model and call it long duration revenue and profits, but it's just a modern way to keep your biggest and best titles fresh and also continue to have the cash pour into Nintendo in a way that wasn't possible in the past.

A (47:27)

And how big of a piece of the business is that today?

C (47:31)

So it used to be 5050 hardware software. Within the last couple years you had an inflection point that I think points the way to the future where software has become an increasingly large piece of the pie. Think of it broadly speaking as 6040 today versus 5050 in the past. I think in the long run that mix will balance out closer to 80 to 20 and as that drops to the bottom line because software is where all their money is made. Unlike Sony and Microsoft, Nintendo does make a profit on its hardware, much like Apple does, where Sony and Microsoft will for many generations would happily sell their consoles at a loss because they'd make it up and then some via software, whether that be their own first party software or the app store tax on other people's games.

A (48:25)

You mentioned there's a delta in the margins even though there's still profit on the hardware. But how big of a gap is that? You hear software versus hardware, you're going to think one is much more economically viable than the other. But do you have some sense that of what the general margin profile looks like for those groups understanding that there's sub segments, has that shown up in the consolidated numbers where you've seen this margin expansion for the business?

C (48:49)

Oh yes. I don't know exactly off the top of my head what their operating margin was coming into the Switch era, I believe it was somewhere in the mid single digits. And this is another thing with the business model transformation. It used to be that every cycle you'd have three or four years of growing profits and then you'd have a year or two of losses. As you through R and D And other means created the new hardware and your best developers started to focus on next generation games. Where with the transformation to a more Apple like iterative model based on a unified software ecosystem, you should never have losses or a massive drop in the profitability of the business as you approach new generations of hardware. That in mind, you start in call it the mid single digits in 2000, call it 17ish, I think it was mid single digits. Today it's operating margins have expanded as all of these various drivers. The mix shift from physical to digital software, the rise of online recurring subscription services, DLC in game monetization of various forms. You put all of these revenue and margin expanding factors into the business model as it stands today. And I think I would be shocked if Nintendo's operating margins, call it two to three years from today, didn't balance out somewhere north of 50%. But high level, very quick and dirty. This is a business that has gone from low single digits in terms of its operating profitability to the mid-30s in.

A (50:31)

Terms of below the line. From an investment perspective, whether it is hardware or new titles or software, they all require some level of investment. It might show up differently in terms of where it fits in a GAAP accounting report. But has the ability to convert that margin into free cash flow or just cash from operations materially changed over the past few years? Does it show up any differently?

C (51:01)

Yes. Of all the secular structural, permanent improvements to its business model, you can really focus on two things that are responsible for driving the lion's share of the improvement in profitability. And that is one, the structural shift to digital software sales versus physical. As we just talked about in the past, Nintendo would have to create physical games, manufacture and produce the game. Then in order to distribute that game to the widest audience, would have to put it at a Best Buy or a Walmart or a Target and give up some margin to that retailer. And that resulted in call it a gross margin net of everything of call it in the 45 to 50% range with digital. You can see this by looking at other forms of entertainment ip and what has happened then. Physical media is dying. And because Nintendo started on this journey about five years later than everyone else, that transformation from primarily physical game sales to mostly digital and I think today industry wide it's right around 65%. But every indicator is that this long running trend is accelerating and the death of physical media is accelerating along with it is that profitability of selling their software. Instead of it being physical, it's now digital. And that means they make Quite a bit more with every game sold than they had in the past. Closer if you include DLC, somewhere to an 80 to 90% gross margin versus a 50%. As the mix of physical to digital sales shifts more towards where the rest of the industry already is today. Nintendo is going to benefit from what I think is a massive idiosyncratic driver of growing profits as it moves from, call it 50. I think in the end it'll probably balance out around 85% of the total. And one thing that's important about this to understand is it really is better for everybody each side of the network. The software developer that makes the game ends up taking home more. Nintendo makes a lot more relative to selling a physical game. And I think most importantly from a consumer perspective, rather than having to, I don't know, drive to your closest GameStop or Best Buy the night before your favorite game is released and elbow your way in and hope to God gets the counter before they're all sold out, you can buy the games digitally ahead of time. That game will download onto your system, call it a week or two prior to release, and then at midnight when the game comes out, you're free to play it immediately. Like any kind of structural technological change and its permanence or durability, you have to really think through how this affects the end consumer and demand. And the things that really have legs, for lack of a better term, are scenarios where the new paradigm is just a much better way for all of the players involved in the process, software developers, hardware makers and consumers. And in this case, I think it's a very clear win. And that's why you've seen the adoption of digital games grow so rapidly over the last 10 years or so, and it continues to do so. That's obviously a very sexy thing for Nintendo shareholders today, looking out, say over the next five years.

