2023-10-04 10:57:44 ET
Summary
- For over 40 years, Games Workshop has managed to excite millions of people with its games, managing to satisfy both them and its shareholders.
- Games Workshop is an outstanding business with excellent returns on capital and run by long-term oriented management.
- Although taking into account the quality of the business, current valuations do not provide an adequate margin of safety.
Introduction
I have been completely immersed in the world of Warhammer for the past two weeks, trying to understand what makes people get so excited about this brand. In fact, I have spent the last few nights reading hundreds of posts on Reddit groups and blogs, and watching YouTube videos on the subject, trying to understand where the magic comes from. I have to admit that until two weeks ago I didn't have the slightest idea of what Warhammer was, so the first contact with this world was extremely confusing to say the least. But now, after this research, I think I understand (at least partially) the reasons that make people approach and stay in this world, sometimes for decades.
But first, let us take a step back: What is Warhammer?
Warhammer is a tabletop battle game developed by the Games Workshop Group ( GMWKF ) that includes several "sagas". To give you an example, Warhammer 40K, Games Workshop's flagship game, was launched in 1987 and still delights millions of people. The first edition of Warhammer Age of Sigmar (AoS) was released in 2015 and Warhammer The Horus Heresy in 2012, so we are talking about extremely long-lived games that from time to time receive updates or new expansions that enrich the story and characters even more.
It is difficult for me to explain in a few words what the world of Warhammer actually is. Therefore, I invite everyone who wants to learn more to take a look at the various subreddits and YouTube channels on the subject.
The extreme complexity of these imaginative worlds leads people to approach and become passionate about the Warhammer brand for very different reasons. There are those who are passionate about painting miniatures and therefore buy miniatures from Games Workshop ((GW)) just to live out their passion without actually playing (from what I could gather from my research, this category represents the majority of buyers of GW products). Then there are those who are attracted to the "lore" behind these worlds and therefore do not necessarily buy dozens of miniatures, but are entertained by the other contents created by GW. A third category is those who play, some just with friends and some in competitive tournaments (this is clearly a very small niche compared to the total). Of course, these are just three exemplary categories, between which there are infinite nuances.
To give you an idea of the volumes, we are talking about 2.4 million people , an estimate from the blog "Goonhammer", which analyzes their users and general traffic between subreddits, YouTube channels and official sites (in this case we are only talking about Warhammer 40K), and only for the English-speaking world. If we consider the rest of the world, they estimate the number of enthusiasts to be between 3.5 and 5 million, with the majority represented by casual gamers and hobbyists. Of course, it is difficult to give an accurate estimate of how many people are interested in this game. GW does not release data on the actual number of miniatures sold, and even if they did, it would still be difficult to give a number of customers, since it's easy to switch between those who buy a few miniatures a year and those who buy several dozen (plus, it does not take into account the used market). However, if you want to think only about the "media coverage" on the various social networks, you can rely on these figures.
I felt this long introduction was necessary because although Games Workshop's business model is simple to understand (its core business is selling plastic miniatures), I think it is necessary to understand why people continue to love this brand in order to think about the future of the company and whether or not there is a competitive advantage. Without this analysis, the real value of this company cannot be understood.
Business Model
To describe Games Workshop Group's business model, I can find no better words than those used by the company itself on its website :
We make the best fantasy miniatures in the world, to engage and inspire our customers, and to sell our products globally at a profit. We intend to do this forever. Our decisions are focused on long-term success, not short term gains.
GW engages in the design, production, and distribution of miniatures and games, as well as the creation of other content such as short stories, audio dramas and novels related to the lore of their games. The company also sells materials and tools for painting miniatures, such as "Citadel" brand paints and brushes. Games Workshop is not only vertically integrated, but also sells its intellectual property to third parties for the creation of multimedia content such as video games or movies.
The business related to the sale of miniatures and books represents about 95% of the turnover, while the remaining 5% comes from the concession of IP. As for the operating income, you can see from the figure that the licensing business is particularly profitable. Even though it represents only 5% of sales, it accounts for about 13% of the operating result.
In terms of distribution methods, GW uses three warehouses, the main one near their HQ in the UK, one in the US in Memphis, and a third in Sydney, Australia. The company uses 3 different distribution channels, one of which it owns (Retail), which consists of 526 stores in 23 countries, of which 399 are single staff stores. A second channel (Trade) is represented by over 6500 independent retailers, which therefore sell other games in addition to those supplied by GW, and finally a third channel, the online channel, which includes the official website. In their physical stores they only sell "starter packs" and some other products that might be of interest to those approaching the world of Warhammer for the first time. In the other sales channels you will also find products that we could call "more "advanced" and that might be of interest to those who already have some experience.
In terms of the licensing business, the breakdown of revenue in 2023 is as follows: 68% PC and console games, 6% mobile and 26% other.
One detail I would like to point out is that, as mentioned before, the physical stores directly controlled by GW (Retail) are designed for those who need to deal with the games offered by the company for the first time. Since this is a long-lived game that can keep fans engaged for many years, growth in this sales channel could lead to a consistent increase in sales in the other two, where it is possible to find more "advanced" products. I will discuss this topic in more detail later, as it is essential for estimating the company's future sales.
