Games Workshop Group — No cracks in the plastic

Games Workshop is the global leader of, and the only quoted company providing exposure to, the rapidly growing market for tabletop miniature gaming. Its miniatures, accessories and games are set in fantasy and science fiction settings that appeal to dedicated enthusiasts with a wide age-range. It is vertically integrated, controlling every aspect of the design, manufacturing, marketing and distribution of its products globally.

The strategy has delivered strong growth in revenue (five-year CAGR 18%) and profit (operating profit including royalties five-year CAGR c 41%) following better product ranges with clear and structured price points, while increasing its use of online and social media marketing to engage with its customers. Global distribution has increased through a multichannel network of stores, websites and more third-party sellers in more countries. The company is highly cash generative, while funding investment in fixed and working capital to support its long-term growth strategy. The impressive growth and high cash conversion have supported strong returns to shareholders. Management’s financial management is reflected in a strong balance sheet and the success of the company’s strategy is evidenced by the quoted ROCE of 94% in FY20.

Our forecasts for FY21 and FY22 are broadly unchanged following the trading update. We assume c 30% revenue growth in FY21 (Trade and Online channel growth more than offsetting a Retail decline) and a further 9% growth in FY22 (all channels contributing growth). Further gross margin gains, albeit lower than the exceptionally high gains reported in H121, translate to EPS growth of c 56% in FY21 and c 12% in FY22. We assume the dividend increases by c 56% to 200p/share in FY21 and by 10% to 220p/share in the following year. Our forecast year-end FY21 cash balance of £68.0m is greater than GAW’s stated required working cash buffer of £50m, presenting the company with flexibility on the uses of its cash.

GAW’s share price has been re-rated in recent years as management’s strategy delivered financial results that have consistently surpassed expectations for revenue growth, profitability and cash flow generation. Our DCF-based valuation of 11,613p per share assumes that GAW’s revenue growth continues to exceed the most recent forecasts for market growth of 9% per annum (source: Statista) through FY24 before gradually fading to 5% revenue growth in the terminal year, FY30. We also assume that royalty income grows in line with revenue, while recognising the limited visibility and lumpiness of the income, and investment in capital (working, fixed and intangibles) that is consistent with recent trends as the company’s scale increases.

Over the long term there is a risk the existing technology for manufacturing plastic miniatures could be replaced by 3D printers. This is a challenge for the future as the best 3D printers cannot replicate the quality and certainly not at the scale of production with which GAW manufactures its miniatures. GAW continues to invest in new infrastructure and updating older infrastructure, as well as the implementation of an ERP system, each of which has the potential to cause near-term disruption. The majority of GAW’s sales and purchases are transacted in sterling, US dollars and euros, and fluctuations in forex rates have the potential to affect sales and margins. National lockdowns and restrictions affect GAW’s ability to generate revenue in physical locations, but online distribution enables this demand to move channel.

GAW is a leading international specialist designer, manufacturer and seller of miniatures, scenery, hobby materials, fiction and artwork for tabletop miniature games set in its fantasy and science fiction worlds. The company’s key brands are Warhammer Age of Sigmar (Age of Sigmar), Warhammer 40,000 (Warhammer 40K or, often simply, 40K), alongside Horus Heresy, an offshoot of Warhammer 40K. It also holds the licence for The Lord of the Rings and The Hobbit tabletop battle game.

GAW’s Warhammer Hobby concept is centred on customers collecting, building and painting miniatures that can ultimately be used in games played against fellow enthusiasts, either privately or at organised events. The company has delivered strong financial returns through better product ranges with clear and structured price points, and extensive use of online and social media marketing to engage with its customers. These have made the Warhammer Hobby more accessible to a wider audience through also increasing its multi-channel distribution network of stores, websites and third-party sellers more globally.

All products are designed in-house and manufactured at the company’s manufacturing, distribution and head office facilities in Lenton, Nottingham. This supplies two distribution hubs in Memphis, US, and Sydney, Australia.

GAW has a clear long-term strategy: ‘to make the best fantasy miniatures in the world, to engage and inspire its 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.’ That it has achieved a revenue and EPS CAGR of 18% and 42% respectively from FY15 and FY20 and now generates three-quarters of its revenue outside the UK is testament to the success of the strategy. The company’s strategy has five key pillars:

GAW started out in the 1970s as three games fanatics selling handmade classic wooden games from their homes in London and, later, a chain of general games shops. In 1981 the company provided funding to help establish Citadel Miniatures, a manufacturer of metal miniatures based in Nottinghamshire, which was later fully integrated into GAW.

