Can Nintendo Rebuild?

Over the past few years, when it was racking up record profits and crushing its rivals in the video game industry, Nintendo often drew comparisons to Apple (APPL). The two had gone against the conventional wisdom to create gadgets and software that consumers couldn't seem to get enough of.

But these days Nintendo is hurting. On Oct. 29 the Kyoto company reported weaker-than-expected earnings for its fiscal second quarter ended Sept. 30. Nintendo also revised downward its forecasts for the fiscal year ending March 2010, saying it expects to sell fewer Wii living-room consoles and game software this year than it had previously thought. A day later, Nintendo President Satoru Iwata told financial analysts and journalists that the company had been unprepared for the sudden drop in sales of its Wii living-room game console. "We sensed that the market mood was cooling off in the spring," he said. "But frankly, we hadn't expected to get as bad as it did by summer." In the past six months the stock has slid 22%

The global financial meltdown and a dearth of hit games have had a chilling effect on the industry's results. In August, Sony (SNE) and Microsoft (MSFT) lowered the price of their machines to spur sales. Nintendo, whose own console sales were flagging, responded with a 20% price cut of its own for the Wii. That move, say analysts, weighed on the company's profits. In the July-September quarter, Nintendo's operating profit dropped 52%, while sales slid 28%. Nintendo now expects full-year profits of $4 billion on $10.9 billion in sales, instead of $5.4 billion in profits and $19.7 billion in revenues. Last fiscal year, the company had its best year ever, raking in profits of $6.1 billion on revenues of $20.1 billion.

Crucial Holiday SeasonThe yearend holidays will be a crucial test for Iwata & Co. Last year, the October-December quarter accounted for a third of Nintendo's revenues and nearly half of its operating profits for the entire fiscal year. Nintendo will need to reverse slowing Wii sales. The DS portable console and Wii are the best-selling machines of their class. Nintendo has sold more than 56 million Wii consoles since November 2006 and 113 million DS machines since late 2004. In the latest quarter, Nintendo sold fewer than 5.8 million Wii machines, down from 10.1 million in the same period the year before. (Sony sold 3.2 million in the quarter.) DS sales dipped, too.

In the coming weeks Nintendo is planning to launch a slew of products. It's introducing a larger portable machine with two 4.2-inch screens, known as the DSi LL, next month in Japan, and at least two additions to its popular Mario and Zelda series will be in stores worldwide by late December. "What's key for the Wii is that sales of popular games, such as Wii Sports Resort and Wii Fit Plus, stay strong," Iwata said.

Recently, Nintendo has been working with museums, malls, and fast-food chains to set up Wi-Fi hotspots and location-specific services for the DS. What else might Nintendo try? Analysts say that with sales in decline, Nintendo is likely already at work on new consoles. "Because of the Wii's rapid slowdown, we assume a new version of the console will be released in 2011," Citigroup Global Markets analyst Soichiro Fukuda wrote in an Oct. 29 report.

Before that, Nintendo could make modifications. It could, for instance, redesign the Wii to play high-definition videos on Blu-ray discs or beef up its online offering so Wii owners can download movies and TV shows from an online servicesuch as Netflix. Rumors abound that Nintendo is already negotiating tie-ups. The company might also equip the portable DS console with wireless technology that connects the gizmo to 3G mobile networks so users can download e-books or access social networking sites.

Free Online GamesNintendo will have to do something soon. In a direct challenge to Wii's unique features, Microsoft and Sony are gearing up to sell motion-sensing handheld controllers for their consoles as early as next year. Nintendo has a formidable new rival as well: Apple. Apple's presence in portable gaming continues to grow, thanks to big-name game publishers and independent developers that have jumped at the chance to create games for an estimated 50 million iPhone and iPod Touch users. Apple's online App Store now boasts thousands of games—hundreds of which are free. Besides Apple's offerings, players can find numerous other free and low-cost online games for PCs.

In a recent study, market research firm NPD Group found that iPod and iPhone owners were buying just two out of every 10 games they were downloading. And few who tried games that could be upgraded for an extra charge did so. That has ramifications for the entire industry, says NPD analyst Anita Frazier. "I can't help but think that the explosion of free gaming options is exercising at least a slight downward pressure on pricing for gaming," she wrote on her company's blog.

In the Oct. 30 press conference, Iwata betrayed a touch of annoyance at questions suggesting that Sony or Microsoft would suddenly lure away Nintendo's audience or that Apple's low-cost gaming model would make people any less willing to pay, on average, $50 for a Nintendo game. "I don't understand how people can say that Nintendo will lose its advantage just because other companies are working on their own motion-sensing controllers," Iwata said. "If it's so simple, shouldn't there be a ton of games like Wii Sports available for the Wii? So why aren't there more?"

Before it's here, it's on the Bloomberg Terminal.