Funko, Inc.
Q2 2019 Earnings Call Transcript

Published: 10 Aug 2019

[Operator:]

Good afternoon, and welcome to Funko's Conference Call to discuss Financial Results for the Second Quarter of 2019. At this time all participants are in a listen only mode, later we will conduct a question and answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call is being recorded.On the call today from management are Brian Mariotti, Chief Executive Officer; Andrew Perlmutter, President; and Russell Nickel, Chief Financial Officer.I will turn the call over to Mr. Nickel to get started. Please go ahead, sir.

[Russell Nickel:]

Thank you, and good afternoon. A press release covering the company's second quarter 2019 financial results was issued this afternoon, and a copy of that press release can be found in the Investor Relations section on the company's website. Management's remarks on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These may include statements regarding our business goals, plans, abilities and opportunities; industry and customer trends; growth, momentum and investment initiatives; collaboration and license relationships; consumer engagement and brand awareness; acquisitions and related expenses; potential tariffs; and anticipated financial performance. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of our Form 10-Q for the quarter ended June 30, 2019, and our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligation to update them.Please also note that we will be referring to certain non-GAAP financial measures on today's call, such as EBITDA, adjusted EBITDA, adjusted EBITDA margins, adjusted net income, adjusted earnings per diluted share and net debt, which we believe may be important to investors to assess our operating performance. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and in the Investor Relations section on our website at funko.com.We have also prepared a visual presentation that investors can consult to follow along with this discussion, and it can be accessed in the Investor Relations section of our website. I will now turn the call over to Brian.

[Brian Mariotti:]

Thanks, and good afternoon, everyone. Funko once again had another terrific quarter, posting growth that exceeded expectations. Given our continued exceptional performance, we are increasing our full year outlook for 2019.Our net sales were up 38% over Q2 of last year. On a 12-month trailing basis, our net sales were over $0.75 billion, coming in at $768 million, up 31% compared to the 12 -- prior 12-month period. Gross margin came in at 37.2%, and we are on track to achieve full year gross margins of 37.5% even with this latest round of tariff increases.We believe we are well positioned to withstand potential increases in tariffs, which up to now have mainly affected just our allowance by division, and we are looking at a number of ways to reduce the impact of these tariffs as well.Our team's strong execution drove excellent performance, allowing us to raise our outlook for the year for sales, adjusted EBITDA and adjusted EPS. And as we've been saying all year, the strong momentum of our business allows us to make disciplined investments to take advantage of the increasing opportunities in front of us. Our future has never looked brighter and I've never been more excited.The factors that drove our excellent performance in Q2 are familiar

[Andrew Perlmutter:]

Thank you, Brian. Our partnerships with retailers around the world are one of Funko's key strengths. As Brian mentioned, we continue to connect our fans with their favorite content through our retail partners. Funko's unique ability to drive traffic to our retailers is one of the elements that differentiates Funko from our competition.As we've been saying for some time, 2019 is a very strong year for content. During the second quarter, newly launched properties like Stranger Things Season 3, Spider-Man

[Russell Nickel:]

