Jeux sans frontiers

I’ve been meaning to publish something on Games Workshop since it has become my largest position.  According to Bloomberg the shares are up 1000% in 3 years (best BREXIT performing stock).  It’s rather nice when a medium conviction idea (ie third largest position by cost) becomes a ten bagger.  Sadly my higher conviction ideas (Bank of Georgia, The Mission Marketing Group) have not done quite as well.

To be honest, it was a medium conviction idea that I bought almost 10 years ago, and was gradually becoming a low conviction idea, until the company started beating expectations.  That 1000% rise in the last 3 years should be seen in the context of 6 years between July 2010 and 2016, when the share price rose from below 450p to almost double…but then fall back to around the same 450p level six years later.  That is, a lot of hard work went on behind the scenes, before it started showing up in the financial numbers and being recognised by the stock market.

Games Workshop shares now trade on 18x tangible book value according to stockopedia.  18x book – that compares to an expensive tech company like Apple on 9x tangible book.  Alphabet trades on 4x book value.

Run with the winners

So Games Workshop is expensive – but I’m not planning to sell.  I’ve lost far more money from selling multi baggers too early than I have from investing in duff businesses.  That’s because although it’s psychologically uncomfortable sitting on large gains, the distribution of gains in the stock market is not the “normal” Gaussian distribution.  Instead, one or two stocks end up contributing the bulk of the gains.  And the nature of exponential growth means that it is mathematically inevitable that you make (or lose out on) the majority of your gains in the last doubling.  If you buy a share at 400p and it doubles 3 times 800p, 1600p to 3200p, you’ll “only” make a total 2800p of gain.  Whereas if the share prices doubles again to 6400p, you’ll make an extra 3200p on the final doubling.

So that’s one reason that I tend not to sell “winners” generally. But I specifically like Games Workshop for its story and the way management talk to their investors.  Of course, the numbers are attractive too, last FY to May 2018 GAW reported its version of Return on Capital rose from 72% to 120%.  With this level of profitability, it’s not hard to build a simple valuation model (assume sustainable RoE of 80%, growth of 5%, and cost of equity of 9%) to get a target price to book value of 18x.

Are these numbers sustainable?

Which rather begs the question what level of profitability and growth might the company enjoy in the future?

To answer this, I went back to 2010.  Given the high gross margin (gross profit as % of sales) of 70%, and relatively fixed operating costs, what would it take to get to today’s financial numbers:

Assume constant tax, gross margin and operating costs grow in line with inflation (2.5%) – and the key input is revenue growth.  Assuming 8% revenue growth compounding annually since 2010 and all other inputs held constant, we get to today’s 2019 numbers.  That is, while 8% revenue growth might not excite a venture capitalist sitting in Silicon Valley, because Games Workshop requires very little incremental capital to grow at this rate, the shares have been a ten bagger. 

Growth and returns

Growth is really uncertain.  It would be lovely if good companies reported 8% steady growth year after year.  But unfortunately the world doesn’t work like that.  Games Workshop’s 2016 revenue was £118m, 7% lower than revenue reported in 2010. That’s why I was beginning to lose my convictions, and contemplate selling. A company where revenue is falling is rarely a good investment, however attractive the gross margin and return on equity might be.

Management were open about this though. In 2014, they said:

Games Workshop has had a really good year.
If your measure of ‘good’ is the current financial year’s numbers, you may not agree. But if your measure is the long-term survivability of a great cash generating business that still has a lot of potential growth, then you will agree.
Having taken on the conversion of our stores to a one man format with all the concomitant complexity of staff changes and new sites and new lease negotiations – a long job not quite finished – we decided to re-arrange the management of our sales channels from a country-based system to a central one. This meant removing four european headquarters, consolidating all trade (third party) sales personnel at our Nottingham base, creating a new continental european grouping of our retail stores, and recruiting new management for these divisions whilst flattening the structure by removing all middle management.

The company suggested revenue growth would take time and warned investors that capital investment would be higher than depreciation and amortisation in the short term as they upgraded their back office systems in Nottingham.

Investment pay off

But then the benefits of prior year investments in store conversions, in manufacturing quality and not least in people, started to pay off.  These investments were both necessary and rather small compared to the future revenue increase they supported.

Companies that try to grow at even growth rates each year, do not necessarily make the best investments.  I’ve dug out a table from a post on Northern Rock I wrote a while ago.  I commented that the table showed something rather worrying.

Northern Rock’s steady 15% CAGR before the financial crisis and high RoE look good at first glance. In fact Northern Rock’s management went so far as proclaim 15% growth as their strategy, which was a case of the tail wagging the dog.

Northern Rock
Total Income56197641515%
Attributable profits22941618716%
Return on Equity20.8%21.9%Increase
Total Assets41,875101,04859,17325%
Customer Deposits15,33622,6317,29510%

But in order for the lender to increase profits by £187m, total assets need to increase by £59bn.  £59bn!  That is a huge amount of £££ in absolute terms for a rather puny increase in profits.  Put another way: to grow profits by 80% (4/5) it needed to grow Total Assets by 140% (7/5) –  and by definition that is not scalable forever.

Super linear growth

Contrast this with GAW. To increase profits by £47m, total assets need to only increase by £49m (and the increase in net assets was even lower). Games Workshop needs very little incremental capital to grow. Perhaps revenue will be flat for the next couple of years, maybe even fall backwards but the long term economics of the business are attractive. Northern Rock scaled sub-linearly, requiring more and more assets to grow profits by less and less. Northern Rock’s high Return on Equity was masking increased risk in the business model.

The risk for Games Workshop is that growth is likely to uneven, and that presents a challenge to management, who have to have faith that their investments pay off. If revenue had remained at 2010 levels, but operating costs had grown by 2.5% CAGR per year, the business would have been loss making in 2020. But you can tell which type of business I’d rather own (clue: it’s not Northern Rock.)

Games Workshop
Total Income11921910123%
Attributable profits12564769%
Return on Equity23%79%Increase
Net Assets52853318%
Total Assets671164920%

What would change my mind?

What would make me sell?  If I thought that management were losing focus on what they do best.  Perhaps even becoming too focused on the financial numbers.

Interestingly Games Workshop is not one of those companies that is always highlighting “one off” bad stuff, or directing investors’ attention to “adjusted EBITDA”.  Indeed they are only covered by two analysts (both of whom they pay). Management don’t spend much time pandering to The City – they focus on telling their story in the Annual Report. Numbers are very clear and the strategy is well articulated, not just good news but the trade offs that management are making to grow the business (see above).  This comes through when looking through historic numbers and building a model. Reading through previous years Annual Reports is much more important to me than having an Earnings per Share, or Discounted Cashflow number in the year 2022.

For now, management remain very clear:

Our ambitions remain clear: to 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.

Photo by Jack B on Unsplash