Games Workshop: a case study in sound management

The business

Not so long ago it would not have been unreasonable to simply describe Games Workshop as a company that made and sold toy soldiers. Anyone looking at the company today would soon realise that it is much more than that.

The company started out in the mid 1970s as a manufacturer of wooden boards for games. In the late 1970s, the foundation of today’s business began when it started making metal miniature figures for role play and tabletop games.

Games Workshop today revolves around two core tabletop games. Warhammer Age of Sigmar is the main fantasy battlefield game. An offshoot, Warhammer 40,000, is a science fiction version based in outer space. The company also holds the licence for The Lord of the Rings and The Hobbit tabletop battle games.

Warhammer players pitch their armies against each other over an ever expanding selection of battlefields and storylines using different fighting figures with different abilities and decide outcomes by rolling dice. It is from the world of Warhammer that Games Workshop makes its money.

It’s fairly easy to get up and running with the game by purchasing a starter kit – typically costing around £25 in the UK – which contains games figures and a rulebook. These figures can be coloured plastic or unpainted. Once up and running, players can start buying from the stable of Games Workshop Warhammer products, which includes:

• Miniature figures. The plastic ones are branded as Citadel miniatures. Resin miniatures are branded as Forge World and are less widely available. The figures can be bought for modest sums of £10, but grand armies can cost as much as £170.
• Paints from the Citadel Colour Paint range, which includes brushes and a painting system. Painting the figures is a big part of the Warhammer hobby. Individual paints can be bought from £2.75 each, with comprehensive paint sets costing around £25.
• Story books and video games that are sold under the Black Library imprint, which includes short stories and audio books. The books range in price from £2.50 to £40 in the UK.

Warhammer tends to be played by teenage boys and young adults. The key to the future success of Games Workshop is to increase the size of the Warhammer community and the number of products sold, as well as keeping existing players happy, which hasn’t always been easy in the past.

In recent years, Games Workshop has started to make significant amounts of money from licensing its intellectual property and the Warhammer brand to other companies. This has seen Warhammer incorporated into computer games and mobile phone apps, as well as clothing and accessories. The royalty income earned from licensing is a considerable source of value as it is virtually pure profit as there is very little cost attached to it. It could hold the key to the company’s next stage of profit and cash flow growth. More on this later.

The business is a global one with 75 per cent of its revenues generated outside the UK in 2019.

Games Workshop revenues

Source: Annual report

Business model and strategy

Games Workshop is a vertically integrated business. It makes its products at its manufacturing base in Nottingham, where it employs around 230 people making miniatures, artwork, games and publications. Outside of the UK, it has two distribution hubs in Memphis, Tennessee and in Sydney, Australia.

The manufacturing operation, with its plant, machinery, tooling for plastic moulds and staff, means that Games Workshop is a business with lots of fixed costs. This gives it a lot of operational gearing. Once the fixed costs have been covered by the profit contribution from selling products, each additional unit sold adds an increasing amount of profit. It is the leveraging of this fixed cost base by selling more products that holds the key to Games Workshop’s ultimate success as a business and the returns its shareholders will receive.

In order to go about doing this, Games Workshop sells its products through various channels:

• Its own stores. As of June 2019, the company had 517 stores in 23 countries, which contributed 34 per cent of total sales last year. These stores are where the vast majority of new customers are recruited. Most of them are managed by just one person and are stocked with the latest Warhammer products and related associated products. People can meet at these stores to play Warhammer and paint their miniatures.
• Independent stores (trade). These are a vitally important route to market in countries where Games Workshop does not have its own stores. Last year the company was supplying 4,700 stores in 69 different countries, which accounted for 47 per cent of total sales.
• The Games Workshop Webstore, which accounted for 19 per cent of sales.

Back in 2015 you could be forgiven for thinking that Games Workshop had lost its way. Revenue growth was elusive and many trade accounts had stopped trading with it. Profits had stagnated as The Lord of the Rings had petered out as a source of growth. The company’s retail stores were losing money and it seemed that a number of its customers felt alienated by the company’s products and the price of them. Recruiting and keeping hold of good store managers was also a big problem.