Thanks, Andrew, and good afternoon, everyone. As Brian and Andrew have indicated, we have again delivered better-than-expected results for the second quarter driven by strong performance globally across multiple product lines, and we are able to bring more of the sales upside to our bottom line. We exceeded expectations on sales, adjusted net income and adjusted EBITDA. As I will discuss later, part of the bottom line upside was due to the timing of investments when compared to the prior year.Before I go into the details of the quarter and our improved outlook for the year, I want to discuss a matter concerning duties paid by Loungefly. During the quarter, we identified that Loungefly had historically underpaid certain duties owed to U.S. Customs. Once we discovered this issue, we acted quickly. And in July, we paid $7.8 million to U.S. Customs. This $7.8 million covers a 5-year statutory limitation period through June of 2019. Of that amount, $6.3 million relates to periods prior to Q2, and the remaining $1.5 million relates to Q2 and is split nearly equally between inventory on hand and cost of goods sold. While we have concluded that these errors identified were immaterial individually and in the aggregate to our previously issued quarterly and annual consolidated financial statements, we have also concluded that correcting these errors cumulatively would have been material to our second quarter of 2019. Accordingly, prior periods' amounts have been revised to reflect the correction of these errors. Additional detail and the impact of this -- of the revision by quarter can be found in our second quarter Form 10-Q.Looking at tariffs more broadly, we are reviewing the potential impacts of the tariffs recently ordered by the administration that go into effect on September 1. While we have moved much of our production out of China, we believe our gross margins in the fourth quarter could be adversely affected. We are looking at a number of ways we can mitigate the impact of tariffs over time. But if these tariffs do go into effect and we are unable to offset them in the near term, it could reduce our Q4 gross margin by as much as 50 basis points. Despite these headwinds, we still expect our reported gross margins in 2019 to be in line with the level we reported in 2018 or approximately 37.5%.Longer term, we believe we are in a very good position to offset the impact of tariffs. We continue to shift production outside of China, and sales to regions outside of the U.S. are growing faster than our sales in the U.S. In addition, given the generally low retail prices of most of our products, we believe that the negative impacts of higher tariffs can be offset with relatively modest price increases that we don't believe would adversely affect demand for our products.Now let's talk about our second quarter results. Net sales in the quarter increased 38% to $191.2 million and were driven primarily by the continued expansion in products and properties in our portfolio, broader distribution into new territories and customers and greater sales per property. In the quarter, the number of active properties increased 16% to 592. And net sales per active property were $323,000, which was up 19% year-over-year. In the first 6 months of the year, we sold again 663 properties, 23% more than a year ago. And our sales per active property were $540,000, up 5% over last year. As a reminder, we expect net sales per active property to fluctuate from time to time. We believe it is a good sign to see leverage from each property and our sales spread over a wider range of properties.The top-performing property in the quarter was Avengers

[Operator:]

[Operator Instructions] The first question is from Alex Perry of Bank of America Merrill Lynch.

[AlexPerry:]

Congrats on the strong quarter. Just first, can you talk specifically on what drove the exceptional growth in the specialty channel, which was up 83% this quarter? Just some more color there would be really helpful.

[Brian Mariotti:]

Yes, I can start. I'm sure Andy will chime in. Like anything else, it's our longest, most established, most mature channel. It continues to grow year-over-year. I think we're seeing continued shelf expansion, one. We're doing a better job of product segmentation, earmarking products for vast retailers and trying to separate ones that are unique for a specialty retailer. That seems to be -- that strategy seems to be helping as well. A lot of that -- those channels are still growing also in EMEA and Latin America as well. I think just all 3 of those strategies are really, really paying off and the business just continues to mature. And with that, we continue to be able to annex other adjacent categories, and I think all of it seems to be working.

[Andrew Perlmutter:]

Yes, I would just -- the only thing I would add, I would echo everything that Brian just said. And I would say that we are seeing some strength from the Loungefly brand or the Funko brand, bringing programs to these retail partners together, which is helping to accelerate the expanded shelf space, and continue proving that Funko is a valued resource for these specialty customers.

[AlexPerry:]

Perfect. That's really helpful. And then maybe, Russell, just for you. Can you help us think through the tariff's impact a bit more? Remind us sort of the percent of U.S.-bound imports that are coming from China. And then are you guys considering any other offsets other than the price increases?

[Russell Nickel:]

Yes, absolutely. So as we've talked about for a number of quarters, we are now -- 70% of the core production is outside of China and located in Vietnam. That remaining 30% is then distributed worldwide, including coming to the U.S. So when you look at it, that mix starts to shift down. And then even that mix that is U.S.-bound is split pretty much between 80% to 20% FOB to non-FOB. So when you layer in that mix, the fact that we're ahead of the game in terms of moving production outside of China, we looked at -- it would take a modest price increase to offset. It is looking like if we did nothing or were unable to do anything, which is not the case, it would have a 50-basis-point impact. But as we said, there are opportunities to raise prices with our retailers that wouldn't affect demand. We are also working with our supply chains as well as our licensors to look at other avenues across the board. That said, I would highlight again that we're seeing favorable trends from a pure product margin perspective that we believe will offset some of those incremental tariffs on -- of the 10% should they go through later in Q3.

[Operator:]

The next question is from Drew Crum of Stifel.

[Drew Crum:]

So the midpoint of your revenue guidance increase was a little less than $30 million. I know you referenced the first half being above expectations, but are you seeing anything in the second half that's also being factored into that increase?

