Nintendo Prepares to Post First Yearly Loss Ever, But Why?

by Michael in ,

Nintendo's Fiscal Year of 2011 is still not over. Just as Apple ends its fiscal year in September, which is not at the end of the calendar year, Nintendo ends its fiscal year in March. Nintendo has released its consolidated financial results for the 9 months ending in December 2011 (pdf), along with corresponding numbers from the previous year. The general gist can be gathered from The Verge or many other sources if you don't want to read the numbers directly.

In the release, Nintendo is predicting it will make a loss of $835 million in fiscal 2011. Let's talk about why. If you ask most people why, they'd say something about the 3DS not selling well, possibly due to competition from the iPhone. That simply isn't true. The 3DS is selling just fine, even with lowered projections. It is, in fact, selling much faster than the DS did in its first year--and the DS has gone on to become the best selling video game system of all time, just passing 151 million units sold to date according to the previously linked financial results. I'm certainly not going to say the iPhone is not relevant to Nintendo, but I will say that it isn't yet a dominant factor. (I'll have to address this in its own post.)

So if the problem isn't the 3DS selling poorly, what is it? As with most financial results from large companies several things come into play. Let's list them off.

First, the Wii has not been selling particularly well compared to previous years while also being sold at a lower price point than before. This means the Wii didn't offer so much sheer profit that it could allow the company to weather any storms it reached. The reasons for this include, but are not limited to, a lack of new compelling software for the system, the large numbers of units already sold, and the obvious age of the hardware from a technical perspective compared to other now-affordably priced alternatives. The reasons could be discussed in far more depth but are not directly relevant to the topic at hand.

Second, people may recall the 3DS was selling below expectations in its opening months. There were three things at play here:

  1. Nintendo simply priced the 3DS far too high, at $250, for most people to consider it.
  2. Nintendo didn't launch any particularly desirable games for the system in order to make room for third parties--and so there was less incentive to purchase the system.
  3. The largest element is expectations were ridiculous. In this case even Nintendo's expectations didn't make sense. There have been very few consoles in history which have ever sold at rates exceeding their predecessors immediately on launch after the opening week or two. It normally takes time for one generation to start exceeding the previous generation's sales. The Xbox 360 and PS3 took a long time to consistently beat the PS2 in sales, the DS took a while to consistently beat the GBA, etc. There have been exceptions, but the word "exception" has a definition for a reason. The Wii's explosive launch was unexpected. It isn't the norm. The Wii's launch also still didn't equate to peak numbers of the PS2 (though it exceeded the PS2's peak sales rates later). The absurdity involved in the 3DS launch sales expectations came in that Nintendo and industry insiders at large somehow expected the 3DS to simply jump into sales numbers equating to a dominant system that has been out for a while. The same problem is happening now with the PlayStation Vita's "disappointing" launch in Japan. I may not believe the Vita will sell very well, but launch numbers aren't evidence for that position.

The 3DS launch numbers being lower than expected leads us to the third major point: Nintendo dropped the price of the 3DS from its $250 to a more reasonable $170 per unit. That's $80 less per 3DS sold going to Nintendo than with an unchanged price. Obviously Nintendo wouldn't have gotten the same volume of units sold at the previous price point, but the point stands because Nintendo was operating with certain expectations of sales revenue with which it could operate.

The previous major points really only indicate why Nintendo might have made less money than expected, rather than why it lost money, though. So let's dig deeper.

The next item of significance derives from the previous one. That $80 price drop lead to the 3DS itself not being profitable in order to build momentum. Loss-leading is normal in the video game industry, but it's not normal for Nintendo. Sony and Microsoft have diverse businesses with which they can weather video game hardware losses for years until a large enough ecosystem is established to begin turning a net profit. Nintendo generally avoids this, with almost every system it's produced making profit from the day of release on every unit sold. The 3DS had to change this in order to get the volume of units Nintendo wanted into peoples' hands. This lack of profit, then, is a sacrifice Nintendo determined was necessary now--with the security of the assets it has built up over the last 5 years of immense success, in orer to position itself best for the future.

