A Wealth Creation Journal

Category: Business (Page 1 of 3)

Thoughts on the video game business

I am a gamer myself and I am very excited about the future of video game as a great entertainment medium and a “subset of reality”. But I am even more excited about the lucrative prospects of video game businesses as an investor!  I have learnt so much from the great thinkers in this industry – Chris Crawford, Nicole Lazzaro, Satoshi Iwata, Gavin Baker, Shigeru Miyamoto, Matthew Ball and many more. And I have taken their work and organized it in a way that is useful to me as an investor.

Note: While I will use game and video game interchangeably here, I recognise that many great games, such as Magic: the Gathering and Warhammer, share many common features with the video game as described below. For this discussion, I mostly focus on video games

1. Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. For example, puzzles in Legend of Zelda, defeat enemies with finite resources in a real-time strategy game, opponents to be killed in a first-person shooting (FPS) game. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a very cheap and effective medium to create all kind of problems for humans to solve. It would be stupendously expensive to recreate a typical role-playing game that involves 100 characters to act out 100 hours of game-play content in real life! So game worlds simulate problems for gamers to solve and gamers derive happiness from solving the problems. 

2. In this context, the video game industry has tremendous future ahead of it! Beyond its current incarnation as an entertainment media, video games can be used to solve real-world problems such as education and politics. Imagine the value that could be created if job interviews involve the candidate playing a game which simulates the work environment with high fidelity or two countries before engaging in a trade war is required to play a game that simulates the economic consequences of their trade policies in a game! Humans can sometimes only learn from things that they have experienced and games are an efficient way for human to learn from experience albeit in a virtual environment. This is very far into the future but I believe this is the direction that we are heading towards.

3. The most important difference, from a business model perspective, between video games and traditional media is that video games’ interactive nature creates a feedback loop of inputs and rewards. Gamers give up time and effort to create inputs into a game and the game rewards the gamer with some kind of positive emotions. If the gamers feel that they receive more reward from the game than the effort they put in, the gamer is said to be in a positive feedback loop where his/her emotional attachment to the game grows with time. Some game companies exploit this feedback loop (through mechanisms such as loot boxes) in a way similar to gambling. Other game companies create truly beautiful games where the gamers are treated to a rewarding emotional journey similar to watching a well-made movie.

4. There are three main roles in the video game value chain – 1) Game developers (Nintendo / Blizzard) who made the game, 2) Game publishers help to market and distribute the game. Game publishers can either buy the game content from game developers outright and take on the marketing cost to sell the game or more commonly finance part of the game development cost and strike a profit share agreement with the game developers. It is common to see big game developers such as Activision develop and publish their own games, 3) Game distribution platforms. Apple / Google for mobile games. Steam / Epic for PC games. Sony / Xbox / Nintendo for console games. Most game companies are involved in multiple roles across the value chain. E.g. Tencent takes on all three roles – game developer, game publisher and a distribution platform 

5. Game developers and distribution platforms capture the majority of the profit pool in the value chain while the game publishers are increasingly squeezed in the middle. Game publishers’ service, relatively speaking, add less value and least differentiated and hence they take the smallest slice of the cake on thin margins. Tencent is a unique case where it began as a game distribution platform and game publisher and grew to become a very successful game developer. As a content creator, the game developers differentiate themselves through game content. Fans are extremely loyal to great games but the challenge for the game developer is to consistently produce great games.  Game distribution platforms such as Apple App Store through their control of users are extremely profitable. For a typical mobile game on iPhone, the Apple app store clips 40-50% of the total revenue and the game publisher takes 10-20% and the game developer accounts for the rest

6. Why do people pay for virtual items in games? Gamers pay because they receive an emotional reward in exchange for time and money spent on the game. Ultimately, the maximum amount of money people is willing to pay depends on the quantum of emotional reward they receive. There are a couple of ways for people to get an emotional reward – not a comprehensive list. 1) enjoy a good the storytelling (similar to emotional reward from movies) 2) sense of competence as one becomes good at the game 3) social interactions – critical for many online games. E.g. gamer pay for cosmetic appearances for their in-game avatar. When my 15-year-old cousin was asked why she pays for virtual clothes in-game, she said “you don’t walk around naked nor wear the same cloth every day so why shouldn’t I behave any different in-game”.