A (54:48)

And you mentioned before in terms of what you would have with a Sony and the AAA game, which is going to be tied to the most advanced hardware. I imagine with consoles, if you don't have the most advanced hardware, you need to rely on something else to bring people in to make the purchase again. Mobile has been a growing industry up until very recently, so you want to be either side of the extreme. But it sounds like Nintendo has found a solid spot in the middle. What makes a consumer buy a Switch versus choosing one of the other consoles? I imagine it is there's gated titles that you will only get there, some of the names we referenced before. But can you get into that a little Bit more as well.

C (55:32)

Yes. So that's actually a fantastic question. So one way to think about this is historically people have bought Nintendo's hardware strictly to play Nintendo's games. When you play a Nintendo game, what differentiates it isn't the raw graphical horsepower, it's more that the gameplay loops. They're just fun. It's not about the graphics, it's about the gameplay. So one, these games are much cheaper to develop and they're just as good as they've always been, if not better. If you look at the software ratings for the Switch generation, they think the metascore for almost all of them is above 85, which is kind of unheard of. And I think that speaks directly to the quality of the gameplay. Typically that's what has sold Nintendo systems. The game changes with the release of the Switch 2 in the fact that Nintendo has with its next iteration. The old saying now you're playing with power was a great 80s Nintendo slogan. What happens when with the Switch 2 Nintendo is once again playing with power that is approximately on par with the latest and greatest from the more graphically intense hardware of Sony and Microsoft. And that answer I think will have a very profound effect on the financial statements of Nintendo over the next five years, which is basically this. The original Switch was a console that it's basically 2013 era mobile technology. And one of the many unfortunate elements of what that means or had meant say over the last seven to eight years is most of the best AAA games made by third parties. So I'm thinking of games like Call of Duty or Madden Football were essentially too powerful to run on this 13 year old hardware. And so what would happen is some of these titles, a very small percentage did get released on the original Switch, but they were essentially dumbed down versions of the original games. And so they would sell decently well because with the Switch you had a radical redesign where Nintendo restructured his business around a single console that was essentially a home and portable console in one. And so that had a variety of permanent impacts relative to the business's profitability. That was a different discussion. But at the end of the day with the Switch 2 for the first time in a really since the GameCube in 2000, Nintendo is creating a system where between a much more advanced system on a chip and Nvidia's AI embedded inside of it, it will be able to play all of the best third party AAA games that were basically limited to Sony and Microsoft systems in true fidelity to those games intended gameplay. So what I mean is it's not just some dumbed down version, if it's available at all, that people buy because they want to be able to play those games on the go rather than in their living room. With the Switch 2 you'll be able to get all of those great Nintendo games that have defined Nintendo hardware historically, plus all of the best day and date third party AAA games. And that should result in a massive step change increase in the number of AAA third party games available on the Switch platform going forward that were not available in the past. And you can look at Microsoft and I think for various reasons the writing's on the wall that Xbox hardware is in terminal decline and I think they're likely to abandon it completely at some point over the next two years. But Sony itself has been struggling to create software for PS5. I mean the budgets have gone into just mind bogglingly insane levels of expensiveness. When you think about it, not only are they creating these video games, but they're essentially with each one, each game is like a motion capture movie plus a video game. And the average big AAA tentpole game for those Systems costs around $300 million. And frankly the installed base of certainly Microsoft. But even Sony now isn't big enough to justify the cost of making these games. Which is why you're seeing Sony and Microsoft go multiplatform with all of their first party stuff. Because they essentially can't make a profit anymore without opening up their software to all of the platforms. It might cost Nintendo 50 to $100 million to make a game where it'll cost its peers many times that. But basically to sum this all up, Nintendo over the last handful of years has basically taken multibillion dollar investments in networked infrastructure. And, and when you take that investment in having dedicated servers and you marry that to dramatically more powerful hardware that will basically come online, pun intended, with the release of the Switch 2, you have all the secret ingredients for an explosion of not just first party profits from software game sales, but from third party games. Think of it as a step change growth in AAA game availability and then with that, all of the online subscriptions and live service revenue that these third party games typically generate.

