Nintendo’s press release on Pokemon Go

Having the information from yesterday’s post, we can take a closer look at what Nintendo said in its press release from last Friday.  (In what follows, I’m assuming that the English version of the release from the Nintendo website is an accurate rendering of the Japanese.)

The heart of the release is this:

“The Company owns 32% of the voting power of The Pokémon Company. The Pokémon Company is the Company’s affiliated company, accounted for by using the equity method. Because of this accounting scheme, the income reflected on the Company’s consolidated business results is limited.

…Taking the current situation into consideration, the Company is not modifying the consolidated financial forecast for now.”

paragraph 1

True as far as it goes.  Because of equity accounting, Pokemon Company results will have, by definition, no impact on Nintendo’s consolidated gross, operating or pre-tax income.  But the paragraph actually says nothing.

In addition, significant information is left out. Nintendo benefits from Pokemon Go in two ways that don’t appear on the income statement at all.

–Nintendo owns about 10% of Creatures, one of its two 32% partners in controlling The Pokemon Company.  That interest, 3.2% of The Pokemon Company, is accounted for using the cost method, so the portion of Pokemon’s profits that this represents appears nowhere in Nintendo’s income statement

–Nintendo owns about 12% of Niantic, the developer and distributor of Pokemon Go.  If we figure that payments to The Pokemon Company represent 25% of Niantic’s profits, then that firm keeps 75%.  12% of that equals 9% of the total.  In other words, if these figures are approximately correct (I think they are), they indicate that Nintendo profits from Pokemon Go through its Niantic holding by about the same amount that it does through its The Pokemon Company interests.  The Niantic interest is accounted for by the cost method, so none of this appears on the Nintendo income statement.

–some analysts maintain that Niantic also makes direct payments to Nintendo for its use of Pokemon characters.  I’m not sure this is correct, particularly since this money would likely appear on Nintendo’s income statement–but is not mentioned in the press release.

paragraph 2

This is simply Nintendo saying, “we haven’t gotten any money in yet, so we’re not going to speculate.”

 

why nothing more elaborate   ….and potentially more useful in the press release?

Two reasons:

–the release is, I think, a report to the public of a formal reply to a stock exchange query, which was something like, “Given the sharp recent rise in your company’s stock, do you have any reason to raise your estimate of March 2017 consolidated profit results?”

Nintendo is simply answering the question, and in its mind avoiding possible future trouble by saying nothing more.

–many companies, and Nintendo is one of them, are intentionally closed-mouthed.  In conversation with someone they don’t know well, they may start out saying something anodyne, or even intentionally misleading.  They want to see if their interviewer has enough professional knowledge, and has studied their company in enough depth, to be able to challenge them.  Only after an analyst has passed one or more of these “tests” will the company begin to answer questions in a fuller way.  If the analyst flunks, the host is insulted and the analyst is written off as a waste of time.   The interview may still last, say, an hour but the conversation will remain on a superficial level.  This press release is part of the same mindset.

three ways to account for associated companies

This post is to lay the groundwork for understanding what Nintendo actually said about Pokemon Go last Friday.

There are three basic ways to account for companies that a firm owns an interest of less than 100% in another firm.

–the cost method.  This is used when the firm whose financial reports we’re talking about has neither influence nor control over the operations of the enterprise held.  A good rule of thumb is that this means a holding of less than 20% of the outstanding shares.

In this situation, the holding is listed on the balance sheet as a long-term investment at acquisition cost.

Under normal circumstances, the income statement contains no accounting of the holding’s financial results.

Two exceptions:  dividends paid are recorded as income; if the asset is impaired, the loss is shown on the income statement.

On the other hand, if the value of the holding increases, there’s no reflection of this in the owner’s financials.  Yes, accounting theory says the holding value should be adjusted periodically for changes in the investment’s fortunes, but as a practical matter this is rarely done.

equity interests.  This is where the holding firm is judged to have influence but not control over the entity held.  Typically, this applies to holdings that fall between 20% and 50% ownership of the investment.

If so, the owner records his share of the financial results of the holding on a single line toward the bottom of the income statement.  This line is called “Equity Interests” or something like that and is an after-tax aggregate of all such equity interests.

The holder also adjusts the balance sheet value for profits (up), losses (down) and dividends received (down).

consolidation.  This is the case where the holding firm exercises influence and control.  The rule of thumb here is that ownership of 50% or higher implies having both.

If the ownership is less than 100%, the consolidating company still reports results–revenues, costs etc.–from operations as if it owned 100%.  But it add correcting, after-tax entries, both in the income statement and on the balance sheet, typically labelled “Minority interests” that subtract out the portion of earnings and assets held by others.  Again, these are aggregate figures and not broken out holding-by-holding.  Minority interests are usually recorded toward the bottom of the income statement, somewhere near the consolidated net income line.