7. Traditionally (let’s say before the 2000s), in the Game as a Product (GAAP) revenue model, gamers pay a fixed sum in exchange for unlimited gameplay time to get an unknown amount of emotional reward. The traditional distribution model of games is in essence very similar to books. A gamer walks into a physical game store to check out the latest games available and make a purchase decision based on very limited information. Pretty much judging a game by its cover. It is impossible to charge each gamer a different price based on how much each gamer liked the game. For the most part, the gamer cannot try the game before deciding on the purchase. Furthermore, the gamer’s relationship with the game developer is indirect because the game developer does not know who plays the game nor how the game is played. Feedback collection mechanism is chunky and ineffective. The entire experience is sub-par for gamer and game developer.

8. Internet and smartphones herald a new revenue model – Game-as-a-Service (GAAS). GAAS employs a continuous revenue model with free-to-play being the most dominant GAAS model for mobile games. GAAS spreads the revenue across the entire lifecycle of a gamer while GAAP is 100% upfront payment. There are many different manifestations of GAAS such as a game subscription, in-game transactions, in-game economy tax. I am excluding the discussion of cloud gaming here because cloud gaming is more about computation and I want to focus on game monetisation method here. Conceptually, GAAS is a superior revenue model to Game-as-a-Product because 1) game developers can build direct relationships with its gamers and own that relationship; 2) price discrimination of gamers; 3) maximise gamers’ lifetime value. Said in another way, for great games that use the GAAS model as opposed to GAAP model, the gamer’s loyalty is higher, generate higher revenue and play longer while also getting more emotional rewards from the game.

9. We are still exploring what is considered fair and ethical in the GAAS model. Some game developers design GAAS games with feedback loops similar to those that cause gambling addiction or create an unfair advantage to paying gamers.  Other GAAS games, such as League of Legends, sell virtual costumes for purely cosmetic purposes and does not impact the competitive gameplay at all. I believe that GAAS is especially powerful for great games with a fair monetisation mechanism.  Because great games are by definition offering tons of emotional reward, and it is likely to be under-monetised in the GAAP model because great games’ sale price is not too different from the average game price. On a price per unit of emotional reward basis, the great games are arguable under-monetised as a GAAP game. Using a GAAS model, gamers who otherwise cannot afford the game could play the game for free and the most passionate fans can be monetised based on the different amounts of emotional reward they each individually receive.

10. A great example is a Chinese online MMORPG game created by Netease called Fantasy Westward Journey. This game has two monetisation methods – 1) gamers pay an hourly rate of USD 1 to play the game and, 2) Netease charges a 1% commission rate for transactions between gamers. Most passionate fans are willing to spend thousands of US dollar to buy powerful characters from players who committed incredible time and effort to train up the character. Netease charges a 1% commission rate for this kind of transactions. The commission dollars help to keep the hourly rate low which then keeps the players with a lot of time and less money in the game to train up their characters which they can sell to players with more money but less time. Such an in-game economy structure improves the game experience, increase gamer loyalty and maximise gamers’ lifetime value in a continuous game world using a GAAS revenue model

11. Gamers can become incredibly loyal to one game over a long period of time once they become invested in the game. I started playing DOTA when it was just a customized game within Warcraft in 2007. DOTA has inspired League of Legends and the entire MOBA genre. DOTA has a reasonably high barrier to entry because the gamers need to develop a base level of game knowledge and skill to start enjoying the game meaningfully. Given that I have already become a reasonably good DOTA player, I don’t want to commit to another game where I need to build up a base level of competence to play that game. Instead, I prefer to enjoy the joys of playing a game that I am already pretty good at. And DOTA, which is now hosted on Steam, continues to release new game content to enrich the game experience which means it is never boring for me. The point here is gamers become loyal to a game when they become highly invested in the game world and the challenge is for game developers to provide new content to continue to enrich the game experience. Again this is only possible in a continuous game world

12. Finally, let’s think about how to value a game developer. There are two components to the value of a game developers 1) the present value of all free cash flow generated by the existing game franchise and 2) the present value of all free cash flow generated by future game franchises. The total profit generated by the existing game franchise requires one to estimate A) longevity of the game, B) revenue per gamer and C) the ongoing operating cost of the game. A game company’s development capabilities determine the probability of producing successful games in the future. It is much harder to assess the value created by futures games but it can have very real value