In 1991 Tom Kirby, who remained chairman of GAW until 2017, led a management buy-out from the remaining founder, Bryan Ansell, ahead of the company’s IPO in 1994. In 2015 Kevin Rountree, who had been CFO in 2008 and COO in 2011, took over as CEO. Kevin and his close team’s focus on customer engagement, greater product innovation and openness to fully exploring the IP’s potential as a licensed property welcomed in a new era of success and rapid growth for GAW. All UK operations have been based in Lenton, Nottingham, since 1997.

One of GAW’s greatest strengths is its control over every aspect of its brand and products, from concept and design to manufacture and distribution. The company creates miniatures, scenery, fiction, artwork and the overarching framework of rules for games to be played in two key Warhammer settings: Warhammer 40K and Warhammer Age of Sigmar.

The Warhammer brand has been in existence for more than 30 years and is the undisputed leader for fantasy and science fiction tabletop miniature games, with a global following of dedicated enthusiasts.

Warhammer 40K: this is one of the most popular and long-established IPs in the world and accounts for the majority of the group revenue. The setting is a mixture of futuristic science fiction and gothic fantasy with battles taking place on a post-apocalyptic war-scape in the 41st millennium. Mankind fights for survival, aided by the superhuman Space Marines as they fend off alien monsters and other horrors. The first edition of the 40K tabletop miniature game was released by GAW in 1987 and the most recent, ninth edition, Warhammer 40K: Indomitus was released in July 2020. Each edition adds new rules for playing games, refines existing ones and expands the IP of the universe in which the game is set. Recent launches of new editions have had a significant impact on the company’s sales performance.

Warhammer Age of Sigmar: GAW developed this unique fantasy IP to replaces its Warhammer Fantasy Battle setting as its core fantasy universe. Launched in July 2015, it is set in the Mortal Realms, a series of eight magical realms interconnected by Realmgates. These are the focus of fierce battles between mighty heroes, vengeful gods and fantastical creatures. With its unique IP and dynamic, engaging game, it has proved itself to be more popular than Fantasy Battle ever was, and its appeal shows no sign of slowing. The second edition of Age of Sigmar, was launched in June 2018.

Horus Heresy: retelling the fictional history of the Warhammer 40K universe, this setting has been developed into a tabletop miniature game. Centred around a galaxy-spanning civil war taking place 10,000 years before Warhammer 40K, it puts one of GAW’s core properties, the Space Marine, front and centre. Horus Heresy is also sometimes referred to by enthusiasts as ‘Warhammer 30K’ or simply 30K.

Middle-earth: for the past 20 years, GAW has held a licensing agreement with Warner Bros and Middle-earth Enterprises that gives it exclusive, worldwide, all-language rights to produce tabletop games and miniatures based on the IP for The Lord of the Rings and The Hobbit. This licensed brand accounts for less than 2% of revenue.

Citadel: the majority of GAW’s products are made from plastic and carry the Citadel logo. Citadel miniatures mostly need to be assembled and painted, with varying levels of skill required. Price points vary widely, depending on the size and detail of the products, of which there are over 2,000. Individual miniatures start from £5 and range up to c £100 for a full squad.

To make Warhammer more accessible, the Warhammer Studio has developed a series of starter box sets for Warhammer Age of Sigmar and Warhammer 40K. These are priced from £25 for a set of 15 miniatures plus an 82-page introductory guide to £105 for a set of 27 miniatures plus scenery pieces, gaming board and complete rule book. A range of easy-to-build squads, which do not require glue to assemble, has been introduced, priced from £6.

Forge World is the division that produces resin models aimed at more experienced Warhammer hobbyists. The models are typically larger than Citadel miniatures and require more time and skill to prepare, assemble and paint. As such, the pieces command a premium price compared with the Citadel range. An individual figure might cost anywhere between £19 and £400, whereas a top-of-the-range Warlord Titan (a hulking war machine) weighing 10kg and measuring more than half a metre tall, costs over £1,300. Forge World products are predominantly sold online via GAW’s ForgeWorld.co.uk website and from its Lenton-based Forge World store (one of the features of GAW’s Warhammer World visitor centre). It represents less than 5% of group revenue.

Other products: the company produces a range of Citadel paints, paint brushes and other modelling accessories. A starter set of paints and tools costs £25+.

