Nintendo Still May Not Track Down Profits with Pokemon Go

 | Jul 13, 2016 | 9:27 AM EDT
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The stock rise of Nintendo (NTDOY) in the past week has been meteoric, since the hit Pokemon Go app was launched in the United States.

The stock is up 56% in the last four trading days. That's an additional $11 billion in market cap that the company has tacked on.

The app is unique in the way it has blended augmented reality with mobile gaming, with social and mapping components to boot. That has led to massive mainstream popularity - it's well past the tipping point, just as the old Super Mario and Donkey Kong games were.Pokemon Go reportedly surpassed Twitter (TWTR) in terms of daily active users on Android yesterday.

Since the weekend, there have been plenty of bulls talking up Nintendo's stock. The argument is that this app is just the tip of the iceberg for Nintendo in terms of unlocking the power of its library of characters on mobile. If the company can continue to monetize characters like Mario and Zelda on mobile, and they achieve the same popularity as Pokemon Go, the stock still appears cheap.

But there are many reasons to be cautious about Nintendo's ability to cash in on the big recent stock bump.

People have been making the case that Nintendo should cash in on its character's intellectual property through mobile gaming for four years. The company has been painfully slow in responding to the shift from consoles to mobile games. Despite multiple CEOs over that period, and constant questions from its shareholder base, the company had not taken any steps until this app. It's still not clear that, institutionally, Nintendo thinks it has to shift to mobile in a big way and away from consoles.

Before the app's debut last week, the company had been keeping investors mostly focused on its newest console, which was supposed to debut in 2016 but has now been pushed back to 2017. This new console is expected to be closed, just like other Nintendo consoles, able to run only Nintendo games and characters.

Although Nintendo obviously supplied the proprietary character and intellectual property for the game, the heavy lifting of making the game original and fun was done by co-developer Niantic Labs. This firm was spun out of Alphabet (GOOGL) , and is co-owned by Nintendo and Alphabet. Niantic took a previously successful game (Ingress) and plugged in Pokemon characters to create Pokemon Go.

If a big part of Nintendo's increased market cap is because investors think that it can now do the same thing with other characters, that is a bet on Niantic doing it and not the in-house team at Nintendo. Nintendo will likely have to acquire Niantic to make investors believe it has the capability to keep the hits coming. However, as we saw with the acquisition by Zynga (ZNGA) of the hit Draw Something a few years ago, this isn't as easy as it sometimes seems.

Nintendo is now expensive compared to some game publishers. As of this morning, Nintendo had an enterprise value to EBITDA ratio of 26x earnings, while Activision (ATVI) was at 21x. Activision had $1.6 billion in EBITDA in the last year, while Nintendo had under $500 million, even though the two companies had similar revenues.

Nintendo's revenue and EBITDA today come from its legacy hardware and games. Are consumers going to still buy consoles in the same numbers that they have in the past? If not, then that legacy revenue and EBITDA is about to shrink, and Nintendo will have to rely on the new Pokemon Go revenue stream. Will it be as large as the lost legacy streams? If the timing isn't just right, investors are likely to find themselves overreaching on valuation, and a correction could be fast and furious.

It's always a good thing to have a hit game, and Nintendo definitely has that in Pokemon Go. Some of the problems described above such as not owning Niantic Labs can be solved with money.

However, it's likely that the biggest obstacle Nintendo will face in cashing in on this Pokemon Go success will be its own culture. It has always done things in a certain way. Japanese companies have shown that once they taste success with one way of doing things, it's hard to shift into a new way, even if it's clear that the old way isn't working.

The seismic launch for Pokemon Go should help the faction within Nintendo that is pushing for change and give it more leverage. But it's not a slam dunk that top-flight Nintendo management will see the need for change in the same way.

So after such a rapid jump in the stock in the last few days, potential investors should look at the stock with more caution than hope.

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