Since Games Workshop (GAW) released a stellar trading update on 10 September its shares have been on a tear, suggesting that investors expect more profit upgrades to come. This is not an unrealistic point of view, so I’ve decided to take a look at how this excellent business can keep on delivering for investors.
One of the key drivers of a higher share price for any company is the expectation that future profits will be higher than previously expected. Games Workshop shareholders have got used to this over the past few years, as regular profit forecast upgrades by City analysts has turbocharged the share price higher with some nice fat dividends on top.
The company has been transformed since 2016. A new release of Warhammer Age of Sigmar and a step change in customer engagement with the creation of a community at warhammer-community.com reinvigorated the brand, which had looked as though it had lost its way.
A simplification of pricing strategy – with price hikes limited to new releases – has kept long-term players on side. The company has also tentatively branched out into leveraging its intellectual property by selling licences to computer game developers and media companies and is now generating a highly profitable source of royalty income.
The company’s miniature games figures, games and books have very high gross profit margins (67 per cent in the year to May 2020 and have been higher than 70 per cent) and sales are spread over a high fixed cost base. Growing sales of highly profitable products combined with significant operational gearing has delivered stunning financial results.
Games Workshop: financial performance 2015-20
Games Workshop (£m) | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 |
Revenue | 119.1 | 118.1 | 158.1 | 219.9 | 256.6 | 269.7 |
Op Profit | 16.5 | 16.9 | 38.3 | 74.6 | 81.2 | 90 |
Post tax profit | 12.3 | 13.5 | 30.5 | 59.7 | 65.8 | 71.3 |
Capital Employed | 52.3 | 54.3 | 63.8 | 85.7 | 108.4 | 167.9 |
Operating Capital Employed | 50.9 | 52.9 | 62.4 | 84.3 | 107 | 166.5 |
Free cash flow | 11 | 11.6 | 31.1 | 48.5 | 50 | 69.7 |
Op margin | 13.9% | 14.3% | 24.2% | 33.9% | 31.6% | 33.4% |
ROCE | 31.5% | 31.1% | 60.0% | 87.0% | 74.9% | 53.6% |
ROOCE | 32.4% | 31.9% | 61.4% | 88.5% | 75.9% | 54.1% |
FCF Conversion | 89.4% | 85.9% | 102.0% | 81.2% | 76.0% | 97.8% |
FCF margin | 9.2% | 9.8% | 19.7% | 22.1% | 19.5% | 25.8% |
Changes £m | 2016 | 2017 | 2018 | 2019 | 2020 | 2016-20 |
Revenue | -1 | 40 | 61.8 | 36.7 | 13.1 | 150.6 |
Op Profit | 0.4 | 21.4 | 36.3 | 6.6 | 8.8 | 73.5 |
Post tax profit | 1.2 | 17 | 29.2 | 6.1 | 5.5 | 59 |
Capital Employed | 2 | 9.5 | 21.9 | 22.7 | 59.5 | 115.6 |
Operating Capital Employed | 2 | 9.5 | 21.9 | 22.7 | 59.5 | 115.6 |
Free cash flow | 0.6 | 19.5 | 17.4 | 1.5 | 19.7 | 58.7 |
Op margin | -40.0% | 53.5% | 58.7% | 18.0% | 67.2% | 48.8% |
ROCE | 20.0% | 225.3% | 165.8% | 29.1% | 14.8% | 63.6% |
ROOCE | 20.0% | 225.3% | 165.8% | 29.1% | 14.8% | 63.6% |
FCF Conversion | 50.0% | 114.7% | 59.6% | 24.6% | 358.2% | 99.5% |
FCF margin | -60.0% | 48.8% | 28.2% | 4.1% | 150.4% | 39.0% |
Source: Annual Reports/Investors Chronicle
The company’s key profitability measures of operating margin, return on operating capital (ROOCE) and free cash flow margin have been transformed and are now at very impressive levels. Between May 2016 and May 2020, Games Workshop added over £150m of incremental revenue (without acquisitions) and added over £73m of operating profit – an incremental operating margin of 48.8 per cent and free cash flow margin of 39 per cent.
These highlight the benefits of operational gearing, but also shifts in profit mix with the growth of royalty profits. There are good grounds for thinking that this trend could have much further to run.
I see four main potential drivers of higher profits:
- New game releases and the leverage of sales from them.
- More efficient selling over the internet.
- Efficiency improvements from new production facilities and warehousing.
- Further growth in royalty income, which is pretty much pure profit.
