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Inside The Minds Of Wall St Analysts & Earnings Reports: Spotlight Nintendo

October 23, 2012 | About:

This post is about Nintendo, specifically, and about the logic of the earnings season and Wall St analysts, generally. Let’s start in reverse order.

The following is from Michael Pachter, a securities analyst with Wedbush Securities (WallStCheatSheet.com):

We expect a Q2 miss. Nintendo is likely to report Q2 results below our estimates for revenue of ¥100 billion and EPS of ¥(127), compared to consensus of ¥108 billion and ¥(84) and implied guidance of ¥145 billion and ¥(22).
I don’t really care what the forecast or expectations are, here. What Nintendo does or does not report tomorrow is immaterial to the point I want to make. Look at who is responsible here.

According to Wall St logic, a company is responsible for missing Wall St’s targets. It is not Wall St that is responsible for accurately modeling and anticipating a company’s results. In this sense, there is something holy and sacred and inviolable about such forecasts– they represent a hurdle for a company like Nintendo to cross over, if it’s good enough. If it’s not good enough, the company will “disappoint” everyone in the financial community by not overcoming these (somewhat arbitrarily chosen) performance targets.

It seems entirely backwards. The company is going to perform as it’s going to perform, regardless of Wall St expectations. If anyone creates disappointment, it should be the Wall St analysts who are held responsible. What should be disappointing is that with their salaries, schooling and deep focus on these companies, they still can’t manage to accurately forecast their earnings from quarter to quarter.

If you think about it, it’s ridiculous for a company to ever “miss” its Wall St earnings forecast because these can be adjusted on the fly, all the time. In fact, this entire exercise of writing a report like this saying you “expect a miss” is an absurdity. If you expect a miss, then recalibrate your forecast to what you think is actually going to happen. It’s preposterous to act surprised with a “miss” tomorrow, when you said ahead of time that you were expecting it.

This seems to be part of the Wall St priesthood tradition. Analysts can’t accurately forecast earnings just like investors can’t– the future is uncertain. This is one of the tenets of value investing. But somehow, despite Wall St analysts trying and failing to do the impossible, the ill result is not their fault.

The last bit of commentary is specific to Nintendo:

We think that Wii U’s price points are appropriate given likely demand from Nintendo’s core fan base, but believe that pricing will be too high to sustain long-term demand. Demand for the Wii U will likely wane once Nintendo’s core fan base has purchased the first 6-7 million units, especially given the number of cheaper, comparable alternatives. For example, the prices of the Xbox 360 Kinect bundles have been reduced by $50 at Amazon, GameStop, and Wal-Mart.

DS and 3DS unit guidance is likely unrealistic. Nintendo guided to growth for combined DS/3DS hardware and software units for FY:13. In our view, handheld hardware sales will continue to decline due to migration of casual gamers to mobile devices. We do not expect handheld hardware to see a rebound in sales without price cuts. Similarly, we think that overall handheld software growth is unlikely.

Maintaining our NEUTRAL rating and our 12-month price target of ¥10,000, a slight premium to Nintendo’s ¥9,000/share in cash, giving it credit for brand equity. We cannot assign a P/E, given the company’s low potential to generate significant profits in light of declining product demand and unfavorable F/X.
I don’t know how to put this… this is just stupid. And it demonstrates zero creativity and zero ability to think beyond the end of one’s nose.

First, the analyst is confusing things. Perhaps casual gamers were partly responsible for the booming success of the Nintendo Wii, but few have ever made the argument that “casual gamers” are a big market demographic for the company’s handheld systems, like the Nintendo DS. Surely, wouldn’t someone who is so in love with gaming that they must have a portable system to carry with them everywhere they go be the opposite of a “casual gamer”?

Second, the analyst is being pseudo-precise. The Nintendo Wii sold almost 100M units worldwide since release. But the analyst calculates that the “core audience” is only 6-7M customers? So approximately 90M, or about 90%, of all sales were to casual, non-core gamers? How precise can an estimate like this be?

Third, the analyst confuses apples and oranges. The emphasis on price cuts to make Nintendo’s products competitive from here on out implies that the experience Nintendo sells is identical to the one offered for free or cheaply on mobile phones and other devices which are now deemed to be “competitors” to Nintendo’s product. By this logic, Nintendo is vastly overcharging for its wares. It’s hard to spell this out in simple terms but, is there an analog experience to that of an epic puzzle adventure game such as the Legend of Zelda series on smartphone app games? How would one play something as complex as Pikmin with the ability only to tap on the screen to control the gameplay experience? Or even something as simple as Mario Kart? These are not comparable experiences so the argument that Nintendo must cut prices to be competitive doesn’t hold water– it’s like arguing that Mercedes-Benz needs to cut the price of the S-Class or else they’ll lose all their customers to the Nissan Sentra.

Fourth, the analyst is being inconsistent. To give the company brand equity credit, and any non-zero valuation at all when one argues that Nintendo must cut their prices when they can’t and won’t do this is idiotic. Because Nintendo won’t do this, by the previous logic they’re doomed to fail, but if they’re doomed to fail the brand has no equity and it certainly shouldn’t get a premium to the cash value of shares. If anything, it should get a discount to the cash value as it’ll probably burn through more.

Fifth, the analyst is being disproportional and lacks perspective. Negative charges due to forex translation have been more than de minimis but are still a small, small fraction of revenues and total earnings. To cite ongoing forex issues as an earnings problem for the company shows a lack of respect for the true magnitude of this issue.

Sixth, and finally, this is another demonstration of Wall St’s short-term focus and inability to think of the big, long-term picture. The analyst doesn’t see ANY WAY that Nintendo can generate meaningful earnings in the next 12 months, even though it’s rolling out a brand new system without any competition from Sony or Microsoft doing the same, and even though it’s gaining sales momentum with the new 3DS system. The analyst sees NO optionality in any initiatives or efforts by this company, whatsoever. And, even though the stock market is supposed to be discounting all future cash flows of a company, therefore qualifying it as a “forward-looking” market, this analyst only cares about the next year.

Will Nintendo even be around 13 months from now? This analyst doesn’t know and doesn’t care, and seems to think that either way, the company represents such a frightening risk with 90% of his share price target in cash and no debt, that he is only willing to assign it a small premium value over that cash.

If Nintendo just scrapes by, the market should lift off once it realizes it’s not dead in the water like this analyst believes it is. And if Nintendo has another hit on its hands, with the Wii U or otherwise, it’s really going to catch everyone with their pants down.

Which is quite an embarrassing position to be in.

Oh, and one other thing– the smartphone gaming ecosystem seems to be in the process of cannibalizing itself. I don’t think they’ll present much of a threat for ol’ Nintendo.

About the author:

Murray Graham is a private investor and a student of the value investing philosophy. He does not hold any charters, certifications, advanced degrees or other merit badges and he doesn't intend to acquire any. He may be contacted at his blog.

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