Games Workshop Group — Winning performance

Games Workshop’s FY20 results show a strong performance in the face of the COVID-19 pandemic, which affected the majority of the company’s final quarter of trading, following a strong performance in H120. Group revenue grew by 5.1% y-o-y to £269.7m, operating profit (pre-royalties) grew by 4.8% to £73.2m and PBT increased by 10% to £89.4m.

The trading update on 28 April 2020, with one month of trading of FY20 remaining, indicated that PBT for FY20 would be not less than £70m. The subsequent year-end trading update for FY20 on 12 June indicated that revenue would be c £270m and that PBT would be not less than £85m. The company saw a better than expected return in demand following the easing of restrictions relating to the COVID-19 pandemic. A focus on managing costs was evidenced by FY20 operating costs increasing by 3.8% in FY20, lower than the revenue growth of 5.1%.

All of the company’s operations, including the factory, warehouses and stores, were closed with immediate effect from 24 March, and where possible staff were encouraged to work from home. Trade sales in Europe and North America re-commenced during the final days of April, and online orders through games.workshop.com (19% of group revenue in FY20) were accepted from 1 May. At that time, a number of the company’s own stores in China, the Netherlands and Scandinavia had re-opened in line with local social distancing requirements. By the time of the full year trading update, production at the factory had re-started and was increasing, the warehouses were operational, and 306 of the company’s 532 stores had re-opened with the remaining stores expected to re-open as restrictions are lifted. Therefore a good proportion of the business stopped trading for just over one month, and other parts of the business were yet to re-commence trading by the year-end and so had been closed for three months.

In descending order of growth rates, FY20 revenues grew by 15.3% in Trade and 9.2% in Online, and declined 11.2% in Retail. It is particularly impressive that both Trade and Online reported positive revenue growth in H220. Trade benefited from the addition of 200 net new accounts during FY20, with, we calculate, an implied increase in the average spend per account, although this figure can be skewed given the wide range of spend per individual account. Retail was the most affected by the pandemic, with a decline of 28.9% y-o-y in H220, despite an increase in the number of stores from 517 at the end of FY19 to 531 at the end of FY20, implying an even greater like-for-like decline.

There is no quantification of the absolute impact of COVID-19 on the results. Prior to the COVID-19 outbreak, for FY20 we were forecasting revenue of £286.4m and PBT of £95.6m; in the event the reported FY20 revenue and PBT were only 5.8% and 6.5% below our prior forecasts. The company’s commentary highlights that it only lost around six weeks of sales and profit, which is equivalent to c 11% of annual sales and profit on an unweighted basis, therefore the numbers were better than might have been expected. The Retail decline of 28.9% in H220 y-o-y is important, albeit in a six-month period, indicating that it has been more heavily affected than might have been expected, but the total group number suggests that demand was satisfied by Trade or Online.

The gross margin declined to 67.0% in FY20 from 67.5% in FY19 due to the disruption from COVID-19 and the impact of sales mix. The operating margin pre-royalties for FY20 was relatively stable for the year overall, at 27.1%, but, as to be expected, was much higher in H120 (32.7%) than in COVID-19 affected H220 (20.4%). Overall, FY20 operating profit grew by 4.8%. Royalty income increased from £11.4m in FY19 to £16.8m in FY20 due to an increase on guarantee income on new contracts signed in the year.

Given the successful trading across the whole year, and the still-strong financial position, management has taken the honourable decision, where possible, to repay any government subsidies claimed during the outbreak and not to make any further claims for any such subsidies.

Cash: The company remains financially strong

During FY20, the company generated £104.5m of operating cash flow, a substantial increase on the £72.5m generated in FY19, which reflects the higher profitability, and improved working capital due mainly to an inflow for creditors, which included some COVID-19 support not yet repaid and higher deferred revenue among other items.

The investment in tangibles and intangibles, including capitalised development, increased by c 9% from £22.5m in FY19 to £24.6m in FY20. As a result, free cash flow pre-interest increased by c 60% from £50m to £79.9m, which provided 1.7x cover of the dividend payments of £47.3m.

At the year-end, the cash position (excluding lease liabilities arising as a result of now reporting under IFRS 16) was c £52.9m, a net increase of £19.9m from the cash position of £33m at the end of H120. When considering IFRS 16 liabilities of c £32.1m the company had a net funds position of £20.8m at the end of FY20.

A new overdraft facility of £25m has recently been put in place, but not drawn. Games Workshop has had a year-end net cash position at every year-end since FY07.

Given the ongoing uncertainty created by COVID-19, no financial guidance for FY21e has been provided by management. However, it highlights six areas of focus for FY21e that are expected to lead to sales growth and a stable operating margin. These include improving digital marketing and customer engagement; greater focus on leveraging online sales; and managing the business recovery, notably in Retail, with no new own-store openings and a hiring freeze in place (but no significant job reductions planned).

Exhibit 2 highlights our new estimates for FY21e and FY22e.

