The Warhammer creator has been one of the market's runaway success stories of recent years, but can it keep delivering?
Games Workshop is one of the most outstanding businesses listed on the UK stock market. Its performance over the past few years has been remarkable and made for many happy shareholders. Can it keep on delivering the goods? I look at the reasons behind the company’s success to try and answer this question.
There are many reasons why Games Workshop is an excellent business with fantastic profitability:
- It sells state of the art miniatures for a big mark up price over cost.
- It leverages its sales over a large fixed manufacturing and selling overhead which gives it significant operational gearing and rapidly growing profits when times are good.
- The engagement with its customers has been transformed and keeps on getting better.
- Consistent new product launches have grown sales to existing and new customers.
- It has reinvested to keep on growing.
- It has developed a rich source of additional profits from licensing its intellectual property.
Most of these are great characteristics for any business to have. The main caveat as far as I'm concerned is that operational gearing can work on the upside and the downside. For the last few years, investors have only seen the benefits of it and perhaps not considered the risks if sales momentum falters.
Games Workshop has always been a business with somewhat limited short-term revenue visibility. In recent years, the company has surprised positively on the upside with the operating leverage working wonders for profit growth and upward revisions to profit forecasts. The share price has continued to march upwards.
If the company continues with its ability to keep pleasing more customers and drive its sales volumes upwards then current investors could still make a great deal of money from here given the way the business is set up.
The danger is that last year’s financial performance was so good that there isn’t enough momentum in the business to match it and grow from it over the next year. If so, then current profit forecasts are too high and the share price would look very vulnerable.
That said, this is a company that has been good at proving doubters wrong. However, it is also true that the bigger the revenue and profit base has become, the more challenging it has been to keep growing. That Games Workshop has done so is a testament to the company's efforts.
I’m now going to look under the bonnet of the company to try and figure out what the future might bring.
The profitability of its products remains very high
The base building block which underpins Games Workshop as a very good business is that it sells very good products that people want to keep on buying. Its plastic Citadel and Forge World resin miniatures are works of art and of very high quality. It does this better than anyone else and quite rightly feels it can charge a premium price for them.
One of the best hallmarks of a business you can look for is one that can sell its products for a big markup on what they cost to make. You can get a feel for whether this is the case by looking at its gross profit margins.
High gross margins are sometimes a sign that a company is ripping off its customers which can lead to new competitors entering its markets and selling for lower prices. This has the effect of reducing margins over time.
However, If a company is making and selling a product that is hard to copy and has built up the scale and expertise to make them cheaper than anyone else then it can hang on to its high prices and the profits that come with it.
It is not always possible for an investor to know and identify the exact cost of sales that has been used to calculate a company’s gross margins.Games Workshop defines its gross profit margins as its revenues less the cost of stock, direct manufacturing costs, shipping costs and depreciation and amortisation. You can identify some but not all of these numbers in its annual report.
An alternative is to just look at the cost of stock or inventory that has been expensed and look at its trend as a percentage of revenues. You can usually find this number buried in a company’s annual report. By doing this, we can see just how profitable Games Workshop’s products really are. In very simple terms, it is the same as making something for 15p and selling them for £1. That’s a very nice business to have.
Source: Annual Report
If we look at Games Workshop’s gross profit margins based on its numbers they still show a business with very high product profitability. They have averaged just under 70% since 2015.
Source: Annual Report
The year to May 2021 saw a healthy uplift in gross profit margins from 67 per cent the year before to just over 72 per cent. There were three main reasons for this:
- The continued high proportion of new products as a percentage of sales. The company’s pricing strategy in recent years has been to increase the selling price of new products only which has seen the average price increase of all of its products increase in the range of 3 to 4 per cent per year. New products remained at 38 per cent of total sales compared with 30 per cent back in 2016. Continued strong demand for new products will continue to support high gross margins.