The Black Library studio produces an extensive collection of fiction novels, novellas and short stories in book and audio format in Warhammer settings that helps to widen the audience. With the cost of paperback and hardback titles broadly comparable with that of high street retailers, Black Library also produces a range of high-value (£45) collectors’ and limited editions.

GAW’s concept and design studios work on a continuous pipeline of new initiatives and improvements to existing product lines to expand the Warhammer worlds and cater to the evolving requirements of Warhammer hobbyists. The lead time for a new product, from concept to launch, is typically 18 months, whereas the recent launches of a new edition of one of the core Warhammer games has taken place every three years. Each new edition of 40K and Age of Sigmar includes rules changes and the launch of new miniatures and accessories, which has the advantage of encouraging existing hobbyists to update and expand their collections, as well as attracting new collectors.

Since FY15, GAW has increased investment in its infrastructure including IT, R&D, manufacturing, and warehouse facilities to ensure it remains at the forefront of miniatures technology, pioneering injection moulding and other techniques necessary to produce the very best quality miniatures.

GAW has been continually investing in its core back office systems, with the final phases of the replacement ERP systems for the UK and European businesses to go live later in CY21.

Following the acquisition of land adjacent to its headquarters in FY18 to increase manufacturing capacity, the first phase of GAW’s second factory became operational in December 2018. The second phase of this factory, with an extended tool room and dedicated R&D function is now complete The number of plastic injection moulding machines available to support growth has doubled. At the planning stage, the new facilities were expected to support revenue of over £400m, just above our revenue estimate for FY21 of c £349m. Another piece of land next to the second factory has been secured. Following completion of the second factory, management is focused on maximising output from the two existing sites; the first is being redesigned and further injection moulding in the second factory will come on stream in spring 2021.

A new group logistics manager was recruited in November 2018. A new purpose-built rented facility, 11 miles from the head office, started to become operational from July 2020 and is expected to be fully operational by May 2021. In total, GAW is investing £5m in fixtures and fittings in the new warehouse. Similarly, a project to increase capacity and make the warehousing facility in North America more efficient is due for completion in FY21.

GAW has an integrated multi-channel approach to selling its products internationally via three channels: Trade, Retail and Online. Over time, Trade and Online have grown in importance to the group, and more recently Retail has been negatively affected by COVID.

Trade, namely sales to independent retailers, has been the fastest-growing component of GAW’s revenue mix, achieving a CAGR of c 26% in FY15–20. Further strong growth during H121 of c 33%, while Retail was recovering from closures and restrictions due to COVID, led to Trade’s importance to the group increasing to c 56% of total revenue. In Appendix 1, we show the drivers of Trade since FY16. There was a minor change to geographic disclosure in FY15 so it is excluded. Strong revenue growth reflects the addition of new trade accounts as the business has expanded geographically. In recent years GAW has added 100–200 net new trade accounts each year and the number of countries served has steadily increased. During FY20, 200 net new accounts were added before the outbreak of COVID. In H121, despite the disruption caused by COVID, a further 200 net new accounts were added, therefore it appears to have been relatively unaffected by the general macro weakness.

Trade is a key part of GAW’s global expansion strategy, particularly in countries where it does not have a store presence. The majority of account sales are made via telesales teams based in Nottingham, Memphis and Sydney, in which the company has been investing alongside its online service tools to enhance customer service and support. In FY20, Europe and Asia were the fastest growing markets, with growth of 21% and 22% respectively, although the disruption caused by national lockdowns may have influenced relative growth rates.

Although this channel is dilutive to gross margin, it is less capital intensive and achieves a higher operating margin than Retail. Its growing importance has therefore been important to the progression of GAW’s operating margin.

Retail’s growth has been driven by new store openings with increased geographic coverage and a general increase in productivity of the locations. The historic drivers of Retail are shown in Appendix 1. COVID began to affect Retail revenue as a result of store closures and opening restrictions from the end of H220 and it declined y-o-y by c 19% in H121. GAW recruits new customers through its stores which only stock the company’s products. Given the company’s extensive IP and product range, the stores do not offer the full range of products, only newly released products, and the appropriate extended ranges. As ‘destination’ stores, these are typically located away from prime retail thoroughfares. The stores are a valuable means of engaging with new and existing customers, and emphasis is placed on recruiting genuine enthusiasts to sell the products and run a variety of workshops and activities in store. The stores are typically one-man stores, with 411 of the 531 stores at the end of May 2020 staffed by just one person.

