Motley Fool Hidden Gems Investing - Future Consolidation in Gaming

Episode Date: May 12, 2022

If the consumer economy is going well, why do our portfolios not reflect it? (0:20) Asit Sharma discusses: - Sonos being "underrated" as a business - Revenue growth being Sonos' key metric to watch - Why we keep hammering the point about taking the long view in stock investing (15:30) Jon Quast and Ryan Henderson talk with Reggie Fils-Aime, former president of Nintendo of America, about finding great business leaders and the future of consolidation in gaming. Stocks discussed: SONO, NTDOY, DIS, NFLX, TTWO, ZNGA, ATVI, SNMSF Host: Chris Hill Guests: Asit Sharma, Jon Quast, Ryan Henderson, Reggie Fils-Aime Producer: Ricky Mulvey Engineers: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. Chris Hill. We've got an inside look at the gaming industry and why more consolidation is on the way. Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst, Asit Sharma. Thanks for being here. Asit Sharma. Chris, thank you for having me. Sonos, like most companies, is talking about the impact of supply chain problems, but Sonos' second quarter revenue was higher than expected. The demand for high-end audio products seemingly is there. This morning, you and I were going back and forth. You said

this is a company that you think is underrated. How so? I think that investors have been trained to look for companies that are really, really capital light over the last few years. If you can avoid investing in a manufacturer, do it. Find the equivalent software as a service model, invest in that. It's going to have higher margins. It's a company you'll be able to ride for long-term growth. That all is great in a lower interest rate environment. But as interest rates have ticked up, investors are starting to second guess some of the theses around only owning those fast growers. Just like in real life, if you go to a basketball game, a pro game or a college basketball game, and the best player on

the opposing team has a bad night, everyone is chanting, overrated. But there's no underrated chant. It's not like the best player on your team who's the role player and is having a great night, it's not like everyone jumps up and starts shouting underrated. But sometimes I want to get out of my seat, out of my chair for companies like Sonos and just chant underrated. We're seeing the stock move up today off of, and I've been saying this a lot lately, off of what was a 52-week low earlier in the week. Let me ask you the question I've asked others, do you look at movement like this as enough investors saying, yeah, okay, we get it. Maybe it was overvalued before, maybe it was overrated before, but this is a business making things that

some not insignificant number of people want. We're going to bid this one up. I see that. This is a company that would have increased its top line even more, as you mentioned, if not for constraints. The demand is there. They're just trying to supply as much product as they can. They've run into supply issues in China, as almost every other manufacturer has. but it's also a company that has a phenomenal brand. If you look at charts of home installers, so professional equipment installers, favorite choice for audio equipment for new homes, it's Sonos by a mile, and that beats companies like Apple, like Bose. If you read their earnings call transcripts, management, especially Patrick Spence, the CEO, constantly talks about the fact

that their best marketing is word of mouth. Here you have a product that can shine in all weathers. It is high-end. They have a nice profit profile. It's diminished somewhat this year because they're fulfilling the demand and they're taking a hit to gross profit to do so. But over time, those margins will pop back. You have this dependable high-teens grower. The other thing I like about it is they're still taking on Alphabet's Google in court saying, you stole our technology. So far, preliminary court cases sort of agree with Sonos. There may come a time in the next couple of years where the courts finish their education and say, hey, Google, start paying this company some royalties, which would be a nice add-on to that

margin profile. I wouldn't include that in your investment thesis, but it's an overhang that could be a nice lift for shareholders. That's also there to think about when you consider investing in this company. I'm glad you mentioned Apple, because I don't remember exactly what year it was, but I remember when they came out with their version of the smart speaker, they clearly priced it. Look, Apple, I'm not going to argue with Tim Cook and his team and their strategy of having high-priced products. That has worked out very well for Apple and for Apple shareholders. But I remember at the time talking with analysts at our company saying, boy, I get what they're trying to do. They are going right at the Sonos and the Bose of the world.

