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Games Workshop design, manufacture and sell all the components towards what the company calls "the Hobby". And the Hobby is that of tabletop wargaming. Within the games, players take control of individual characters or armies, and continually fight battles against enemy battalions to achieve a predetermined end goal. The Hobby has two main games: Warhammer, the theme of which contains characters and locations you'd probably find in any book from J.R.R. Tolkein, and Warhammer 40K, a sort of "Killer Hobbit In Deep Space" type contest.
A few quotes from the management.
Revenues have grown each year throughout the last decade, from £10.6m recorded in 1990 to £72.6m in 1999. Here's the record of the last five full financial years.
A great compound record overall, but keen-eyed readers will spot a noticeable slowdown after 1997. More on this important point later. One significant feature of the record is that all the historic growth is organic. Apart from two immaterial acquisitions in 1999, Games Workshop has had no recourse to look for corporate purchases to help secure and consolidate its industry position. That is extremely good news.
Up until 1997, everything was rosy, with chunky equity returns and minimal working capital absorption compared to profits. But all that changed during 1998. The strength of sterling put a dampener on the fast-expanding international sales run. At the same time, the company underwent a move to new premises. The relocation -- operating hiccup number one -- required a large one-off fixed asset outlay and a significant case of pre-move stock building.
Hiccup number two came at the interim stage between 1998 and 1999. The expected post-relocation stock clearance didn't materialise, but instead stock levels rose again. Of course, ballooning stock levels without a commensurate sales increase usually means underlying trading trouble. After a sigh of relief was felt from the full year results of 1999, where stocks were held level, hiccup number three came with the latest interim numbers last January.
The late entry is Games Workshop (LSE: GAW). I know I'll receive one or two groans from certain Qualiport discussion board regulars, but having looked at a few of the quite possible Qualiport candidates and many other "so-so" companies, I feel Games Workshop merits a look.
As I mentioned on Wednesday, Games Workshop have endured an operational hiccup. Well, three hiccups in fact. With a lot of despondency surrounding the company, the shares collapsed from 858p in 1998 to 315p today. The company may have been irrationally marked down. Games Workshop, if or when they get on back onto their historic growth performance, and could well be an exciting mix of a "turned-around" long-term growth stock.
And just like the MMT Computing feature, I have to own up and state that I own Games Workshop shares. Again, readers should be aware of possible rose-tinted statements!
The Warhammer Business
Having played some similar games many, many years ago, I think I have a basic understanding of the products. The games may be complicated to comprehend, but the concept of rolling dice and playing with miniature soldiers is not a difficult one. It's not as if we're talking about genomics or esoteric Internet incubators here. Games Workshop pass the "a company that you understand" hurdle.
Games Workshop produce all the soldiers, paint, rule books and even a monthly magazine for their games. The products generate a fair bit of repeat purchasing. The UK accounts for 40% of total revenues, with the remainder largely split between continental Europe and the US. The products are sold through independent retailers (48%), the company's own stores, or "Games Workshop Hobby Centres" (43%) and mail order (9%). Growth has stemmed from increasing the number of stores worldwide (221 at November 1999) and from expanding the range of products sold.
The beauty of Games Workshop is that the company is unique. There is, to my knowledge, no other worthwhile direct competitor. Certainly in the UK, I've not come across any other retail chain that sells its own brand of wargames. The impression that I have got from the Games Workshop discussion board is that Games Workshop is without direct competition. Indeed, posters on the Games Workshop board have commented that the company "is the Microsoft (Nasdaq: MSFT) of war gaming" or it's the "number one in a field of one". As a characteristic of a company, surely having no competition must be the greatest investment "must have" of them all?
There are two reasons that I believe Games Workshop passes the Qualiport's "sustainable competitive advantage" hurdle. Firstly, all the "creative" content of the games took years to develop. Any new industry player would have to produce something from scratch, and something totally differentiated from the Games Workshop product. Secondly, Games Workshop products are unlikely to be "transferable" to any rival's offering. So customers who've spent a lot of time, money and effort collecting and developing Games Workshop soldiers are unlikely to drop everything they've already bought at a drop of a hat for any rival's game. All in all, I feel any new industry entrant would have a rather difficult task to establish itself in a meaningful way, let alone establish itself as the market leader.
And if there's no direct competition who constantly move the industry goalposts from one day to the next, there's a good case for Games Workshop having "predictable" earnings. As for the "strong brand name" hurdle, I'm not sure. But one thing I have discovered from the Foolish discussion boards is that I've only come across two companies that, although having no US listing, do attract messages from American Fools. One is Games Workshop, the other is Manchester United (LSE: MNU). So there's recognition of the brand away from these shores, which is unusual for a company valued at just £100m.
