Games Workshop: Delivering The Goods

Founded in 1975, Games Workshop (“GW”) owns and cultivates the dark, gothic, dystopian and distinctly British fantasy worlds of ‘Warhammer Age of Sigmar’ (historic) and ‘Warhammer 40,000’ (sci-fi), which it originally conceived in the 1980s. It monetises its intellectual property through the sale of plastic and resin miniatures for tabletop wargaming, as well as the sale of related paints, tools and books. It is vertically integrated, with a design studio and three production facilities at its headquarters in Nottingham, England, distributing through an online store, a global chain of self-operated retail stores and a network of independent trade partners. It also licenses its IP to third parties for development into video games and other content.

Over the last twenty years, GW has earned a very consistent 70% gross margin and an average return on equity of 31%, with virtually no financial leverage. Margins and profitability like this suggest it’s selling more than plastic; these are goods of desire with price-inelastic demand. The company enjoys a cult-like following among fans, who spend hours researching, coveting, collecting, painting and fighting their tabletop avatars. As one YouTube gamer described, “It doesn’t matter who you are in the real world. In this world, you’re a general on the battlefield”. Others, only half-jokingly, call it ”plastic crack”.

ROOTED IN THE PHYSICAL WORLD

My mental model for understanding GW’s business comes from the years I’ve spent studying Asian online game giants Tencent, Netease and Nexon, which for various accidents of history, stumbled into building evergreen, free-to-play, open-world online games in which players build identity, status and connection. They then learned to sustain these games through frequent, regular updates, including new maps, characters, items, and costumes (“skins”).

There are high upfront costs for development and player acquisition. But besides channel partners’ take rate and payment processing, there is virtually zero marginal cost to scale up to tens and even hundreds of millions of players. It’s a hugely profitable model when successful and far more predictable than hit-driven alternatives (ref. this presentation from Nexon’s CEO Owen Mahoney).

GW’s business is analogous to these online cousins but distinct because it is rooted in the physical world.

The first distinction is with regards to demand.

Online game companies cast their nets wide to take advantage of their zero marginal costs, making games free-to-play in the hope of attracting a small number of high-spending whales who will buy enough add-ons to deliver the lion’s share of their profits. Their barriers to play are very low.

In contrast, it takes a meaningful commitment of time and money to play Warhammer. This makes GW’s barriers to play relatively high, even though the average spend per player will be also be relatively high.

The most basic Warhammer 40,000 starter set costs USD43 on Amazon and comes with sixteen miniatures, a printed version of the core rules, an introduction to the lore, dice, rulers and some basic terrain. To build and paint the miniatures to a ‘battle ready’ standard, novices should also buy the USD38 paint and tool kit. That’s USD81 spent right out of the gate.

It will take about an hour to build the miniatures and thirty hours to paint them (at least, at my speed!). The rules will take half an hour to read and far longer to internalise to play fluently. Finally, at this small scale, it will take a minute to set up the board and about half an hour to play. Of course, you’ll also watch at least a few hours of YouTube before, during and after to get a feel for what’s what.

To be fair, GW use its retail network to make it easier to get into the hobby. These stores are intended to operate at breakeven and are not so much for distribution as they are for exposure and education. Their most important asset is a passionate store manager who can bedazzle new recruits as they run them through a quick demo game. I’ve seen this in action, and the best ones are very, very good at their jobs.

And perhaps a bit of delayed gratification isn’t such a bad thing. As a senior GW executive put it to me at last year’s AGM, “The time it takes you to build and paint a model is time for it to percolate through your imagination, and for you to fantasise about the lore. Moreover, when you place the model on the table, it is *your avatar*, and that’s a very special feeling.”

But there’s still the most significant hurdle: finding someone to play with. Unlike an online game where you can hop on to a server anytime, from anywhere, a Games Workshop game requires two people to actually get together in person. That can be pretty hard! Especially since the time commitment only grows as armies get larger and games become more complex with various missions and faction abilities. I speak from experience when I say this is very frustrating when your interest in the hobby is peaking.

The second distinction between GW and its online cousins is with regard to supply.

While online games can produce, ‘stock’ and distribute an infinite number of digital goods with zero friction, GW’s miniatures are physical objects and must be manufactured and delivered in advance of sale. The right amount of raw materials must be ordered and find their way in time through a global supply chain; there must be sufficient capacity at the factory; then, the right number of finished goods must navigate a global distribution chain to reach the right customers at the right time.