Ok, so now we're starting to see where some actual losses come from, but $800 million is a huge number. What else is there?

One huge point that can not be overlooked is the 2011 Tōhoku earthquake and tsunami in Japan. While direct impact to Nintendo was fortunately minimal, the entirety of Japan's economy was effect. Energy costs increased, LCD and other component costs increased, partners were damaged more directly, Japanese consumers were harmed (and therefore couldn't purchase as much), etc. And all this happened just after the 3DS launched, thereby probably hurting sales as well. The losses caused to Nintendo probably aren't the bulk of the company's losses and are very hard to quantify, but they also were assuredly subsantial.

The final major point is Japan's strong Yen. You might think that a strong Yen would be good, but for an economy so heavily export-based, a much stronger than historical local currency hurts quite a bit. Let's take a hypothetical ¥9,000 Nintendo DS sold in January 2010 and compare it to the same one sold in January 2011. If that DS is sold in Japan in 2010, the costs and revenue associated are both handled in terms of Yen. Let's pretend that ¥9,000 cost Nintendo about ¥6,000 to produce, ship, and market, meaning Nintendo made ¥3,000 on the unit--a margin of 33.3%. If Nintendo sells the same unit the following year in Japan for the same price, and its costs have dropped a little bit, it will make marginally more money due to the cost decrease--but all of its financials look pretty similar on that same unit.

Now let's look at the international situation. Let's take that hypothetical Nintendo DS and have Nintendo sell it in the US for $100 in January 2010. I picked these price points purely for convenience (¥9,000 was roughly equivalent to $100 in January 2010), but we're going to pretend this price point was chosen carefully by Nintendo in order to maximize the combination of profit per unit and number of units sold in the target market--in this case the United States. So this hypothetical DS in January 2010, because ¥9,000 is equivalent to $100, brings Nintendo ¥9,000 in revenue. Subtracting the costs for the unit--let's say ¥7,000 because it costs more for Nintendo to ship to the US than Japan--gives Nintendo ¥2,000 profit per unit. Now let's jump to January 2011, where things start to get slightly more complicated. That Nintendo DS is still priced at $100 in the US. By this point, though, $1 is no longer worth ¥90, but instead worth ¥83. That means that $100 is now just worth ¥8,300. So Nintendo sells that DS and gets ¥8,300 in revenue from it. It's costs, though, don't go down proportionally, because its costs are still counted in Yen. So now subtracting the ¥7,000 costs means Nintendo only gets ¥1,300 instead of ¥2,000 profit on the unit unless it somehow manages to decrease costs by a proportional amount--a difficult task to accomplish when your hardware is already mature and has been cost-reduced several times.

To make things even more complicated for export-heavy Japanese companies, the Yen has continually fallen over the course of the fiscal year at a rapid pace. That means all external revenue becomes worth less and less as time continues even while local costs essentially stay the same and prices go unchanged. Having price drops at the same time the Yen continues to get stronger against foreign currencies (as Nintendo did on both the 3DS and the Wii this year) compounds the issue--the revenue drop-off is immense.

Every single device Nintendo sold outside of Japan this year made the company less money than it did the previous year, regardless of whether it got a price drop or not--for reasons entirely out of Nintendo's hands. Combine that with stagnant or even increased costs and weakened domestic sales because of a disaster, and you start to see a picture that looks an awful lot like large financial losses.

So this year's posted financials are a result of a confluence of events combining to make things look bleak. They aren't a sign, however, that Nintendo is doomed. The exchange rate is forever out of Nintendo's control, but with the launch of a new Wii U system before Christmas 2012 and a now-fast selling 3DS console ready to start making money again, it's possible Nintendo can make up for these new difficulties. Only time will tell if it can manage the immediate struggles--and then we'll talk about the viability of Nintendo as a competitor in the games industry (and the viability of that industry's existence as it exists altogether) on a later date.