Nihon Falcom:
Small Cash Rich Niche Video Game Developer

Introduction:

Nihon Falcom was founded in 1981 and is a small video game developer in Japan. Nihon has been growing its highly lucrative license revenue since 2011 at a 25% CAGR. Nihon’s business strategy is to develop video games creating memorable characters, music, and stories. They then license this created IP from the video games to various platforms, media, goods, services, etc. The licensing revenue is extremely profitable too. The company is trading close to cash or 5 times normalized earnings ex-cash most likely due to seemingly flat revenue and historical conservative management. I think the company is poised for significant upside with very little downside.

Currency Blurb

The company does most of its business in Japanese yen. The yen has done poorly against the dollar over the past year. The yen is now very undervalued against the dollar. According to the Big Mac Index, the yen is now 42% undervalued against the dollar. This creates an extra opportunity in the investment if you’re a US dollar investor to benefit from currency appreciation over time. Japan is also a current account surplus nation which also is a long-term benefit to the currency. 

History

An excellent documentary on Nihon Falcom came from the YouTuber Bowl of Lentils (Link). To summarize, Nihon Falcom was founded by Masayuki Kato in 1981. Masayuki Kato is still involved with the company to this day on the board. The company was one of the first to develop an RPG game in Japan. With the release of one of the most popular video games in Japan in the 80s, Dragon Slayer. Nihon’s two most popular game franchises currently are the Ys and The Legend of Heroes franchises. Both these video game franchises were born in the 80s and have a long storied history. 

In 2009 management had a bad game release where their two distributors dropped them which resulted in a bad year financially. Even in their worst year, they were still profitable. This event scarred management and made them become very conservative keeping a high cash balance and no debt. Conservative management isn’t a bad thing however and the financial results have been fantastic for the company since 2009.

Financials

Nihon product revenue has been quite volatile over the years ranging from ¥2B to ¥700m. However, the licensing revenue has been growing very nicely. Over the past 10 years licensing revenue has increased at a 27% CAGR and over 5 years at a 15% CAGR. Also licensing revenue seems to be more stable than product revenue. 

Revenue has kinda been flat since 2014. This is mostly due to the volatile product revenue. However, now that license revenue makes up the majority of revenue I do see an opportunity for growth to start occurring.

Also license revenue is way more profitable than product revenue. As licensing revenue has increased from 2014 from 25% of sales to 73% of sales in 2021. Profit margins have followed suit 30% to 40% in the same time. These margins are some of the highest in the video game industry.

The company’s cash balance has increased quite a lot over the years as the company is quite conservatives and only pays a small dividend. The company’s market cap is only 12B while the cash balance sits at 7.1B. With no debt on the balance sheet and the extremely high cash balance, Nihon has a beautiful balance sheet and would almost be considered a graham net net. 

The most important financial metric is ROIC or return on investment capital which measures how well management is running the company and also how good the industry the company is in. 

ROIC for the company clocked in at 90% in 2021 which is very high and represents a very strong business. Average business typically only have a 10% ROIC for example. As license revenue has increased so has ROIC which was only 44% in 2014. Still great though.

The only negative for Nihon is their revenue growth which may be changing in the future.

Future

In December 2021 management put out a medium-term plan presentation(Link) which hinted to be more aggressive in the future. The company also had a shareholder meeting that had some interesting tidbits as well(Link).

Below are the highlights from that presentation 

1. They intend to start releasing more than 1 new game a year. They have been only making 1 new game a year since 2013.
   
2. Plans to create a new game IP. All of their releases in the past decade were from the same franchises.
   
3. In the past, the company has focused development on a single platform. In the future, they intend to develop games on multiple platforms.
   
4. Nihon has a large cash balance and the company has said it may be interested in buybacks.
   
5. Increasing revenue from countries outside Japan. From 2020 to 2015 revenue outside japan was only 20% of total revenue. This is an easy place to grow revenue in the future. Revenue outside Japan for 2021 was over 40%.

I noticed a slide in the company’s presentation showing them hiring a steady amount of new employees over the past five years. They went from 46 employees in 2016 to now 63 employees in 2021. This is probably the best signal that management isn’t just talking but intends to follow through on these plans of expansion.

Game Releases

Financial performance isn’t everything, it’s also important for Nihon to be releasing quality products. Looking at the past 5 years of releases the company has produced 5 straight well-reviewed games. Nihon Falcom has been on a steady one-game-a-year release schedule since 2013. I looked at both Steam reviews which are for PC versions of their games and also the Amazon Japan reviews mostly for PS4 versions of the game. The company usually releases a game onto a single platform, usually the PS4. Recently they have started releasing on the PS5 and the Nintendo Switch as the PS4 is outdated. Also, they partner with other companies to produce ports of their games to other platforms. 

The fact that Nihon has been able to create consistent quality in the video games it produces speaks to the quality of management. 

Insiders

In total insiders own over 26% of the company. This provides good incentives for management. The founder is still involved with the company on the board however the day-to-day operations are done by the CEO. The current CEO Toshihiro Kondo was a fan of the games Nihon Falcom was putting out. He started a fan website before starting at the company. He worked in various positions in the company before eventually being given the CEO role. The documentary I linked to above seems to highlight him as pretty good.

Risks

The main risks for the investment are capital allocation decisions of management and the execution of future video game titles.

Capital Allocation

The company has a very large cash pile. If used correctly this could be a big source of future value for the company. If used incorrectly the company could be considered fairly valued. The company looks to be wanting to expand development in the medium term so we’ll see if management is a strong or poor capital allocator. 

Execution

The video game industry is highly dependent on being able to produce a hit. And Nihon Falcom is no exception. A bad couple of years with subpar game releases would be detrimental to the company’s performance. However, the company has a large cash balance to weather a storm. Also, the company has produced five straight games that were received well. 

Valuation

The company is currently trading at 15 times 5-year average earnings. This is an average video game company with multiple movies. The value of the company comes from the cash which makes up 60% of the market cap. Once you ex cash out of the market cap the multiple becomes 6 times 5-year average earnings. This makes the company one of the cheapest in the video game space.

Nihon Falcom Valuation 

I think this severe undervaluation in the market could be due to the market assuming the cash won’t be used effectively, flat future revenue growth, or earnings not being sustainable.

Even then though the company is too cheap. Within the next five years if the company can at least perform at a similar level Nihon will have more cash than the value of the entire company. So risk seems very limited. And if anything goes right in terms of the company’s medium-term plan there could be a big upside. 

Conclusion 

Nihon is a small video game developer trading at 5 times normalized earnings ex-cash. The company has flat revenue growth through 2014 but underneath licensing revenue has been growing at a fast clip. Management has announced more aggressive growth plans so revenue should start to increase going forward. Due to the high cash and high profitability, the company may have more cash than the market cap within 5 years. So risk seems very limited. And if anything goes right there could be a big upside.