Source: Annual Report
- A reduction in stock provisioning compared with 2020. As a manufacturer and retailer of stock occasionally the company will have items that don’t sell as well as it had hoped. In these circumstances, it will make a provision for the loss of value and this will be reflected in a lower gross profit margin. Lower provisioning last year gave a 210 basis points boost to gross margins compared with 2020. With stocks as a percentage of revenues improving, I think it’s unlikely that that stock provisioning will produce a similar gross margin boost in 2022.
Games Workshop: stocks and stock provisioning
|Year||Stocks £m||Revenue £m||% of Revenue||Stock losses £m|
Source: Annual Report
3: A favourable shift in selling mix. There has been a shift of sales away from the company’s own retail stores to trade sellers and direct sales to consumers over the internet. This was more pronounced last year given that its own stores were closed due to Covid-19 restrictions.
Source: Annual Report
Games Workshop has relied heavily on trade sellers of its products in order to promote them in markets where it does not have its own stores. The growth in trade accounts in recent years has been impressive with the average sales per trade account more than trebling since 2016.
Games Workshop: trade accounts
|Year||Trading Accounts||Avg Accounts||Trade sales £m||Avg sales per a/c|
Source: Annual Report
Trade sales tend to have a higher proportion of discounting given their bias towards existing rather than new products. Intuitively you would think that this is dilutive to margins given the cost of shipping and having to give the trade seller a cut of profit. On the other hand, the rise in internet sales which are made direct to the customer means that no profit is given away to a third party. The near 70 per cent growth in internet sales last year was undoubtedly helpful to margins and the question will be whether this can be sustained if sales patterns shift back a little with stores reopening.
That said, retail manufacturers are increasingly embracing the attractions of selling direct to their consumers not only in terms of the higher profit margins but also the ability to control distribution and pricing. Games Workshop will undoubtedly look to grow its overall share of online sales going forward. With 90 of its own stores loss making at the end of last year, shifting more towards online sales from this source alone may be a quick win, especially when the company’s plans for more digital engagement are taken into account. As far as the company’s margins are concerned there are grounds for optimism here.
Volume growth and high operational gearing
As well as selling products with very high gross margins, the ability to sell them over a very high fixed cost base of manufacturing, warehousing and design costs is the reason behind the company’s stellar levels of profitability and growth in recent years.
It is also the main reason why the company has been able to say that its profits would be better than expectations. When it is selling very profitable products, it only needs for sales volumes to be much better than expected for forecast profits to be materially higher as well.
There are a couple of useful ways to see the impact of operational gearing on a business and its profits. The first is to compare the actual money changes in revenues and profits and see how much of the extra revenues drops through to profits.
You should pay particular attention to the change in gross profits as this is a proxy for the profit contribution to pay fixed overheads. A high drop through rate from revenue and gross profit shows that a company has fixed costs which don’t increase with revenues and this shows high operational gearing.
It is vital to understand the operational gearing as it can and does work both ways. For the last few years operational gearing has been the friend of Games Workshop and its shareholders. If sales volumes fall short of expectations or fall in absolute terms they might just see how operational gearing can bite them.
I’ve seen so many investors mistake operational gearing for genuine sustainable growth without considering the risks that come with it. When operational gearing is high it is important that the revenue visibility of the business concerned is good because if it isn’t then profit visibility is poor as well.
I’m not convinced that Games Workshop has great revenue visibility going forward and this perhaps explains why the company is often coy and conservative with its profit guidance. It just happens that the company’s revenues have been on an upwards trajectory for a while now and have been muchbetter than expected. When combined with the high operating leverage, shareholders have had plenty of reasons to smile.