[Brian Mariotti:]

I would continue to say the content year as a whole, it's extremely strong. And we have 2 big bullets left to fire with Frozen 2 and Star Wars

[Drew Crum:]

Okay. Okay. And then, Russell, just setting aside the tariffs, the 37.5% gross margin guidance for the year, can you talk about some of the other puts and takes to getting to that number? In the press release and the preamble, you mentioned lower license and royalty costs. Any detail behind what drove that?

[Russell Nickel:]

Yes. Yes, broadly speaking, I mean, obviously, there are a lot of puts and takes to gross margin as a whole. The -- we are seeing favorable trends or progress that we've been making. We talked about this the last couple quarters in terms of customer chargebacks that have a headwind from a gross margin perspective. We are seeing favorable trends in our product costs, which I think speaks to our strong pricing -- ability to hold pricing as well as our strong demand.On the royalty front, naturally, with the licensor mix, we're actually -- there is a -- the shift would suggest a higher royalty rate. But what we're seeing is in the last couple of years, we've had some higher minimum guarantees that we've had to write off in 2017 and 2018 that we're not seeing this year. Those adjustments or write-offs really related to our exit of the subscription box business as well as the acquisition and the timing of the ramp-up of sales in Europe. So largely, just we continue to do a better job and be disciplined from a minimum guarantee perspective on the royalty front.

[Operator:]

The next question is from Christopher Horvers with JPMorgan.

[Christopher Horvers:]

Great quarter. So a couple of questions. Just on the -- a follow-up on the tariff situation. So you've talked to the -- your major retailers and they basically said that they would -- they're willing to sort of take this price increase and are comfortable moving off like the $4.99 or $7.99 price point and, just psychologically, for the consumer?

[Andrew Perlmutter:]

Yes. I'll take that one. It's Andrew. So we have been in conversations with most of our retailers. Where we sit with our retail price points, we believe that the type of price increase we're talking about could be absorbed easily without having to change the retail. There is more margin built in for the retailers on some of our products than other traditional action figure-type products. So we don't believe we're talking about anything that would shift the retail price point and we do believe that it would be absorbed.

[Christopher Horvers:]

Understood. And then just understanding the -- Russell, you mentioned the Customs charges. So that ran through cost of goods sold and that impacted the second quarter?

[Russell Nickel:]

So there was a mix. So it was immaterial. The ultimate findings related to a 5-year period on each individual quarter, the adjustments or the error, were deemed to be immaterial. If we had run the entire adjustment through in the first quarter, it was deemed to be material. So what we've done is revise our prior period numbers with the adjustment and the impact. So what's running through cost of goods sold this year is -- or this quarter is simply the incremental duties owed on Loungefly products appropriately reported and appropriately paid that were sold in the quarter. So comparatively, when you look at the revised numbers quarter-over-quarter or the prior years that I would point to that are disclosed not only in our 10-Q but also in the earnings presentation on our website, it would show kind of the true impact as we've revised those prior period numbers to reflect the correct duties owed.

[Christopher Horvers:]

Got it. So my more -- bigger question is that the 37.5% for -- that you're seeing on gross margin for the year, the gross margin from the first quarter, which was 38.1%, that's intact? I'm just trying to figure out like...

[Russell Nickel:]

Yes, that's intact. And so we're -- for the year-to-date, we're at 37.6%, and we are seeing the favorable trends from a product margin perspective that we believe will offset this higher-than-expected duty rate on our Loungefly products as well as the proposed or requested incremental tariffs on the core Funko products at 10% on the -- which, again, only relates to the U.S.-bound portion that's coming out of China. So all factoring that in, we still believe for the year we will be at that 37.5% rate.

[Christopher Horvers:]

Got it. And then on the back half, are there things that pay attention to around the phasing of the third quarter versus the fourth quarter? I know you mentioned up to 50 basis points for the tariff in the fourth quarter. But for example, on the top line, do you expect retailers to adjust their -- when they're taking receipt of goods relative to last year because of the tariff and any other factors? And also, on the grosses, do you expect to get some of these chargebacks as you lap them in the fourth quarter?

[Russell Nickel:]

So on the timing of revenue, I would say we're not specifically seeing a change in buying pattern or timing at this point given the proposed or requested tariffs. What we are seeing, and I would point back to this -- the consistent guidance, we would expect the Q3 to be stronger than the Q4 growth rate, in part because of the high growth rate and the high numbers that we saw in Q4 of last year with the Fortnite sales and other FOB. So broadly speaking, I think the cadence is similar to what we expected coming into the year, and we're not really seeing a shift on that.

