Note: all figures are cited in Pound Sterling (over the past 12 months, $1 has averaged 1.79 Pound Sterling) unless otherwise noted. All of the research and opinions expressed herein are mine own, and is based on public information believed to be reliable. I will be happy to answer any questions with respect to the following. I have also taken the initiative to stickie this thread for future reference.
On July 25, 2006, Games Workshop Group plc ("GW" or the "Company") published its financial and operating results for fiscal 2006 (year ended May 28, 2006). The Company's operating revenues continued to decrease during the fiscal year, falling by 15.7% to 115.2 million compared with 136.6 million reported during fiscal 2005. Although the rate of revenue decline was noticeably higher than during fiscal 2005, when it had stood at 10.0%, we note that the first and second halves of fiscal 2006 accounted for 49.6% and 50.4% of total sales, respectively, suggesting less of a Christmas sales shock than that experienced during fiscal 2005, when the first and second half revenues had amounted to 52.0% and 48.0% of total sales, respectively; whereas fiscal 2003-2004 first and second half sales percentages were reported as 45.0%-47.4% and 55.0%-52.6%, respectively. As such, while the 14.2 million year-over-year decline in sales experienced in the second half of fiscal 2005 (Christmas 2005) as well as a portion of the 13.9 million year-over-year sales drop in the first half of fiscal 2006 (summer of 2005) could be traced to an expected decrease in revenues for the LOTR product associated with the conclusion of the LOTR film trilogy, the remainder, and any revenue declines going forward, are likely indicative of broader sales and distribution issues. Of particular note, these sales declines have come in a period of rising product prices; adjusting for unit price increases, the Company's fiscal 2006 revenues are likely to be significantly below reported fiscal 2002 levels (108.6 million), which had been buoyed by the maturation of 3rd Edition 40k and 6th Edition WFB product lines. Separately, we note that the release of 4th Edition 40k had merely slowed, and not reversed, fiscal 2005 and 2006 revenue declines.
On a regional basis, over fiscal 2006 GW's UK revenues fell by 18.1% to 30.0 million, versus a 13.0% decline to 36.7 million during fiscal 2005; Continental Europe sales decreased by 19.9% to 49.5 million, compared with a 7.4% drop to 61.7 million during fiscal 2005; North American revenues declined by 6.3% to 27.8 million, compared with an 11.0% decrease to 29.6 million during fiscal 2005; and Asia-Pacific sales fell by 8.3% to 7.9 million, versus an 11.1% drop to 8.6 million during fiscal 2005. The reported declines in the UK and Continental Europe regions are especially meaningful as these have historically provided virtually all of GW's operating income before corporate eliminations as well as the primary source of revenue growth, and carried by far the highest operating margins. Thus, whereas during fiscal 2005, the Company reported regional operating income of 6.9 million (18.8% margin) in the UK, 15.3 milllion (24.8% margin) in Continental Europe, 0.3 million (1.1% margin) in North America and 1.1 million (12.2% margin) in Asia-Pacific, the respective fiscal 2006 figures are 3.8 million (12.7% margin) for the UK, 8.2 million (16.5% margin) in Continental Europe, negative 0.5 million in North America, and 0.7 million (8.7% margin) in Asia-Pacific. The drop in UK and Continental Europe operating income is even more drastic when compared with GW's fiscal 2004 operating profit figures for these two regions of 11.4 million (27.0% margin) and 19.9 million (29.9% margin), respectively. This rate of decline in operating margins when compared against the Company's falling revenues suggests a high proportion of fixed costs in the business, primarily associated with owned and leased retail locations. Significantly, labor costs, the largest single component of operating expenses, have meaningfully increased as a percentage of revenues during fiscal 2006, rising to 46.7% (52.3 million) during the year from 44.4% (54.5 million) in fiscal 2005 despite an 11.6% (367 person) reduction in headcount over the respective periods. Whether this is a one-time phenomenon or serves a symptom of inability to further decrease labor costs except through meaningful store closures, a step management has resisted to this point, remains to be seen.
Group-wide operating income, including corporate and design expenses, amounted to 3.2 million during fiscal 2006, down from 13.9 million in fiscal 2005 and 19.7 million in fiscal 2004 (22.8 million excluding the tail end of Warhammer Online development costs). These figures translated into operating cash flows of 15.8 million in fiscal 2006, 21.2 million in fiscal 2005 and 23.5 milllion in fiscal 2004. Significantly, we believe that GW's net working capital remained somewhat to significantly negative through fiscal 2005 and 2006, suggesting sizeable undisclosed non-cash expenses during those years to account for a substantively slower decline in operating cash flow than in operating income. Furthermore, free cash flow before equity dividends actually grew to 2.1 million during fiscal 2006 from 2.0 million in fiscal 2005 and 1.2 million in fiscal 2004, primarily as a result of meaningful declines in tax expense as well as significant capital expenditures on U.S. production facilities during fiscal 2004-2005. Subtracting shareholder dividends, the free cash flow figures for fiscal 2004, 2005 and 2006 amounted to negative 4.0 million, negative 3.8 million and nevative 3.8 million, respectively. At the same time, the Company's outstanding debt rose from 0.4 million at May 28, 2004 to 8.7 million at May 28, 2006, while cash declined from 8.7 million at year-end fiscal 2005 to 4.8 million at year-end fiscal 2006.
