Analyst: Microsoft, Nintendo Preparing to Make Moves in China

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The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Microsoft (NASDAQ:MSFT) announced that it will launch the Xbox One in China this September. Last year, China relaxed its rules on consoles after having previously banned them in 2000 over concerns about the potentially harmful effects of violent video games on youths. Consoles are now allowed in China as long as they are manufactured in the recently created Shanghai Free-Trade Zone and approval from the authorities has been granted.

We think Microsoft’s strategy is interesting, insofar as they are leading with their most expensive console. The market for games is huge in China, and the country has a large middle class. However, the price point for the Xbox One ($500, and we believe likely to be more expensive in China) may limit initial penetration. Over time, we think that the company can sell as many as 10 million consoles, making the Chinese market one of the largest for the Xbox One.

The key to the Xbox One’s success in China will be Microsoft’s content strategy. The company partnered with BesTV, a subsidiary of Shanghai Media Group, and its strategy is to deliver not only game content, but over-the-top television content. We expect to see Microsoft roll out its OTT strategy in China at around the same time it rolls out the strategy in North America; this suggests to us that there will be additional announcements (and partnerships) for a U.S. rollout later this year.

Game piracy has long been a problem in China, and Microsoft announced that it will work with developers to build, publish, and sell games on Xbox One in China and elsewhere. We think that the company will likely have to develop a new business model for publishing games, as the packaged $60 console game is unlikely to be popular in a culture that “invented” free-to-play gaming.

We think that Microsoft’s move portends an announcement about launching in China by Nintendo (NTDOY.PK) later this year. Nintendo has several products that we believe would sell well in China, including the DS, 3DS, Wii, and even the Wii U. The company’s first-party content library is unsurpassed for the quality of the offering, and should Nintendo develop a business model that allows it to protect its games against piracy, we think that the Chinese market could present a compelling opportunity. With that said, we have not heard any commentary from Nintendo management about a push into China, though we think that Microsoft’s move may prompt reconsideration of the issue.

With its launch in September, Microsoft will achieve a “first mover advantage” over Sony and Nintendo. We believe that this deal has been in the works for some time, and believe it will likely take a year or more for Sony and Nintendo to launch successfully in the region. The middle class in China is sufficiently large to support more than one console manufacturer, but we believe that the first mover is likely to capture disproportionate market share in the country.

We expect little benefit to our covered publishers for the foreseeable future, as it remains unclear whether their content will be popular in China, and if so, whether they will be protected from piracy. Ultimately, a large installed base of game consoles in China should create a market for software, so we could see games like EA’s Titanfall and Activision’s Destiny performing well there.

Investment thesis: We would continue to avoid the stock until Nintendo can demonstrate that its sales can again grow, or it cuts spending sufficiently to support sustainable profitability at lower revenue levels. Nintendo has two pressing issues to deal with: its current console hardware offering is not as innovative and “fun” as the Wii, and its handheld hardware offering is under assault from smartphones and tablets, and is unlikely to ever recover to its historically high sales levels.

In our view, the company must address a declining addressable market either by reducing its cost structure or by growing revenues. It appears unwilling to do the former, and has historically been reticent to seek other revenue sources (such as licensing or allowing its games to appear on mobile platforms). Until it changes its cost structure or strategy, we would continue to avoid Nintendo shares.

Maintaining our NEUTRAL rating and 12-month price target of 12,000 Japanese yen. Our PT reflects a 10x forward EV/adjusted EPS multiple, and is a premium to its 9,000 Japanese yen per share in cash and investments.

Risks: Risks to attainment of our share price target include changes to game release timing, greater-than-expected deterioration of the average selling price (ASP) for game software and hardware, the effects of competition, changing macroeconomic factors, unexpected changes in foreign exchange rates, and slower-than-expected consumer demand for video game hardware and software.

Michael Pachter is an analyst at Wedbush Securities. 

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