Funko

Q3 22’ SUMMARY

Funko delivered mixed results on the earnings call with strong revenue performance in Q3 along with weaker than expected earnings results. The strong revenues materially outperformed management’s guidance, consensus expectations, and Pragmatic forecast. This was driven by continued robust demand for the business’ products on a global basis. The strength was as broad based as it could have been, which is strong evidence that demand is intact.

The weakness on the bottom line was largely the results of the former management team poorly executing on an important strategic decision. Funko’s warehouse consolidation into a single distribution center was supposed to support the business’ strong global trajectory; however, failure to launch a custom ERP system created massive disruptions for the business. The former management team then went on to poorly communicate the extent of the issues, which is very likely the reason that the Board brought Brian Mariotti back to the helm after briefly stepping down to work in a creative capacity. The Board also fired the CFO, initiated a search for a superior CFO, and initiated the search for the first COO.

Overall, the business is still in a great position in the licensed product industry, which has a massive TAM that continues to expand. Even with the headaches from the internal issues, Funko continued to take share in the industry as the business model is very compelling. The business certainly has to work its way out of the logistical mess it has found itself in; however, this is a much better problem to have than a demand problem.

Key Takeaways from Q3 22’

Key Takeaway 1- balanced growth across geographies

• The core domestic business continued to demonstrate strength.

• The growing international business continued to recover from COVID and geopolitical headwinds.

• Wholesale and D2C strength across global channels.

Key Takeaway 2- balanced growth across product types

• Core collectibles demand was robust even with price increases driven by general momentum and strong festival performance.

• Loungefly business continued to scale as an integral line of business for Funko as global expansion continued to play out.

• Other products business demonstrated strong momentum driven by demand for Funko’s broad game portfolio.

Key Takeaway 3- licensed products, cinema, and toy momentum

• Restaurant spending remained strong in Q3 22’ as consumers return to outdoor activities now that the pandemic is behind us.

• Market research firms forecast sustained momentum through 22’ and the next several years.

GROWTH TRENDS

growth Factor 1- core collectibles business

Funko’s core business demonstrated material strength in Q3 22’ across every reported metric. This is critical to Funko’s trajectory as the business is driven by the Pop!’s products although the secondary businesses/products are gaining significance. In Q3, core collectibles drove growth from strength in both the wholesale and D2C sales channels as demand was robust for these products. This strength was driven by both evergreen and non-evergreen products. The business drove particularly strong growth in the non-evergreen products as the content calendar was much stronger in 22’ than it was in 21’ as several major movies were released this year. Strength in both evergreen and non-evergreen is a positive development for the business as there is risk to overreliance on current properties. Additionally, there are lost monetization opportunities from having an overreliance on evergreen properties and ignoring current properties.

The business drove strong monetization in the quarter on a slightly smaller active property base. While it is always good to see the active properties expand, Funko has already increased the portfolio massively since the pandemic. The fact that average revenue per active property growth was over 40% is a testament to the business’ ability to drive velocity on a property by property basis. Additionally, Funko saw strength in both the top 10 property portfolio as well as the broader property portfolio as evidenced by revenue and monetization growth. This broad strength provides overwhelming evidence that Funko’s fundamentals were stellar in Q3, which gives confidence that Funko can move beyond headwinds in Q4.

• Trends in the mass channel were called out as particularly strong.

• Trends at in-person events drove momentum in the core collectibles business.

• Popsies products performed very well at Walmart, which has led to the products earning more shelf space in 23’.

• Velocity was strong with traffic, average order value, and conversions up Y-O-Y.

growth Factor 2- Secondary Products Business

Funko continued to scale the secondary business to augment the total company revenue sources, which is necessary to realize the long-term potential of the business. Funko’s business model is based on leveraging IP that consumers love by way of imposing the IP onto various products in a differentiated and fun way. This has positioned the business to launch and scale Loungefly (primary leather goods) and other products (primarily games and digital products). Given Funko’s existing property portfolio, the business has been able to extend these licenses across product types.

