QUALIPORT
Stock Market Lessons From Games Workshop

By Maynard Paton (TMFMayn)
November 19, 2001

Rochester, Kent – Back in March 2000, I put forward Games Workshop (LSE: GAW) as a potential Qualiport company. At the time, the proposal met with widespread criticism. And rightly so, it seemed. Just days after the write-up, Games Workshop promptly issued a profit warning. After being proposed (but not bought) at 315p, the shares then touched 100p in October 2000. However, following some encouraging company results, Games Workshop shares have since surged to 512p.

With Games Workshop's subsequent operational and share price performances in mind, for me, the lessons are two-fold:

* Don't be put off by others when considering an investment:

As Ben Graham says: "Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it -- even though others may hesitate or differ. You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right"

* Companies undergoing temporary problems can make great investments:

I wrote the following October 2000: "The mismanaged franchise type of glitch is my favourite. Find a company that has industry leading products and a great niche, but requires fresh managerial input to get the company back on track. Then wait until the new management's actions start to filter through into the accounts and buy in."

That paragraph describes Games Workshop down to the ground. So not keeping up to date with the company post-profit warning, especially after a recovery was evident, has caused the Qualiport to miss out on some substantial gains.

Warhammer

Established in the mid-1970s, Games Workshop designs, manufactures and sells all the components towards what the company calls "the Hobby". And the Hobby is that of tabletop wargaming. Rather than go over old ground, this feature goes into Games Workshop's business in a bit more detail. But essentially, the long-term attractions to Games Workshop are:

* A distinct lack of worthwhile industry competitors;

* Plenty of difficult-to-replicate creative content, and;

* A product that has proven overseas success (over 70% of group sales are outside the UK) and growth potential;

But while Games Workshop has many attractive business traits, that didn't stop the company tripping up during 1999 and 2000. A move to larger premises, the consolidation of various warehouses and attempts to rationalise product lines led to numerous operational problems. On top of that, Games Workshop also faced the Pokemon phenomenon, which became a major, if short-lived, distraction to its young customer base.

The five-year record of Games Workshop shows the financial impact of the problems:

To 31st May                1997     1998     1999     2000     2001
Turnover (£m)              58.4     64.8     72.6     78.0     92.6
Operating Profit (£m)      10.9     11.7     12.9     10.1     11.3
Exceptional Items (£m)        -        -        -     (3.4)    (1.9)
                           ----     ----     ----     ----     ----

Pre-tax Profit (£m)        11.1     11.5     12.6      6.7      9.5
        
Earnings per share*(p)     22.6     24.1     26.0     20.2     22.8
Dividend per share (p)      8.4      9.0      9.7      9.9     10.5

(*adjusted for goodwill and exceptional charges)

Hampered by expenditure to improve the company's logistics, operating profits for 2001 were barely ahead of those reported in 1997. In the early 1990s, the company was regularly registering double-digit profit growth and 18%-plus operating margins. The test for the company now is to raise operating margins from their present 12% back to their historical level.

However, while profits have stagnated, the popularity of the company's products never waned during the troubles. After reporting sales of £10.6m in 1990, turnover has since increased every year, compounding at an average of 24% per annum. Significantly, that performance has been entirely organic. What's more, the opening of overseas stores has been the main driver of growth. Since 1996, European turnover has doubled to £29.5m, while North American turnover has nearly quadrupled to £32.0m.

Cash flow

To 31st May                1997     1998     1999     2000     2001
Operating Profit (£m)      10.9     11.7     12.9     10.1     11.3
Change in                                                           
working capital (£m)       (0.1)    (4.1)    (0.1)     0.9      2.1        
Depreciation (£m)           2.3      2.7      3.4      4.0      4.1
Capital expenditure (£m)   (6.3)    (8.0)    (3.9)    (4.8)    (3.5)

Games Workshop's cash flow profile has been somewhat volatile in recent years. A build up of stock in 1998, resulting in £4.1m being absorbed into working capital requirements, heralded the operational problems that were to follow. However, over the past five years, just 3% of operating profits have, on average, been absorbed into working capital.

During 1998, cash flow was also constrained by significant fixed asset expenditure to consolidate the group's office and warehouse operations. With all the extra stores, new offices and relocated distribution centres, capital expenditure has averaged 1.6 times the annual depreciation charge since 1996.

The downturn in profits has obviously hit shareholders' returns. Since May 1996, Games Workshop has retained £17.4m of earnings, while spending another £3.9m on an exceptional restructuring. Over the same timescale, pre-exceptional earnings have increased by just £1.4m to £7.1m. Thus, the incremental return on shareholders' equity is just 6.75% ((£1.4m/(£17.4m+£3.9m)).

However, it should be noted that Games Workshop has historically generated very attractive returns for shareholders. For instance, between the go-go years of May 1994 and May 1999, the incremental return on equity comes to about 25%. Taking the 25% figure as the company's best, and the recent 6% performance as the company's worst, you could say Games Workshop averages a decent 15% return on reinvested profits. Furthermore, this accomplishment is unaided by any long-term debt.

Recent developments

With the latest full-year results highlighting 18% sales growth and the near completion of the company's restructuring programme, it's no surprise that Games Workshop's management believe the prospects for the business are "very good".

Alongside greater international expansion, further product innovation and the exploitation of the company's intellectual property by way of online computer games, perhaps the most exciting current development is the tie-up with the upcoming Lord Of The Rings film. Whilst the exclusive five-year license to manufacture and retail LOTR models may not be a money-spinner in itself, the film and its products should increase the awareness of Games Workshop's similar offerings.

In terms of valuation, Games Workshop shares are not cheap. Assuming maintenance capital expenditure is 1.3 times the depreciation charge, at 512p, the shares offer a trailing free cash flow yield of 4.4%.

If you want a real chance of doubling your money over five years (which the Qualiport aims to do with every investment it makes), at 512p, you have to believe Games Workshop shares will retain their present premium rating in 2006 with the company putting in 15%-ish annual earnings growth in the meantime. That's a relatively tall order. All things considered, a share price below 350p would attract the Qualiport's interest.

More: Games Workshop discussion board | Qualiport discussion board

The author owns shares in Games Workshop.