QUALIPORT
The Gods Of War

By Maynard Paton (TMFMayn)
August 1, 2002

Games Workshop (LSE: GAW) is a fantastic little business. Capitalised at just £150m, the Qualiport watch list company is the dominant player in the niche world of 'wargaming'. Annual figures on Tuesday showed significant profit and operational improvements. For those with a penchant for small company growth stories, the company is well worth monitoring.

The business

The key investment features of Games Workshop are:

* In its own words, Games Workshop is "the largest and the most successful tabletop fantasy and futuristic battle-games company in the world."

Games Workshop's major gaming brands are Warhammer and Warhammer 40K. The group designs, manufactures, distributes and retails all the components that make up its various games, including a vast array of miniature soldiers, paint, rulebooks and associated novels and comics. The products are sold via the company's own stores, third party outlets and direct through mail/online order.

Nearly 70% of group sales are generated outside of the UK. Alongside products that have proven overseas success, shareholder attractions include a distinct lack of worthwhile direct competition and plenty of difficult-to-replicate content.

In a superb effort, Games Workshop has already published its full 2002 annual report on the company website. Contained within the report is an introduction to its business, which explains its operations in more detail. The text also addresses some of the misconceptions about its inherently niche industry.

* Games Workshop has had its problems. During 1999/2000, a move to larger premises, the consolidation of various warehouses and attempts to rationalise product lines led to numerous operational difficulties. On top of that, Games Workshop also faced the Pokemon phenomenon, which became a major, if short-lived, distraction to the company's young customer base. Games Workshop embarked on a costly restructuring programme to get back into shape, the fruits of which are shown in the latest preliminary figures.

The financials

Here's the five-year record of Games Workshop:

Year to May 31st          1998     1999     2000     2001     2002

Turnover (£m)             64.8     72.6     78.0     92.6    108.6
Operating profit (£m)     11.7     12.9     10.1     11.3     13.8
Exceptional items (£m)       -        -     (3.4)    (1.9)       -
Pre-tax profit (£m)       11.5     12.6      6.7      9.5     13.8

Earnings per share* (p)   24.1     26.0     20.2     22.8     28.2
Dividend per share  (p)    9.0      9.7      9.9     10.5     13.0

(*Before exceptional items. All figures adjusted for goodwill)

Tuesday's figures showed underlying sales rising 16% to £108m, operating profits increasing 23% to £13.8m, earnings per share improving 24% to 28.2p and the dividend jumping 23% to 13.0p per share.

Growth was experienced throughout all of Games Workshop's global operations. Improvements stemming from the restructure programme and interest kindled by the company's Lord Of The Rings products supported the progress. During a year when no new domestic company-owned stores were opened, UK sales surged 18%. Notably, sales from North America improved 4% and "confirmed the Hobby is relatively immune from local economic conditions". Continental Europe registered sales growth of 30%.

Although the logistical improvements have now been completed, Games Workshop's operating margin still remains at a historically low level. At 13%, it's still somewhat below the 17%-plus level regularly witnessed pre-2000. It remains to be seen if Games Workshop can regain those chunky margins.

Cash flow and ROE

Although the record is complicated by the operational hiccups, the latest annual figures highlighted Games Workshop's attractive cash flow characteristics:

Year to May 31st          1998     1999     2000     2001     2002

Operating profit (£m)     11.7     12.9     10.1     11.3     13.8

Change in
working capital (£m)      (4.1)    (0.1)     0.9      2.1      2.0 

Depreciation (£m)          2.7      3.4      4.0      4.1      4.8
Net capital
expenditure (£m)          (8.0)    (3.9)    (4.8)    (3.5)    (5.0)

In terms of capital expenditure, the last four years has seen depreciation largely match the money spent on fixed assets. Indeed, as this study shows, being able to generate a £13.8m operating profit from fixed assets of around £15m does indicate Games Workshop has a great reliance on precious intangibles.

Since floating in 1994, net cash absorbed into working capital has been negligible. In addition, it's worth noting that the overstocking of 1998 (in retrospect, a forewarning of the troubles to come) has gradually unwound. The table below shows how the management of working capital has improved over the past few years:

Year to May 31st          1998     1999     2000     2001     2002

Stock days                 111      134      122      105       92
Debtor days                 30       26       21       19       18
Creditor days               74       67       54       49       51

Furthermore, such was the cash generation during fiscal 2002, Games Workshop spent £9.5m buying back 6% of its own share capital. Indeed, 681,500 shares were purchased in April for 600p each, a value 23% higher than today's share price.

Over the seven years ending May 2002, Games Workshop has increased its earnings by £4.9m. During the same period, the company's asset base has increased by £22.1m (adjusted for exceptional expenditure). The resulting incremental return on equity comes to an attractive 21.9%. This performance has been without the aid of substantial debt. Over the years, Games Workshop has generally operated with a net cash position, the bank balance being a net £6.6m (22p per share) at the start of June 2002.

Summary and valuation

Games Workshop is a great example of a mismanaged franchise come good. The logistical and management problems the company suffered were eminently solvable. The fact that sales continued to rise throughout the troubled 1999/2000 period suggested Games Workshop's popularity with its customers had never diminished. Anybody getting in when the shares touched 100p in late 2000 has since quintupled their money. But the turnaround is in the past. Games Workshop is now fighting fit.

At 488.5p, Games Workshop shares are no bargain. Assuming the 2002 performance is repeated in the current year with the reduced number of shares in issue, Games Workshop shares are presently valued on free cash flow yield of 5.9%. Assuming the £6.6m net cash can be deemed 'excess', an entry price of 404p is required for investors demanding a 7.5% free cash flow yield.

More: Stock Market Lessons From Games Workshop

The author owns shares in Games Workshop.