GAW’s retail presence is increasing in most geographies. Prior to the COVID pandemic, management was targeting c 25 net new store openings per year, predominantly in North America and Germany. As a result of COVID, management has paused store opening plans for 2021 to focus on improving performance of the existing stores. In the H121 results, management indicated that c 50 stores, just over 9% of the portfolio, would not break even if current revenue trends persist for the remainder of FY21. From a capital perspective, the cost of shop fits for new and existing stores is relatively low at £1–2m pa.

Excluding FY20 as the majority of the estate was affected by COVID, and noting that FY18 was a 53-week accounting period, revenue per store has increased in every year in most regions. The increase in store productivity despite new store openings is testament to the strength of demand.

The company runs three websites: gamesworkshop.com for Citadel products plus separate sites for Forge World and Black Library, and sales of books through Audible and e-books are included here too. The main website was re-launched in April 2014, followed by the migration of forgeworld.com to the same platform in summer 2015 at a cost of £1.1m. GAW continues to invest in the online shopping experience, and develop its sites in other languages and currencies. Every GAW retail store has a web terminal for customers to access the full range of more than 1,000 products, compared with c 700 items available in store.

Online has been a relatively stable proportion of GAW’s business at 18–21% of total group revenue between FY15–20, but recent strong growth relative to Trade and Retail has led to it representing 25% of group revenue in H121. The y-o-y growth rate for Online slowed to c 4% in H220 from c 15% in H120 due to the complete closure of all operations on the initial COVID national lockdown from March 2020. In H121, demand was significant leading to Online revenue growth of c 88%. On an absolute basis, Online revenue grew y-o-y by £21.5m in H121 versus the decline in Retail revenue of £8.9m, which implies strong underlying growth as well as likely switching of customer spend between channels.

GAW has been extremely successful in its strategy of seeking enthusiasts across the globe, such that international accounted for three-quarters of total sales in FY20. Although its own stores are in 23 countries, it sells in many more countries through the additional reach of its websites and trade accounts, many of which have their own international multi-channel offering.

The company delivered impressive growth across all of its main markets in FY15–20. Management believes there are significant opportunities for growth in North America, Germany and Asia. In both North America and Germany, GAW continues to drive growth via new store openings, investment in its trade sales teams, and multi-language and currency websites, alongside extensive use of social media marketing to promote the brand and new product launches.

Outside the sale of physical products, management was historically cautious about leveraging its IP into other media due to its desire to protect the integrity of its IP (a matter of finding the right partners, formats and contractual terms) or the potentially prohibitive internal investment required to develop content in specific media, eg films or television programmes. This has changed in recent years as management has invested resource in understanding how the media and entertainment industries work, as well as investing in staff, including the addition of own licensing staff in China, to develop new partnerships.

The greatest success during the past 20 years has been in video games (PC, console and mobile), which have represented the majority of royalty income, but also includes board games and accessories. By the end of FY20, GAW had 73 video games licences and was typically signing a new licence every two to three months. With respect to other media, in July 2019, GAW announced that it had signed an agreement to develop a TV series based on one of the Black Library novels, Eisenhorn. Management admits that progress in media and entertainment has been slower than it would have liked. GAW is regularly in discussions with potential new partners while continuing to invest in recruiting people with media experience to accelerate the development of the business.

Warhammer World visitor centre, located at GAW’s Lenton HQ, has become a place of pilgrimage for enthusiasts of the Warhammer Hobby. In 2015, the centre was expanded and revamped and now accommodates three retail sections (Warhammer World, Black Library and Forge World), ticketed entry exhibition areas for Citadel and Forge World, a Warhammer World-themed bar and a dedicated events and activities arena.

Given the niche nature of the Warhammer Hobby, GAW engages in only targeted marketing. It does this with a dedicated in-house team which creates all of the marketing content. This allows for greater quality and better cost efficiencies. GAW has three dedicated filming studios for which it records and streams Warhammer TV, a channel which has attracted c 433k subscribers since its launch in 2016. The company releases more than one video per day on average, including tutorials on how to build and paint miniatures and how to play the various games. Beyond this, there is a wealth of content available online, which has been created by enthusiasts. The company has continued to develop its own Warhammer-community.com website. It also streams events live on the interactive gaming site, Twitch.

GAW has an impressive track record of long employee service across the organisation and its senior management team is no exception. Few companies can boast a wall of photos of employees who have worked for the company for more than 10 years, as GAW proudly displays in its staff canteen.