13. To assess the existing game franchise, one must understand the drivers for gamer loyalty to a specific game (longevity) and the quantum of emotional reward (revenue per gamer) received by the gamers. One can investigate the strength of the game community to get some sense of the social bond between gamers. The social bond formed through the game can be one of the most powerful retention mechanism. Another neat trick to assess gamer loyalty to the game is to investigate the behaviour of returning players. For example, Warhammer 40K has many gamers who played as a teenager but stopped playing as they got older. However, given a chance, many old Warhammer 40k players readily come back into the game. The “relapse rate” for Warhammer is very high. The revenue per gamer should be proportional to the emotional reward per gamer. However, if the game is fun for a sub-group of gamers at the expense of another group of gamers then the game might not be sustainable. Hence the pay-to-win model is inherently quite risky. Sometimes it is clear that the game is under-monetised. For example, Nintendo’s Animal Crossing is a great example. Many gamers are paying hundreds of dollars to acquire certain items from other gamers which Nintendo is not capturing. Finally, for any game franchise to attain super long longevity, the game developers must continuously innovate and create new game experiences in the game world.

14. There are a few exceptional game franchises that have proven their capacity to sustain themselves for a very long time into the future. Pokemon, League of Legends, Magic the Gathering, Legend of Zelda and the sports franchises are such examples. Pokemon is able to build an incredible IP and continue to generate high-quality game content. While Pokemon has sustained its longevity under the GAAP model, its transition to a GAAS model through Pokemon Go is going to make Pokemon a much more valuable franchise!

15. To assess the game development capabilities of a company, one must understand the game company’s culture, its development process and historical success rate. It is hard to define the commercial success of a game on an absolute basis. Typically, the game industry, just like any other creative industry, is defined by huge but few successes. So it is better to define success through return on investment. For the sake of this discussion, I define a 10x return on investment as a successful game. A great game company tend to have a very strong and unique culture. Some game company care more about making really great games than others who are more concerned about short term commercial success. Some great game companies have well-defined game philosophy, for example, Nintendo is a big believer in hardware and software integration as a source of differentiated game experience. One needs to assess if the game development team’s organizational structure makes sense for the games that they are trying to build. From an investor perspective, the most important method is to study the game development track record. CD Projekt Red is developing a very impressive track record and its future game franchise value makes up the majority of its market value. Nintendo maintains a very impressive game development track record over a long period of time though it is not proven in the mobile game space. Blizzard has a great track record but they are struggling in the mobile era. Netease and Tencent both have impeccable game development track records!

16. Scale matters a lot for game developers. Luck plays an important role in the outcome of any one particular game. Assume a good game developer can expect a 5% success rate and each successful game yield 10x return, then the game developer’s expected return is 50%. However, the game developers need many tries before the expected value can be achieved. Hence the two gamers with the same expected return, the larger of the two is much more likely to realise the expected return. But as game companies grow larger, they tend to become more bureaucratic and hinders the creative process and reduce the expected return. So scale matters only to the degree that the expected return doesn’t decline with scale.

17. GAAP vs GAAS involves very different game development process. Chinese game companies are generally leading in this regard. GAAS requires a game development team that continuously create and improve game experience after the game is launched. However, GAAP game development process pretty much ends after the game is launched. This difference to game development approach is, I think, one of the main reason why traditional console game companies, such as Nintendo and Activision, are not able to be very successful in the mobile game era.  Mobile games almost exclusively adopt GAAS model while console games are still very reliant on GAAP revenue model.

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. Please let me know if you know of any! The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

Ryman Healthcare – Update #5

Finally! I executed my first share purchase since the beginning of this crisis. I bought some Ryman shares @ NZD 10.45. It is a relatively small position now (~2%) and I aim to buy more if situation becomes favourable again.

Ryman Healthcare is a company that I have been following for more than one year now. I really started to do work on the company in Nov 2019. It is the largest retirement village operator in New Zealand. Globally, retirement villages are typically average businesses but there is one little quirk about retirement villages in New Zealand that completely transforms the economics of the business. For most real estate asset developers, there are really two ways to generate profits – either sell the assets for a profit upon completion or rent the property to collect the fixed income.  For example, most residential property developers would sell the asset upon completion while shopping mall developers often choose to rent the retail property as the long term rental growth would generate a higher return over time. The IRR is better if the property is sold upon completion while the rental model has lower IRR initially and can be more profitable over the long-term if rental growth is respectable.

But is there a business model in which the property is sold immediately upon completion while also retaining the right to collect rental payment over time?  You know, have the cake and eat it too.

Turns out that is exactly Ryman’s business model.

It builds retirement villages and “sells” elderly folks the right to live in their villages. The resident pays a deposit that is roughly equal to the value of the retirement unit. Ryman would charge up to a maximum of 20% of the deposit value as a management fee and the residents are granted the right to live in the retirement unit for as long as they wish to. At the point of exit, the resident is paid back 80% of the original deposit. In reality, most residents only stay in the retirement villages for 6-7 years on average because the average entrance age is more like 75+. This business model allows Ryman to recycle capital on day one through the deposit (great for IRR) while retaining the ability to collect fixed payment through the form of the management fee.

