Stockwatch: Games Workshop shows risks of growth stock valuations

19th March 2021 13:13

Edmond Jackson from interactive investor

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A question of market euphoria, and whether it can be supported by fundamentals.

Is a 7% fall in the share price of Games Workshop (LSE:GAW), the producer of Warhammer miniature games chiefly company-specific?

Or is it more widely relevant as an example of how market euphoria cannot now be supported by fundamentals and sentiment is liable to break down?  

Its market value of more than £3 billion does seem high for a fairly specific games manufacturer. Yet Games Workshop is very well established and popular across the US, Europe and Australasia.  

A heavy price does not alone imply ‘over-valued’ 

A first and key point to appreciate is that while a current price around £94 - down from an all-time high of £112 in the new year – seems very expensive, price can have little bearing on value.

This company has 32.8 million shares in issue, which is relatively low versus those busily issuing for acquisitions and employee bonuses. A low number of shares is a good sign, reflecting a cash-generative business able to self-fund its investment needs. Cash flow per share from operations is consistently and materially ahead of earnings per share, versus moderate capital expenditure – to keep refreshing designs. 

But yes, the near-term chart looks toppy in context of a five-year parabolic rise, and an approximate doubling in value since lockdowns began a year ago. Recently the ex-chairman and his wife sold nearly half their stake, a classic act of risk management.

Assuming Games Workshop makes around £120 million net profit going forward, its forward price-to-earnings (PE) ratio is around 25x – nowhere near as rich as many US ‘growth’ valuations but high enough to mean a scant sub-2.5% yield despite paying out roughly half of earnings. 

Three expectations beaten in a row, then ‘in line’ 

It supports that theory that the chart drop is stock-specific.

A year ago, the narrative was pretty dire, like many. With global performance already hit by the pandemic, all Games Workshop’s stores, headquarters, factories and warehouses had been shut down. But its annual results to end-May still proved the best in its history.  

The goal was re-asserted: to make the best fantasy miniatures in the world “for a price we believe represents the investment in their quality”.

It has still helped operating margins soar from around 14% to 33% in recent years, hence an enviable aspect of operational gearing which does make profit sensitive to revenue changes. 

This was shown by the first expectations beat in a 10 September update: the company’s first quarter showing like-for-like sales up 15% to £90 million and operating profit before royalty income up 61% to £28 million. Royalty income rose 50% to £3 million.  

Online and trade channels had quickly substituted stores and lockdowns.

On 6 November, another ‘ahead of expectations’ update cited first half-year pre-tax profit up at least 37% to £80 million. By 7 December this was upgraded to not less than £90 million. 

Now the company reports it is “in line”, but relative to the hysteria common in late-stage bull markets generally many traders would interpret that as ‘behind’ the trend. 

Chart has consolidated lately  

A circa 7% drop later this week is in fact consistent with a downtrend from £117.30 on 6 January. Indeed, from 3-8 March the price fell over 9% from £100.50 to £91.35 despite no adverse news from the company.  

It is also consistent with portfolio switching from ‘growth’ to ‘value’ situations although investors sitting on big gains here are likely alert to the chart. Over five years, Games Workshop has multiplied in value more than 20 times over, and January’s all-time high represented a forward PE of more than 30x estimated 12-months’ forward earnings. 

The likes of Microsoft (NASDAQ:MSFT) and other technology behemoths may warrant a 30x PE because they can tie customers into subscription arrangements for essential services in the modern economy.

Yet even one of the very best global games designers is subject to changes in habit.  

While Games Workshop’s products have proven more durable in concept than serial fads experienced, for example, by Bluebird Toys in its listed years, it is reasonable to assume lockdowns have offered a unique boom – quite like DIY - given so many people have had time on their hands, with families at home. 

Previous chairman and wife sell nearly half their stake 

Last 26 February the couple sold 8,000 shares at £97.21 each, raising £737,680, and kept 8,700 shares worth around £818,000 currently.

It appeared a logical move, both to protect gains and retain a meaningful stake if Games Workshop gets acquired by a larger multinational – especially from the US, which constitutes the company’s largest source of revenue.

While speculative, it would be consistent with serial examples of British design snapped up by foreigners on our relatively open market for corporate control. 

Several other disclosed shareholders also trimmed their stakes late last year. Standard Life Aberdeen from 6.7% below 5%. JP Morgan Asset Management from just over 5% to just below this level. Likewise, Norges Bank around the 3% level, and, going back to August, Tom Kirby from 4% below 3%.  

There has not, however, been any disclosed selling during the chart breakdown from January. 

Holders just became a little less optimistic  

Games Workshop’s chart still has a message for the wider market: that despite no adverse change in fundamentals it is possible for a bull trend to reverse simply because mild hysteria eases.

Moreover, when prices are high relative to potential long-term returns, investors are more likely to follow each other’s behaviour – watching the chart. 

The crux looks likely to be the full financial year’s trading update in June, when to sustain confidence management must be clear about the revenue trend as Britain slowly emerges from lockdown.

It will initially be interesting to see what might be the ‘back to school’ effect. There looks to be a risk to valuation, as the March 2020 to March 2021 period has been exceptional. 

Games Workshop Group - financial summary
Year end 31 May

  2015 2016 2017 2018 2019 2020
Turnover (£ million) 119 118 158 221 257 270
Operating margin (%) 13.8 14.3 24.2 33.6 31.6 33.4
Operating profit (£m) 16.5 16.9 38.3 74.3 81.2 90.0
Net profit (£m) 12.3 13.5 30.5 59.5 65.8 71.3
Reported EPS (p) 38.3 42.0 94.5 182 201 218
Normalised EPS (p) 41.9 43.5 93.4 182 204 219
Earnings per share growth (%) 3.3 3.8 114 95.4 11.5 7.6
Price/earnings multiple (x)           43.1
Operating cashflow/share (p) 72.7 75.4 136 214 221 319
Capex/share (p) 38.6 39.4 39.7 65.9 68.6 75.1
Free cashflow/share (p) 34.1 36.0 96.3 148 152 244
Dividend per share (p) 52.0 20.0 80.0 120 120 135
Yield (%)           1.4
Covered by earnings (x) 0.7 2.1 1.2 1.5 1.7 1.6
Cash (£m) 12.6 11.8 17.9 28.5 29.4 52.9
Net debt (£m) -12.6 -11.8 -17.9 -28.5 -29.4 -20.8
Net assets/share (p) 161 166 196 272 328 409

Source: historic Company REFS and company accounts

Risk/reward profile tilts unfavourably at current prices 

The end-November balance sheet was in excellent health: only 11% of £182.2 million net assets constituted intangibles, with no goodwill. Cash had nearly doubled, to £96.5 million, and there was no debt beyond £45.3 million lease liabilities. 

Yet even after the chart pull-back the stock trades around 17x net asset value – a huge premium despite ‘book value’ being far less relevant here than earnings. A circa 2.4% prospective yield does not offer a prop. This puts a lot of focus on potential changes in revenue given the earnings’ sensitivity.   

There is logic to lock in at least some gains, given this stock would also be affected by further rotation from ‘growth’ to ‘value’, especially if highly-priced US stocks crack. With fresh money: ‘avoid’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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