Chairman – Elaine O’Donnell: Elaine became chair on 1 January 2021, having been an independent non-executive director at GAW since 2013. She has been the senior independent director and chairman of the Audit and Risk Committee since 2019, and was a member of the Remuneration and Nomination Committees. Elaine is also a non-executive director (NED) of Studio Retail Group and On the Beach Group. She was recently a NED of MSIF, the chair of the board of directors at Alliance Fund Managers and a NED of The Manufacturing Institute. Prior to these roles, Elaine was a partner at Ernst & Young, where she specialised in corporate finance, mergers and acquisitions, having worked in audit and corporate finance at PwC.

CEO – Kevin Rountree: Kevin heads the executive management team. He has significant experience in the business, having joined as assistant group accountant in 1998. He became group finance director in 2008, before assuming responsibility for GAW’s global service centres as COO in 2011 and being appointed CEO in 2015. Kevin trained as a chartered management accountant with Price Waterhouse.

CFO – Rachel Tongue: Rachel joined as group tax manager in 1996. She worked in a variety of finance roles in the company before being appointed company secretary in 2008 and group finance director in 2015. From the start of November 2020, Rachel assumed responsibility for group-wide support services and legal and compliance functions. She trained as a chartered accountant and chartered tax accountant with Arthur Andersen.

Technology: GAW has invested heavily in its manufacturing facilities and equipment to produce plastic miniatures. Although there is a small risk that existing processes are eventually replaced by 3D printers, this is a challenge for the long-term as even the best 3D printers cannot replicate the quality, and certainly not at the scale of production with which GAW manufactures its miniatures. As an expert in its field, GAW remains at the forefront of this, and all other miniatures technology.

Brexit: although non-UK exposure is, in our view, highly attractive, a key risk for GAW is its ability to ship products to Continental Europe, which represents more than a quarter of total sales. Following the resolution of a trading agreement with the EU, there remains potential for disruptions/ delays to the company’s ability to transport goods from the UK to the EU across all sales channels and/or for logistics costs to increase to reflect less efficient customs processes.

COVID: national lockdowns and other restrictions affect the company’s ability to generate revenue in Retail locations and Trade accounts, therefore the outlook for these will depend on the speed of roll-out of vaccines globally. GAW’s Trade accounts and online presence enables demand to shift across the channels.

Exchange rates: the majority of GAW’s sales and purchases are transacted in sterling, US dollars and euros, and fluctuations in exchange rates have the potential to affect headline sales and margins. The company does not hedge its exposure to foreign exchange risk.

Infrastructure: GAW continues to implement an ERP system in the UK and Continental Europe, with work due to finish in 2021. Given the complexity of the project, there is a risk of business disruption, which is being minimised using an internal project team and specialist ERP software consultants. GAW is also expanding its factory and warehouse capacity.

Product ranges: GAW has an extensive range of existing and new products, which it must ensure remain relevant to its customers’ evolving needs.

Following the appointment of Kevin Rountree as CEO in January 2015, the stated strategy has delivered strong financial results driven by the pipeline of new product launches, geographic expansion of the store base, an increase in the number of trade accounts, growth in online distribution and better leveraging of its IP.

From FY15 to FY20, the CAGRs for revenue, operating profit before royalties and other operating income, namely royalties, were 18%, 37% and 62% respectively. This compares very favourably with the preceding years: in FY15, GAW’s revenue of £119.1m was lower than FY09’s revenue of £125.7m, and the more recent peak of £134.6m in FY13.

With three-quarters of revenue earned overseas, foreign exchange changes can affect GAW’s revenue growth and profitability as the exposure is not hedged. Since FY15, currency translation has had a relatively benign effect on reported revenues. In FY17, following the EU referendum, sterling depreciated versus the euro and the dollar and, in aggregate, currency translation contributed c 13% to FY17’s revenue growth. The recent c 5% strengthening of sterling versus the dollar to $/£1.37 represents a translational headwind for H221 and into FY22.

In H121, GAW reported exceptionally strong revenue growth, due to a ‘step change’ in volumes from the launch of the ninth edition of 40K, Indomitus in July 2020, good growth across the rest of the product offer and, geographically, in North America. Revenue grew by 25.9% (26.8% at constant currency), and operating income excluding/including royalties of £83.3m/£92.0m both exceeded the total for the whole of FY20 (£73.2m/£90.0m).