[Christopher Horvers:]

And then on the grosses?

[Russell Nickel:]

Oh, on the chargebacks, I think it's just an incremental improvement quarter-over-quarter. So when you compare against Q4 of 2019 versus Q4 of 2018, we will -- we would expect that we will have made substantial improvement. That's also part of the reason why we still feel confident and comfortable with that gross margin number for the year even with the incremental tariffs in the fourth quarter.

[Operator:]

The question is from Erinn Murphy of Piper Jaffray.

[Eric Johnson:]

This is Eric Johnson on for Erinn this afternoon. First, congrats, Russell, and best wishes going forward on behalf of our team. And then I just wanted to ask one quick question on Pokémon development. What does the road map look like from here? Should we think about SKU expansion or distribution being the bigger driver moving into 2020?

[Brian Mariotti:]

Yes, a great question. I think it's going to SKU expansion. First and foremost, we are still talking about how to expand international territories. So there is ongoing dialogue right now. But I would tell you, you'll see a significant bump in overall SKUs for us in '20 as compared to '19. So to see this wonderful license that took us for a long time to get into our portfolio, hover at number 11 with almost so little on a development against it and limited distribution is super exciting, because it really talks to what the strength of that brand is going to be for years and years and years to come, and the relationship just gets better on both sides with Pokémon. So we love that they're in our backyard. There's a lot of time spent between the 2 companies, so we're really excited.

[Eric Johnson:]

Is it fair to say that density in terms of revenue per point of distribution or SKU is as high as you've ever seen in your portfolio?

[Russell Nickel:]

On Pokémon specifically.

[Brian Mariotti:]

Yes. It's strong. It is definitely a -- it would definitely be in that, we'll call it, the A category. We like to go A, B, C and D, as someone as basic as me likes to simplify things. It's an A level property. I'll leave it at that.

[Eric Johnson:]

Got it. That's helpful. And then just on European operations after you've made a few key hires, what are the top priorities from here to refine across the region?

[Brian Mariotti:]

Well, I mean, first and foremost, the new hires have been transformational as far as what we've been able to accomplish in a very short period of time, starting with the ability that -- we hadn't really onboarded any new customers in about a 6-month period as we try to get our ducks in a row over there. That faucet's been turned back on. Now we're being able to onboard new customers and know that we can do it with a sense of professionalism and an ability not to have a hangover later on with chargebacks and vendor compliance issues. So first and foremost, that's number one.Two, on-time deliveries are through the roof with our key partners, accuracy with our key partners. All these things are really starting to turn the corner as far as making us more of a world-class organization over there. We always say that we believe that we're just starting to make inroads into what Europe is going to be for us overall. And to get these transformational, high-level people onboard is really, really making a difference over there. So I think as that team continues to grow and we continue to broaden our base as far as our brand awareness and diversity of product categories, I think it's just going to be nothing but amazing results over there.

[Eric Johnson:]

Great. And then one final one, maybe for Russell. How do you feel about the incremental investments that have been pulled forward? What are the biggest pieces? And are those playing about -- playing out about as you had expected 90 days ago?

[Russell Nickel:]

Yes. Great question, Eric. I mean, I will say that in terms of the investments that we're pulling forward, I would say those are playing out as expected and are on track as we talked about on the last quarter. That being said, I think what we're seeing with the stronger demand and the stronger opportunities, really, the great opportunities that Brian alluded to earlier in terms of revenue opportunities for the future that we haven't seen in the past or didn't even see 6 months ago, it's leading us to really kind of lean forward and also invest -- continue our investment in the second half of the year, as I alluded to on the phone call. So not only are the ones we thought about 30 days -- or, 90 days ago on track and running smoothly, we're seeing also opportunities to invest further in the future and the opportunities in front of the company.

[Operator:]

[Operator Instructions] The next question is from Steph Wissink of Jefferies.

[Steph Wissink:]

Most of our questions have been asked. But one for you, Russell, just on Chris' earlier question on the chargebacks. Wondering if you're willing to quantify how meaningful the handicap that is to your gross margin? And then maybe walk us through what needs to happen either to the infrastructure or to your processes to fully close those chargeback issues within the margin structure.