Tomorrow, how this applies to the Nintendo announcement

 

Nintendo (TYO:7974) and Pokemon Go

Nintendo in a nutshell

Nintendo is a non-establishment Japanese company that started out making playing cards but became a worldwide sensation early in the videogame era.  It’s the creator of the Nintendo console and Gameboy handheld machines, plus proprietary games and characters like Mario, Donkey Kong and Zelda.

When gaming shifted from consoles to mobile, Nintendo pretty much disappeared.   Its stock has languished since, despite the company’s extensive intellectual property.

That’s the main reason, I think, that the stock took such a huge leap–it came close to doubled in two weeks on 20x normal volume–when Pokemon Go was released.  Not only is that game a smash hit, but its success underlines the continuing relevance and therefore the still enormous profit potential from Nintendo’s extensive intellectual property.  Of course, this potential can most likely only be realized through mobile games, something Nintendo has, in a fashion bewildering to those not familiar with the company or with Japan, so far avoided as a matter of long-term corporate strategy.

 

Friday’s press release

After the close of business in Japan last Friday, Nintendo issued a short press release about Pokemon Go.

The release starts out with stuff anyone could have found out on Wikipedia. Pokemon Go was developed by Niantic, a spinoff from Google, not Nintendo.  Nintendo participates in the game’s success, however, through its 32% ownership in The Pokemon Company (PC).  PC will  receive a licensing fee from Niantic, as well as compensation for continuing collaboration in Pokemon Go’s development.  (Nintendo also owns an undisclosed (12%?) interest in Niantic, which might turn out to be much more valuable than any one game–but that’s not mentioned.)

brass tacks

The heart of the release is in the next-to-last sentence, which reads:

“Taking the current situation into consideration, the Company is not modifying the consolidated financial forecast for now.”

Monday trading

On Monday in Tokyo, short-term traders frightened by the press release quickly pushed Nintendo shares down by the maximum allowable daily amount (that percentage varies for each stock but in Nintendo’s case it’s 18%), where the stock stayed all day.  Today the stock rose slightly.

my thoughts

I don’t view Nintendo’s press release as containing much news at all.  I think it’s a response to an official inquiry from the stock exchange (Tokyo or Osaka) about whether there’s any reason for the unusual trading in Nintendo shares.  The inquiry will have been very specific:  whether Nintendo has any reason to revise up the earnings forecast for the fiscal year ending in March 2017 that it has on file with the exchange. (Note: publicly traded Japanese companies are required to revise their forecasts if/when they know earnings will be +/- 25% from what’s on file.)

Nintendo’s answer:  No, not at this time.

In my experience, this is a very Nintendo-like answer.  It’s also typical of mid-sized Japanese companies in general.  It responds narrowly to the question, and volunteers nothing more.  If a revision is warranted, it will most likely only come in February.  In this case, though, it probably is way too early to tell the significance of the new game.

More tomorrow.

 

 

 

 

 

 

earnings calls: Apple (AAPL) vs. Microsoft (MSFT)

Last night after the market close, AAPL reported earnings per share that beat the consensus of Wall Street analysts–and the stock went down in the after-market.  MSFT, in contrast, reported results that fell short of analysts’ estimates–and the stock went up!

What’s going on?

AAPL gave next-quarter guidance that fell below Wall Street’s projection–but it always does this, so that’s not the reason.  MSFT’s income statement looks better after factoring out the large operating loss generated by Nokia, but I don’t think that’s the reason for the market’s positive response, either.  After all, if you wanted to (I didn’t), you could have gotten a reasonable guess at how much Nokia would subtract from the MSFT total from Nokia’s recent results as a stand-alone company.

I think the market’s response is much more a a conceptual response.

Tim Cook has made it clear that AAPL is a manufacturer of high-end mobile consumer technology.  There’s no “next big thing” on the horizon, however, with only a periodic refresh of the company’s smartphone line due any time soon.  If reports from suppliers are accurate, new offerings will include a phone with a large, Samsung Galaxy-matching screen size, and a(n even larger) tablet/phone.  For Jobs-ites, this departure from Steve’s view that phones should be small enough to operate with one hand may be earth-shaking.  But for the rest of the world, this is only catching up to what Samsung already has on the market.  So a ho-hum Wall Street response is appropriate.

For MSFT, on the other hand, the news is relatively better.  The company seems to have a focus for the first time in a long while.  The fact that Nokia is putting up operating losses at a near-$3 billion annual rate seems to me to justify the downsizing MSFT has recently announced.  The only surprise is that this wasn’t started sooner.