So why do the elderly folks chose to move into a retirement village? Many elderly folks find it very hard to maintain their large house as they get older. Property management service provided by the village operators relieves them of these chores. Another important motivation is a change in life circumstances such as the passing of one partner. Many prefer to live in a close-knit community than living alone. There is the hospitality aspect of living in retirement villages. There are weekly drinks, movies, field trips, exercise classes, and parties. It is kind of like living in a hotel with strong healthcare capability. Finally, a move into a retirement village helps to release equity in their home which can be used to finance their lifestyle.

New Zealand has a rapidly ageing population which will see the 75+ population grow by  ~3.5% for the next 10 years. The supply of retirement village is growing 5% and hence the penetration of retirement village is growing. The retirement village sector is ramping up supply to meet the growing demand; I would keep a vigilant outlook on the pipeline of new supply. However, Ryman should continue to do well relative to its peers because its villages offer better value for money.  Ryman charges 4% management fee p.a. capped at 20% while most competitors charge 5-6% management fee p.a. capped at 25-30%. Furthermore, people will always want the best care and safest pair of hands to take care of them in the twilight of their lives. They also need to trust operators that don’t take advantage of them when their mental and physical states are not in the best shape.

Hence Ryman’s competitive advantage comes from its reputation as a high-quality care provider and a trust-worthy retirement village operator. It offers a continuum of care model for its residents where independent units (normal houses with minimal care provided) and care centres (including hospital care) are on the same site. Elderly folks are not the most flexible bunch. Ryman pays its care staff above market rate to provide premium care and a strong culture of care.

The market also clearly acknowledges Ryman’s superior quality as its valuation is twice of its peers such as Summerset, Oceania and Arvida. Despite the valuation premium, I prefer Ryman over its peers as a strong culture of care is the best protection for long term franchise value. For example, I have found Summerset to have a mercenary attitude as compared to Ryman. This is not to say I will not invest in Summerset. Just that I think the valuation premium is at this moment reasonably justified. While I believe that Ryman is the best operator in the sector, the entire sector is likely to do well given the favourable economics of the business model.

If I am asked to buy the entire business (which I do sometimes fantasize about), I would value Ryman in a similar manner to an asset management company in that it clips ~3% of the total capital base. The capital base is generated by resident deposits. If I assume that Ryman builds out its existing landbank in the next 5 years without adding to the land bank, it would be able to generate, in my estimation, ~NZD 200m of incremental earnings. Note I exclude new sales gain from this analysis. Putting on a 25x earnings multiple, it would imply a share price of ~NZD 12. I think 25x is reasonable because the capital base enjoys 2-3% of house price growth even if there is no unit growth. This is comparable to the 4-5% rental yield in New Zealand. Of course, in reality, Ryman will maintain its land bank for growth beyond 2025. Hence our entry price is a very attractive one.

Now let me address the elephant in the room – can Ryman survive current pandemic?

  1. Ryman’s care revenue is well protected even in a national lock-down as the residents still live in the care centre. New residents are allowed to be admitted because these are typically need-based demand. Of course, there will be stringent isolation protocols in place
  2. Ryman’s care revenue more or less covers the fixed cost of the entire company. So they have liquidity to cover fixed cost even in a prolonged lock down situation
  3. New sales activity will cease but the company has a lot of leeways to stop existing construction projects to conserve cash. As of Sep 2019, the capital commitment is NZD 150m.
  4. Resale activity will cease too and this would impact Ryman’s ability to repay resident deposits on exit. Typically, Ryman promises to repay the deposit within six months after which Ryman will pay ~1-2% interest on the deposit. Legally, Ryman has three years to repay the resident. Even if we assume that COVID-19 lasts for 3 years (super unlikely in my view), Ryman can sell the apartment to pay back the resident
  5. It has roughly NZD 300m of liquidity headroom in an NZD 1.9bn credit facility. The credit facility is secured with underlying assets.
  6. According to the company, there are two main covenants – interest rate cover and gearing ratio

Given the above facts, it seems that Ryman has a very high probability of surviving this crisis.

The demand for Ryman product is mostly like to be delayed and not lost. Hopefully, we should see a reasonable demand recovery.