Games Workshop: operational gearing
|Change in revenues||-1.1||40.0||63.2||35.3||13.1||83.5|
|Change in gross profit||-1.5||33.8||42.7||16.2||7.3||76.3|
|Change in op profit pre royalties||-4.0||19.9||33.9||5.1||3.4||62.2|
|Drop through rate||377.8%||49.7%||53.6%||14.6%||25.6%||74.5%|
Source: Annual Report
Looking at the drop through rate from revenues we can see plenty of evidence of high operational gearing. In 2018 and 2021 the company managed to hold onto a large chunk of its gross profit increase in operating profit. In 2016, you can see a revenue fall of just over £1m led to a profit fall before royalties of £4m. A fall in sales volumes off a much higher revenue base today therefore has the scope to do a lot of damage to profits.
The other way to look at the impact of operating leverage is to see the changes in a company’s costs as a percentage of revenues. When revenues are growing fixed costs become a smaller percentage of them and margins expand. The opposite happens when revenues are falling.
Games Workshop: costs and profits as percentage of revenues
|% of revenues||2015||2016||2017||2018||2019||2020||2021|
|Cost of sales||31.0%||31.7%||27.6%||29.0%||32.5%||33.0%||27.3%|
|Op profit pre royalties||12.5%||9.2%||19.5%||29.2%||27.2%||27.1%||38.3%|
Source: Annual Report
We are looking at margins and costs before royalties here as royalties are largely pure profit. We can see how since 2016 selling costs and administrative costs as a percentage of revenues have collapsed. The change in the pre-royalty operating margin from 9.2 per cent to 38.3 per cent has come from:
- Gross margin +4.7 per cent
- Selling costs +17.5 per cent
- Admin costs + 7.2 per cent
Just looking at the numbers. A cumulative increase in revenues of £235.1m since has increased gross profit by a cumulative £176.3m and pre-royalty operating profit by £124.5m. Not all of this is down to operational gearing - the company has invested in production capacity and become more efficient - but a lot of it is.
Customer engagement has kept sales volumes and profits on an upwards trajectory
The key to leveraging the fixed overheads of the business is to get customers to buy more products. Games Workshop has been really good at doing this.
Its recent success has been driven by a big improvement in its engagement with its customers. This started with the launch of Age of Sigmar in 2016 which saw a simplification of the Warhammer game rules and changes to the product ranges. Sales momentum has then been built with regular new releases of Warhammer 40,000 and Age of Sigmar.
Source: Annual Report
One of the biggest drivers of growth has come with the creation of an online community when the company created the warhammercommunity.com website. This has showcased the Warhammer products and storylines to millions of online viewers and has been a great success. Page views to the website continue to grow strongly and this is undoubtedly driving sales.
The launch of Indomitus, the latest version of Warhammer 40,000 in July 2020 has been Games Workshop’s most successful launch to date. Sales often peak with a new version launch according to the company but in 2019, Warhammer 40,000 sales were higher than the previous launch year so if this happened again in 2021/22 it would not be unprecedented.
For me, one of the most impressive characteristics of Games Workshop in recent years has not just been the success of its new releases but its ability to keep selling more of its existing catalogue as more people have taken up the Warhammer hobby. The online engagement has undoubtedly helped with this.
Games Workshop: growth of new and existing products
Source: Annual Report
The decision to launch a new subscription service called Warhammer + is therefore very interesting given that the company’s existing engagement has been going so well.
It is aimed at hardcore Warhammer fans and costs £4.99 per month or £49.99 per year. Subscribers will get exclusive access to new Warhammer products and content which will be showcased on TV and mobile apps. Members will also get a free exclusive miniature on their first anniversary of membership.
I must admit to being a little puzzled by this. Subscription businesses can be very profitable and are a great way of tying in customers but I’m not sure Games Workshop sees Warhammer + as a push for a lucrative new revenue stream.
One of the reasons I believe why Warhammer-community.com has been so successful is because it has been inclusive. Warhammer + changes that by creating exclusivity and it remains to be seen whether some gamers push back against this.
It can be argued that it is a no brainer for Warhammer fanatics to sign up. The value of the free miniature and now the offer of a £10 voucher as well until the end of October essentially means the membership goes some way to paying for itself. The key question is whether it will drive sales for Games Workshop as my view is that the new products would have normally been showcased elsewhere for free and bought anyway. Time will tell.
