QUALIPORT
Catching A Falling Knife

By Maynard Paton (TMFMayn)
April 12, 2005

Quality companies undergoing temporary problems can become great investments. I should know -- I own shares in Games Workshop (LSE: GAW).

Five years ago, the portfolio watch list member was in all sorts of trouble. The shares, which had been trading at over 800p in 1998, plunged to under 200p following a profit warning in April 2000. What was quite ironic was that in the week preceding the profit warning, I'd been singing the company's praises and was pretty much set to make a Qualiport investment at 315p! Read more | more.

Flushed with embarrassment, I quickly scrapped any idea of a portfolio purchase. Read more.

In October 2000, Games Workshop shares touched 100p. In retrospect, that was the time to buy.

As we'll see, the company had the wherewithal to turn around. By February 2001, signs of a recovery had pushed the shares to 226p. But the Qualiport still wasn't buying.

And between November 2001 and February 2004, the company was reviewed at 512p, 567p, 488.5p, 437p, 653.5p and 715p, and the same conclusion was reached every time: good business, too expensive.

In short, anything up to a potential eightbagger -- during the worst bear market for a generation -- had gone begging.

But so much for the ancient past. Now to last week, when history began to repeat itself and Games Workshop issued -- guess what -- a profit warning…

Having touched 884p at the end of 2004, the shares have slumped this year to 455p. This time I'm not ditching the company. On the contrary, I'm monitoring developments keenly and hoping the portfolio can profit from this falling knife. I've learnt my lesson from five years ago.

Recap

To recap, Games Workshop describes itself as "the largest and the most successful tabletop fantasy and futuristic battle-games company in the world."

The group's major gaming brands are Warhammer and Warhammer 40K. It 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 (319 worldwide), third-party outlets and direct through mail/online order.

Nearly 70% of group sales are generated outside the UK. Alongside products that have proven overseas success, shareholder attractions also include a distinct lack of worthwhile direct competition and plenty of difficult-to-replicate content. For a full explanation of Games Workshop, read this introduction from the 2002 annual report.

Games Workshop floated in 1994 and its financial record until 1999 was excellent:

Year to 31 May	1995	1996	1997	1998	1999
Turnover (£m)	32.1	44.9	58.4	64.8	72.6
Operating profit (£m)	6.2	8.8	10.9	11.7	12.9
Exceptional items (£m)	-	-	-	-	-
Pre-tax profit (£m)	6.0	8.9	11.1	11.5	12.6
Earnings per share (p)	13.1	18.2	22.6	24.1	26.3
Dividend per share (p)	5.2	6.8	8.4	9.0	9.7

(All figures adjusted for goodwill)

But in 2000, the company tripped up. A move to larger premises, the consolidation of various warehouses and attempts to rationalise product lines eventually 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.

After overseeing the company's expansion from 1986 to 1998, Tom Kirby was re-installed as chief executive in late 2000. The company soon turned around, registering record earnings in 2002, 2003 and then 2004. Most importantly for shareholders, Kirby remains in charge today. (I spoke with Tom Kirby and finance director Michael Sherwin in February 2003. Read more.)

Notably, although profits were hit during the troubles, the sales and dividend momentum continued:

Year to 31 May	2000	2001	2002	2003	2004
Turnover (£m)	78.0	92.6	108.6	129.1	151.8
Operating profit (£m)	10.1	11.3	13.8	18.0	20.2
Exceptional items (£m)	(3.3)	(1.9)	-	-	-
Pre-tax profit (£m)	6.7	9.5	13.8	17.9	19.9
Earnings per share (p)	11.8	18.7	29.0	38.5	42.0
Pre-exceptional EPS (p)	20.1	22.7	29.0	38.5	42.0
Dividend per share (p)	9.9	10.5	13.0	17.0	18.8

(All figures adjusted for goodwill)

Among the main positives from Games Workshop's accounts are:

1. Organic growth: Games Workshop's growth over the years has been almost exclusively organic. In the ten years to May 2004, UK store numbers have grown from 65 to 117 and domestic turnover is up from £13m to £48m. In the same time, overseas store numbers (mainly in North America and Europe) have increased from 9 to 193 and associated sales have surged from £16m to £104m.

