I do not believe that I have ever written a finance article advocating the purchase of gaming stocks like Activision or Electronic Arts. It’s not that video games aren’t profitable—far from it, intellectual property that costs a few bucks to manufacture per disk and can be sold for $50 is a great way to make money while putting down a small amount of initial capital.
Instead, the challenge is sustainability. When Nestle sells a cookie, I can make intelligent guesses about how many cookies are going to be sold several years into the future. For the past century, the world consumes about 4.5% more cookies each year, and the Nestle Tollhouse usually sells 4% more cookies than the year previous. If someone is in the habit of buying 6-8 cookie rolls per year, that behavior is likely going to continue indefinitely. Through technological advances, boom and bust cycles, and the changing dietary preferences of Americans, it’s still pretty easy to figure out that people will be eating cookies ten years from now.
In the video game industry, I can’t make those kinds of prediction. I have no idea how much money Activision will be making in 2025 because no one may even be playing Call of Duty then. Whereas products like Hershey chocolate has a market base that never disappears, there will come a time when people get sick and tired of playing Call of Duty and move on to the next big thing on the gaming industry. I have no idea if that product will come from Activision. And the hardest part is that the investor community not only wants Activision to replace the revenues generated by Call of Duty, but achieve actual growth above what Call of Duty currently generates.
I prefer businesses that are blindingly obvious. Companies like Coca-Cola, Johnson & Johnson, Hershey, and Colgate-Palmolive have a license to print money for at least the rest of my life. I prefer to stick with that. It is so much more difficult to find long-term passive investing success in the video game industry because you have to constantly play catch up. Old revenue lines dry up, and you have to make double the energy expenditure compared to a Colgate-Palmolive as you must come up with revenue replacements as well as revenue growth above the prevailing baseline.
That said, I try to find good lessons wherever I might find them, and Nintendo provides good example of excellent long-term planning.
Most investors are familiar with the stock market crash of 1929, or even the Black Monday crash of 1987. What fewer people remember is the “Video Game Crash of 1983”, also sometimes called “The Atari Shock.” It was an out-of-nowhere economic depression that hit the video game industry, shriveling the industry’s revenue base from $3.2 billion to $93 million in under two years. Most of the industry went bankrupt, and even the once-dominant Atari of Pong and Atari 2600 fame was sold for scraps by its parent company Warner Communications in 1984.
The definitive cause of the ’83 crash is still debated to this day, although it was likely a confluence of factors that caused video program values to collapse from $35 in the summer of ’83 to $4 by the fall of 1984.
Some possible explanations include: (1) video gaming was a teenaged fad that had run its course; (2) the mismanagement and collapse of Atari carried collateral consequences that affected the rest of the industry; (3) the public criticism that video games were rotting children’s minds, thus prompting the tightening of parental purse strings; (4) the overproduction of games mixed with new entrants that were willing to sell video games at heavily reduced costs; (5) the poor release of inferior products like Pac-Man that had to meet a Christmas 1983 deadline and contained poor visual quality and interaction; (6) the saturation of the market with new console systems like the Atari 2600, Atari 5200, Bally Astrocade, ColecoVision, Coleco Gemini, Emerson Arcadia 2001, Fairchild Channel F System II, and the Vectrex; and (7) the introduction of the home computer as a new platform for playing games. (Source attached at bottom).
As industry revenues plunged over 90%, Nintendo was on the brink of bankruptcy until it released the Nintendo Entertainment System (“NES”) that infused the company’s Kyoto treasury with cash and resuscitated the industry on the path to recovery. Hiroshi Yamauchi, the President of Nintendo from 1949 through 2002 (Nintendo has only had four presidents since starting out as a card company in 1899), swore that Nintendo would never find itself in such perilous position again and vowed that the company would keep enough cash on hand to continue operating for 100 years even if the company endured another crash.
Instead of doing the popular thing of paying out high dividends or repurchasing stock, Nintendo spent years building up its cash hoard. It currently has 930 billion yen in cash (if you look at the company’s balance sheet, you will initially think that it only has 530 billion in yen available. The remaining 400 billion yen are held in dollars, euros, franks, and pounds and get reported as short-term investments rather than cash holdings.)
That has come in handy over the past five years, as Nintendo is currently losing about 9 billion yen per quarter because the Mario Brothers brand has fallen out of favor and the Wii gaming console has absolutely no economic moat as a desirable technological product. Since 2011, Nintendo has lost almost 100 billion yen. The current 930 billion yen cash hoard is close to a low—for most of the 2000s, Nintendo had over one trillion yen in the bank effectively.
Do I recommend Nintendo stock? No, I’m almost certain that owning an S&P 500 Index fund from 2015 through 2065 will result in dramatically higher overall wealth than making a Nintendo investment. But I am also certain that Nintendo will survive much, much longer than the operating performance of the company will merit. Nintendo experienced cataclysmic failure in the 1980s, and is riding through today’s rough patch because it built a fortress of cash unlike any other company in the world because it knew what it needed in order to survive a worst case scenario.
There is no real parallels in the United States. Microsoft and Apple have seen their cash hoards balloon to over $100 billion at points in their recent corporate histories, but that was the result wildly successful products that were growing revenues at 20% annually which had 40% operating margins. The company couldn’t pay that money all out as dividends because the payout ratio base got too high, and it couldn’t engage in a monster buyback because Apple and Microsoft would flood the market with buy orders and drive the market price upward on account of its own buying.
Maybe Johnson & Johnson is a close American equivalent, as it is sitting on over $33 billion in cash. But that isn’t quite analogous because most of the money is trapped overseas and it seems that Johnson & Johnson is waiting for another repatriation tax holiday to bring that money back home as part of its tax strategy.
It gets a bit stale using Warren Buffett as an example for good corporate governance, but hey, I don’t want to be like the sports media that gave Karl Malone the MVP in 1997 over Michael Jordan. Berkshire Hathaway is sitting on over $60 billion in cash, and I would expect that a large cash hoard will be typical of the company in the decades to come.
Although the lesson from Nintendo may not lead us to purchase its stock, I do find three important lessons from studying the company. It is (1) important to know when it takes to survive in a worst case scenario and lay out the groundwork to ensure that success; (2) it can be hard to carve out a corporate identity that is so much different from one’s peers because most people make their decisions relative to what other people are doing rather than trying to tackle problems independently and rationally but it can ensure greater success over the long run; and (3) catastrophe often comes in quick, short bursts that is difficult to fathom if you are used to thinking about life linearly. A failure to recognize this will leave you unprepared for your own crises in life.
Source: Down Many Times, But Still Playing The Game: Creative Destruction and Industry Crashes In The Early Video Game Industry 1971-1986
Originally posted 2015-06-15 19:32:01.