GAW’s revenue growth led to significant operational gearing as the operating margin ex-royalties increased from 12.5% in FY15 to 27.1% in FY20 and 44.6% in H121. The improved margin arose from leveraging the semi-fixed operating costs which fell from 56.4% of revenue in FY15 to 30.9% in H121, while the gross margin has been more variable.

GAW typically demonstrates a high level of gearing at the gross margin level. H121’s revenue growth of 25.9% produced a very impressive gross margin increase of c 6pp y-o-y to 75.5%. Gross margin gearing was 99%, namely for every £100 of incremental revenue, £99 fell through to gross profit. As might be expected given the manufacturing base, gross margin gearing works in both directions: in FY15, FY16 and H220 (due to COVID), lower revenue versus the prior period was accompanied by lower gross profit.

GAW’s gross margin is influenced by changes in scale, the phasing of product releases including pricing benefits, channel mix, geographic mix including FX and sourcing costs.

Exhibit 8 shows the phasing of major product releases and GAW’s financial performance.

The most recent annual peak in gross margin was 72.4% in FY17 before it reduced over the next three financial years. FY18 and FY19 were negatively affected by the use of third-party warehousing to accommodate higher volumes, and FY20 reflects the COVID outbreak in H220. The peak annual gross margin in FY17 was prior to the launch of the eighth edition of 40K. The intra-year margins show a higher gross margin on launch, due to the initial volumes of the release, which then reduces after volumes peak, and the inventory provision is made at the year-end. For example, the gross margin in H118 was 2.2pp higher than the 69.9% reported in the following six months. The lower gross margin in H119 on the release of the second edition of Age of Sigmar reflects, in part, the strong comparative of the more popular 40K release. The higher gross margin of 75.5% in H121, on the launch of the ninth edition of 40K, is consistent with the results of prior launches, albeit gearing was significantly higher than historically, therefore a lower gross margin into H221 is likely.

The mix of revenue from new products has increased from 30% of revenue in FY16 to 38% in recent years, and therefore the annual impact of average annual price increases (typically 3–4%) on newer products is likely to have been beneficial to gross margin.

Exhibit 9 shows there is not a consistent direct relationship between channel mix changes and reported group gross margin, as other factors highlighted above also influence the margin. Until FY20, Online revenue, with a higher gross margin, was a relatively consistent percentage (18–21%) of group revenue. Trade has a lower gross margin due to its wholesale nature and has constantly grown in importance to the group at the expense of higher-margin Retail. In H121, the significant increase in Online coincident with the 40K release proved to be very beneficial to gross margin.

We have deconstructed the constituent parts of COGS using the company’s disclosure for costs including inventory, depreciation of owned assets and amortisation, and our estimates for other costs (staff costs and other) to determine the sources of change in gross margin.

The key long-term changes on a relative basis versus revenue were an increase in staff costs as the number of production and warehousing staff grew more than threefold (assuming the group-wide average cost per employee), a reduction in amortisation of development costs and a modest reduction in materials costs. The net inventory provision (for ageing inventory) increased relatively consistently as the company’s inventory grew with scale and stock turn slowed (see below). ‘Other’ is the residual after reversing out the above costs from reported cost of goods sold. It includes depreciation of right-of-use assets (a ‘new’ cost in FY20 due to the introduction of IFRS 16 in the place of operating lease payments) and staff bonuses. The allocation of these costs between COGS and other operating expenses is not disclosed.

As highlighted above, GAW has leveraged its semi-fixed operating cost base to deliver operating margin gains. Broadly, Exhibit 10 shows the increasing importance of higher-margin Trade and Online revenues at the expense of lower-margin Retail have been positive for the group’s operating margin. We believe all channels have increased profitability over time. As GAW is vertically integrated, determining profit by channel is complicated by the not being able to identify costs by channel. The company’s disclosure of the sources of operating profit changed in FY20, since which time the disclosed operating profit of the main functions is determined by benchmarking versus peers. Therefore, the disclosure is of limited use in tracking/modelling profitability of the different channels.

The breakdown of the main operating costs, namely their scale and how they change, provides some insight into how profitability has changed. The main line items in total operating costs of £104.5m in FY20 were Retail £55.6m (53% of total), Operations and support £26.5m (25%), Trade £9.3m (9%), and Online £5.5m (5%). In H121, GAW’s operating expenses increased by 6% y-o-y versus revenue growth of c 26%. Cost reductions for Retail (-14% y-o-y), Operations and support (-5%) were partially offset by increases for Online (+33%) and Trade (+4%). Therefore, the operating costs of Trade (+4%) and Online (+33%) increased more slowly than their respective revenue growth rates of 33% and 88%, but the reduction in Retail’s operating costs (-14%) was lower than its revenue decline of 19%.