Leaving the X-Box content creation business is probably more symbolic than anything else, but it removes a potential distraction–especially given the continual mess the company has typically made of its game software development efforts.

One, admittedly small, figure what caught my eye was that MSFT has added another 1,000,000 individual/small business users to its Office 365 rolls during the June quarter.  I think this just shows the power of the cloud–easier administration, much lower cost-of-goods expense, and hugely better protection against counterfeiting.

For MSFT, then, the earnings were nice, but the fact that the company’s board is allowing significant changes is nicer.  True, the message may turn out only to be that the company will try harder not to shoot itself in the foot again, but even that’s an uptick.  Hence the positive market response.  Absence of missteps won’t be good enough for long, but it’s ok for now.

rent vs. buy: examples

Olympus Optical of Japan (yes, the huge-derivative-speculation-losses, put-out-a-hit-on-the-new-chairman Olympus) was the first company to open my eyes to the value of the rental model vs. selling an item.  The company makes endoscopes, the computer plus coated fiber optic cable devices used in colonoscopies and endoscopies.  Olympus initially used a razor/razor blade model to sell these devices around the world.  It sold the computer devices at slightly above cost.  The fiber optic cables were supposed to be the razor blades, being replaced at regular intervals with new ones, generating high profits.

Olympus didn’t make much money from endoscopes, however.  Physicians generally refused to buy replacement fiber optic cables, even when Olympus salesmen told them they risked having the cables break apart in patients’ bodies.

So Olympus tried an experiment in the US.  It switched to a rental model.

Let’s say an endoscope kit sold for $60,000 (a number I made up).  If so, the new idea was to rent the units, throwing replacement cables to avoid safety problems, for $1,000 a month.  Because $1,000 a month was easier for a doctor to stomach than $60,000 upfront, more doctors signed up for the machines.  In addition, because Olympus was collecting rent for each machine over something like a ten-year useful life, reported profits skyrocketed.  Yes, this is partly a question of accounting technique (more about this tomorrow), but the amount of money Olympus ultimately collected for each machine was double what it had before.

Anixter, the wire and cable company.  This was one of the first companies I covered in my career as an analyst.  Back then, Anixter’s main business was industrial wires and cables.  It ran a national system of warehouses.

The Anixter salesman would call on a customer, ask how much wire and cable inventory a company had–usually a lot more than anyone realized– and offer to buy it all on the spot.  Anixter would guarantee to meet all the company’s wire and cable needs from Anixter warehouses.  Outsourcing to Anixter would mean the customer could repurpose its warehouse space, lay off or reassign the three guys who dealt with the inventory, and free up, say, $10 million the firm had lying around in wire and cable stock.

The manager who shifted the company from owning its own inventory to working with Anixter would be a hero in the eyes of top management.  People couldn’t sign on the dotted line fast enough.

At the same time, although apparently not many clients realized this initially, there’s no going back from a decision like this.  If you’ve taken a victory lap for creating $10 million in cash out of thin air, as well as saving $300,000 in annual expense, you can’t subsequently return to the board to say you need money to build a new warehouse, hire new employees–and, by the way, you need another $10 million (or more) to fund inventory.

As well, in the case of Adobe, there’s no place to go back to.  As the company put it, ADBE has burned the boats.  It no longer sells its media products.  It only rents them.

Electronic Arts  In the early days of MMOGs, I was at an analyst meeting for ERTS.  Someone asked how many users the company had for its MMOG.  The then-CFO, long since retired, said he didn’t know.  All he knew was that the company collected $10 a month from 180,000 credit cards.

I took this to mean that the company had a significant number of people who were renting the game but never using it.  This isn’t necessarily a good situation.  You’d prefer that people love your service so much that they’re heavily engaged every day.  On the other hand, the no-show users are pure profit.

Tomorrow:  the Achilles heal of rental, the upfront capital needed to get going.

a short reprise of the Zynga (ZNGA) IPO

King Digital Entertainment, PLC  is the maker of the fabulously successful mobile-centered game Candy Crush Saga.  The firm has filed a form F-1 in preparation for an IPO.  King (proposed ticker: KING) intends to raise around $500 million.

Not surprisingly, the KING offering has reawakened bad memories of the 2011 IPO of ZNGA, which was led by Morgan Stanley and Goldman (no shock, either, that neither of those firms has a role in the KING IPO).

I haven’t yet read the KING offering document.  It’s possible that I won’t.  But I still thought it might be useful to look back at the characteristics of ZNGA that, in my view, made that stock an unattractive investment from the start.

1.  Virtually all the traffic coming to ZGA’s games was generated by Facebook.  This made it difficult to tell whether ZNGA’s games were successful because they were great games, or because they were being featured on FB.  If the latter–which subsequently proved to be the case–FB held the economic power in their partnership.  Any lessening of FB’s marketing efforts would quickly translate into a reduction in ZNGA’s profits.  A big weakness of ZNGA, not a plus.

