Re: GW sales down

"Garth" <garthas@xxxxxxxxx> wrote in message
news:BGbyg.182852$F_3.148123@xxxxxxxxxxxxxxxxxxxxxxxxxxxxx

This year has seen both sales and profits decline. The decline in sales
was expected, but it has been hard to project accurately the amount. Most
of the decline is due to the trading cycles I spoke about last year -
partly product cycles and partly channel problems.

GW's sales dropped 15.5% (£136m in 05 to £115m in 06) but their net pre-tax
profit dropped 73% (£13.39m in 05 to £3.7m in 06). GW's fiscal year ends in
May, so "06" is actually from May 29, 2005 through May 28, 2006. In
addition, their profit margin plunged as well -- from 10.8% in 05 to 3.21%
in 06. For a manufacturing company, this is a lousy margin.

By any rational measure, this is a severe financial blow and should cause
serious concerns about the company's long term business prospects. That
said, GW should be in no immediate danger. In May, GW had net current assets
of £10.0m (net current assets = current assets [assets they could get there
hands on relatively quickly] - current liabilities [payable in 12 mos or
less]). The point is that GW *did* make a (small) profit, and appears to
have adequate liquidity (£6.44m) to ride out any likely cash flow crises.

I see two main dangers --

1. GWs stock price will fall, making it an attractive target for a hostile
takeover. While it seems hard to imagine that someone else could operate GW
any worse (from a customer perspective), I can assure you that such is
possible. Far more worrying to me is the possibility that management would
spend their time trying to prevent such a takeover. This usually includes
tactics to keep the stock price up in the short run, but that have long term
negative effects. GW is already doing this to some extent; they are keeping
their stock dividends the same as 2005, despite the 73% drop in profits.
This cost them £5.8m last year; such dividends this year will effectively
wipe out all profit and consume a fair chunk of their cash. Since GW's cash
position isn't great to begin with, I consider this a desperation ploy.

2. While it made a profit this year, GW could quickly find itself losing
lots of money. It's hard to say for sure, but when profits drop 5 times as
much as sales, I find there are usually only a few causes:

-Sales are being articifially propped up by spending excessive amounts
on marketing and promotion. This would lower profits and the gross margins.
The chilling implication here is that sales would be even lower if GW had
reasonable margins. However, there's little evidence for this in my opinion.
The cost of goods sold % (the percentage of sales that are paid to make the
stuff sold) has declined from 33.4% in 01 to 29.6% in 06. So the stuff isn't
costing as much to make these days. Operating expenses -- all the costs that
aren't directly related to making the products -- grew from £51m in 01 to
£80.6m in 05. Sales grew from 92.6m in 01 to 136.6m in 05. So through 2005,
GW's operating expenses grew at about the same rate as sales. But this is
critical -- both declined in 2005 and again in 2006 (see below). Bottom line
is that GW operational costs and manufacturing costs are in line with
historical numbers.

-Sales are rapidly declining due to a contraction in the target market
or poorly conceived pricing (or both). The company is as efficient as it
ever was, but the sales are simply not there. The historical evidence is
compelling:

Year Sales
2001 - 92.6
2002 - 108.6
2003 - 129.1
2004 - 151.8
2005 - 136.6
2006 - 115.2

This is devastating in GW's case because the sales appear to be very close
to the break even point. GW, like all companies, has costs that vary with
sales (cost of goods sold for instance), and "fixed costs" -- costs that
don't vary much with sales. From their financial statements, I'd estimate
this number to be about £76m. *Radical* restructuring can reduce this number
a bit, but this can kill the stock price (and cripple the company). Since
30% of the sales go to making the product (and are usually paid within 30
days of making the product), you can see the math. The bottom line is
that -- assuming the same manufacturing costs and operating costs -- if 2007
sales decline by the same percentage as they did this year, GW will lose
£6-7m in 2007. And if it continues, they will lose £18m in 2008. They do not
have the cash to sustain such losses, which will make the actual losses even
worse. And at such a burn rate, they will be insolvent in 2009, if not
sooner.

Of course, such Armageddon scenarios should be taken with one major
caveat -- this assumes GW does nothing different. In the real world, this
seldom happens.

So what could GW do to halt the slide?

Some factoids first. Geographically, their sales are distributed thusly --
Europe - 43%, UK - 26%, Americas - 24%, Asia/Pacific - 7%. Their product
distribution -- 42% through local hobby stores (45% in 05), 48% through GW
stores (45% in 05) and 10% direct (9% in 07). The percentage of sales from
local hobby stores has declined slightly, but not much. Direct (internet)
sales -- 2002 - 9%; 2003 - 7%; 2004 - 7%; 2005 - 9%; 2006 - 10%.

If the market is truly declining, then they can (a) radically downsize; or
(b) raise huge sums of additional capital to spend on marketing to grow the
market. GW did cut its administrative costs in 06; had they not done this,
they'd have posted a slight loss. Since they're so close to the break even
point, additional marketing would have to be extremely effective in the
short term. A tall order I'd think.

If the market is still there -- as GW management claims -- then the problem
is simply stated. Increase sales without increasing operating expenses. Or,
significantly reduce production costs. I don't think that they can cut their
production costs radically. They've modestly reduced the cost of goods from
33% to 29% over the last six years. Hard to see any radical decrease in this
number. In fact, every number except sales (and therefore profit) is in line
with past numbers. So sales is the problem. And increasing sales is the
solution.

So why have sales declined if the market is still there?

A couple of economic factoids first -- all else being equal, increasing
prices reduce demand. If demand exceeds supply, the price will normally
increase. If prices don't increase, there will be shortages of the product
in the marketplace. The seller's goal is to price his product at the most
profitable level, taking into account plant capacity, cost of manufacturing,
market size, desired rate of return, etc. Manufactured products usually get
cheaper as production volume increases. So, all else being equal, more
profit is earned if more manufactured goods are produced in a given period.