- Going forward, we expect continued revenue decline due to: sustained drop in LOTR product line sales; growing competition within the sector, potentially exacerbated should GW continue to raise unit prices; a likely overall reduction in available disposable income during the next macro-economic downturn, which, while more visible in the broader Consumer Retail and Leisure & Entertainment sectors, should at least partly affect the Company's niche market; and continued stagnation of North American revenues due to a weakening dollar. Of particular concern will be the rate of revenue decline in the UK and Continental Europe segments, which had apparently been harder hit by LOTR sales declines and competitive pressures than other regions. Notably, GW's overall rate of revenue decline may be slowed or temporarily reversed by the upcoming release of the 7th Edition Warhammer product, though we note that the fiscal 2005-2006 ex-LOTR revenue drops occurred during an aggressive release of the 4th Edition 40k product as well as of the Ogre Kingdoms miniature line, suggesting that absent large-scale new releases the Company's overall sales would have been considerably lower. In general, we would suggest, as revenue base case, a stabilization of total sales in the 80-100 million band over the next several fiscal years, with fiscal 2007 sales figures likely to fall within the 100-110 million band.
- Notably, a majority of GW's revenue decline occurred on the independent retailer level. Independent store revenues were down to 48.4 million during fiscal 2006 from 61.5 million in fiscal 2005 and 71.3 million in fiscal 2004, an overall rate of decline of 32.2%, while branded store sales decreased to 55.3 million in fiscal 2006 from 62.9 million in fiscal 2005 and 69.8 million in fiscal 2004 for an overall rate of decline of 20.8%. We believe this indicates a combination of loss of independent retail outlets, retailer unwillingness to stock certain or all of GW product lines, and successful competitor encroachment on the Company's market share. Given the likely U.S. and European macro-economic trends as well as rapidly growing competition within the sector, we believe that the erosion of independent retailer revenues will continue into the forseeable future.
- Given GW's falling operating revenues and the associated decline in operating margins as well as the demonstrable ineffectiveness to date of its labor cost reduction program, we believe that management will be forced to make the choice between sustaining positive or neutral operating income and foregoing store closures at some point within the next few years. As the Company has thus far seemed to focus on expanding rather than contracting its operations (though without disclosing the exact number of retail stores in operation in its most recent financials), we expect fiscal 2007 operating income and margins to experience further deterioration, either prompting a financial crisis or else a reduction in GW's retail footprint in some or all of its geographic regions.
- Although the Company's operating cash flow and free cash flow before shareholder dividends have held up surprisingly well over fiscal 2004-2006, we note that, at best, the likely revenue and operating income trends will at best allow for roughly breakeven cash flow before dividends. Thus, even in the best case scenario, management's insistence on sustaining equity dividends (at 5.2 million in fiscal 2004, 5.8 million in fiscal 2005 and 5.9 million in fiscal 2006) will likely necessitate a business contraction coupled with further unit price increases or else precipitate a liquidity crisis over the next 2-3 fiscal years. Notably, total availability under GW's bank and credit lines presently amounts to 11.4 million, with a further 4.8 million in cash & equivalents, compared with a cash balance of 8.6 million and credit line availability of 15.0 million a year ago. In all this, we stress that the Company's cash flow and income statements seem to contain a number of adjustments not made readily visible in its financial reports, and as such the exact rate of liquidity deterioration cannot be accurately estimated at this juncture.
- A further cash flow drain may be provided by a share buy-back program announced on July 26, whereby up to 14.9% (4.6 million) shares could be repurchased through December 12, 2007, subject to cash availability. We believe this is a program designed directly to placate shareholders, as GW's stock price has fallen by roughly 25%-30% over the past 12 months after falling by over 50% during fiscal 2005. At best, repurchases under this program would serve to substantively eliminate any positive pre-dividend free cash flow generated during fiscal 2007, assuming this cash flow proves positive to begin with.
- In summary, GW's near- and intermediate-term financial profile and likely management responses can be summed up as follows: continuing deterioration of the revenue base, partly offset with one-time large-scale product releases as well as further unit price increases; a deliberate policy of branded retail floorspace expansion in the face of at-best breakeven pre-dividend free cash flows; continued efforts to placate equity investors with debt-financed dividend payouts and share buy-backs, although at some point in the future the dividends will have to end. Given this, we recommend against investing in GW equity at this juncture unless the possibility of a private equity buyout is considered.
- Separately, while design expenditures excluding new product development (presumably electronic gaming products) have risen to 4.039 million in fiscal 2006 from 3.983 million in fiscal 2005 and 3.549 million in fiscal 2004, we note that design employee headcount has declined from 99 in fiscal 2005 to 92 in fiscal 2006. Moreover, future operating margin difficulties coupled with a lull in development of next-edition rulesets may precipitate a reduction in R&D expenditures and Studio headcount over fiscal 2007 and beyond.
- For those interested, GW's Chairman and CEO, Tom Kirby, had been with the Company since 1986 and had led the management buyout in 1991. Mr. Kirby presently holds roughly 6% of GW's shares, and his salary and benefits/pensions over fiscal 2006 amounted to 350 thousand and 40 thousand, respectively. The Company's Chief Financial Officer, Michael Sherwin, had joined GW in 1999 and during fiscal 2006 drew a salary of 240 thousand with benefits and pensions of 31 thousand. Neither executive's salary nor benefits/pensions have changed over fiscal 2005-2006.
- Interested parties can find further information on GW's Investor Relations website, and specifically in the fiscal 2006 year-end document located at:http://investor.games-workshop.com/investor_relations/financial_results/Results2006/full_year/documents/GW2006FullYearAccounts.pdf
The Chairman's Preamble within that document (as well as the fiscal 2002-2005 preambles re-posted at the end of the fiscal 2006 financials), at least, is worth reading in full.