Identifiable growth prospects
August 1998: "The board believes that there remains scope for significant long term organic growth for the business... The outlook continues to be very good. As each year goes by our faith in the Hobby and the methods we use to introduce and retain enthusiasts around the world is strengthened. The march towards total global domination goes on."
January 1999: "The Games Workshop Hobby remains undiminished and... there is huge potential in overseas markets."
August 1999: "The Hobby continues to grow strongly. The test is whether Games Workshop can continue to serve it -- and it seems to me that the prospects for the business... are as gloriously rich as ever".
August 1999: "The UK is our most developed territory and we use this to judge just how far we have got to go in all the others. Against this measure the US operation is currently operating at one fifth potential and the German operation at one quarter".
(Using financial 1999 figures, and supposing Germany reflects Europe as a whole, this statement implies an extra £136m of revenues could be at hand from the US and Europe, as opposed to current group revenues of just £72m. Obviously, as sales in the "benchmark" UK increase, as they have done after the statement, so the overseas potential increases too).
August 1999: "We are especially pleased with the progress of our Internet activities where we have seen our Internet sales more double (to £1m) in the period. We believe the Internet represents an extremely exciting opportunity for Games Workshop given our customer profile." Martha who?
No problems in this department, I feel.
Financial Record
To 31st May 1995 1996 1997 1998 1999
Turnover (£m) 32.1 44.9 58.4 64.4 72.6
Operating
profit (£m) 6.2 8.8 10.9 11.7 12.8
Earnings per
share (p) 13.1 18.2 22.6 24.1 26.1
Turnover
growth (%) 31.0 39.9 30.1 10.3 12.7
Earnings
growth (%) 23.6 38.9 24.2 6.6 8.3
Operating
margin (%) 19.3 19.6 18.7 18.2 17.6
Unlike a few other companies I've looked at recently, there's no worry that an acquisitive strategy is masking the signs of a poor corporate performance. With the proviso of the operating hiccups, Games Workshop pass the "company that has a proven growth record" criteria, and with operating margins at 17%, the "strong margins" hurdle is cleared as well.
When we turn to return on equity and cash flow, the financial performance becomes a little murky.
To 31st May 1995 1996 1997 1998 1999
Earnings (£m) 4.0 5.7 7.1 7.5 8.2
Shareholders' Equity 6.7 10.4 14.0 18.3 23.5
Return on average 66.3 57.4 46.3 39.2
equity (%)
1 year incremental 45.7 36.9 11.2 13.6
ROAE (%)
3 year incremental 50.3 41.3 23.1 12.5
ROAE (%)
Change in working (0.5) 0.4 (0.1) (4.1) (0.1)
capital (£m)
The slowdown in profit growth coupled with the fixed asset and stock increase in the equity base has led to the deterioration in equity returns. Whereas the return on average equity for financial 1999 is still near 40%, looking at the incremental returns of late, it's easy to see how Games Workshop have lately been reinvesting their profits at mundane rates of return. Overall, there are no bouquets for recent equity returns and cash flow performances.
Problems, problems
Games Workshop imposed an exceptional charge at the latest interim stage, the half year to last November, providing for a restructuring programme. The overstocking from prior years appeared to have been a more fundamental business problem, rather than purposeful stock building in the run up to the premises change.
According to the company: "We have suffered from our sales companies, manufacturing and distribution activities being out of step. This has caused stock shortages... resulting in lost sales. This inadequate supply has at times triggered excess stock building."
A £5.2m charge is to be spread over two years (£1.9m in the half year to November 1999, £2.5m in the half year to May 2000, the rest in the year to May 2001) to accommodate the restructuring process. Annualised benefits from the streamlining of £2m-£2.5m should be felt by 2002. To put that into context, the latest full year profits were £12.8m.
With Games Workshop, I can't help thinking about my investment resolutions made at the start of the year. I wrote: "My resolution -- to realise that quality companies undergoing temporary problems can make attractive investment propositions". Guess which company I was talking about then!
The group has two major positives -- scope for organic growth and a sustainable competitive advantage. The trouble is all the problems, impacting the financial performance of the company, that lie firmly at the door of the management. There has been a boardroom shake up and other external managers are being drafted into the company, but questions could be asked of the overall directors' talent to lead a small business evolving into a big business. There are also question marks over the "exceptional" charges. Are Games Workshop writing off stock or other unrelated charges in a "big bath" provision? And will the expected benefits all come through anyway?
On Wednesday, I'll go into more detail over the current valuation of Games Workshop, while trying to elucidate further on the prickly subject of the restructuring and the management. And then there's the potential for intellectual licensing income at the company as well.
In the meantime, you can let me know your thoughts over on the Qualiport discussion board.
Related Links
• Games Workshop website
• Games Workshop discussion board
• Investment Resolutions
• Incremental Return on Equity
Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.