This is a hugely complex exercise at best and only became more so when Games Workshop introduced its strategy of “more Warhammer, more often”. First articulated at the AGM in 2019, it seeks to keep fans excited through frequent launches, short production runs and near-constant hype (cf. streetwear brand Supreme). Of course, Brexit and COVID only made things worse.

But mis-estimating demand means either making too few miniatures and disappointing fans (as happened to the beautiful quest game, Cursed City, in 2021) or making too many and straining trade partners’ balance sheets and writing off inventory (as happened in FY22). Moreover, because manufacturing capacity is limited, one production run necessarily comes at the expense of another. Mistakes, therefore, come as a double whammy: too much of one SKU and not enough of another.

More Warhammer, More COMPLEXITY

I suspect GW has grown far faster and to a scale far larger than current management ever anticipated. What used to be a niche hobby has become very popular thanks to the internet and eCommerce. The problem is that GW’s infrastructure has not kept pace, which is why the distinction between digital and physical goods is so important to understand.

Let’s put this in context. Seen through the lens of its revenue growth, the company has gone through three distinct periods since listing in 1994:

From FY93 until FY04, sales grew at a 20% CAGR. Tom Kirby (“TK”) - a larger-than-life figure - bought Games Workshop from its founders in 1991 and was CEO for most of this period. He gradually articulated Games Workshop’s business philosophy and strategy, which remains largely intact today (see the Appendix below). He expanded the company’s reach from Britain to the world, introduced more games around its core IP, and partnered with Peter Jackson to develop and retail ‘Middle Earth’, a tabletop wargame based on The Lord of The Rings (“LOTR”).

From FY05 to FY14, sales declined and then stagnated. Interest in LOTR proved fleeting, Games Workshop’s own product grew stagnant, and the company fell into a decade-long funk. TK believed customers either had “the hobby gene” or didn’t, and eschewed marketing to recruit new players. As TK became isolated and embittered, morale within the company slumped, and relationships with fans and distributors became increasingly antagonistic (see here, here and here for flavour).

From FY15 to 1H FY23, sales have grown at a 15% CAGR, finally regaining their FY04 high in FY17. Kevin Rountree (“KR”) succeeded TK as CEO in 2015 and sparked a renaissance at the company. Under his leadership, Games Workshop has:

Improved the quality of its product by moving from pewter and alloy casting to high-grade plastic injection moulding, allowing miniatures to be built with exquisite detail and the company to justify higher prices
Made the hobby more accessible by introducing lower-price starter kits and standalone games, and better-value boxed sets
Raised awareness by moving retail stores to higher-traffic locations; promoting Games Workshop at trade conferences like Gen Con; establishing a dedicated online presence at warhammer-community.com; more actively licensing its IP to third parties for video games; and engaging with a legion of (unpaid) evangelists on social media and YouTube

The Lollapalooza of these initiatives has proven wildly successful in rebuilding interest in North America and with trade partners, the company’s most important engines of growth. But has Games Workshop become a victim of its own success? Even cursory fieldwork reveals that trade partners are constantly frustrated when they can’t get the products they want or, in a winner’s curse, are stuck stocking products they can’t sell. New releases sell out in minutes, leaving players little choice but to buy from scalpers at inflated prices on eBay or elsewhere.

Not being able to supply enough to meet demand might sound like a good problem to have. But GW appears to have hit the limit of its current capacity: additional growth is now coming at the expense of lower operating margins.

Looking at the business again through the lens of its operating profit margin (which I show above with and without its high-margin licencing income) brings home GW’s challenge:

From listing until FY04, the business did not scale well. Costs grew faster than revenue, and overall margins halved.
From FY05 to FY07, the business hit the wall when revenue declined and operating leverage reversed.
From FY08 to FY16, TK undertook a deep restructuring of the business and its cost base. Even as revenues remained stagnant, operating expenses were reduced from a high of GBP 84 million in FY09 to GBP 70 million in FY16.
From FY17 to FY21, the business proved it had enormous latent operating leverage. Revenue growth massively outpaced expense growth, and the core margin rose from 9% to 38%.
From FY22 to 1H FY23, the business did well in navigating COVID, supply chain challenges and Brexit. But expenses grew faster than revenues, decreasing the core margin from 38% to 33%.

MORE WARHAMMER, A LITTLE LESS OFTEN?

