Games Workshop Group — Third consecutive year of record results

FY19 results demonstrate the ongoing global success of the Warhammer brand.

GAW delivered impressive FY19 revenue growth of 15.9% (15% constant currency) to £256.6m, on the back of two years of exceptionally strong comparatives (FY17: 33.9% and FY18: 40.0%). Demand has remained strong across all channels and major geographies, supported by a robust pipeline of new product releases and ongoing focus on customer engagement.

The anticipated gross margin decline of 350bp year-on-year to 67.5% reflects the ongoing channel shift towards trade and the new vs existing product mix (38% vs 62%), in addition to higher costs associated with the use of third-party warehousing. Tight cost control led to a 140bp reduction in operating costs as a percentage of sales to 40.3%, despite £4.1m investment in the store opening programme and £2.6m additional spending in operations, support and marketing teams, alongside an increase in discretionary staff bonuses and variable costs attributable to sales volume growth.

The company continues to leverage its rich IP via relationships with the major digital gaming publishers. Royalty income increased by 18.2% to £11.4m due to the strong performance of two titles, Total War: Warhammer II and Warhammer: Vermintide 2, and the signing of new licensing agreements. In combination, these factors resulted in a 9.5% increase in pre-tax profit to £81.3m. There were no exceptional items.

GAW has an integrated multi-channel approach to selling its products internationally via three channels: trade, retail and online.

Trade has remained the fastest growing channel y-o-y over the past three years and now represents 47% of the sales mix. In FY19 trade sales grew by 29% (28% CCY), with sales to trade accounts that primarily sell online performing notably well. 600 net new trade accounts were added during the year, taking the total to 4,700 accounts across 69 countries.

Consistent with our expectations, retail sales growth moderated to 7% (7% CCY), largely driven by 28 net new store openings, the majority of which were in North America and Asia. Management has maintained its guidance for c 25 net new openings in FY20, focused on North America and Germany. Online sales rebounded strongly in H2, after a modest decline in H1 to deliver 5.3% growth across the year.

Geographically, all key regions performed well. The company continues to focus on developing its presence in China, where it now has six stores and a Warhammer website on one of China’s e-commerce platforms, and the Rest of Asia. Sales grew by 67% and 23% in these two regions, respectively.

Net cash increased by £0.9m y-o-y to £29.4m at year end. This was a result of cash from core operating activities of £69.0m and royalty income of £9.1m offsetting capex of £22.5m, dividends of £50.3m, group profit share and discretionary employee bonuses of £5.5m, and smaller items. Company policy is to distribute surplus cash to shareholders.

Games Workshop has taken its first steps towards bringing the Warhammer worlds to TV and animation. During July, it signed a development agreement with Big Light Productions, a script writer, show runner and production company. The collaboration will bring a story based on Eisenhorn, one of the most popular Black Library novels, to TV.

Additionally, the company is poised to start production of an animated series, Angels of Death, which showcases the popular Space Marine characters. Management has indicated that it may distribute the animated series via Warhammer TV, although it is exploring other avenues.

While it is too early to determine potential profitability, these new ventures present a significant opportunity to showcase the brand and introduce Warhammer to new audiences globally.

Against tough prior year comparatives and in light of macroeconomic uncertainties, we continue to factor in potentially overcautious sales growth assumptions. We expect FY20 and FY21 trade and retail sales to both grow at c 5% pa and online at 0.5%, consistent with our like-for-like store sales growth assumption in each year. We factor in 25 net new store openings in each year.

We assume 50bp gross margin expansion in each of the two forecast years. Although channel and product mix are likely to continue putting pressure on the margin, we expect some improvement as a result of production efficiencies from the new manufacturing facility. Key infrastructure projects to upgrade IT systems and logistics capacity are not expected to complete before the end of 2020.

Following the adoption of IFRS 15 in FY19, GAW now recognises minimum royalty guarantee income when a new contract is signed, as opposed to previously being recognised as deferred income, which was released in line with licensee sales. This serves to reduce visibility and we therefore cautiously assume the same level of royalty income over the next two years as in FY19, noting that it is one of management’s priorities for FY20 to sign new licensing deals.

Our FY20 capex forecast increases by £5m to £21.5m (broadly in line with the previous two years) to reflect investment in fixtures, fittings and technology for the Memphis warehouse, which is being extended by its landlord from 100k sq ft to 150k sq ft. The project commenced in May 2019 and is expected to complete in 2020.

In FY21, we forecast total capex of £16.5m including c £5m investment in the fit-out of a new pre-let UK logistics facility, which is to be developed on a site approximately 10 miles from GAW’s Nottingham head office campus. Building work is scheduled to commerce in autumn 2019 and complete in the second half of 2020. The new facility will reduce third-party warehousing costs.

We forecast end-FY20 net cash of £40.8m.

GAW will adopt the modified approach in FY20, meaning that it will not restate prior years. The company estimates that the adoption of IFRS 16 at the end of FY19 would have resulted in an opening right of use asset of c £34.9m and a corresponding lease liability of c £34m. It expects the overall net P&L impact of IFRS 16 to be broadly neutral. However, the current operating lease charge will be replaced with a depreciation charge on the right of use asset (therefore increasing EBITDA), and there will be an interest charge on the lease liability. These are non-cash changes. We will incorporate IFRS 16 adjustments into our forecasts when the company reports interim results in January 2020.

Our 4,486p valuation for GAW is a blended average of the DCF and peer group comparison.

We have rolled our DCF forward a year and adjusted the sales growth assumptions in our 10-year DCF forecast so that the modest and, we believe, achievable (based on recent performance and strategic initiatives for global expansion) growth rate of c 4% is maintained for four years beyond our two-year forecast horizon, then gradually fades to our terminal growth rate of 2% (previously faded towards 2% from the third year). Our EBITDA margin improves slightly from 37.8% (FY19) to 40.0% over the forecast period. The 100bp uplift in the terminal margin to 40.0% compared with our previous DCF reflects the FY19 result (90bp higher vs our forecast), and factors in gross margin recovery and tight cost control. We make no change to our assumption that capex returns to a lower rate of 5% of sales and factor in a 7.7% equity-only cost of capital (risk premium 6%, company beta 1.1).

Our DCF returns a value of 4,703p per share. Below we set out implications for the share price of differing terminal growth rate and cost of capital assumptions.

GAW does not have a direct quoted peer. In terms of products and market, the closest comparators are mainly small unquoted companies. We therefore compare it with a range of companies that broadly fall into two categories: 1) multinational ‘mainstream’ toy and game designers, manufacturers and distributors; and 2) specialist interest companies. Although far from an exact comparison, it does provide some context to the valuation compared with adjacent sectors.

We note that GAW and the peer group have performed strongly since our last valuation. GAW’s strong share price performance (up c 40%) following the earnings upgrade in April has modestly extended its premium to peers on a P/E basis in both years and EV/EBITDA in CY20. We believe the current premium is merited based on our expectation of continued growth and possible future earnings upgrades (based on the core business performance and potential for additional licensing deals), and a sustained generous dividend yield of c 4%, which is underpinned by a strong balance sheet. Absent any premium to the group, the implied valuation would be 4,270p based on average peer group P/E and EV/EBITDA multiples for CY19 and CY20.