And Sonos and Bose, this is all they do. This is their area of expertise. And I think if I'm an Apple shareholder, I'm not banking on a lot of profits off of these high-end speakers because they're going up against really good competitors. You nailed that, Chris. Apple is amazing at product design, but in terms of acoustical design, in terms of being true audio nerds, as are the engineers at Sonos or Bose, they really don't have that element in this product as much as resources they have. They have unlimited R&D, spending budget, unlimited ability to mold a product in a visually pleasing form. But what they lack, I think, is the true passion and audio that this company has exhibited since its inception. The original

founders moved out of that ownership structure, but there are many long-term employees and many members of management who just truly love the product, love to innovate. That's hard to compete against over time if your heart isn't in that space. Apple's heart is phones in those types of devices, and they have gradually let Sonos and Bose and other companies remain competitive and capture more and more market share. Last thing before we move on, what is a metric to watch with Sonos going forward? Yeah, that's a good question. I feel like the best metric to watch here is the most obvious metric, and that's the revenue growth. This is because, again, you go back to what the

quarter could have been if not for supply constraints. They project over the long-term this mid-teens growth, but it potentially is a conservative estimate. If you're a shareholder, I would watch over the next quarter whether they start to lift up that long-term cadence as conditions improve. That will tell you a lot about their ability to be a successful investment because the bottom line is already in place. They've got great unit economics. They keep their overhead to a very disciplined level. I think this more than looking at numbers of products sold or how some of the non-product service type business is doing, is the best metric to look at. Sometimes the biggest metric is the most obvious, but the best. Our e-mail address is podcasts

at fool.com. An e-mail from Mike in Ohio writes, when I drop my son off at school, I have to time my drive so I don't get stuck in the Starbucks drive-through traffic that backs out onto my street. My wife has to time her trips to Target to ensure she can park at least within a quarter mile of the store, and I don't even go to Lowe's or Costco on the weekend anymore because I can't get a cart and I don't want to wait in the checkout line for 20 minutes. I can go on and on, but if everyone is shopping and buying and being good capitalist consumers, why do I feel like the world's falling when I open my brokerage account. Thank you, Mike, for listening and for the question. I think part of what Mike wrote lays out the case for businesses like Amazon that just

delivers stuff to your home. But I get where he's coming from. I had a similar thought yesterday evening just walking around Old Town Alexandria and just seeing the hustle and the bustle of of people in restaurants and shops and just all of this consumer activity going on on a Wednesday night and just sort of thinking to myself along the same lines, like, boy, if all you looked at was the stock market or your individual brokerage account, you would be forgiven for thinking, as Mike says, the world is falling apart. Yeah, it's such an era of cognitive dissonance. we're a consumption economy. By that measure, things look great. I agree. The Costcos of the world, the Targets of the world, they're all very busy. Restaurants, et cetera, we've been

getting out more. There's pent-up demand from the last few years of pandemic. I think you saw this in MasterCard's results because they're a good barometer of consumption and their volume was way up. People want to get out, people want to travel, go to restaurants and spend. I think the dissonance part of it is investors who are like, okay, I know that these companies are going to make more, they're going to rake in more cash because I can see the people too with my own eyes, but I'm worried about what it's going to cost these companies to supply those goods. I'm worried about the rising price of food, for example, which will cut into restaurant margins. I'm worried about the rising cost of gas, which is part of what's

happening in Costco. People always try to get in and get gas from Costco when times are bad, which makes it hard on the shoppers. Worrying about the commodity inflation part of earnings is a large part of what's hitting the market. The other, too, is so much of the market success has been tilted towards those SaaS-type companies and tech companies I was mentioning a few minutes ago. Those are based on future dollars. A lot of them don't have earnings and substantial cash flows now. In a low interest rate environment, folks are okay with waiting for those cash flows to come in. But when interest rates start to rise, inflation starts to rise, the value of those dollars in the future, they don't

look as great versus profits you can get right now from other types of companies. As those companies have sold off, it's dragged the market down, and now we're getting slow rotation into the types of stocks that our listener is talking about. I think Starbucks is a good example of that. They've got other problems, some unionization problems and sketchy management over the past year, but this is one of the reasons that Starbucks is down, say, 40% over the last 12 months. It's because of worries about inflation, rising costs for them. Well, and we were talking earlier about the supply chain. It really does seem like more than, let's just call it the past, most of the past 10 years. And let's just put aside the