What’s more likely to be going on is that Games Workshop is taking more control of its intellectual property (IP) and being more aggressive in the monetization of it. It has recently changed its IP policy which has upset some Youtubers who are now not allowed to make money from using the company’s IP - such as creating stories and staging game animations - on their sites by charging subscribers.
It’s very sensible for a company protecting its IP and closing down rogue sites which breach copyright. However, there are Warhammer fans out there who think Games Workshop has been too aggressive as many fan sites have undoubtedly been instrumental in driving the growth of the hobby in recent years. Whether this does any damage to Warhammer sales remains to be seen.
The combination of Warhammer + and the change in IP policy could be mistaken for a margin grab and signs of a company that is verging on hubris - something that Games Workshop is not known for.
The risk of copyright infringement through things such as 3D printing have been around for a while and there has been no signs that this has damaged the revenue and profitability of the company. However, the company’s aim to expand in China where the respecting of IP has a very patchy reputation to say the least should be perhaps more of a worry to existing shareholders.
Investing for future growth
The rapid growth of revenues in recent years has put some strain on the company’s production capacity, warehouses and IT. The good news is that it has not rested on its laurels and has invested heavily in new assets such as a new factory, more warehousing and many new tooling and injection moulding machines to make new and better miniatures. Its distribution hub in Memphis, USA has seen a significant increase in capacity to pave the way for new growth in this key target market.
The company’s IT systems are also being upgraded whilst work will soon begin on the e-commerce website to improve the customer experience and integration with the rest of the business.
Games Workshop: capex
|Shop fit outs||0.8||1.8||1.3||1.4||1.7||1.1||0.6|
|Production & Tooling||3||2.6||3.3||8.8||7.2||6.7||7.5|
|IT & Software||1.6||3.5||2.4||2.6||3.7||3.4||5.2|
|Depreciation & Amortisation||11.1||10.4||10.2||12.2||15.9||14.9||15.1|
|Capex as % of Revenues||6.5%||6.8%||4.5%||7.3%||6.3%||6.7%||5.8%|
Source: Annual Report
You can see the step up in capex since 2017 on expanding production and tooling but also the development of its manufacturing facilities. Capex is in excess of depreciation which shows an expanding asset base but it is worth noting that depreciation and amortization as an expense is not increasing that much. Excluding land, depreciation has increased from £8m to £8.7m since 2019 despite higher capex.
This could be due to the company having a heavily depreciated asset base where fixtures and fittings are 75 per cent written off and mouldings nearly 85 per cent written off. Mouldings have a very prudent depreciation rate and with 25% straight line depreciation for non product specific moulds and 50% reducing balance of net book value for product specific moulds.
It is therefore possible that Games Workshop could have quite a lot of fully depreciated moulding assets which will be helpful to profits. This may also be a sign that moulding capex will stay high for the foreseeable future as new products come on stream.
As well as investment in assets the company continues to invest heavily in its design team to keep the new product releases coming along as well as the continued development of its intellectual property.
An increasing amount of development spend has been capitalised on the balance sheet and amortised through the income statement. This provided a noticable boost to profits last year. The profit boost comes from the amount being expensed in the income statement in terms of amortisation and cash costs being less than the total amount of cash spent.
This is all perfectly above board as long as the projects where the money is being spent are likely to be profitable which in Games Workshop’s case is very likely, but the impact of capitalising what are mostly employee salaries is worth keeping an eye on.
Games Workshop: development costs
|Total Development Spend||8.5||10.0||11.0||13.3||15.9||17.4|
|Amortisation of Development||3.8||2.9||4.1||5.3||4.9||4.8|
|Total Costs going through income statement||7.7||7.2||9.7||11.7||14.8||12.5|
|Total Cash spent||8.5||10.0||11.0||13.3||15.9||17.4|
Source: Annual Report
The other thing to keep an eye on is the amortisation rate - the percentage of capitalised assets expensed against revenues each year. A decline in the rate can be a sign of aggressive accounting.