Impressive long-term profit development has enabled the payment of a profit share and discretionary annual bonus at a combined cost of c £5m in recent years. The latter was not paid in FY20 due to the effects of COVID, but was reinstated in H121 at a cost of £5m, 2.7 margin points.

Licensing income has become an important contributor to group profitability, growing from £1.5m in FY15 to £16.8m in FY20, as management has sought to extend use of the IP. There is no visibility on future licensing income as it depends on how quickly management becomes comfortable with potential partners and their use of the IP, and in turn, how successfully the partners generate revenue. IFRS 15 (Revenue from Contracts with Customers), which requires full recognition of guaranteed licensing income on signing the contract, exacerbates the lumpiness of the income. In H121, royalty income of £8.7m declined by c 23% y-o-y against a tough comparative. Within the £8.7m, guaranteed (initial) income declined y-o-y by 63% to £2.3m, but additional royalty income above the initial guarantee levels increased by 42% to £6.4m. The latter is a good indicator of management’s success at finding the right partners.

GAW’s dividend policy is to return ‘truly surplus cash’ to shareholders. Distributions are not made with any reference to an earnings or cash payout ratio, but we include them below to show how they have developed. Typically, the company announces and distributes multiple dividends in a financial period.

As well as providing spectacular share price returns in recent years, the CAGR for the total annual dividend was 23% since FY15, lower than the growth in free cash flow per share and EPS, as cover for both has increased. In H121, GAW declared two dividends totalling 80p/share, and after the period end declared a further dividend of 60p/share, compared to three dividends totalling 100p/share in the prior interim period. In the Q321 trading statement, management declared a further dividend of 45p/share taking the total for the year to 185p. We assume a total dividend of 200p per share in FY21, y-o-y growth of 38% and further growth of 10% to 220p in FY22. These would represent cash costs of £65.5m and £72.2m versus our forecasts of FCF of £91.1m and £126.8m.

Our forecasts for FY21 and FY22 are relatively unchanged, despite the inclusion of a minor foreign exchange headwind of c 3% in FY22. This mainly reflects the recent strength of sterling versus the dollar to U$/£1.39, c 7% stronger than the year to date average of U$/£1.30.

We forecast y-o-y revenue growth of c 30% in FY21 to £349.1m and further growth of c 9% in FY22 to £381.4m. The former implies y-o-y revenue growth of c 34% in H221, versus growth of 26% in the interim period. It reflects continuing strong sales growth from 40K and the easier comparative from H220 when most operations ceased trading from the end of March to at least the start of May. We assume continued growth for Trade (+33%) and Online (76%) and a marginal decline for Retail. The forecast for H221 implies lower average monthly revenue of £27.1m than H121’s £31.1m, bur more than H220’s £20.2m.

For FY21, we forecast a gross margin of 72.5%, gearing of c 90% on incremental revenue and lower gearing (c 80%) in FY22 to reach a gross margin of 73.3%. The gross margin for H221 of c 69% is c 650bp lower than H121’s 75.5%, reflecting the typical lower gross margin in the second half of the year of a major product release, and an increase in logistics following Brexit.

With the release of the H121 results, management announced that it is in the process of cancelling the UK expanded business rates retail discount scheme for 2020/21, which has been completed. GAW had already repaid other financial assistance received from governments, eg for furloughed staff, during lockdown in H121.

Further down the P&L, our assumptions are unchanged except for a modest change in net interest due to higher interest on lease expenses following the increase in the lease liability at the interims.

Our forecast for FY21 EBIT pre-royalty income of £128.1m represents y-o-y growth of 75% and a margin of 36.7% (FY20: 27.1%). We assume operating cost growth of c 27% in the second half of the year due to increased headcount and associated costs as well as higher marketing costs. It follows cost growth of just 6% in H121, including the reinstated discretionary staff bonus of £5m.

The company’s revenue and profit growth have led to a significant improvement in operating and free cash flow generation on an absolute basis and relative to revenue, whilst investing in its infrastructure and product development to support long-term growth.

