Games Workshop drops its fantasy valuation


One of the more unusual investment themes of recent times has been the rise of non-fungible tokens (NFTs). Many commentators have derided the $41bn (£31.5bn) spent on them in 2021, but for those in the know the value was clear. It was – and still is – a matter of community. If you owned an NFT, it gave you the right to attend events with other NFT owners and perhaps bond with the reviews you received from the rest of the world.

Bullish points

  • Strong cash generation
  • High return on equity
  • A strong brand contributes to pricing power
  • Increase IP licensing revenue

bear dots

  • Increase in wage inflation
  • The cost of living could lower demand
  • Slower revenue growth

The creators of NFT were not the first entrepreneurs to harness the value of a shared sense of identity offered by a minority business. Games Workshop (GAW), which was founded in the 1970s, created the fantasy tabletop game Warhammer in 1983. To play the game, you must purchase and paint miniature models. Games Workshop stores provide a physical space where players can meet and play with each other.

The community has grown steadily since the 1980s and last year Games Workshop’s mailing list saw 21.2 million cumulative opens. His creative intellectual property (IP) has spawned hundreds of books, as well as television series, animations, and video games. Although all tabletop models are still manufactured in Nottingham, Warhammer distributes to fans worldwide, including Europe, America, Asia and Australia.

The fanatical nature of Games Workshop’s customers, combined with a totally unique and differentiated product offering, results in strong financial performance. Being a Warhammer fan doesn’t come cheap, but fans are willing to spend. In its last full fiscal year to May 2021, the company’s gross margin was 72.7% and its return on equity was 73.9%. At £353.2m, sales were up 38% from the pre-pandemic high of 2019.

Until recently, the combination of strong market growth and high investment returns had also made Games Workshop a darling of the stock market. Between 2018 and the summer of 2021, its share price more than quadrupled, soaring to more than 30 times forward earnings. However, over the past six months, investor sentiment has cooled markedly.

Supply chain issues undermine trust

In the six months to November 28, 2021, pre-tax profit fell 3.9% and gross margin fell six percentage points to 70%, following a $5.6 million increase in pounds in input and transport costs and a £3 million increase in personnel costs.

From the company’s two factories in Nottingham, international model orders are shipped to centers in Tennessee and Sydney before being routed to local stores. This process requires a lot of shipping, and as any savvy investor knows, the price of shipping has risen dramatically over the past year. More than 75% of revenues are generated internationally.

In total, higher shipping costs accounted for half of the decline in gross margin in the first half. The hold-ups in the supply chain also led to a £6.6 million increase in inventory and a £32 million increase in customers and receivables. With more working capital tied up, net operating cash fell 31% to £76.5m.

Management said the delays meant the business had not “reached its full potential” and joined the growing chorus of businesses who expected the disruption to ease over the winter. These predictions did not initially come to fruition, although the price of shipments began to decline fairly steadily since the start of March. Over the past month, the Drewry World Container Index has seen a 13% drop to $8,000 per 40ft container.

This is still 60% higher than April of last year, but down significantly from the September high of $10,000.

As the pandemic consumer goods craze in the US and Europe subsides, demand for container space is expected to continue to decline and help Games Workshop’s gross margin return to historic levels.

Increase in intellectual property royalties

To offset some of the rising costs, Games Workshop has recently turned to the opportunities of its wildly popular intellectual property (IP). In the six months to November, royalties received more than doubled to £20.1million. To put this into perspective, only £1.5m was generated from royalties over the whole of 2015. The company points out that royalty income is not constant, but over the past few years has have been steadily increasing.

This year, the company is releasing several “major video games”, including Total War: Warhammer 3 and Warhammer 40,000: Darktide and lost crusade. Until now, Total War: Warhammer 3 was well received by fans and critics. There are also plans to launch a video game in Age of Sigmar, a new fantasy world launched last July. A trailer for the title has been viewed over 28 million times, which management hailed as “the best fantasy launch yet by a considerable margin.”

In short, last year’s problems seem to have little to do with a lack of demand from Warhammer fans.

Capital for durable assets too

Although the digital world of gaming and animation offers new sources of revenue, management has not forgotten to continue investing in its manufacturing capabilities. During the first half of the year, £2.6 million was invested in capital projects.

At the Nottingham factories, five additional injection molding machines have been installed, bringing the total number to 43. Meanwhile, at the Memphis factory, new technology has “significantly increased” the speed at which orders can be packed. This improvement made it possible to clear at the start of January the £5 million of orders outstanding at the end of November.

Accelerating order processing will help improve operating cash by clearing receivables more quickly. The improved efficiency of capital investment is likely part of the reason why management was able to declare a special interim dividend of 70p per share to investors at the end of March, payable to shareholders of record on April 1.

Brokers seem confident that cash flow will continue to improve over the next two years. The FactSet consensus is £155m free cash flow in 2022, rising to £175m in 2024. This gives a very healthy free cash flow return of 7.1% in 2024.

Games Workshop’s high return on equity and strong cash generation have made it a very expensive stock. As recently as May last year, it was trading on a forward price-earnings (PE) ratio of 30.6. However, recent supply chain issues and shrinking margins mean the market has cooled down a bit and is now trading at a more affordable 19.3x ratio.

Pessimists may point to the cost of living crisis as a reason for caution. As the price of food and household bills rise, shelling out for another new miniature model might start to feel like an unaffordable luxury. However, brand strength confers pricing power and few companies build customer loyalty as much as Warhammer. Just look at the 70 percent gross margins for proof.

Speaking of the Warhammer franchise, Superman actor Henry Cavill, said he “really can’t get enough of the tradition they’ve built over the decades”. There are very few products with such glowing recommendations and the recent re-rating offers an attractive entry point into that world. NFTs may be a fad, but Warhammer has the track record to suggest it’s here to stay.

Company Details name Market cap Price 52 weeks high/low
Games Workshop (GAW) £2.50 billion 7600p 12310p / 6365p
Size/debt NAV per share Net Cash / Debt (-) CAGR NAV 5 years Operating cash/EBITDA
598p £41.0 million 29% 92%
Evaluation PE before (+12 months) JJ (+12 months) FCF yield (+12 months) EV/ EBITDA
19 3.2% 4.2% 16.3
Quality/ Growth EBIT margin ROCE CAGR of sales over 5 years CAGR EPS 5 years
34.1% 67.0% 24.5% 54.7%
Forecast / Momentum Fwd EPS grth NTM Fwd EPS grth STM Mom of 3 months % change in EPS before over 3 months
3% 6% -23.3% -1.3%
End of year May 31 Sales (£m) Profit before tax (£m) EPS (p) DPS(p)
2019 257 81 201 155
2020 270 89 218 145
2021 353 151 371 222
f’cst 2022 384 158 383 228
f’cst 2023 416 165 393 244
load (%) +8 +4 +3 +7
Source: FactSet, adjusted PTP and EPS figures
NTM = next twelve months
STM = Second Twelve Months (i.e. in one year)

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