There is a risk with house price deflation in the event that we go into a recessionary environment coming out of this pandemic. Even though Ryman’s units usually sold at a discount to comparable houses in the same market, it would still impact Ryman because elderly folks need to sell their house to afford a Ryman unit.

Games Workshop – 1H 2020 Results Update – The Best Is Yet To Be

07:57

1H 2020 (6 months ending 1st Dec 2019) results were excellent! What a privilege to be a partner in this spectacular business! Especially the kind of hardworking partner where all I have to do is just sit and watch.

The most exciting part of the earnings release was the doubling of the licensing income from GBP 5.5m to GBP 10.7m due to the launch of a new video game. A big part of my investment thesis on GW relies on the increased monetisation of its Warhammer IP beyond just miniatures. While this is a step in the right direction, I fully expect the licensing income to be lumpy and would take years to materialise fully.

In the meantime, the core miniature business is firing on all cylinders….

The revenue grew 18.5% to GBP 148.4m which is above my long term expectation of 10-15%. New games and miniatures release schedule will impact the growth in a specific period. My long term expectation remains unchanged in this regard.

A more detailed study of the revenue growth reveals some encouraging signs. GW breaks down revenue into three channels – Trade, Retail and Online.

Trade channel is 52.6% of the total revenue and growing the fastest at 27.2%. Trade is mostly made up of local mom and pop hobby stores which stocks a variety of trading card and board games such as Magic the Gathering & Catan. These hobby stores are usually the centre of local hobby community which is very similar to GW’s own retail stores. There are 4900 distributors at the end of 1H 2020. The distributor count grew 11.4% and the annual revenue per distributor grew 14.2% to GBP 31.9k. The annual revenue per store for GW’s own retail store is GBP 173k. So there is a 5x gap. Over time, distributors should increase retail sales productivity to close this gap.

Retail channel is 31% of the total revenue and growing at a slower rate of 7.5%. Retail consists of Warhammers stores owned by Games Workshop. The store counted increased by 2.5% while the revenue per store increased by 5% on a YoY basis. Finally, the online channel grew 15.6% and makes up for 16.5% of the total revenue base.

Opening retail stores will help to build brand awareness and seed the initial Warhammer community in a new locality. However, the independent hobby stores is likely to remain the most important driver for revenue growth for the next few years. Because it is uneconomical for GW to open stores everywhere. Online will remain a complementary channel to help fans acquire miniatures that are not stocked in the local hobby store.

Due to the completion of the new factory and optimisation of operational controls, the gross margin has expanded by 2.5% to 69.5%. Different revenue mix of newer vs older miniatures in any one period lead to fluctuating gross margin. Gross margin of an older miniature is higher as the fixed cost of building a plastic mould is amortised over a larger volume. I would expect the gross margin to fluctuate between 67-70%. The core operating profit was GBP 48.5m which was up 37.8% due to the beautiful effect of operating leverage. Core operating profit margin stood at 32.7%.

Investment consideration – at ~GBP 67 per share, GW is valued at roughly 25-28x 2020E earnings. While it is not cheap on a headline basis, I am holding onto my positions due to 1) healthy top-line growth + operating leverage and 2) a very positive prospect on IP monetisation.

Games Workshop – An Investment Fantasy

Games Workshop (GW) is the largest investment (20%) within my portfolio as it is the cheapest and simplest idea that I can find. When GW ownership was first acquired in April 2018, I only committed 5% of total investment funds because I did not fully appreciate GW’s outstanding business quality. Despite the share price increasing from GBP 22.75 to GBP 61 since then, I further increased the investment in GW as my understanding and conviction in the business developed positively. I may be a slow learner, but it is better to be late than never.

GW is the UK-based creator of Warhammer Hobby which makes fantasy miniatures set in endless, imaginary worlds called Warhammer Universe. The Warhammer Hobby involves painting and collecting Warhammer miniatures with rich backstories developed over 500+ Warhammer novels in the last two decades. Fans can form armies with the miniatures to participate in the tabletop wargaming with the rules developed by GW. All miniatures are designed and manufactured in the company’s headquarter in Nottingham. The story writers collaborate with miniature designers and game makers to weave new characters, games and stories seamlessly together. GW generates revenue through the sales of miniature and the royalty income from licensing its intellectual properties (IP) for PC and mobile games.

