QUALIPORT
The Market's Best Small-Cap Growth Share

By Maynard Paton (TMFMayn)
July 31, 2003

Valued at £195m, Qualiport watch list company Games Workshop (LSE: GAW) is probably the best small-cap growth share on the market. Not only does the firm have a dominant position in the world of tabletop battle-games, Tuesday's preliminary results showed profits up 30% and a company firing on all cylinders. Furthermore, comments within the statement and the full annual report (commendably published on Tuesday morning, too) emphasised a sensible and straightforward management team focused on building long-term shareholder wealth.

(Refreshers on Games Workshop's business and investment quality can be found here, here and here.)

Five-year record

The table below summarises Games Workshop's financial performance since 1999:

Year to June 1st          1999     2000     2001     2002     2003

Turnover (£m)             72.6     78.0     92.6    108.6    129.1
Operating profit (£m)     12.9     10.1     11.3     13.8     17.9
Exceptional items (£m)       -     (3.4)    (1.9)       -        -
Pre-tax profit (£m)       12.6      6.7      9.5     13.8     17.9

Earnings per share* (p)   26.0     20.2     22.8     29.0     38.5
Dividend per share  (p)    9.7      9.9     10.5     13.0     17.0

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

Turnover jumped 19% to £129m during the twelve months to June 1st 2003. An additional 28 stores, which took the worldwide total to 278, helped the top-line momentum. Progress was particularly buoyant on the Continent, where revenues surged a staggering 37% to £50m. The UK didn't do too badly either, with turnover up 21% to £39m.

Supporting the domestic improvement was a third-party serialised gaming supplement entitled Battle Games in Middle Earth, which prompted a sales bonanza for Games Workshop's Lord Of The Rings products. Commendably, Games Workshop warned that an element of these UK sales "could represent a 'bubble' effect which may not be sustainable in the future". An improvement in operating margins, from 12.7% to 13.9%, helped operating profits soar 30% to £18m. Earnings per share improved by a similar factor, to 38.5p.

Cash flow

Tuesday's statement indicated no real problems with cash flow:

Year to May 31st          1999     2000     2001     2002     2003

Operating profit (£m)     12.9     10.1     11.3     13.8     17.9

Change in
working capital (£m)      (0.1)     0.9      2.1      2.0     (0.6)

Depreciation (£m)          3.4      4.0      4.1      4.8      5.7
Net capital
expenditure (£m)          (3.9)    (4.8)    (3.5)    (5.0)    (8.2)

There were no issues with working capital, though capital expenditure ran ahead of depreciation -- and will continue to do so over the next few years -- as Games Workshop builds the infrastructure for future growth. However, as this study shows, being able to generate an £18m operating profit from fixed assets of around £17m indicates Games Workshop has a relatively heavy reliance on precious intangible assets.

The cash flow performance allowed the full-year dividend to improve 31% to 17p per share, while net year-end cash stood at nearly £12m (or 39p per share). On the subject of excess cash, chairman Tom Kirby had this to say in the latest annual report: "Our owners, quite rightly, ask from time to time what we intend to do with their cash. All the cash we generate belongs to our shareholders. Our attitude to that cash is as owners. Simply put: if we can't use it to generate better returns than the average over the long-term then we should hand it over." Good to hear.

Games Workshop's incremental return on equity remains impressive. In the five years to June 2003, earnings have improved by £4m while the equity base has grown by £17m, giving a profit reinvestment performance of 23%. The equivalent figure since 1995, the company's first full year as a listed company, is a sound 26%

Summary and valuation

Following the latest results, it's difficult to believe Games Workshop was undergoing a variety of operational problems three years ago. But changes to the boardroom presaged a two-year restructure and the group is now firmly back on track. Looking ahead, what counts is whether the company can sustain the momentum.

Certainly the management think the prospects for business remain good. Tom Kirby noted on Tuesday that Games Workshop should deliver "linear growth in sales and profits" in the current year. In addition, Games Workshop continues to provide a 'rough indication' of its future potential. If the company's international markets could sell the same volumes per head of population as that presently seen in the UK, then Games Workshop has global sales of £400m to aim for. Having only 54 company-owned stores at the moment, the US in particular offers great promise.

Unfortunately, the market has cottoned on to all the positive developments. At 653.5p, Games Workshop shares offer a historic free cash flow yield of 5.4% (assuming maintenance capital expenditure is 25% higher than the depreciation charge). Demanding a 7.5% historic yield therefore requires a 467p buy price. If free cash were to expand by 20% in the current year, the forward free cash flow yield comes to 6.4%.

Finally, the last word goes to chairman Tom Kirby. Taken from his 2003 annual preamble, this extract should comfort all buy and hold investors: "We are running this business for the very long term. We expect it to be there so it can pay into our children's pensions. We will never do anything in order to improve our share price that is not in the long-term interests of the business. Not only do we believe this is the best way to build a business, we also believe it is the best way to enhance shareholder value over time."

More: Qualiport Meets Games Workshop | Games Workshop 2002 | Stock Market Lessons From Games Workshop

The author owns shares in Games Workshop.