pandemic for just a moment. I realize that's a big thing to put aside, but let's just put it aside for the moment. But if you think about sort of the factors that are out of control of any company's management. In the same way that we sort of poke fun a little bit, once a year there will be a big winter storm and retailers will talk about the impact of it. You can always count on at least one company that wasn't really affected by the winter storm, but they sort of throw that in there as one more reason why their quarterly results didn't work. What's happening in China is having a real impact on so many businesses. Eventually, we're going to get past that. You talk about pent-up demand for travel, for going out to restaurants,

that sort of thing. That's another version of pent-up demand, isn't it? At some point, the supply chain is going to be unclogged, and then hopefully all of these businesses that have been rightfully, I don't blame them, rightfully citing the global supply chain as a challenge. Hopefully, they've got all their ducks in a row for when it gets cleared up because when that's no longer an issue, God help the companies that can't perform once that's cleared up. Yeah. That's why there's so much magic in trying to be objective during the pain of a time like this in the markets. Because if you're able to identify companies that are adapting to present conditions and still

investing for the future, you do have some companies that are on sale. I'm fond of pointing out that during recessionary periods, if we do go into recession, some of the greatest companies have come to market because they've been answers to higher interest rate, high inflation environments. Walmart is an example, McDonald's is an example, but it doesn't have to be that model. It could simply be companies that understand, hey, we have to change the the way we work a little bit, shift some things around and be very proactive here. I think what you're pointing out is absolutely true. On the backside of that, you're a more vital company, you're stronger, so the profits start flowing again. That's when, as an investor,

you see the returns on that patience, but it is painful right now. You just got to remember, this is a good time in some ways to invest if you can hold onto stocks as we say ad nauseum here at The Motley Fool for at least a five-year period. I say that with all the love for that concept that I can have, and I do love it. Awesome. Really appreciate the perspective. Thanks for being here. Thanks for having me. It was so much fun, Chris. The gaming industry is bigger than Hollywood, so why aren't traditional media companies making video games. Reggie Fils-Aimé was the President and Chief Operating Officer of Nintendo of America and author of the book Disrupting the Game, From the Bronx to the Top of Nintendo.

Reggie joined John Quast and Ryan Henderson to discuss how he identifies great business leaders, the future of consolidation in gaming, and why a company like Disney has had a tough time jumping into this industry. One of the things that we look for, of course, at The Motley Fool, we're all about investing, finding great companies that we can invest in for the long haul. And as I hear you talk, one of the things that is really rising to the surface for me is the fact that leadership is so important in a company and how the culture is formed and how everyone under the leadership performs and how the business ultimately does. And I'm just curious, maybe an insight from you, and I hate to put you on the spot, but what separates a leader who is

visionary, even thinking outside the box, but it's a good vision, and then a leader who's just going off the rails? What is something that you look for in a leader, maybe something that you admire and other leaders? You know, I believe that great leaders surround themselves with people who bring different points of view, people who are unafraid to challenge the leader's thinking. And it creates an environment where positive discourse is happening, looking at the business, looking at the opportunity from a variety of different ways in order to move the business forward. And I would absolutely agree that the hallmark of not only great companies, but companies that can overcome adversity, companies that can overcome challenges in

the marketplace, typically what you will find is, yes, a great leader, but a great leader that's cultivating a great management team that is driving the execution and is driving that overall performance. So look at the management team. Just don't look at the CEO. Look at the management team. You know, I now serve on three public boards. The other piece I would share from an investor's mentality is look at who's on the board and look at who is active on the board in helping the company make the right strategic decisions in moving the business forward. If you look at a company that has a bit of a paper tiger board, you know, they're not very engaged. It's been the same people for 20 years. You know, you will typically find a company that can get itself into