A (61:11)

Maybe we can jump into the ip, because I think it is a key piece of this story and I think so much of it we framed through the shift in the business model. You could also look at the business and frame it as these are the major IP franchises and these are how we can think about value coming from them. We're in this unique age of IP Monetization, the Barbie movie, so much more. So talk a little bit about how you think about that within the business, whether it's through the idea of Mario or something else that you would point to as an interesting way to think.

C (61:46)

About IP prior to 2015. And it really all have to lay it at the feet of, I think it was 92 when they did the original live action Super Mario Brothers movie. That event, the fallout from just how bad that movie was, created a very deep level of PTSD within the culture of Nintendo. And between 92 and 2015, Nintendo was almost psychotically averse to allowing anyone to touch any of their IPs for fear of not only degrading it, but creating the painful experience that they went back through with the original movies. But Nintendo began in a very Nintendo slow and steady way to open itself up to the proper monetization of what is indisputably the most valuable IP in the video game industry. And so that has taken place over the years in a couple of key ways. The first is obviously their push into movies and tv. Obviously we've all seen the massive global success of Super Mario Brothers that they did in partnership with Universal and Illumination. And for the first time, I think this was right about maybe three or four quarters ago, you had Miyamoto come out and explicitly state their larger ambitions, which was essentially this, that they were building up to a movie cadence of approximately one ncu. And NCU is a shorthand for Nintendo Cinematic Universe, which is pulled from the much more well known and commonly used term of the mcu, which is the Marvel Cinematic Universe. But essentially Nintendo has confirmed that not only was the movie not a one off, but since then they've released that the sequel Super Mario Bros. 2 comes out in early 2026. They've announced a new motion cap Zelda movie, but there are many more in the works. And the idea is as much like Disney did with Marvel, Marvel to work up to a one movie per year cadence that essentially acts as a infant return marketing to drive more video game console and game sales. Each movie, obviously animation tends to be more profitable. Their partnership with Illumination, which is easily the most capital efficient high return movie studio in the history of man. It's truly incredible how consistently profitable illumination driven animated features are. So I think they've hit a home run there. And then there's obviously leaning in with Zelda and their partnership with Sony. Actually the guy that had kickstarted the MCU will be working with Miyamoto to create the Zelda franchise. But I think you're looking at profits from the movie side of the business just from box office receipts and the digital window that encompasses what is called, call it the theatrical release window of a business that is worth somewhere between 50 to 20 billion in and of itself outside of the core video game business. Obviously not only is it a good standalone new pillar of profits or earnings engine for the company, but there are network effects. The more people that see the movie and get familiarized with Nintendo's IP and characters all the more are likely to go purchase its video game hardware software. And you saw that, I think Mario titles increased roughly 50% in total sales in the aftermath of the Super Mario Brothers movie. So again, it's a great business. I think it's probably worth somewhere between a third to half what you're paying for Nintendo in its entirety today. Just this one simple segment of their IP entertainment division that didn't exist in prior cycle.