I think of Warhammer fan base in three categories – Collectors, Gamers and IP fans. The Collectors preoccupy themselves with collecting and painting miniatures because of their design and beauty. The Gamers are passionate about the wargames and strategically acquire miniatures based on their roles and powers in the game. IP fans, fascinated by the Warhammer Universe, mostly enjoy the Warhammer novels. In reality, the fans have one main preference but also participate in other aspects of the hobby in varying degrees. Interestingly, the Collectors make up for 30-40% of GW’s revenue.

While not everyone is a natural fan of the Warhammer, those who carry the Hobby Gene have an innate tendency to become a fan. This love affair between fans and GW was under trial during the period from 2010 to 2015. Under the leadership of previous Games Workshop management, the company had minimal communication with the fan community, shun social medial (because they did not want to deal with criticism from the fans), closed down popular product lines and increased prices excessively to offset a shrinking fan base. During this 5-year period from 2010 to 2015, the revenue shrunk from GBP 126.5m to GBP 119.1m while the net profit declined from GBP 15.1m to GBP 12.3m.

Just when it seems like GW is set on an inevitable slow decline, Kevin Roundtree took over as the new CEO of Games Workshop in 2016. The first thing he did was to reconnect with the Warhammer fan base through the Internet. Then, he reintroduced the popular Warhammer games that fans loved. Most importantly, he makes it easier for fans to get into the hobby by offering lower price point starter sets and simplified the game rules. The fans are elated and came back into the hobby in droves. One fan even commented that “it is like Games Workshop was taken over by someone who actually knows about sales and marketing in the twenty-first century.” Its revenue doubled to GBP 256.6m while its net profit jumped five-fold from GBP 12.3m in 2015 to GBP 65.8m in 2019. This is a testament of the fans’ loyalty towards Warhammer. Few companies can not only keep their customers after years of mistreatment but also win them back with one big gesture.

So why are fans so loyal to Warhammer? Warhammer has a differentiated customer experience that few can match – beautifully designed miniatures with great details, a strong physical network of players, and cleverly crafted fantasy worlds that fans can immerse themselves into. Even as fans complained about GW during 2010 – 2015, they acknowledged GW’s miniature as best in the industry. GW has the unique competence to mass-produce high-quality miniatures in a cost-effective manner because it has years of accumulated manufacturing know-how and the scale to internalise its entire manufacturing process. As the largest fantasy miniature producer, they can cover the fixed cost of investing in customised tools and mouldings. The design team can work closely together with the manufacturing team to push the limits on manufacturing the next best miniatures.

Gamers are going to play the games that have a decent chance of finding another Gamer to play against in the local community; thus it is critical to have a minimum player population size locally. Hence, GW uses its fleet of 500+ physical retail stores to provide physical space for local fans to meet and recruit new blood into local Warhammer communities. Local Warhammer clubs are formed as the fan base grew. It took GW over 30 years to build this physical network of Gamers globally which new competitors will find it hard to replicate.

Put in another way, GW’s moat lies in its physical social network of Gamers. Warhammer – the game – is the equivalent of Facebook – the digital platform – that binds these players together. Each new player joining Warhammer strengthens the social network because it increases the existing players’ probability of finding a good game quickly. Physical social networks are of course inferior to virtual social networks because 1) Gamers cannot have a game whenever and wherever they want, 2) Gamers’ social relationships are not digitalised and hence not accessible to GW, and 3) Gamers’ interactions cannot be stored in a useful format. Nonetheless, the physical social network is still a powerful moat for the business.

Finally, GW’s IP elevates Warhammer above other board games and tabletop games. Most board / tabletop games are hit-driven businesses where new gameplays are easily copied by competitors. Unlike most board / tabletop games, Warhammer fans immerse themselves in the narratives as they collect and play the miniatures. It is a common scene to see Warhammers fans tries re-enact plots from the narratives through the games. Ask any Warhammer fan what they like most about their favourite miniatures, and the reasons usually are the characters’ personalities and their struggles and victories in the narratives. The progress in the narratives will introduce new characters which then is made into new miniatures. The stories give meanings to the lifeless miniatures and emotional bonds are formed when fans project themselves into the characters. This emotional bond with Warhammer drives repeat purchase. Or in the modern business parlance, Warhammer fans have high lifetime value. This strategy is common among other successful media franchises such as Pokémon and Star Wars.

I believe GW’s moat is likely to grow stronger with its unique corporate culture and first-rate management team. GW’s culture is formed by employees who are themselves biggest fans of Warhammer and they come to work here because they love what they do. GW also has a very strong creative culture where people have the creative freedom to try new things. After spending two decades at GW, Kevin, the CEO, is the right steward of company culture. I have come to know him better over the last year. He cares deeply about Games Workshop and he understands the full potential of Warhammer IP. Kevin set up a new media business unit to bring the Warhammer IP into mainstream media. If this is done successfully, the acquisition cost of new fans is going to decrease significantly. One of the biggest investment risks is Kevin’s departure due to some unforeseen reasons.