From a shareholder’s perspective, there was a growing frustration that the company was not making the best of its intellectual property assets and store network, which represents a significant barrier to competition and a key source of competitive advantage. Yet it seemed that the company had perhaps become too defensive, too accepting that sales and profits would be good in some years and not in others.

A management story

Medium-sized companies are rarely dependent on the actions of just one individual, but I think it's fair to say that much of Games Workshop’s current success can be attributed to the strategy implemented by its current chief executive, Kevin Rountree, and the team of people he has surrounded himself with.

Mr Rountree has been with the company since 1998 and became chief executive in January 2015. The transformation of the company under his leadership has been nothing short of astonishing 

He started with fixing the company’s lossmaking stores in North America either by closing them or converting them to one-man stores. The European business was also restructured. Many stores were rebranded under the Warhammer name to reflect the realities of the business in the eyes of customers.

Product ranges were revamped and the range of selling prices were increased to appease some disgruntled customers who thought that prices were too high. The premium pricing of new miniatures was retained in order to preserve their reputation for being of the highest quality, and with it the brand image.

The way the business was managed also changed. Instead of a flat management structure across the business, it moved to individual country management and gained more control over its direction as a result.

However, what has been by far the biggest step change in the business has been the way it has interacted with its customers. There have been two key events in 2015-16 that highlighted this.

The first was the relaunch of the Warhammer Age of Sigmar title. This completely refreshed the game with new models and a set of simplified rules, which meant that it was much easier for new players to get started with the game. 

The second came in late 2016 with the launch of warhammer-community.com, a website that created an online community for the game and a way to engage with new and existing customers. 

These two events kick-started the growth in sales volumes and profits that has transformed the company’s fortunes and its share price. It saw the start of the growth in licensing income with games such as Warhammer:Total War.

Combined with a renewed focus on store openings, new trade accounts and a continued roll-out of high-quality new products and games, the seeds were set for revenues and profits to take off.

A closer look at the numbers

The transformation of Games Workshop’s fortunes can clearly be seen in its financial performance.

Games Workshop revenues and profits

Source: Annual reports

Between 2014 and 2016, revenues and profits were stagnating. From 2016 onwards they have soared. You can see how the retail stores have moved from losses into profit and how trade accounts have seen stellar growth. Internet profits more than doubled, while the profits on the central manufacturing and design facilities (product & supply) is up nicely as well. Royalty profits are up from just over £1m in 2014 to over £10m in 2019. These royalty profits come with very little costs attached to them and are a rich source of profit margin.

Games Workshop royalty profits

Source: Annual reports/Investors Chronicle

The realistic hope that many shareholders have is that the company takes a big step forwards with its licensing, which leads to another step change in sustainable profit.

The significant upturn in sales volume and revenue has driven a drastic improvement in operating margin, which highlight the very high operational gearing within the business.

Games Workshop royalty income

Sources: Annual reports, Investors Chronicle

The core operating margin has advanced from 12.5 per cent to nearly 30 per cent since 2014, with the increase in royalty income giving a nice boost on top.

One of the best ways to try to identify significant operational gearing within a business is to simply look at the changes in revenues and profits in absolute terms over a period of time. Doing this for Games Workshop between 2016 and 2019 shows some very impressive results.

Games Workshop incremental returns 2016-19

Sources: Annual reports, Investors Chronicle

Over this period, revenues have increased by £138.5m, operating profit by £64.4m, capital employed by £54m and free cash flow (FCF) by £33m. This gives incremental profit margins of 46.5 per cent, return on capital employed (ROCE) of 119 per cent and FCF margin of 23.9 per cent. The company has also been good at converting its after-tax profits into FCF for shareholders, who have benefited from some chunky dividend payments to complement the rising share price.

Games Workshop key performance metrics

Sources: Annual reports, Investors Chronicle

Looking at some key performance metrics, we can see that Games Workshop has all the hallmarks of an outstanding business and are a testament to the business strategy that it has employed in recent years.

Where will the future growth come from?

