Marginalia

I switched schools for my junior year of High School. During my first term at the new school, I struggled through English Lit. The class was first thing in the morning. Our teacher was ancient. Our first read was Nathanial Hawthorn's "The Scarlet Letter." Our teacher may have given notes to Hawthorn on his first draft. Early in our reading, she asked "who is Pearl's father?" — one of the big plot points of the book. No one raised a hand.

I’d waited until just before school began to make the decision to switch. I hadn't collected all the materials for my classes so, I was reading from a classroom copy. The book's previous owner had been a better student than me. She'd helpfully scribbled her theory of the baby daddy in the margin the section we were talking about. I raised my hand and offered up her answer. It was correct. Our teacher asked "Why do you think that?"

Here, I had a choice. I could bullshit together some half-baked answer to cover my blunder, or I could tell the truth. I told the truth. I told her someone else wrote it in the margin. That was the wrong choice. The teacher had it out for me the rest of the term. Really the wrong choice was to offer up an answer to begin with and this dug me deeper into a hole.

Two takeaways here: sometimes what happens in the margins tells us important things. Sometimes what happens in margins misses the bigger picture.

Detention

Anyway, Here's Nintendo's earnings debrief. The first question in the Q&A brought up margins. A few of the later questions returned to that same topic. Margins disappointed investors. They were lower than expected. Investors worry they'll keep being lower. This has pushed share price lower.

Nintendo — and every other hardware maker — has struggled to get DRAM. AI has eaten all the DRAM. Scarcity launched prices like a rocket. Lamplighter's talked about the other side of this. For Nintendo and others, memory often makes up the biggest line on the bill of materials. Nintendo's margins are likely to be lower. That's bad, right?

Nintendo's gross margins have dropped to 37% this year from 61% last year. That's not great. Some of this is a casualty of memory prices. Most of it is not.

Most of the drop is because it's selling a lot of Switch 2s. It earns lower margins on hardware than its overall business — close to zero. Its hardware sales are 70% of its business this year versus 44% last year.

Nintendo doesn't mind earning low profits on hardware sales because it earns its profits on software. For a long time, this meant game cartridges. It's been slowly catching up to the 20th century and shifting its game business to digital delivery. When the original Switch launched, digital sales were 15% of its software sales. By the time the Switch 2 launched, that was 53%. It earns close to all profit on digital sales.

So, Nintendo's game plan for the Switch 2 is to get as many of them out as quickly as possible at low margins and drive profits through software, preferably digital sales. So far, the plan looks solid. Software strength has boosted gross profit in the first six months of the Switch 2 launch. It already doubled what it achieved in the first year of the Switch with three months left to report.

Recess

What's happened to Nintendo's margins is they've shrunk. Memory prices look likely to keep a lid on hardware margins. The main Nintendo arc, though, is that the sales ramp of the Switch 2 is going faster than the original switch. Its earning a much greater share of gross profit from digital sales than it was at the outset of the original Switch. Even at somewhat higher memory prices, the results so far suggest it could earn more profit quicker. The margin story is important. But the plot is more complicated than "higher memory prices mean lower profits." The early sales ramp and digital success point to economics that support much greater value for the company and the shares than the market expects today.

Disclaimer: None of this is investment advice. It's meant to illustrate ways LCM thinks about investing. Things that LCM decides are good investments for LCM and its clients are based on many criteria, not all of which are covered here. Some or all of LCM's ideas may not be suitable for other investors. LCM does not recommend investing either long or short any position mentioned. LCM may own positions in some of the companies mentioned. Some of its ideas will lose money — investing entails risk. See full disclaimer here.