I’ll discuss these shortly and look at what might be assumed in analysts’ forecasts, but first I want to revisit the September trading update and why it might be pivotal in the resetting of investor expectations for Games Workshop’s future profits.
Revisiting the September trading update
I think it’s fair to say that most investors were shocked – in a good way – about how strong Games Workshop’s first-quarter profits were, especially given the uncertainty created by Covid-19, which saw the company close its factories and shops for a while.
The update was very revealing in the trends in operating margins with and without the impact of royalty income, and raises some interesting issues.
Games Workshop: revenues and margins
£m | H1 19 | H2 19 | 2019 | Q1 20 | Q2 20 | H2 20 | FY 20 | Q1 21 | LTM | 2021F | 2022F |
Revenues | 125.2 | 131.4 | 256.6 | 78 | 70.4 | 121.3 | 269.7 | 90 | 281.7 | 302.5 | 322.2 |
op profit | 35.3 | 34.6 | 69.9 | 28 | 20.5 | 24.7 | 73.2 | 45 | 90.2 | 105.4 | 113.4 |
Royalties | 5.5 | 5.8 | 11.3 | 2 | 8.7 | 6.1 | 16.8 | 3 | 17.8 | 11 | 12.1 |
Tot Op Profit | 40.8 | 40.4 | 81.2 | 30 | 29.2 | 30.8 | 90 | 48 | 108 | 116.4 | 125.5 |
Margin | 28.2% | 26.3% | 27.2% | 35.9% | 29.1% | 20.4% | 27.1% | 50.0% | 32.0% | 34.8% | 35.2% |
Margin incl Royalties | 32.6% | 30.7% | 31.6% | 38.5% | 41.5% | 25.4% | 33.4% | 53.3% | 38.3% | 38.5% | 39.0% |
Source: Games Workshop/Investors Chronicle/Edison Research
The first-quarter (Q1) results were different to anything seen from Games Workshop in recent times. A £12m increase in revenues led to a £17m increase in operating profit before royalties. Operating costs were actually £5m lower than a year previously.
Some of this is probably explained by Covid-19, which may have lowered store costs, but are mainly due to the higher profits that come from selling over the internet. I know from speaking to a contact with a private gaming company that internet sales have been a big profit kicker in 2020 and are grounds for optimism going forward.
Judging the long-term impact on Games Workshop’s operating margins is difficult, but I think it’s not unreasonable to assume that they will be positive and that a moderation of the pace of store openings and a gradual shift towards online combined with even more social media customer engagement can boost profits.
The other impact that was undoubtedly positive – and which the company did not mention in its trading update – is the benefit of new releases. Indomitus – a new edition to the Warhammer 40,000 series – was launched in July and apparently sold out so quickly that the company had to make more of it. Its launch also coincided with new Warhammer sets named Recruit, Elite and Command that incorporated Indomitus.
This is just a guess, but Indomitus probably contributed for around half the first quarter period, and that momentum from it could continue into the second quarter, which will also see the release of a new boxset called Warcry. These can probably be seen as a source of profit upgrades.
The mix of new product sales to existing sales can have an impact on gross profit margins as the company’s pricing strategy between the two is different.
Under previous management, Games Workshop came in for a lot of criticism on its pricing, which led to many players feeling that they were being ripped off and taken for granted. This led to some even leaving the hobby altogether.
This has changed under the current management, with only new products seeing price hikes and these are capped to around 3 per cent, and customers have clearly given this a big thumbs up. This may also explain why gross profit margins have come down slightly in recent years.
New product sales are also a good guide to the rate of innovation within the company, and the customer response to them is a good gauge of the health of the business.
Here the signs are good. New products have accounted for 38 per cent of total revenues for the past three years and it will be interesting to see if this changes much in 2021. New products become existing products and the sales base and the growth of it over the past few years has been very impressive, doubling since 2016.
It remains to be seen what the impact of mix will be on gross margins for the year to May 2021, but given the Q1 update you can’t help thinking that it might be positive.
Is profit guidance too cautious?
The September trading update saw management unable to give any meaningful guidance due the uncertainties relating to Covid-19. Given the increase in social restrictions happening now this is not unreasonable.
What investors could easily calculate is the last year’s rolling revenues and profits up to the end of August 2020. Revenues are £281.7m with operating profits of £90.2m with royalties of £17.8m giving total operating profits of £108m. This gives operating margins of 32 per cent and 38.3 per cent with royalties included. This compares with 27.1 per cent and 33.4 per cent for the year to May 2020.