2.  A reasonable way of assessing social games is to measure:

–the time needed to reach the peak number of players,

–the number of peak users, and

–the rate at which the number of users fades from the peak.

Even prior to the IPO, ZNGA offerings launched after its signature game, Farmville, were peaking faster than Farmville, and at lower numbers of users than Farmville.  In addition, they were as fading from the peak more quickly.  In other words, none of them had anything near the oomph of Farmville. This was all bad news.

3.  The actions of  the lead underwriters, both before and after the ZNGA IPO were quite odd, in my view.

For one thing, according to the New York TimesMorgan Stanley mutual funds bought  $75 million worth of pre-IPO shares of ZNGA in February 2011 at $14 a share.  Some have suggested that this was done to help persuade ZNGA to choose Morgan Stanley as a lead underwriter.

For another, the underwriters released the top management of ZNGA, as well as some venture capital investors, from IPO share “lockup” agreements that prevented their sale of stock prior to May 29, 2012.   Instead, a sale of 49,4 million shares at $12 each raised close to $600 million in early April for these high-profile holders.  By the original lockup expiration, the stock was trading at little more than half that level.

My overall impression is that the underwriters (incorrectly) thought that the heyday of tech investing was over.  This would imply that they and the companies they were moving to initial public offerings had only a short time to cash in before the rest of the world figured this out.  As a corollary, the traditional rules of trust and fair play between underwriter and professional portfolio manager/wealth management client no longer held–because there would be no follow-on business that once-burned clients would shy away from.

relevance for KING?

Again, I should mention that I haven’t yet analyzed KING.  Candy Crush Saga may well prove a fleeting fad and KING a one-trick pony.  On the other hand, the underwriters are different this time.   And I don’t sense the same IPO-before-it’s-too-late urgency that was in the air in 2011.

cable TV cord-cutting is here to stay

That’s according to media consultant, SNL Kagan.

SNL Kagan is the firm that first called widespread attention to the phenomenon that significant numbers of subscribers to multi-channel entertainment service providers, like cable TV or satellite, are cancelling their service.  People are watching increasingly their favorite programs over the internet through services like Hulu.  And they’re using Netflix as a substitute for on-demand movie watching.

During the middle two quarters of last year, cable et al. in the US actually showed declines in subscriber numbers for the first time ever.  The fact that subscribership has since rallied back into the plus column has some observers concluding that internet-based “over the top” content distribution will remain a fringe phenomenon.  SNL Kagan disagrees.

The consultant points out that:

–while traditional cable/satellite is growing, its expansion is less than the rate of new household formation.  This means the older services are gradually losing market share;

–the number of OTT households will likely rise by 80% this year to 4.5 million, or about 4% of the market;

–for at least the next several years, the consultant expects OTT households to expand by a steady 2 million annually.  This means they’ll number 12 million or so by 2015, and represent 10% of the market.

Netflixing and Huluing are different

Neilson observes that, although they may be the same people, individuals behave quite differently while Netflixing from when they’re Huluing.

–Netflixers, as you’d suspect, primarily watch movies using the service.  A small majority view content on their TV screens, with a game console as their preferred connection device.  42% watch the movies directly on their computers.

–Huluers, as you’d also figure, watch almost nothing but TV shows.  They view their content almost exclusively on their computers, however, although sometimes they’ll hook the computer up to a TV screen.

One constant for both services:   almost no one uses Google TV or Apple TV.  More people watch on cellphones or tablets than on either.

my thoughts

Let’s assume that Huluing and Netflixing give us a peek into the future.  What are we seeing?

–a world where cable TV companies are valuable because they deliver internet access to customers, not entertainment content directly to a TV. Their rivals will principally be the wireless companies that are building their own mobile internet networks.

–a world where TV sets no longer play a prominent role.  Maybe you’ll have one in the house to watch sports events (the only kind of entertainment where people are willing to pay for picture quality), maybe not.  Viewing gets done on computers or tablets.

–a world where the low-end PC disappears.  Tablets are one successor, as the market already realizes.  Traditional PCs, laptop or desktop, with larger, better resolution screens and good audio may be another.   APPL is moving in this direction by eliminating the MacBook from its lineup and offering customers only the MacBook Air and the MacBook Pro as choices.  (This seems to me to open the door to Chromebooks in the education market, but time will tell.)

Implications for INTC are, at worst, mixed and maybe pretty favorable.  It may sell fewer chips, but its product mix will shift to higher value-added products.  Cloud computing becomes much more important.  And the performance bar is raised for ARMH’s much-discussed entry into the PC market.