We forecast that revenue will increase by 2.1% in FY21e to £275.3m and by 6.5% to £293.1m in FY22e. This compares with our pre-COVID-19 forecast for FY21e of £300.8m. We forecast an increase for Trade revenue of 6.2%, Online to grow by 17.6% and Retail to decline by 15.5%. This implies average monthly revenue of £22.9m in FY21e versus £21.4m in FY19 and £24.7m in H120, which were both unaffected by COVID-19.

For Trade, we assume that the economic environment will make it more difficult to grow the number of Trade accounts and therefore include no net growth year-on-year in FY21e before adding 200 accounts in FY22e, and an increase in spend per account as these gradually re-open post lockdowns and then normalise against lost revenue due to COVID-19 in FY20. In FY18 and FY19, the company added 200 and 600 new Trade accounts, respectively. For Retail, we assume no new store openings in FY21e and declines in like-for-like growth through the year, before resuming store growth in FY22e. For Online, we assume 15% underlying growth in FY21e and the return to the normal run rate of revenue that was lost due to COVID-19 in H220.

We estimate that the gross margin will be stable in both financial years.

We assume no structural cost saving plans in response to the more difficult operating environment beyond the natural change of variable costs due to the declines in revenue. Operating costs overall are expected to increase marginally, mainly due to the annualising of new staff who joined during FY20, and the ongoing investment in the business infrastructure. Overall, we forecast operating profit (pre-royalties) in FY21e to increase by 1.7% to £74.4m from £73.2m and to £79.8m in FY22e. Prior to COVID-19, our FY21e forecast for operating profit (pre-royalties) was £88.9m, therefore the new forecast is 15.4% below this prior forecast.

We assume lower royalty income of £11m in FY21e before returning to growth of 10% to £12.1m in FY22e, while recognising that the income stream is volatile and difficult to forecast.

In aggregate this leads to our forecast PBT decline in FY21e of 5% to £84.9m from £89.4m in FY20. Prior to COVID-19, we were forecasting PBT of £101.3m for FY21e, therefore the new forecast is 17.2% below our pre-COVID forecast. On an absolute basis versus FY20, our new forecasts for FY21e are c £6m higher revenue, c £4m higher gross profit, c £1m higher operating profit (pre-royalties) and c £4m lower PBT. The main driver of the forecast decline in PBT is the lower royalty income.

With respect to the dividend, the company’s policy has been to distribute ‘truly surplus cash’ to shareholders. Historically, this has, broadly, been equivalent to free cash flow ie operating cash flow less investment in tangibles, intangibles and capitalised product development. The statement highlights that, given recent events, a buffer equivalent to three months’ working capital will be set aside before deciding how much cash is truly surplus. We assume that management retains an extra buffer versus recent year-end cash levels. Our forecasts include c £15m of investment in tangibles and intangibles versus £18.6m in FY20, although it is possible that there could be some additional ‘catch up’ outlays. We forecast that the dividend in FY21e will be 125p/share versus 145p in FY20. With these results, management has already declared a dividend of 30p/share.

The share price reached a peak of 7,350p in February 2020, before falling to 3,590p in March during the wider market sell off due to the COVID-19 pandemic. The shares have subsequently recovered to reach 9,300p.

At the current share price of 9,300p, the EV/sales (excluding IFRS 16 debt) multiple for FY21e is 10.8x and for FY22e is 10.2x, which compares with the average multiple since FY08 of 1.9x. The average EV/sales multiple since FY17, when growth accelerated under the new management team, was 3.6x and the previous highest EV/sales multiple was 9.5x in FY20. If our forecasts prove too conservative and the company generates revenue halfway between our new revenue forecast for FY21e of £275.3m and our forecast from before COVID-19 of £300.8m, ie £288.1m, then the EV/sales multiple for FY21e would be 10.4x.

The valuation ascribed by the market reflects a higher growth rate since FY17, ie pre-COVID-19, as the company has grown internationally and profitability has risen materially, with a reported EBITDA margin before royalties in FY19 of 33.4% versus 10.3% in FY07, margins in the low 20%s from FY13 through FY15, and 30%+ from FY18. Other operating income, ie royalties, with an effective 100% margin, is a significant part of the total group profitability, representing c £16.8m in FY20, from £11.4m in FY19, as there was an increase in guarantee income on new contracts signed in the year, and £6–10m pa from FY16–18.

The P/E multiples for FY21e and FY22e are 45.0x and 41.7x, versus the long-run average since FY08 of 15.6x.

For the purpose of illustration, a reverse DCF with a WACC of 7.7% and terminal growth of 2% from FY29 suggests that the current share price is discounting approximately from FY22e: a revenue CAGR of c 15.5% pa, an annual increase in the EBITDA margin pre-royalties of 30bp to reach a terminal margin in FY29 of 39.1%, and growth in other operating income, ie royalties, of 20% pa. The sensitivity of the DCF to changes in the cost of capital and terminal growth is highlighted in Exhibit 4, and to changes in assumptions for sales growth and royalties growth is shown in Exhibit 5.