Games Workshop: amortisation of development costs
|Rate based on Starting||13.7%||9.7%||11.8%||15.2%||12.0%||10.6%|
|Rate based on average||13.2%||9.0%||11.8%||14.0%||11.4%||10.3%|
|% written off||85.9%||79.8%||76.4%||76.2%||76.7%||67.9%|
Source: Annual Report
The amortisation rate is coming down compared with a recent peak in 2019. This does not necessarily mean that there is anything bad going on - and I’m not going to dig deeper into this issue now - but it’s worthy of note as to explaining the positive impact on profits, albeit not a very material one in the context of total operating profit.
The money being spent on development and new assets is very positive and shows a lot of confidence about the company's future growth prospects. The key question in the shorter term is what any future growth looks like given that last year’s results were so strong.
How safe are current profit forecasts?
Games Workshop does not tend to give future profit guidance with its full year and half year results and instead gives regular trading updates throughout the year. If recent history is any guide, a first quarter trading statement is likely in the second or third week of September.
What can be said with some degree of certainty is that if trading in the first few weeks of the year had indicated that full year trading would be materially below current forecasts then the company would have had to have said so. It's early days but the fact that it did not is encouraging.
My concern with Games Workshop is that last year was so strong - particularly in the first quarter - that it may find it hard to grow off last year’s profit base.
The current consensus of City analysts is for operating profits for the year to May 2022 to be £162.6m. This compares with £151.7m last year.
Games Workshop: forecasts
|Free cash flow||124.0||153.3|
This figure will include an estimate for royalty profits. Edison Research - who are commissioned by Games Workshop to write research on the company - is currently forecasting royalty profits of £17m which seems reasonable but they are very difficult to predict with any accuracy.
If this is similar to the consensus forecast of four analysts on SharePad then pre-royalty operating profit is expected to be £145.6m which equates to a margin of 38.1 per cent which is very similar to the margin achieved for 2021. Revenue growth is expected to be 8.2 per cent which looks impressive following last year’s stellar growth. Are these assumptions reasonable?
I find one of the best ways to weigh up broker forecasts is to look at the incremental changes in profits from the previous periods. This can mean looking at the annual run rate of profits and margins at a half year stage and second half profits and margins at the end of the previous year.
Games Workshop: 2021 H1/H2 split
|Op profit pre-Royalties||48.5||24.7||73.2||83.3||52.1||135.4|
|Total Operating Profit||59.2||30.8||90||92||59.7||151.7|
|Op margin pre-royalties||32.7%||20.4%||27.1%||44.6%||31.3%||38.3%|
|Op margin incl royalties||39.9%||25.4%||33.4%||49.3%||35.9%||43.0%|
|Cost of sales||45.3||43.8||89.1||45.7||50.6||96.3|
|Op costs %||36.8%||43.5%||39.8%||30.9%||38.3%||34.4%|
Source: Company Reports
The first half of last year was stellar in terms of revenue growth and margins. There was the pent up demand from the factory and store closures at the end of the previous year, the great performance from the launch of Warhammer 40,000: Indomitus and the margin benefit from selling over the internet. This is unlikely to be repeated to the same extent in my view.
The second half was understandably calmer but the pre-royalty margin was much lower at 31.3 per cent which is considerably lower than what is currently being forecast for 2022.
Stock provisioning is unlikely to boost margins this year whilst warehousing costs as a percentage of revenues are expected to rise slightly.
Last year’s higher staff bonus payment was not a one off with a change in policy announced in the latest annual report. Annual bonuses can now be expected to be as high as 10 per cent of annual pre-royalty operating profits going forward.