2. Cash flow:

Year to 31 May	2000	2001	2002	2003	2004
Operating profit (£m)	10.1	11.3	13.8	18.0	20.2
Working capital (£m)	0.9	2.1	2.0	(0.6)	(2.0)
Depreciation (£m)	4.0	4.1	4.8	5.7	6.1
Net capital expenditure (£m)	(4.8)	(3.5)	(5.0)	(8.2)	(13.9)

Over the past five and ten years, aggregate cash absorbed into stock, debtors and creditors has been minimal. On the other hand, cash diverted into capital expenditure has been sizeable. Obviously this has been used to fund the group's store expansion, but it's worth noting that since flotation, the average annual spend on capex has exceeded the reported depreciation charge by 70%.

3. Debt: Although volatile due to seasonal factors, borrowings aren't a problem. Net cash at May 2004 was £8m, net debt at November 2004 was £0.5m and gross interest payments in the most recent half-year were covered thirty times by operating profits.

4. No pension worries: Games Workshop does not operate a defined benefit pension scheme and thus has no liabilities under FRS 17.

Latest warning and valuation

The upshot of the company's business strengths, previous recovery, impressive long-term record, experienced management and solid accounts is that the recent profit alert -- and any further bad news -- could present a buying opportunity.

The key points from the warning issued last week were:

* Games Workshop had experienced strong turnover growth in 2003 and 2004 thanks in part to an association with the Lord of the Rings films;
* Sales growth has slowed as LOTR interest waned, and sales in the UK and Europe during March were well below budget;
* Sales for the year to May 2005 are likely to be down on 2004's £152m, but comfortably ahead of 2003's £129m;
* Profits and earnings per share for the year to May 2005 are likely to suffer a material impact, and;
* The forthcoming final dividend will be maintained.

Previously around the 45p per share mark, broker earning estimates now range centre on 28p for the current year. The full-year dividend will be a fraction under 19p.

Here are three ways of valuing this falling knife:

1. Last time's bargain basement: When Games Workshop stumbled in 2000, the 100p share-price nadir equated to a price to (underlying) earnings (P/E) ratio of 5 and a dividend yield of 10%. (Yes, the shares were that cheap.) A similar rating this time around would mean a maximum buy price of 190p.

But this view could be far too pessimistic. Investors have seen Games Workshop recover once before and, unless another series of catastrophes strike, the market is this time likely to give the shares the benefit of the doubt and factor in a revival.

2. Free cash flow yield: Alternatively, the Qualiport's traditional demand for a 7.5% free cash flow yield can be used. Assuming current-year earnings are reflected as free cash (which generally hasn't been the case at Games Workshop,), a buy price of 373p is derived (28p/7.5%).

3. Recovery valuation: Then again, a recovery valuation may be in order. For instance, if it's assumed:

* It takes four years for Games Workshop's earnings to recover fully and equal the record 42.0p earnings level set in 2004;
* After the recovery, the shares sit on a P/E of 15, and;
* Dividends of 76p are accumulated over that time (i.e. the payout level remains static).

 …in 2009, a share price of 630p (42p*15) could be expected. Combined with 76p of dividends, that would give a total prospective investment of 706p four years out. On these assumptions, buying at 404p could produce a 15% per annum return.

Buy price

The results of the third valuation tally quite nicely with the second and splitting the difference leads to a revised Qualiport buy price for Games Workshop of 389p. At today's 455p, the knife will have to fall further.

Maynard owns shares in Games Workshop.

Portfolio value

Holding	Number of shares	Closing price 11/04/05 (p)	Value (£)
Associated British Ports	681	492.5	3,353.93
Emap	372	845.5	3,145.26
Halma	1,920	159	3,052.80
Johnston Press	1,608	540.5	8,691.24
London Stock Exchange	2,018	460	9,282.80
Cash			207.07
Total			27,733.10