The implication of these basic economic facts is that price increases will
usually benefit a seller up to a certain point -- typically when the demand
matches his ability to produce and distribute the product. After that point,
price increases will drive demand down, which will result in lowered
production, loss of economies of scale, and reduced profit.

So here are my thoughts on why GW's sales are down.

1. Prices. After many years of raising prices to unprecedented levels, GW
may have crossed the point of maximum profit noted above. At some point,
people will spend their money on other things, even if they like GW stuff.
The problem is that the perfect price point is hard to find...and changes
constantly. There is some evidence that GW has raised prices beyond what the
market can bear. As noted, their production costs were 33% of sales in 2004
(their best year). Their production costs are now 29% of sales. Assuming
that GW hasn't gotten any more efficient, then they have increased prices
relative to costs. This means that GW has charged more simply because they
could do so, not because their costs went up. The largest price increases
(as percentages) appear to have fallen in 2005 and 2006...the very years
sales have plummeted. Maybe coincidence. But...an economist would predict a
reduction in total sales after the optimum price point is reached. And the
rate of sales decline would increase as prices are raised. Exactly what
appears to have happened in this case.

2. Customer Anger. I think that this is overrated, at least with regards to
gamers. However, GW is seeing a drop in sales from local hobby shops. Since
this was about half of their sales in 2004, it seems woefully shortsighted
to alienate local retailers. Their reduction in retail discounts last year
was particularly ill-advised in my opinion. If a retailer makes less money
on a product, he'll be less inclined to push it. And if price increases
reduce demand for that product, well, you can see the problem.

3. Strength of the pound. The pound has increased 1/3 in value relative to
the US dollar since the late 1990s. This makes GW products more expensive
when bought in US dollars. As noted, higher prices reduce demand (and lower
sales).

4. Crappy Rules. Sorry, but I think that Warhammer and WH40K suck. With
sufficient effort and hassle, they can be made playable (barely). But they
have systemic problems that cannot be solved, only mitigated. And if I'm
right, this could account for the reason sales are off. While collectors are
a small part of the market, most people buy the miniatures to *play* with.
If the game sucks, less playing will happen. And eventually, less sales.

5. Poor resource allocation. Much is made of the disappointing performance
of the LOTR line. No hard data is available to support this. However, if the
line is a problem, then GW inflicted its own injuries. First, anyone with
business experience should expect for demand to soften after the last movie
runs its course. So high expectations after that are unwarranted. Second,
what idiot came up with the idea of making LOTR figures incompatible with
existing GW fantasy figures? Finally, how could GW possibly execute a
license that would leave them exposed if demand declined after the last
movie -- as any reasonable person would expect. Personally, I don't buy it.

Possible Solutions --

1. Spend more money on marketing to increase sales. Well, they seem to be
doing this already, and sales declined by 31% over 2 years. And I don't
think they have the cash to do it -- especially after paying out £5m to
investors as dividends.

2. Raise prices (again). This will fail, IMHO, and will lead to more sales
decline (or it will stall other strategies that might have increased sales).
Unfortunately, GW's history indicates a tendency to constantly raise prices.
And price increases can often provide short term increases in sales, which
is attractive to executives desperate to keep stock prices up. The problem
is this -- GW raised prices an average of about 20%, yet total sales
declined by 30%. They've announced other price increases that seem to
average about 20%. Why wouldn't we expect these increases to have the same
result? If they do, then GW will be out of business (or bought in a
takeover) in a couple of years. Sadly, I see this as the most likely
strategy.

3. Lower prices. Though unprecedented, this could work. Most of the numbers
in 2006 are the same as in 2004 -- except sales (and profit). So maybe a
return to 2003 pricing levels would accomplish a turnaround. The problem is
that this would be a very risky strategy and I am dubious that GW's
management would take the risk. Personally, I think this is the best
strategy.

4. Abandon the core Warhammer/WH40K rules and rewrite them from the ground
up. Optimize them for fast play and for large armies. If GW doesn't want to
piss off current players, offer the new rules as free downloads and continue
to support the old rules for awhile. Won't happen, IMHO. GW is wedded to
these mediocre systems for some unfathomable reason.

5. Cut retailer discounts again. This has the same problem as raising
prices -- it reduces demand because it lowers a retailer's incentive to push
GW products.

6. Increase retailer discounts. Same advantages as lowering prices. And just
as unlikely IMHO.

7. Try to expand direct (internet) sales. In theory, this is a highly
profitable activity, since no brick and mortar stores are required. The
problem is that there is little evidence that this market can really be
expanded that much. While the percentage of direct sales has increased 50%
over the last 5 years, the amount sold has seen only a modest increase --
£9.7m in 2002 vs £11.5 in 2005. This implies that there is a fairly limited
amount of money that will be spent on direct sales. Marketing is unlikely to
change that. The only thing that could dramatically increase these sales
would be a significant discount on prices. Unfortunately, this would enrage
42% of the distribution chain. And such a discount would reduce GW's profit
on the internet sales, reducing the advantage (to GW) of those sales. A very
foolish and short-sighted strategy IMHO. So of course, I expect that GW will
do it. Note the mention of a "new internet strategy".

8. Radical restructuring. Costly and could scare investors. TO have any
chance of working, there would have to be specific operations that were
unprofitable that could be eliminated. I doubt this will be the solution.

Well, it should be interesting. Of course, GW will show a boost in sales in
the second half of 2006 -- it has every year except 2005. But the long term
challenges look formidable.

--Ty


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