The first quarter of FY 2022 has seen the release of Age of Sigmar: Dominion which has met with favourable reviews in the gaming press. That said, Age of Sigmar plays second fiddle to Warhammer 40,000 in terms of sales and the sales boost is therefore unlikely to be as strong as was seen last year from the launch of Indomitus.
I therefore don’t think it's unreasonable to think that the company may find it hard to match last year’s first quarter performance. Will it be able to catch up over the remainder of the year?
I don’t know and I don’t think anyone else outside the company really does either. However, I note that some very diligent private investors track the company’s US imports on a website called importyeti.com and follow forums both which suggest that all is well in the US.
That said, management will have a good feel for the current sales run rate of its existing products and a decent estimate of how well new ones will do. Short-term visibility of revenues will be ok but anything further out than 3-6 months perhaps becomes more difficult which is a position many companies find themselves in.
In recent years, sales volumes have been much better than expected and profit guidance has had to be upgraded significantly as the company has progressed throughout the year due largely to the effects of operational gearing.
After such a stellar performance last year, I can understand why management has kept its feet on the ground in terms of profit guidance. It needs to see how revenues and profits build throughout the year before it has more confidence in the likely full year outcome.
There is nothing wrong with this but it perhaps explains that revenue visibility is an issue and with an operationally geared cost base, the range of potential profit outcomes at the start of a new financial year is likely to be big.
These factors introduce a degree of uncertainty and risk but just as operational gearing can work both ways, so can risk. In recent years, this risk has been to the upside and it’s entirely possible that Games Workshop can keep on outperforming.
The US business was held back last year by bottlenecks at the Memphis Hub and could not meet customer demand. It is possible that North America could be a source of upside to offset any first quarter comparative challenges elsewhere.
The other potential source of upside comes from royalties which are always hard to call but are largely pure profit. The company has been quiet on the progress of the Eisenhorn TV series but existing demand for licensed products has never been better whilst the development pipeline is strong.
I was surprised that management did not discuss shipping costs in its full year results outlook. This has been a source of cost pressure for many exporters in recent months. Price rises will be needed to offset higher costs and could well be a test of Games Workshop’s pricing power.
Games Workshop has proven the doubters wrong for the last few years. As I mentioned earlier, this has come from sales volumes surprising on the upside combined with the benefit of substantial operational gearing. It could do so again.
My concern now is that the bar has been set so high from last year’s performance that a shortfall in volumes could see a material downgrade to profit forecasts. I’m not predicting a profit warning but merely stating that the conditions for one are there and operational gearing could kick in on the downside. It could also keep on working on the upside.
We do not yet know how much of a lockdown benefit the company received in the first half of last year but it looks as if it was significant. It would not surprise me if a trading statement contained words along the lines of: “profits are expected to be second half weighted.”
Longer term, there are many grounds for optimism. A short term bump in the road is not unreasonable after a stellar year and may be cushioned by an upwards reappraisal and improvement of the company’s medium term growth outlook.
At £119, the shares trade on a rolling one year forecast PE of just over 30 times. That’s not unreasonable for a business as good and outstandingly profitable as Games Workshop and could well prove to be good value if it continues to keep on growing strongly. However, it leaves little room for disappointment and already implies a healthy amount of optimism about the company's future prospects.
Games Workshop: key numbers
|Games Workshop £m||2015||2016||2017||2018||2019||2020||2021|
|Post tax profit||12.3||13.5||30.5||59.7||65.8||71.3||122|
|Operating Capital Employed||50.9||52.9||62.4||84.3||107||166.5||244.2|
|Free cash flow||11||11.6||31.1||48.5||50||69.7||92|
|Incremental Changes £m||2016||2017||2018||2019||2020||2021||2015-2021|
|Post tax profit||1.2||17||29.2||6.1||5.5||50.7||109.7|
|Operating Capital Employed||2||9.5||21.9||22.7||59.5||77.7||193.3|
|Free cash flow||0.6||19.5||17.4||1.5||19.7||22.3||81|
Source: Annual Reports