A (65:46)

If you were to just stack rank the IP within Nintendo, I'm thinking about Mario Zelda. I know they own a stake in Pokemon. Do you have any stack ranking of those? Just out of curiosity. And then any that you think are maybe springed coils ready to be better monetized?

C (66:07)

There's probably 10 separate franchises that I think could be billion dollar plus global blockbusters. Presuming they take the same care and devotion to creating the films as they have to date with Mario. And if there's one thing that you know for sure with Nintendo that is not true elsewhere is yes, they are properly monetizing this world class IP and all these ways that they had not been willing to historically. But they take their devotion to their IP and the permanence of their art deadly seriously. And ensuring that it is at that qualitative threshold to be released and to grow the value of the franchise is pretty much everything. And I'll give you an example of how hardcore Nintendo is about this stuff. I almost cried as a shareholder, but I think it was 2018 or 2019. Nintendo had a tentative deal for three seasons to sell the rights to an anime Zelda franchise to Netflix for something like a half a billion dollars, something very large. And one of Netflix's employees leaked the project to. I don't know if it was Variety or. But the press and Nintendo was so pissed off they nuked it. Said you can keep your half a billion. Our trust has been betrayed. We'd rather just figure something else out. I don't know. When you look at what Disney has done to other kind of storied franchises and managed to take what I think was the greatest IP monetization layup in the history of the world with Star wars and proceeded to destroy it in inconceivably ways that I would have thought were impossible. I think Nintendo is very much focused on a middle way where they take again the permanence of their art and the care of these franchises they have built up over the last years very seriously. And you're not going to see the cash grabs or injecting contemporary politics into escapism or any of the other unforced errors you've seen at Disney that has frankly, permanently impaired some of the best IP in the world. You're absolutely not going to see that at Nintendo. And in fact, I almost fell out of my chair when they announced the Legend of Zelda movie. Miyamoto himself actually takes a clear shot directly at Disney by reminding the press that they, unlike someone else, will never betray our beloved fans to make money.

A (68:44)

Essentially, it segues into the next question on the management team and the management of the business. And I know there's been frustration from shareholders over time and something like pride over a leak related to that size of a deal. I can understand if there was some frustration. What would you point to that leads that? And then what are the signposts that would suggest that things are moving in a more shareholder friendly direction?

C (69:15)

That's a very broad and important question. I think the very fact that they have opened up their IP to movies and theme parks, the fact that they have opened up their IP at all shows that there has been a transformation of the guard and a grand expansion in the scope and strategic vision of the company in a way that would have been thought impossible prior to that. The very fact that they're doing all of these things and not just doing them, but leaning into them and doing them. Nintendo is by nature a very conservative company, but what people forget is they're also, when they have a ton of conviction, any new direction, they not only lean in, but they swing for the fences. So there's that. And then secondly, there's capital allocation. In the last 10 years, they've bought back roughly 11% of their equity in various bits and pieces. But that has stopped, I'd say, over the last two years as they have been moving towards the first major iterative upgrade transition of their hardware with the Switch 2. Once we're past this console changeover, I think you're going to start to see those buybacks reignite, much like you had in the past, but actually at an even bigger pace for the sole reason that when you have a balance sheet or a war chest as huge as Nintendo has, whether you're talking about just cash and diversified by currency or all of its hidden balance sheet assets, the cash will start to pile up so fast that they'll really have no other choice but to start returning it in droves. Mostly through buybacks, but through continuously increasing dividends as well. Don't make any mistake here. This is not the second coming of Henry Singleton or even what most Westerners would dream of if they were installed as king of Nintendo and what they would do with respect to capital returns and the ability, given how stable the business is. It's not like they're going to tender for a third of the shares, which they could, and then lever up a few times because the business is dramatically more profitable and stable than it has been in the past. Which for the record, they could do and they could do very safely. They're not going to be like that. But in terms of the Japanese Inc. Boogeyman where management doesn't give a shit about shareholders and they'll just let the cash pile up into infinity, I think you not only have a dramatic change internally with management's philosophy, but. But anyone that's being paying attention to the structural changes that are ongoing in Japan writ large right now should be pretty clear. Essentially, the government is forcing companies through various means and through the court system and whatnot to improve capital allocation and improve just general economic efficiency. So for the first time in history, not only has the Japanese government basically forced corporates to unwind a lot of the insular habits of the past, like cross holdings, various companies, all owning pieces of each other. So if an external acquirer came and tried to buy them, they would have the votes to basically ensure that that would not happen or couldn't be the case. But they've put various things in place with respect to buybacks and improving ROE for the corporate sector.