A key element of Games Workshop's strategy is to focus on product quality and developing intellectual property that can excite people. As I explained in the introduction, a large portion of those who buy GW miniatures do not play, but use them only to maintain their hobby, and the quality of the miniatures is a very important aspect for this type of customer. Creating high-quality intellectual property (unique designs and stories), on the other hand, is a great way to get people excited about game worlds and keep them engaged.
In exploring the various subreddits related to the world of Warhammer, I couldn't help but notice that many people have been in this world for many years (some even for over 30 years!) and that there are communities that are very interested in current and future releases. from GW. This is clearly an intangible asset that is fundamental to the company's business model, but unfortunately extremely difficult to value.
In the picture you can see the geographical distribution of the stores. In December 2022, the first café store was opened in Tokyo and 3 more are planned for 2023/24. Regarding China, in the last annual report they stated that they have completed the process to obtain the China Compulsory Certificate (CCC), currently all their most relevant products have permits to be sold in China.
A quick search on Google Trends revealed that in addition to the increase in interest in Warhammer 40K over the past 5 years (from 34 to 65), the countries that search for the term the most(besides the UK) are: Australia, Sweden, New Zealand, Canada, Denmark, Finland and the USA.
The geographic distribution of sales is as follows: North America 44.3%, Continental Europe 23.5%, UK 21.8%, Australia and New Zealand 6.5%, Asia 3.3%. GW began providing geographic diversification data across its three distribution channels beginning in FY21. In the three tables below, you can see a summary of sales for these three years (excluding royalty income), broken down by geographic area and distribution channel.
Financial Overview
In the images you can see the revenue growth from FY14 to FY23. The geographic areas that most favored this growth were North America (£39.9 million in 2015, £197.4 million in 2023) and Continental Europe (£33.5 million in 2015, £104.8 million in 2023).
Operating margin has improved significantly in recent years thanks to economies of scale and excellent cost management. To make the pictures easier to read, I stopped at 2014, but you have to keep in mind that revenue has not changed between ups and downs from 2004 to 2017 (£151.8 million in 2004, £158.1 million in 2017). This is a fact that I think needs to be taken into account in future estimates.
The return on invested capital ((ROIC)) is excellent, reaching a level achieved by very few companies. It reflects management's excellent capital management and GW's dominant position in its market. It should be noted that GW is not in a position to reinvest all of the cash generated at these rates of return; in recent years, it has distributed most of the cash generated to shareholders. Opening new Warhammer stores in Japan (and probably China) could be an excellent investment opportunity that could generate exceptional returns given its history.
There is no point in dwelling too much on the balance sheet, given that GW has total cash and short-term investments of £90.2 million and total liabilities of £91.7 million. The company is easily able to finance itself, which significantly reduces the risk for shareholders.
In conclusion, cash generation is also excellent. Management is very cautious in evaluating investment opportunities and only distributes to shareholders only the resources that it believes cannot be invested with satisfactory returns. I recommend that you all read the Chairman's Preamble in the 2017 Annual Report , written by Tom Kirby. It clearly expresses in a few lines the values that guide Games Workshop's management and the leadership style of CEO Kevin Rountree.
For those who want stable dividends, I will say right now that GW is probably not for you. For the few of you who are long-term oriented (GW management by long-term means 25 years) and want your money managed by managers with the same time horizon, you have come to the right place!
In its last trading update on September 15, GW reported that it had achieved results in the three months to August 27 that exceeded management's expectations. Core revenues were £121 million (£106 in 22/23) and licensing revenue was c. £6 million (£3 in 22/23). PBT also improved significantly by 46% year-on-year to approximately £57 million. Although results were ahead of expectations, management indicated that it is too early to update full-year expectations.
Management
I think it is necessary to spend a few lines on speaking in more detail about the management of this company. By now I can say that I have read at least a hundred annual reports of various companies, and so far I have found in only two of them such a degree of transparency, clarity and fairness to shareholders that I was surprised. The first of these two companies is Berkshire Hathaway, and I think it needs no introduction; the second is Games Workshop itself.
in 1991, under the leadership of Tom Kirby, Games Workshop underwent a management buy-out, in 1994 the company went public, in 2014 Mr. Kirby assumed the role of Non-Executive Chairman, and in January 2015 handed over the throne to Kevin Rountree, who continues to lead the company to this day. As you may have seen from the preceding paragraphs, Mr. Rountree has done an outstanding job in leading the company from 2014 to the present. He has brought GW out of a period of stagnation by breathing new life into the Warhammer brand and expanding the business in various geographic areas.
What you can deduce from the results achieved and what you can read on the investor relations website and in the annual reports is exactly what a true value investor looks for in the management of the company in which he wants to invest.
Catalysts
As for estimating future results, keep in mind that the customers who spend the most are usually new customers who need to build their "army" or those who already have one and want to gather another. Of course, prices can vary widely, but if you want to play and not just collect and paint, a complete army can cost anywhere from $1000 to $2000. For those who want to continue the hobby, expenses usually drop significantly in subsequent years, perhaps buying a few miniatures or paints now and then. You can get an idea of the average person's spending in the various discussions on Reddit. The company is currently looking to expand into Japan by opening new stores. This could attract a lot of new people and significantly increase sales in that region (as mentioned earlier, new players tend to be the ones who spend the most).