trouble. I mean, just to pick on one company in the gaming space, look at Activision. You know, the Activision board largely has been the same people for over 10 years. You know, a company that has stumbled on cultural issues many, many times with no apparent reaction or no apparent remedy put forward either by the leadership or the board. And now it's a company that finds itself on the verge of being acquired. Um, and, uh, you know, it's just an example where, you know, looking hard at the leadership, looking hard at, uh, at the board can give you insight as to whether a business is going to be there for the longterm or not. Kind of a follow-up on that. And you talked about the acquisition, uh, or the, the potential acquisition of Activision Blizzard. And we've started to see

a lot of consolidation, I guess, in the video game space. And this is something that John and I have talked about before. I'm curious whether or not you think that's something that's going to continue, whether we're going to see more acquisitions, more bigger acquisitions in the future, or is it potentially a lot of smaller studios? Is there room for that? So, in my view, the answer is both. And here's what I mean by that. I do believe that there will be more consolidation amongst the video game companies, especially as companies make what I would call strategic acquisitions, bringing a critical skill base or a critical capability to the company. Take-Two's acquisition of Zynga is a perfect example of that. Take-Two,

a company with a number of very effective, strongly performing assets, but a company that has not done well in the mobile space. Zynga, very effective in the mobile space. So they're bringing some key capability to a company that has some very strong intellectual property. I do believe there will be those types of acquisitions. However, I also believe that as those acquisitions happen, some very smart, very capable executives, predominantly creators, people in the creative side of these businesses are going to opt to leave and start their own studios. And I believe what this is going to create is a magnificent time where smaller studios are going to be born. These are going to be highly innovative companies, people that are

creating content that's new and different, taking risks, uh, in their content that will bring, um, you know, new innovation into the industry. When you, when you look at some of the top performing games today, like Fortnite, Fortnite, and that battle Royale approach didn't exist five years ago, right? So it's a brand new area that's been brought forward, not only by Fortnite, but other games that are similarly in that space. I think we're on the cusp of that type of innovation again, as senior executives leave some of these mega mergers and go start off their own studios and do things that are unique and highly creative. I have another question. I want to get your take on it. This is another idea that we've

kicked around where I think that there's beginning to be a bit of a blend between traditional linear media and interactive media. I think we saw that with Sonic just released a really good movie. I know that Nintendo has plans for their Mario movie. Is that something that you see maybe these interactive entertainment companies become more entrenched in movies as well? Is there room for maybe traditional ones like Disney to move into gaming? So I'll answer your question in two parts. I do believe that strong IP holders will look to take the franchise in a variety of different places in order to best monetize those franchises. And I see it as three different pillars. There's a physical play or physical manifestation of the intellectual property.

There's the digital manifestation, and then there's the video-based manifestation of that intellectual property. And I do believe effective companies are going to explore all three. I sit on the board of a leading toy company called Spin Master, and their strategy is exactly that, to exploit their world-class intellectual property like Paw Patrol in the video-based space. They successfully launched a movie last year that did incredibly well to leverage it in the physical space, which they've done historically quite well with physical toys for young kids. And now they're exploring how to leverage that in the digital space. So all three are going to come to bear, and it's going to be those companies with great intellectual property that drive that forward.

The second part of your question, though, is if you think about some traditional video-based entertainment companies, what's their ability to enter the digital space? The challenge there is you need to have knowledge and skill in order to do this effectively. Disney, as an example, has been in and out of the video game space for years and years and years. And they got to a point where they were essentially doing deals working with external development partners because their ability to stay on top of development capability within the video game space was just something that they weren't able to do. So I do see that type of activity. Will they themselves recreate an internal studio focused on development for

their intellectual property, I think it's going to be tough. They may do that better by doing a large-scale acquisition and bringing those game development capabilities in-house versus trying to grow it from scratch and do it themselves. Netflix, obviously, is also experimenting in this space. They've done a number of small acquisitions to start building that type of capability. I think that type of execution is certainly possible, but it's going to take time because it's a very different, it's a very different industry. Ask Amazon, who historically has tried to get into the space and only recently has had some success, ironically, with a game that first launched in South Korea and then was tailored for the Western audience. So it's not as easy as

it looks to just say, I want to be a games company and to do that and to do that effectively. Chris Hill. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.