A (72:46)

I understand that the thesis and the idea here is you're going to see a shift away from new console cycles really being the business model for Nintendo. But I am curious, historically, when you saw new consoles come to market, what was the stock performance like just in those periods of time? Did it just tie very naturally to the release of a new console? And did you see that type of cyclicality that correlated pretty much to consoles?

C (73:12)

Yes.

D (73:13)

If you go back and you look at a history of Nintendo, say pull up Bloomberg and were to essentially look at the stock price approximately one year before the launch of the new console, and then you were to sell two years after it had been released. I think the average net annual gain over that three year period is roughly.

C (73:36)

200% ish or thereabouts.

D (73:38)

And I think that that data point makes a lot of intuitive sense. Obviously in the past you would have three or four good years a year, maybe 2 of losses as you started to really reinvest in not only the next hardware, but more importantly all of your software developers would turn their focus towards the back half of the console's life and start working on the next games.

A (74:02)

So what other risks would you highlight that exist for the business?

C (74:07)

The risk is very simply that they start to unwind all of the progress that they have made since 2015. They resort to becoming insular again and guarding their IP and they stop making movies, they stop expanding on the theme parks, they stop using their excess cash in value accretive shareholder friendly ways. Essentially the biggest risk by far is that all of the immense transformational progress we've seen over the last seven, eight years starts to unwind and creep back the other way. That would not be good for the company. Second risk would be the failure of the Switch 2. I think that is very low to basically zero given the fact that no Nintendo generation of hardware has ever sold less than 90 million. Even in the disastrous Wii U area you had between the 3Ds and the Wii U, I think they sold 90 million units there. Even at that, given the installed base is not resetting to zero, they should do very well for shareholders. That's the stuff I think about. Ultimately. It's all qualitative stuff and related to the ongoing transformation. And I would watch like a hawk any walking back of all of these profound changes that have taken place since we got involved.

A (75:30)

This has been fascinating. We close these conversations out with lessons that you can take away from this business and potentially apply elsewhere. You got a whole century plus long history of a business. But what would you point to just in terms of key lessons that stand.

C (75:46)

Out from Nintendo as an investor? I would say the key lesson with Nintendo and think this applies broadly to investing intelligently in general, is to look for value. Unlocking change what we do best at Crossroads. But one way to think about it is situations where the past and the present will look look very different. Whether it's due to structural changes in the business or changes in philosophy by the C suite or the management team, there are things that come with that. By definition, when you have extraordinary value and lacking change, that means that the future in the past are going to look very different and that creates, in and of itself, a lot of opportunity, both long and short. The only preface I would say there is this is not about predicting or forecasting the future at all. Rather, it's about recognizing change that is already underway that the markets don't understand or properly appreciate. And I think that's a critical distinction here.

A (76:46)

Oh, this has been excellent, Ryan. It's a fascinating business, just from a fun standpoint, but also the business model being particularly fun and seeing that shift. So thank you for sharing the knowledge.

C (76:57)

Thank you guys for having me. It's been a pleasure to find more.

B (77:00)

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