[Russell Nickel:]

Yes. I think it's -- from a gross-to-net spread, it's been 100-or-so basis points' impact improvement that we've been seeing. In terms of what needs to be closed or needs to be ramped down, I mean, a lot of it was what Brian alluded to. It's not only the investments that we've already made and continue to make in the U.K. that allows us to ship on time, ship in full, onboard customers, make sure we really fully understand the requirements by each of our customers in terms of fulfilling for them, making those same investments in the U.S. as well. And so it's just a continued evolution and a continued process of review and enhancement that we continue to make. And each time we are doing that, it's leading to incremental improvements.

[Steph Wissink:]

All right. That's great. And then our next question is just on inventory in the channel. I think you mentioned -- I think it was a U.S. comment, the sell-in up about 16% but sell-through up about 21% that's spread between in and through. Are you finding that your retailers are calling on you for more inventory, chasing a bit more inventory? Or how does the inventory position look in the channel?

[Andrew Perlmutter:]

Yes. So it's Andrew. I'll take that one. So we saw certain retailers build inventory positions at the end of last year because of the fact that they found themselves in a chase position all too often. And so they were anemic on inventory during peak times and would come back to us and we would have it already allocated to other customers. So what we saw was -- the reason why you're seeing the 16% sell-through -- or sell-in on a 21%...

[Russell Nickel:]

Sell-through.

[Andrew Perlmutter:]

Sell-through, is because there was a little bit of inventory in the channel with certain retailers, and they've actually been selling down and are continuing to build up on certain items. But the truth is they're still seeing that sell-through. They're still seeing that pull-through and the chase that they had before. So there are some bigger retailers who will have to understand the cadence that goes along with it. But yes, we're very happy with where we are, and we think that the inventory and sell-through is in a very healthy place.

[Steph Wissink:]

Okay. Last one for us is just on the games business. I mean, your enthusiasm is palatable about how big and how far you could go with it, but can you give us a sense of how the margin structure of that business is relative to your core business? And then some of the products we saw at Comic Con had this really unique mash-up or ability to mash up characters from different licenses. Is that something that you feel like it's hyper unique to the gaming space and then an area or an attribute that you can lean into going forward?

[Andrew Perlmutter:]

Yes. It's Andrew. I'll take that one as well. We just actually came off of Gen Con, which is a -- it's the Comic Con for the gaming industry. And we did launch at Comic Con. We thought that, that was the right thing to do to let our fans know about this, our hardcore collector fans that attend that show. The reception that we got at Gen Con blew us away. We are very enthusiastic about the retailers' reception of us getting into this gaming category. I think we have mentioned before that it is a margin-positive business for Funko. And that said, we are starting with very intricate games that do have figures in them. So those are probably the lowest-margin games that we could get into and it's still margin-positive. So we are very bullish on that aspect of the business.But when you're talking about the overall game system that we've created, customers can -- will do a number of things with these in the aftermarket. If you're a Harry Potter fan and you want to buy the Harry Potter game, that's fantastic. I'm a DC Comics fan. I'm going to buy that DC Comics game. What we decided to do with it in the aftermarket is really on us, but I can tell you that the options are limitless. And I think people are starting to catch on to that. And we are as enthusiastic, if not more, than we've ever been about this opportunity, not just for Funkoverse but for the games category in general. There's a lot of opportunities that are coming our way outside of this initial launch.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Brian Mariotti for closing remarks.

[Brian Mariotti:]

In closing, we recently announced that Jennifer Fall Jung will be joining us as our new Chief Financial Officer. Jennifer has been working with us over the past several weeks and will take over formally as CFO on August 13.We are pleased that Russell's last quarterly earnings report as CFO was a blockbuster quarter for us. Russell has been an absolute pleasure to work with over the last 6 years, an amazing valuable member of the team, navigated us through our sale with ACON in 2015. He basically led 4 acquisitions, our IPO and our incredible growth throughout his term. So we're going to miss Russell. We have him through the rest of the year. He's going to be working hand-in-hand with Jennifer throughout a transition period, but we are super excited about his future and our future with Jennifer as our new CFO.So finally, just say thanks for your interest and support of Funko. We look forward to seeing some of you guys at our upcoming conferences that we'll be attending in the upcoming months, and we'll be speaking to you guys again on the third quarter earnings call, if not sooner. Thank you very much.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.