Games Workshop Stock: My Macro Fears Proved Misplaced (OTCMKTS:GMWKF)

Although bullish from a long-term perspective, my fears that British firm Games Workshop (OTCPK:GMWKF) could fall victim to macro-related woes has thankfully not materialized in the circa 14 months since I first covered the company. Indeed, up over 85% in USD terms including dividends, the stock has significantly outperformed the broader U.K. small-cap space in that time:

Just to recap, Games Workshop owns fantasy tabletop gaming IP like Warhammer 40,000. This is a niche business, with the firm operating a vertically integrated model whereby it is responsible for the design and manufacturing of miniatures as well as distribution. Company-operated stores number around 525 globally and generate around 23% of total company revenue, with independent retailers (~53%), its online store (~19%) and licensing deals (~5%) accounting for the remainder.

Company-owned IP like Warhammer obviously creates a captive customer, and while that lends itself to pricing power these shares only really took off in circa 2016 having previously seen years of flat revenue, earnings and stock price performance. As I mentioned last time, a big driver of the explosive returns since then has been the cost leverage displayed by its business, with operating margins up significantly since the mid-2010s:

The catalyst for that has been a combination of top line growth and channel mix. Retailers in general typically display decent cost leverage, and the company’s own-store channel has likely benefitted to a degree. For instance, back in 2014 the company operated 412 stores which together pulled in annual revenue of £53 million (~$87 million at the average GBP/USD rate for that year). Store count has since increased modestly to around 525, yet Retail channel sales had nearly doubled in GBP terms to around £103 million (~$131 million) by fiscal 2022/23. Spreading those extra sales over fixed costs like rent, salaries, insurance and utility bills creates nice profit growth.

A bigger driver, though, has been shifting mix to the Trade channel, which represents sales to independent retailers. Sales through this channel have increased by a factor 5-6 over the same timeframe, with its mix of overall revenue increasing from around 35% to the 53% outlined above. Now, these sales will likely come with lower gross margins as the company will need to sell products to third-party operators at a lower cost than in would in its own outlets (so that they can capture some markup for themselves), however this will be more than offset by higher overall operating margins as the company won’t generate the corresponding store-level expenses with this revenue line. Although demand creation is obviously the genesis of all of this (sales are up by a factor of 3-4 since 2014), this channel mix effect has been a big driver of returns here.

My chief concern last time out was a potential economic slowdown/recession impacting sales. At the time, interest rates were rising rapidly, with the impact on the economy and consumer finances looking bleak. Discretionary retailers are typically quite vulnerable in such circumstances, particularly those that rely on physical stores. The risk is that this sends the above operating leverage into reverse, leading to sharp declines in profit even on more modest falls in sales. Fortunately that has not proved the case. The U.S. economy and consumer has been much more resilient than I anticipated back in Q4 2022, and even the relatively weaker U.K. economy has managed to muddle through and outperform then-expectations of a recession.

Management’s last trading update, covering the six months through November 26, was released a few weeks ago. Sales were seen at “not less than” £247 million (~$315 million), representing growth of circa 9% year-on-year, comprised of core revenue of “not less than” £235 million (~$299 million) and licensing revenue of £12 million (~$15 million). Licensing revenue can be somewhat volatile year-to-year, so core revenue might be a more instructive yardstick by which to measure performance. On that basis, revenue was up around 11% year-on-year, with core operating profit of “not less than” £82 million (~$105 million) representing year-on-year growth of around 16%.

One thing to bear in mind is that this year (i.e. fiscal 2024) marks a launch year for a new edition of the Warhammer 40,000 game. This is now the 10th edition dating back to the late-1980s, mapping to a rate of one every three years or so (the 9th edition landed in fiscal 2021 and the 8th in fiscal 2018). New editions typically see a boost to sales and profits alongside fresh launch products. Bear that in mind as this has fueled the most recent comp, which will likewise be comparatively tougher in the following year.

Looking ahead, I remain quite bullish regarding the company’s long-term prospects. Although revenue growth has clocked in a 16% CAGR going back to 2014, there is still plenty left in the tank. I base that on implied penetration rates in key markets like North America compared to its U.K. home territory, plus the company’s relatively small footprint in higher growth markets like Asia. In the U.K., current annual sales of ~£97 million (~$124 million) map to a per-capita figure of around £1.45 (~$1.85). In North America, annual sales of circa £198 million (~$252 million) only map to a per-capita level of £0.60 (~$0.77). This is a key factor that can propel outsized growth versus the domestic British market.

Now, this is obviously a very rough way of looking at things given the company’s total addressable market is only a small demographic subset of the total population, but the point stands nonetheless: there is still plenty of organic growth left in mature economic zones like the United States. Factor in faster growing parts of the world like Asia, which was only 3% of sales in fiscal 2023, and there is plenty of growth left to be had here, though I do expect operating leverage to be much more modest than in the recent past as the trade channel mix won’t produce the same tailwind as previously.

In terms of valuation, Games Workshop shares have re-rated upwards to circa 22-23x EPS from around 16-17x last time out. Cash conversion is typically excellent here, so profits do largely end up as free cash flow. On that basis, and assuming a 9-10% required rate of return, the current £98.85 share price (~$126) only needs around 5-6% annualized FCF growth to work. While that is doable, it is not a target I would be inclined to chase at this point of the business cycle either. My macro fears proved misplaced last time out, and I should have been a buyer at the then-price and valuation. With these shares now around 50% more expensive in terms of P/E, I would wait for a sub-20x P/E entry point, and as such I maintain my Hold rating on the stock.

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