Historically, Games Workshop has been a volatile business. Revenues and profits have moved up and down depending on the release schedule of new Warhammer games. The step change in the business over the past three years has led to an increased confidence from the company that it can keep on growing for a while yet.

Further growth is likely to come from doing what it has been doing. Opening more stores in places such as North America and Germany is the current aim in retail, while there remains a focus on signing up more trade accounts.

Engagement with customers is ongoing, with programmes with schools and the Scouts in the UK to bring on more young players. There is still considerable scope to improve the digital marketing of the business on warhammer-community.com.

There is also a significant amount of effort being placed on digital entertainment with the hope of bringing Warhammer to an animated form on TV and launching new stories on its own Warhammer TV. More licensing deals for the mobile platform are likely.

A big media deal for Warhammer could see a step change in royalty income and the rich incremental profit margin it could bring.

The company’s confidence in its future growth has been shown by a significant increase in manufacturing capacity in Nottingham, as well as extra logistics investment. Its new factory has doubled the number of plastic injection moulding machines. As well as giving the business scope to grow, this should improve the efficiency of the manufacturing process.

Is there anything to worry about?

The extra investment in logistics – particularly warehousing – could put some short-term pressure on profit margins if sales growth weakens. Logistics costs were running at 3.7 per cent of sales in 2019 and this would rise to 5 per cent on a 2019 sales basis after the new costs are taken on. It needs sales to keep on growing to absorb these costs.

Games Workshop has benefited from significant operational gearing in recent years. The new investment in manufacturing and logistics adds more fixed overheads and more operational gearing. It gives the business scope to grow, which is good but arguably adds more risk as well.

If sales volumes and profit contribution rise to cover these additional costs then investors will be happy, but they must not forget that operational gearing can work in reverse and the business may suffer significant profit falls if revenues fall in the future. 

Another thing to keep an eye on is exchange rates. With 75 per cent of its sales coming from overseas, a rise in the value of the pound could put pressure on profits. Back in 2014, Games Workshop had to sell $1.62 in North America to make £1 of revenue. Last year it only had to sell $1.30 to achieve the same result.

One of the biggest challenges for Games Workshop is managing its stock. It needs to have enough to meet customer demand, but not have too much which increases working capital employed in the business and the risk of stock losses, which will reduce profit margins.

The company’s stock position needs to be closely watched in my view.

Games Workshop stock and stock losses

Sources: Annual reports, Investors Chronicle

Stock as a percentage of revenue has been increasing in recent years and so have stock losses, which reduced profit margins by 2.2 per cent of sales in 2019.

A difficult business to forecast and value

Games Workshop is not an easy business to forecast or value in my view. Working out how many teenagers will be playing Warhammer and how much they will be spending on it in five years’ time is not easy to predict. Bulls of the shares will cling to the view that the company is on a long-term growth path, whereas history suggests there will be ups and downs or at least a pause in growth.

One reason why Games Workshop has been such a successful share is because profit forecasts have been consistently upgraded as sales volumes have been better than expected and the operational gearing effect has kicked in. This is not easy for an outside investor to forecast.

Yet, despite some possible pressure on margins from higher costs, the forecast upgrade cycle might not be over yet. The company reports its half-year results next week (14 January) and they are expected to be very good.

In its 8 November 2019 trading statement is said that it expected revenues to be at least £140m and pre-tax profit to be at least £55m. This compares with £125m and £40.8m respectively a year ago.

What this means is that virtually all the increase in revenue has fed through to pre-tax profit. This continues to show the positive effect of operational gearing and a decent increase in royalty income. It also shows that profit margins are not under pressure at the moment.

Assuming these profits as a minimum, trailing 12-month pre-tax profits would be £95.3m, which would give an estimated EPS of around 233p. At a share price of £62.38, this would put the shares on a forecast price/earnings ratio (PE) of 26.8 times. This is not cheap by any means, but not out of kilter for an outstanding business that is still growing. 

There’s a great deal to like about this company and, while its operational gearing is a double-edged sword, it would not surprise me to see the shares continue to move higher over the coming years.