Back to the future at Games Workshop

Rebuilding its fortress

Mark Wells, chief executive of Games Workshop (GAW), is as clear about what his company isn’t, as what it is, in its latest annual report.

It’s a manufacturer, not a retailer. It sells games and models people play together, really, not virtually ‘with a screen’. It makes fantasy war games, models and figures, not historical ones. Its outlets in retail centres are hobby centres, not shops, although particularly abroad, it also sells through shops.

I’ve visited a hobby centre and it was unlike any shop. More like a cross between a factory outlet and club. It sold only Games Workshop merchandise and customers were playing and modelling in there. Perhaps it’s like an Apple Store, where people go to play and learn as well as buy.

I think there are two reasons Games Workshop stresses it’s different. The first, it has always played up. It owns the fantasy worlds of Warhammer and Warhammer 40,000, which gives it a kind of monopoly Wells calls a "Fortress Wall". The second is that when it ventured beyond its Fortress Wall in the second half of the last decade it suffered a rout.

If Games Workshop has a big competitive advantage, a captive band of passionate gamers and modellers who demand the Warhammer experience, and the bits and pieces that go with it, it ought to be very profitable.

It was, and judging by its results in 2010 it might be now. But it’s endured a few years of famine, and so have shareholders.

On the past, the chairman Tom Kirby‘s comments are most compelling because he led the company as it grew rapidly through the nineties, until Dec 2007, when sales were falling and profits were about to be erased. Like Wells, he’s also very quotable.

Foreign campaigns like GW’s excursion beyond its fortress walls are expensive, and Kirby blames his generals:

Due to its growth and international nature the business was run federally and I was relying on those local leaders to do the right thing and remove unnecessary cost out of their businesses. It didn’t happen and it took a lot of changes all across the senior management to get the improvements that were needed.

Now, according to Wells GW is sticking fanatically to its niche:

We no longer spend money on things we don’t need, like expensive offices or prime rent shopping locations or advertising that speaks to the mass market rather than our small band of loyal followers. We only invest where it makes a positive improvement to our business model, such as in tooling to make better plastic miniatures, in opening more Hobby centres to improve our customer service…

And Kirby draws a comparison between the frenetic pace of the computer games companies it seeks to licence its games to, and GW’s steady business:

From Sinclair ZXs, to Atari STs, to Commodore 64s to PCs to consoles and now, apparently, to Facebook and the iPhone. How different their world is to ours. In all that time we have simply carried on making miniatures and encouraging people to collect, convert, paint and play with them. I trust it is ever thus!

But this is a rose-tinted interpretation of GW’s past, which ignores its recent troubles. The company has made forays into other worlds. The Lord of the Rings, a game based on the books that was immensely popular when the films came out early last decade, taught Games Workshop all it needed to know about the fickle mass market. Now Kirby, who still owns about 6% of the company, and Wells are taking Games Workshop back where it was before a few years of unsustainable growth and a long hangover. Customers bought the game, but not the hobby, and the company got carried away spending bumper profits on costly expansion that lasted longer than the money did. That’s putting it politely, in his annual report for 2007 Kirby admitted:

We grew fat and lazy on easy success

Now record profits and financial strength confirm the recovery, and the shares are nowhere near as cheap as they were. At eighteen times average earnings over the last ten years they look expensive, but I think the last ten years were exceptional, mostly in a bad way.

I prefer Games Workshop now it’s rebuilding its fortress, instead of conquering the world. I like its new found focus on cost and quality and suspect it can maintain high levels of profitability while it cultivates new customers in the traditional way, by inducting them one by one into the hobby. If this year’s profits are typical, the shares look cheap. Its plain old PE is just 9.

But perhaps Games Workshop doesn’t deserve a glamour rating. So far, the return to profitability has been achieved by cost-cutting, replacing tin with plastic, reducing staffing levels, relocating stores and closing offices and since there’s a limit to how many offices you can close, future returns for shareholders depend increasingly on selling more soldiers. It didn’t last year.

It’s at this point, when a company has recovered and may be on the cusp of growth again, that value investors traditionally bow out. At its current price, GW has all but made the Thrifty 30 the minimum 50% profit I require. When it does, I’ll be forced to reconsider its position in the portfolio, and if the situation hasn’t changed, I’ll be even more conflicted than I was when I removed XP from the portfolio last month.

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