In Q3, Funko drove meaningful growth in the Loungefly business. This strength was driven by additional properties available under the Loungefly brand as well as continued international expansion. Additionally, Funko drove strength in the other products business with Funko Games continuing to gain traction in the large board game market. In just a couple of years, Funko now has over 180 games in the catalog. These lines of business are showing even better strength than the core business, which is still in high growth mode.

growth Factor 3- geographies and channels

Funko is still scaling the business on a global basis through the D2C channel as well as the wholesale channel, which includes mass and specialty retailers. This broad distribution is a testament to the massive base of consumers engaging with the brand. While the pandemic disproportionately affected the international business, these headwinds have largely subsided in 22’. Funko continued to drive strength in the wholesale channel while scaling the D2C channel, which was nascent before the pandemic. While the former management communicated that retailers were pulling back on purchases, results through Q3 indicate that the headwinds in Q4 are likely self-inflicted as retailers are highly incentivized to continue stocking products with high velocity.

Importantly, Funko has immense potential in the D2C and international businesses. These two segments will be the drivers of growth over the long-term given the business’ lower penetration rates. Funko saw material traffic increases on the site combined with higher order values, which indicates robust demand. The business’ expanded distribution center was created to service the next phase of growth, which will primarily be D2C and international.

OPERATIONAL EFFICIENCIES

Funko’s operational efficiency was poor in Q3 22’ as the previous management team poorly executed on a major project. The business’ growth forced Funko to look for better fulfillment options to sustain the massive growth. The business decided to consolidate several warehouses into a massive distribution center that launched in Q2 22’. This was a great move; however, the business was expecting to launch a major ERP system to support operations at the new distribution center. Unfortunately, the ERP system was not ready in time so Funko suffered massively as the ERP system was integral to efficiently operate the distribution center. This was a real failure to execute by the former management team, which resulted in material expenditures to hire third parties and additional staff to help mitigate the effects of the ERP launch failure. As a result, margins were materially compressed during a period that margins should have expanded. Overall, the business’ trajectory remains strong despite this rather disappointing delay.

INDUSTRY TRENDS

The licensed property industry is expected to generate moderate growth in 22’ and 23’ as momentum continued from the strong spending in 21’. This momentum is expected to continue on a global basis as demand shows no signs of reversing based on data from market research firm, Euromonitor. The industry is supported by consumers continuing to embrace new and legacy properties, which creates a monetization opportunity for licensed property businesses.

Additionally, active figure sales continue to generate strong spending in 22’ as consumers demonstrate robust demand for a wide range of toy products. Lastly, the box office has been much stronger in 22’ than 21’, which is a major signal that demand remains robust for large films. This creates strong tailwinds for businesses with licenses to IP from major movies. Going forward, the box office has a strong lineup for 23’ that elongates the tailwinds from 22’.

FORECAST AND VALUATION

Funko’s outlook for Q4 is much different than it was going into Q4 22’ as the company clearly has operational issues impacting revenue and profit. While the former CEO and CFO communicated that revenue growth in Q4 would be primarily impacted by retailers cutting orders to optimize inventory, this just does not seem to explain what is really occurring. After strong pressure from analysts on the earnings call, management stated that the issues with the new distribution facility are also impacted Funko’s ability to service demand. This is a much more plausible explanation for the abrupt downgrading of revenue momentum. It appears that the business is undergoing a logistics fiasco, which impairs Funko’s ability to fulfill global demand. Also, Funko has relationships with dozens, if not hundreds, of retailers so inventory corrections at Walmart and Target do not explain the downgrade in revenue trajectory in Q4.

Overall, Funko’s trends through Q3 22’ provide overwhelming evidence that the business has strong underlying demand. The fact that Funko continued to see increases in traffic, conversion, and average order value is strong evidence that demand is strong. This is even with material price increases that went into effect. As a result, the Pragmatic forecast for revenues is at the high end of management’s guidance, which is likely highly conservative given the bad news given on the call. Additionally, the Board’s decision to revamp the leadership team gives meaningful confidence in the general trajectory of the business. On the expense side, Funko is likely to realize material inefficiencies as significant money must be spent to make up for the lost productivity in the distribution center. Overall, the business is positioned to generate strong growth for the full year; however, profitability will certainly take a hit.

The market had a terrible reaction to the earnings results. This was likely amplified by the sheer lack of confidence that the previous CEO and CFO demonstrated. While the negative response is definitely understandable, the stock is deeply oversolf given that the fundamental trajectory is sound based on numerous data points that indicate consumer demand for Funko products remains strong. Importantly, the elevated expenses related to under-productivity will pass in 23’, which sets the business up for a resurgence in operating leverage in 23’. The stock is presently trading at a steep discount to the historical averages from a P/E and EV/EBITDA perspective. This is likely to reverse as the new leadership team delivers results consistent with Funko’s proven potential.