Sales have followed a distinct pattern under KR’s leadership: they surge every year a new edition of the best-selling Warhammer 40,000 game is launched (FY18 and FY21) and are sustained in the intervening years by follow-on releases and launches from other games. But as GW approaches half a billion pounds sterling in annual sales - and is days away from launching pre-sales for the Tenth Edition of Warhammer 40,000 - the question is, can it fix its logistical logjam?

For fans, the good news is that the company has made “a mind-boggling quantity” of the boxed set to ensure supply. So, it should be able to deliver the goods this time.

And beyond the launch, there are lots of reasons to be excited about GW’s prospects:

Compared to Britain, penetration is still low in North America and infinitesimal in Asia
The Tenth Edition of Warhammer 40,000 introduces a new mode of play called “Combat Patrols” based around smaller, pre-defined forces. This will make it easier for players to dabble in other factions and spend more
There are some great new Warhammer 40,000-inspired video games on the market, like Darktide, Space Marine II, Shootas Blood & Teef and Boltgun. GW also signed a licencing agreement with Nexon in 2021 to develop an evergreen open-world game based on Warhammer Age of Sigmar. These games will contribute high-margin licencing fees and raise awareness with new players
Championed by British actor Henry Cavill, Amazon has agreed in principle to produce a TV series based on Warhammer IP. If this goes into production, it will again be perfect for raising awareness of the hobby. GW will likely seek to capitalise through special releases tying into the show.

But will the logjam constrain revenue growth? Or further erode margins? Or both?

In the 2018 annual report, KR wrote, “The challenge of managing global sales volume growth at the same time as delivering a step change in our capacity (not forgetting delivering major IT projects) is, I hope you appreciate, a fair challenge.”

Over the last several years, the company has opened a new manufacturing plant at its Nottingham HQ site, opened a new distribution centre in the East Midlands, and updated its North American distribution centre in Memphis, Tennessee. It has also appointed John Brewis as Chairman, which is notable given John’s thirty-year career in manufacturing and operations.

Elsewhere, KR’s “fair challenge” feels like an understatement; it’s more like changing the engine on an aeroplane while in midflight.

In particular, he has written about upgrading GW’s Enterprise Resource Planning (“ERP”) system every year since 2015 before “pausing” the project in early 2022 because “we were not spending money wisely”. KR elaborated in the FY23 interim report that, “it remains an ongoing challenge to integrate new IT systems when we are still heavily reliant on working with our legacy IT systems”.

It’s impressive that they have come this far with software that predates the Internet, but they must get it fixed. I would love to know why this proved so difficult and how the new Global Head of IT will tackle the problem differently.

Learning how to forecast demand better is another area with room for improvement. KR wrote in the FY23 interim report, “Our current level of global sales is relatively new to us, so we are rapidly changing and learning as we go: managing and forecasting new release products for our broad range, at our highest ever volumes, is a reasonable challenge. We are working even harder on range management processes to ensure our whole offer gets its due attention at all times: as a team, we need to scale with a little more nous”.

Is “nous” a polite word for sticking a finger in the air, though? Could the company do away with this challenge altogether by moving instead to a ‘made-to-order’ system for big launches?

Is the company’s emphasis on return on invested capital holding it back from investing in more manufacturing capacity? Otherwise, why doesn’t it expand, especially in North America?

Finally, a radical thought suggested with the best intentions by some diehard fans is simply to have more Warhammer but a little less often. Would it be possible to solve the logjam by slowing the cadence of releases? Or, with such a large design team now, is there an institutional imperative to keep churning out amazing new products? Again, I would love to know the answer.

Valuation

GW’s historical valuations confirm my suspicion that few people (perhaps just one) saw the revenue growth and operating leverage that KR would unleash when he became CEO. The company hit an all-time high valuation in the wake of the Ninth Edition of Warhammer 40,000’s explosive sales, and trades now at roughly half that multiple.

(Fun fact: At the end of FY07, Nick Sleep and Qais Zakaria’s Nomad Partnership owned 20.3% of GW’s shares outstanding, making it the company’s largest shareholder. But the partnership was dissolved in 2014, just before KR lit the blue touch paper).