The most significant driver of the improvement in free cash flow generation has been the increase in operating profit and reported operating margin from 13.8% in FY15 to 33.4% in FY20, offset in part by an increase in cash tax payments. In H121, the step change in operating margin led to a further improvement in operating cash generation.

Working capital typically represents a modest cash outflow, reflecting the company’s increasing scale. GAW’s investment in capex and intangibles has been broadly stable at 6–7% of revenue. Capitalised development, mostly the staff costs for those in product development, has reduced modestly on a relative basis. In aggregate, total fixed and intangible investment has averaged 9–10% of revenue over the long-term.

GAW has a strong balance sheet and operates with a net cash position. At the end of FY20, the net cash position was £52.9m pre IFRS 16. The adoption of IFRS 16 introduced £32.1m of lease liabilities, leaving GAW with a net cash position including lease liabilities of £20.8m. Reflecting the company’s greater scale, management has stated that in future years it would like to retain a larger working cash buffer of roughly £50m. At end H121, the net cash position pre IFRS 16 increased to £96.5m, and increased lease liabilities of £45.3m took the net cash post IFRS 16 to £51.2m. Following the period end, the reinstated staff bonus, expensed during the interim period, was paid in December. Furthermore, in December a dividend of 60p was declared, a cash cost of £19.7m. For FY21, we forecast a year-end cash position of £68.0m ex IFRS 16, higher than the stated required buffer of £50m, providing flexibility on further internal investment or cash returns.

As a manufacturer, the largest item on the balance sheet at the end of FY20 was £42m of PPE, mainly relating to GAW’s freehold land and buildings, production tools and machinery, and IT. The adoption of IFRS 16 led to the capitalisation of a further £31.9m of right-of-use assets, which increased to £44.8m at the end of H121. With respect to working capital, there has been some variation in the net working capital cycle between FY15 and FY20. Stock turn (relative to COGS) slowed from FY15 (4.9x) through FY18 (3.2x) as volume growth increased, leading to higher inventory provisions, as noted earlier, and stock turn improved thereafter. Debtor days (relative to sales) have been more consistent over the same period, ranging from 26–31 days, while creditors days (relative to total expenses) have ranged from 41–52 days typically. The increase in FY20 was due to government support for furloughed employees, which was subsequently repaid. In our forecasts we assume underlying working capital movements are consistent with FY20.

Our 11,613p valuation for GAW is derived using a DCF valuation.

Our 10-year DCF forecast assumes revenue growth beyond our two-year forecast horizon of 10% (a slight premium to prior expected market growth of 9%) in the first two years, namely FY23 and FY24, with a gradual fade down to 5% in our terminal year, FY30. We model 50% of incremental revenue flowing through to the EBITDA margin (pre-royalties), increasing the margin by 20–40bp per year to reach a terminal EBITDA margin of 47.5%. We assume royalty income grows in line with revenue, and the investment in working capital, tangibles, intangibles and capitalised development are consistent with historical trends. We include an outflow for the effective capex for right-of-use assets. We factor in a cost of capital of 6.5%, mainly equity (risk premium 6% and company beta 1.05). Below we show the sensitivity of the share price to differing terminal growth rates and cost of capital assumptions.

At 11,613p per share, the EV/sales multiple for FY21 would be 10.6x and the P/E multiple would be 34.2x. The P/E multiple compares with GAW’s previous highest multiple of 36.5x (FY20), which reflects the pre-COVID peak share price on lower post-COVID reported earnings.

GAW does not have a direct quoted peer. In terms of product and market, the closest comparators are mainly small unquoted companies. We compare it with companies that fall into two categories: 1) multinational ‘mainstream’ toy and special interest/hobby companies and 2) global leaders in IP creation. Although far from an exact comparison, given different revenue streams and investment requirements, it provides some context to the valuation.

GAW’s EV/sales multiple for FY21 of 8.7x is a premium of c 235% to the average multiple for the toys and special interest peers. A higher multiple is justified given GAW’s higher revenue growth (note revenue growth rates of Focusrite and Future include M&A) and profitability, with a 33.4% EBIT margin in FY0 versus the peer average of 15.0%. The higher margin leads to GAW’s P/E multiple of 28.2x for FY21 being a more modest premium of 25%. Relative to global content IP/content, GAW’s EV/sales multiple for FY21 is a more modest premium of 26%. However, the peers have a very wide range of multiples and operating margins. GAW’s high operating margin is reflected in EV/EBIT and P/E multiples being at a discount to global IP/content companies.