I value GW in two parts – core earnings from the sale of miniatures and royalty income from IP licensing. Through acquiring new fans and growing spend by existing fans, GW can grow its core earnings by 10-15% annually. I do not need to know precisely the size of the total market to believe that GW has a very long growth runway ahead. Another popular card game called Magic the Gathering has ~ USD 500m in revenue double that of Games Workshop’s revenue. GW has a sizable fan base in China but negligible revenue. I think China can be at least as big as the US which is GBP 100+m (50% of total revenue). On the royalty income side, GW is significantly underearning relative to the strength of its Warhammer IP. It is currently generating GBP 11.4m which is only 5% of its miniature sales. The top media franchises, such as Pokemon and Dragon Ball, make the majority of their income from licensing rather than merchandise sales. Despite paying a hefty multiple of 24x 2020 earnings, I believe we are getting a fantastic bargain because this is a very high-quality franchise with strong growth prospects, under-appreciated IP monetisation potential and strong corporate culture that reinforces its moat with time.

Information Flow – A Force of Nature

I have been going through old interviews by Meituan founder, Wang Xing. He is obsessed with the mechanism of information transmission in our society and technological advances that improves information transmission brings about drastic changes to how people interact and conduct their daily lives. And when people change their ways of conducting daily lives, it usually means formation of new businesses that take advantage of these changes. Incumbent businesses that rely on the older way of information transmission will be left in shatters.

Wang Xing likes to define information technology (IT) as technology that enables the flow of information. So in this sense, just like Internet and smartphones, older technologies such as printing press & books are also IT. In fact, three out of the four ancient Chinese inventions (papermaking, printing, gunpowder and compass) are about IT. Papermaking is about storage of information. Printing is about mass replication of information. Finally compass is about production of geospatial information.

Internet brought about a revolution in terms of information transmission. Not only does it lower the cost of information transmission, it also unlocks new ways to transmit information. For example, social networks built on top of Internet allows information to pass through the network of humans. We share news, products, services, personal experiences with our friends on social network. Direct to consumer businesses have taken advantage of this change. This is challenging the long-held belief that FMCG companies have impregnable moats.

Technology does not just reduce cost of information transmission. They also allow new types of information to be transmitted. For example smartphone allows the individual location information to be transmitted instantly and hence new businesses such as ride-hailing and food delivery platforms to emerge. Smartphones also allow companies like Meituan which is a marketplace for local services such as hairdressers, beauty salons and restaurants to market to potential audiences more efficiently than before. Meituan will show consumers nearby local services based on location information which are most relevant to the user.

The impact of information flow is even more nuanced than just allowing new business models to emerge. I believe that because the digital revolution has brought about reduced communication and management costs which has reduced the transaction costs within a firm. This partly explains why we are seeing companies becoming larger than ever. I don’t think this trend will reverse.

As investors, the appreciation of the magnitude of changes and the path of change can be very lucrative. For example Uber drivers have driven demand for vehicle hires and this demand for rental vehicle has driven fleet sales in Brazil. Since fleet sale is done at wholesale price, this meant that auto OEMs has to accept lower unit price and margin compression.

The increased digitalisation will transform the food industry in the next 10 years. The first step has been the arrival of the food delivery platform which brings food from the restaurants to the consumers. This can happen because the consumer side has been “digitalised” with smartphone. The next step is to digitalise the restaurant. Currently the bottleneck in terms of food delivery efficiency lies with waiting time at the restaurants. Digitalisation of the kitchen will allow the food delivery platform to predict cooking time much more accurately. Then it is about the logistics. Instead of delivering with clumsy human beings, the next step is to deliver with autonomous robots. Eventually, I believe that food production will be centralised and cost of food comes down dramatically. People will continue to go to restaurants for social experiences. But new flats might not have kitchens anymore.

After studying Wang Xing carefully, I am 100% with him that digitalisation will continue to change the society. And the next stage of change is mostly focused on the enterprise side. While Warren Buffett has derided “change” as detrimental to the investors, I think “change” can be quite lucrative if it is misunderstood by most.

Thoughts on great shopping malls

Given the threat of e-commerce making inroads on convenience/time-spend of shopping (innovations such as augmented reality improve online shopping experience further), what makes a shopping mall’s future relatively bright?