Despite not giving guidance, Edison Research – which has been commissioned by Games Workshop to write research on the company – has published detailed forecasts, which are freely available on its website. It is highly unlikely that Games Workshop would have allowed these forecasts to be published if it did not think that it could meet or beat them.
What we can do is take the forecasts of Edison for the remaining nine months to May 2021 and compare it with the last nine months of last year to see what kind of outlook is currently predicted.
Edison forecasts vs last year
£m | Aug 19 - May 20 | Aug 20 - May 21F | % change |
Revenues | 191.7 | 212.5 | 10.9% |
Op Profit | 45.2 | 60.4 | 33.6% |
Royalties | 14.8 | 8 | -45.9% |
Total Op Profit | 60 | 68.4 | 14.0% |
Margin | 23.6% | 28.4% | |
Margin incl Royalties | 31.3% | 32.2% |
Source: Edison Research/Investors Chronicle
We can see that Edison’s forecasts see Q1 as a one-off in terms of profitability and profit margin and expect a slight moderating of sales growth. For the remaining nine months of 2021, profit margins are expected to be much lower. However, a significant leverage effect is still expected with £20.8m of extra sales adding £15.2m of extra operating profit – an incremental profit margin of 73 per cent. Whether this effect is too low remains to be seen, but is a key variable in forecasts and the company could surprise on the upside.
Operating costs are expected to rise, but by only 3.8 per cent, but some of this will be the cost of sales. Depending on gross profit margin performance, it does not seem as though much cost growth is expected and this may imply that higher internet selling is factored in to some extent.
Total operating profit forecasted for the year to May 2021 is £116.4m compared with £108m in the year to date.
This forecast does not look too unrealistic to me, but could be beaten with stronger sales growth and positive mix effects from new releases and internet sales. The company should also begin to get a boost from new production and warehousing facilities coming on stream, but the full benefits of this are likely to be seen in later years.
The key uncertainty with the forecast is royalty income. Edison is expecting a significant fall-off here despite royalties increasing in the first quarter. Royalty income is volatile and hard to forecast. Last year, the increase was driven by a big increase in guaranteed income, which is recognised upfront when the licensing contract is signed.
Remaining royalty income is determined by a share of the licensee’s sales of products.
There’s no doubt that the potential for royalties is significant, but the size and longevity of them needs to be treated with caution. While there is big potential – especially as a source of profit upgrades – trying to put a value on it is hard to do.
The company had 73 licences in issue at the end of May 2020 and said it was signing new ones every two-to-three months. A big media deal has the potential to see big one-off inflows of initial guaranteed income, which can trigger profit forecast upgrades. The long-term benefit is more uncertain.
This is because the majority of royalties (85 per cent last year) came from PC/console and mobile gaming licences. This market is notoriously fickle and the longevity and size of annual royalties is hard to predict. There must be a big risk that initial income is strong before tailing off. This of course can be offset by new contracts.
However, while the potential to leverage its intellectual property is significant, I do think that it is in danger of being overplayed as a huge source of incremental value. The first reason is related to ongoing revenue streams discussed above, but the other more important point is that the company will not do anything that threatens its core business.
Games Workshop makes its profits from selling miniature figures, games, books and accessories and wants to keep it that way. The last thing it wants to do is encourage a shift away from physical products and games to virtual and computer-based ones, which could cannibalise the core business. Thoughts that royalty income profits could exceed the profits from the main business are some way wide of the mark in my view. They should be seen as complementary and enhancing the overall brand of the company, which in itself is no bad thing.
How much good news is priced into the shares?
Quite a lot is my view. That said, Covid-19 risks aside, there is scope for profit forecasts to go up. I also think that the spending power of the company’s customers – especially from the savings made from working at home and not taking holidays – is another source of upside in the short run, but one that could be taken away quickly if unemployment increases.
Looking further out, I think there is a lot to be positive about. This is a business that has historically been hard to predict, but the enhanced strength of the brand that has come from the way it has engaged with customers is probably still underappreciated by the wider investing community and arguably has the potential to deliver more revenue and profit growth.
At 10,350p, the shares trade on a forecast 2021 PE of 38 times. This is a high valuation, but not out of kilter for a business with outstanding profitability that can grow in a world of very low interest rates. Should the company continue to build on its impressive run of trading then the confidence that this is a business that has been built to last will increase and the share price could well continue to keep investors happy.