Furthermore, if GW were able to penetrate further into China (where it already has a small fan base, mostly related to video games), I think sales in Asia could easily match current sales in Europe or North America. The key question, which is difficult to answer, is when will it succeed?
Given management's current intentions in Japan, we could see excellent results starting next year and especially in 2025/2026. As for China, I do not expect any big surprises before 2026. GW is acting like a virtual monopolist with Warhammer, there are currently no competitors of this size, so management is in no hurry to attack the first possible new markets, evaluating investment opportunities and taking the necessary time without taking excessive risks.
As for other geographies, a strong growth catalyst that can attract new fans is the future Amazon Prime series based on Warhammer 40K (theoretically to be released in 2024), for which Henry Cavill, a well-known Warhammer enthusiast, has been hired. Not only would this mean enormous publicity for GW, but it would also lead to a substantial increase in royalties.
In the next paragraph, I will use three growth scenarios in which I will consider the catalysts I have listed in this paragraph.
Valuation
In a research by Edison , which GW has linked to in Investor Relations, the estimates of revenue and profit for 2024 and 2025 are as follows:
I will use these estimates as a reference for the base case and the worst case.
Before moving on to the valuation, I feel it necessary to point out that it has been extremely difficult for me to make estimates for this company. As we have seen in previous data analysis, the growth we can expect from GW is unlikely to be linear. There could be years of little or no growth, followed by years of revenue explosion with double-digit growth. This unpredictability makes it necessary to have a high margin of safety. For all three cases, I used a discount rate of 12% and assumed a payout ratio of 80%.
Base Case:
Best Case:
Worst Case:
With a current market capitalization of around £3.5 billion, Games Workshop seems fairly valued only by my best estimate, which takes into account a revenue CAGR of around 9% to 2033. They could probably achieve better margins, but to remain conservative, I have applied a maximum net margin of 33% (the highest they have ever achieved). Finally, I assumed a multiple of 25 in 2033, which is the same as the current one. In my opinion, GW can only achieve these results if they manage to continue to grow sustainably in North America, Europe and the UK, and develop significantly in Asia. This hypothetical scenario also takes into account the possible Amazon Prime series, which could give a strong boost to the core business, but also to royalties.
If we disregard this scenario, the company appears overvalued in the other two cases. As I wrote in the previous paragraphs, it is not unlikely to expect periods in which GW's sales practically stagnate and then start growing again rapidly, for example, after a particularly successful relaunch or a strong geographic expansion.
If we believe analysts' estimates of modest sales and earnings growth over the next few years, the valuation seems decidedly high at the moment. As much as I am convinced that the long-term future of the company is absolutely bright (by long-term I mean 15+ years), I find it difficult to decipher the next 5 years. I will better express my thoughts on this in the conclusions.
Risks
From an operational perspective, GW has limited risks. It has sufficient cash to cover all debt, inventories are low, margins are excellent, and cash flow is good. Management has excellent cost control and the company is ready to easily overcome any future difficulties. From a competitive point of view, Games Workshop also has no competitors, and acts like a "monopolist" in its market.
From my assessments, it emerges that the currently most relevant risk for an investor is the company's valuation. If you consider current analyst estimates, a P/E of 25 is quite high (even if you look at the historical average). If the company enters a phase of revenue stagnation, it could mean years of zero or negative returns for investors. However, if the company managed to obtain the results I hypothesized in the Best Case, it would currently be correctly valued (for an expected return of 12% per year). I therefore believe that the lack of an adequate margin of safety makes investing in Games Workshop at these prices particularly risky. For those willing to accept a lower return (around 8%), there is a minimum margin of safety.
Conclusion
I hope that with this analysis I have managed to show the main aspects of Games Workshop Group, even if I had to leave out many of them for obvious reasons.
To conclude, Games Workshop is an exceptional company, with an inimitable competitive advantage and excellent management at the helm of the company. From what I have been able to learn from my research, the long-term future of GW is absolutely bright, the community of enthusiasts is very strong and in the near future there could be several catalysts that will allow many more people to approach this world. My only concerns are the difficulty of estimating future cash flows and the share price which currently does not reflect this uncertainty.
The past growth of the company has not been linear and I think that the future growth will not be linear either. We know well that Mr. Market does not react very well to non-linearity, if a company is not able to grow in a constant and predictable way every year, it is punished by the market.
I think (and partly hope) that the market could reserve excellent entry opportunities for us in the future, and it is therefore appropriate to analyze and understand this exceptional company now, in order to be able to seize these opportunities immediately. If I were already a shareholder of this company, and had purchased the shares at more reasonable prices, I wouldn't worry too much about the ups and downs of the market and would continue to own it for decades. It's foolish to sell exceptional companies just because they seem slightly overvalued, in the long term these companies will always find a way to amaze you!
For further details see:
Games Workshop Group: What's Behind The World Of Warhammer?