On some counts, offline has advantages, on the other hand there’s weak points that need to be minimized. I make a distinction on this basis and call them “pulls to offline” and “lack of push to online”.

Pulls to offline

  • Having a “great experience”
    • Beautiful and clean mall
    • Meeting friends
    • “M’as tu vu” (requires mall to be frequented by many shoppers, ideally local)
    • Day trip allure of a mall: a whole family can enjoy a day off in one place
  • For buying apparel: human advice
    • In-store advice and advice from friends. As online is making in-roads on human advice, I believe friends’ advice is more of a selling point

Lack of push to online

As buying online is efficient w.r.t time spent, this is a weak point for some offline shop. Mitigators:

  1. Easy-to-reach
    • great location close to population with disposable income: an outlet might be a pain to reach in the middle of nowhere versus a shopping centre next to a train/tube station, or simply on the way for tourists walking by
    • population density in the neighbourhood (think city centres)
  2. Access to multiple shops at once
    • Large shopping malls offer time-efficient access to many shops
    • High occupancy rate is a win for consumers as well in this respect
  3. Access to non-shopping stores that consumers need to visit anyway
    • Mall with gyms/restaurants/grocery/barbers
      • the sunk cost of getting to these places near other stores might even make shopping before/after more time-efficient than online shopping. These places might be the next shopping mall “anchors

The points in green are arguments for large shopping malls with many tenants from diverse categories such as gyms that cannot be done online.

If some shopping malls are indeed able to offer a “great experience”, this might even pull more footfall to these outfits over time as leisure time rises around the world.

The best shopping malls are aggregators of great brands for the best consumers. As such, there are some winner-take-all dynamics at play in this weak two-sided network (weak because the network is very local, but luxury brands and shoppers compound the network effect through increased possibility of building long-term relationship).

On property management

Best property managements are therefore long-term thinkers: willing to invest in renovations / repurposing to keep footfall and tenant quality high. For example, buying back shares at 8% current yield might optically look better than making a 7% ROI renovation, while the renovation can avoid atrophy in the type of customers, tenant base indirectly for years ahead.

It seems that the number of retail shops will certainly grow slower versus the growth in retail sales as the weaker brick-and-mortar links get shut out. The highest quality shopping malls meanwhile will still see a change in tenant base as tenants with products that are great to sell online disappear (uniform products with long-tail offerings such as books, films). Experience in managing tenant base is another important treat.

Brand advertising

Some companies such as Apple (Stratechery, Scott Galloway podcast), BMW use beautiful retail stores to raise brand awareness and customer experience. Some other functions that these stores serve besides selling products:

  • advertise brand (a superior physical impression is superior to an ad on a screen; what is in particular interesting is that the human brain better memorizes physical as opposed to digital impressions example 1, example 2). The superior physical interior, product design, aroma can convince the consumer that Louis Vuitton is for example superior to Zara in a way that digital ads cannot.
  • high-end product feature awareness, customer education
  • Genius bars in themselves are a point of differentiation as competitors do not offer this service

In short, these stores are but one piece in a consumer’s product experience. In Apple’s case, an iPhone is not only hardware, but also software (iOS) and experiences such as customer support and trying out new launches of features in Apple stores, underlying again how experience is becoming more important for shopping centres.

Conclusion

The economics of growing sales for brands is permanently changed because of a growing online sales share. Whereas in the past brands grew by growing quantity of offline presence because of the fixed link with sales, today, brands will want to occupy the best offline spots and rather not want to be associated with inferior malls. A “flight to quality” malls seems plausible.

To remain competitive, shopping malls have to pull consumers through strengths and avoid a push to online by remaining competitive on the strong counts of online (convenience, price). Multiple factors require malls to be

  1. In the vicinity of high-density affluent population or transport anchors (metro, train, highway) (time-saver, social aspect)
  2. Beautiful and well-kept (experience)
  3. Diverse tenant base with anchors such as gyms, restaurants that will largely remain offline experiences (time saver)
  4. Big (experience for a whole family)

The advantage that offline offers in terms of branding seems most relevant for luxury brands and hence luxury malls.

As malls ideally aggregate the best brands with local consumers, it is in a sense similar to the newspaper business: you want to own the number one mall in each city.

A major risk concerning e-commerce is that luxury brands themselves might become less important in an increasingly online sales world. We see this with Amazon trying to sell white-labels as consumers increasingly weigh functionality and price over brand as information asymmetry is smaller online (driven by e.g. customer reviews).

TC

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