Wrapping It Up

Games Workshop has been good fun to research. I played Warhammer 40,000 as a kid, and my time studying the company reignited my passion. I’ve bought and painted models, joined a community of avid gamers and watched far too much Warhammer YouTube (I’m looking at you, Chapter Master Valrak!). This has let me experience first-hand the hobby’s desire, a club’s camaraderie, a battle’s adrenalin and - unfortunately - the disappointment of missing out on new releases which quickly go out of stock. I’ve also felt overwhelmed by the dizzying number of launches which come so quickly on each other’s heels that there’s barely enough time to enjoy what you’ve just purchased.

GW owns and curates something very special: two distinct worlds which have captured the imaginations of generations of hobbyists. The people who work for the company are just as passionate as the players, and I like the way they think about business (see the Appendix below). Supplying goods of desire in the physical world isn’t easy. But if management can figure out how to grow into their scale, there is a lot for owners to look forward to.

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.

APPENDIX: GAMES WORKSHOP IN ITS OWN WORDS

The best description of GW’s strategy is the company’s own. This extract is from the FY2022 annual report, and I quote it in full to give you the exact flavour of management’s thought process and wording. Variations have been published every year since former CEO Tom Kirby first articulated it in the 2002 annual report. Current CEO Kevin Rountree’s major contribution to the canon was the addition of the third element in FY18, the year Kirby stood down as Chairman and hung up his spurs.

Strategy and objectives

Games Workshop is committed to the continuous development of our IP and making the Warhammer hobby and our business ever better.

Our ambitions remain clear: to make the best fantasy miniatures in the world, to engage and inspire our customers, and to sell our products globally at a profit. We intend to do this forever. Our decisions are focused on long-term success, not short-term gains.

Let me go through our strategy part-by-part:

The first element is that we make high quality miniatures. We understand that what we make may not appeal to everyone, so to recruit and retain customers we are absolutely focused on making our models the best in the world. In order to continue to do that forever and to deliver a decent return to our owners, we sell our miniatures for a price that we believe represents the investment in their quality.

The second element is that we make fantasy miniatures based in our endless, imaginary worlds. This gives us control over the imagery and styles we use, and ownership of the intellectual property (‘IP’). Aside from our core business, we are constantly looking to grow our licensing income from opportunities to use our IP in other markets.

The third element is that we are customer focused. We aim to communicate in an open, fun way. Whoever and wherever our customers are, and in whichever way they want to engage with Warhammer, we will do our utmost to support them.

The fourth element is the global nature of our business. Our customers can be found anywhere, and we seek them out all over the world.

They’re a passionate bunch with an interest in science fiction and fantasy. They’re collectors, painters, model builders, gamers, book lovers and much more. And while no two customers engage with Warhammer in exactly the same way, they’re all deeply invested in the rich characters and settings of our IP.

To reach them, we have two key tools: our retail chain and our digital content. In retail, we showcase the Warhammer hobby and offer a fantastic customer experience. Our digital offering has never been richer. Through warhammer-community.com and social media we reach thousands of people every day, showing them the very best aspects of the Warhammer hobby and inviting them to join our global community of enthusiastic fans.

Our retail channel is supported by our own online store (it has the full range of our products) and our independent stockist and trade accounts across the world. These independent accounts do a great job supporting our customers in parts of the world where we either have not yet opened one of our stores or where it is not commercially viable for us to have one. Our long-term goal is to have all three channels (retail, trade and online) growing in harmony. We will always have more independent accounts than our own stores. Our strategy is to grow our business through geographic spread, growing all of the three complementary channels.

The fifth element is being focused on cash. By delivering a good cash return every year we can continue to innovate, surprise and delight our loyal existing customers and new customers with great products. To be around forever we also need to invest in both long-term capital and short-term maintenance projects every year, pay our staff what they have earned for the value they contribute and deliver surplus cash to our shareholders. Our dedication and focus should ensure we deliver on time and within our agreed cash limits.

We measure our long-term success by seeking a high return on investment. In the short term, we measure our success on our ability to grow sales whilst maintaining our core operating profit margin at current levels. The way we go about implementing this strategy is to recruit the best staff we can. We look for those with the appropriate attitude and behaviour a given job requires and for those who are aligned with our principles and who are quality obsessed. It is also important that everyone we employ has a real desire to learn the skills needed to do their job and has a great attitude towards change (there’s never a dull moment here!). To support them, we offer all of our staff both personal development and skills training.

We continue to believe there are great opportunities for our business to grow, particularly in North America and Asia, the latter being on a longer timeframe.