Funko, Inc. Q2 FY2022 Earnings Call

Hello everyone, and welcome to the Funko Reports Second Quarter 2022 Financial Results. My name is Emily, and I will be moderating today's call. Operator Instructions. I will now turn the call over to our host, Ben Avenia-Tapper. Please go ahead.

Thank you, and good afternoon. With us on the call today are Andrew Perlmutter, Chief Executive Officer; and Jennifer Fall Jung, Chief Financial Officer. Before we begin, I'd like to remind everyone that, during the course of this conference call, management will discuss forecasts, targets, and other forward-looking statements regarding the company and its financial results. While these statements represent our best current judgment about future results and performance as of today, our actual results are subject to many risks and uncertainties that could cause actual results to differ materially from what we expect. In addition to any risks that we highlight during the call, important factors that may affect our future results are described in our most recent SEC reports in today's earnings press release. In addition, we will refer to non-GAAP financial measures during the discussion. Reconciliations to their most directly comparable U.S. GAAP financial measures and supplemental financial information can be found in the earnings press release and 8-K that we released earlier today. All of these items, plus a visual presentation that investors can consult to follow along with this discussion are available on our Investor Relations website investor.funko.com. I will now turn the call over to Andrew.

Good afternoon, and thank you for joining us today. I'm excited to report record second quarter net sales of $316 million, a 34% increase over the prior year, capping off the strongest first half net sales in our company's history. Robust demand for our compelling product lineup led to another quarter of broad based strength across brand categories, geographies and channels. The strength of Funko's pop culture platform continues to shine in our second quarter performance. Net sales for all three of our reported brand categories grew double-digits, with Loungefly more than doubling for the second quarter in a row reaching $70 million in net sales for the quarter and $120 million through the first half of the year. Our international business also had the best quarter ever with Europe growing 22% to $63 million. In June, we announced the acquisition of Mondo, a high-end collectibles company, best known for its vinyl records, posters and other collectibles. In much the same way, we've integrated and grown Loungefly and Funko Games, you can expect us to nurture the unique elements that define the Mondo brand while leveraging Funko's best-in-class resources within the collectible space to elevate that brand to the next level of growth. Finally, demand for in-person events has seen a dramatic recovery and we're thrilled to reconnect with our loyal, passionate fans at live events throughout the quarter. Sales exceeded expectations at all our tentpole events in Q2, culminating in San Diego Comic-Con two weeks ago, where we recorded our largest day of direct-to-consumer sales ever. Of course, these events are more than just about direct sales. We've been able to expand the fan engagement we've become known for to a level that surpasses anything we've done before. Demand is through the roof, enthusiasm for our brand is the highest we've ever seen and fans are thrilled to get back to celebrating with us. We continue to monitor many factors impacting the global supply chain and macroeconomic climate, but we remain cautiously optimistic about the second half of the year. On the strength of our first half, we are raising our net sales outlook for the full year by $25 million at the midpoint reaffirming our implied second half guidance. I'll now review some of the highlights from the quarter for each of our brand categories. Within the core collectible brands category, continual innovation across the category is what drives the amazing loyalty from our fans. Our flagship Pop! brand generated double-digit growth as exciting evergreen activations like Pop! Die-Cast and Pop! Deluxe supplemented a robust content slate across multimedia formats. Complementing Pop! and contributing to the category's 21% year-over-year net sales increase are emerging brands, including Soda and Popsies, all delivered strong incremental growth, each with additional expansion opportunities on the horizon. While still in its early integration, Mondo will sit within the collectible brands category. We expect Mondo's high-end limited release business model and diverse range of high-quality collectibles to be an excellent addition to our current portfolio of brands tapping into a new segment of attractive market opportunity for Funko. Turning to our toys and games brands. One of our key areas of revenue diversification, Funko Games continues to drive category growth with a growing catalog of legacy titles as well as multiple exciting launches. Chief among these new releases during the quarter was the Ted Lasso Party Game, our best-selling launch to date. Ted Lasso provides an exciting blueprint to leverage universally loved content to reach a broad target audience. On the collectible gaming side, we'll soon expand our collectible gaming portfolio with the recently announced Disney Kingdomania, designed for ages six and up. Kingdomania introduces a collectible gaming platform built on some of the most popular Disney and Pixar characters. Further, this game targets a slightly different audience from Battleworld, which remains a top five game for Funko. Within our toy brands, Five Nights at Freddy's again made our top ten best-selling products across all of Funko. Loungefly had another amazing quarter as the brand continues to resonate with a large and growing community of devoted fans, while serving as the flagship of our revenue diversification strategy. We've leaned into our deep connections within the collector community as the brand continues to expand its loyal fan base. This is particularly visible on loungefly.com, where we've seen a significant uptick in traffic as fans go directly to the stores for their favorite brand. The brand's net sales have grown tenfold in the five years since we acquired it, and we continue to see tremendous upside. Finally, turning to our Digital Pop! NFT business, participation and enthusiasm continue to grow as we increase drop size and frequency. Our recent DC Comics NFT drop saw nearly 0.5 million fans in queue while the Scooby Doo and My Little Pony drops both sold out in under 30 minutes. We're excited to continue exploring this new world of digital collectibles with our fans and the many opportunities it presents. As I mentioned earlier, our international business delivered record net sales in the second quarter with particularly strong results from Europe. Strength was broad-based across the region, driven by improvements in operating efficiency and continued strategic targeting of Pan European retailers. Importantly, we generated double-digit growth in net sales across our brand categories in the region and we continue to expand our brand portfolio internationally to match the breadth domestically. At Funko, we'd like to say we are our own largest customer, reflecting the growth we've seen in our direct-to-consumer business. Despite ongoing supply chain headwinds, and the relocation of our distribution center from Everett to Buckeye, Arizona during the quarter, we maintained strong double-digit growth in net sales. We continue to drive higher average order value and conversion rates through additional payment options, improved site operations, and new merchandising tools. In summary, we maintained the first quarter momentum and delivered strong results in Q2, while reinforcing Funko's foundation for growth. While we're thrilled with the first half, we are mindful of the uncertainties that remain in the macroeconomic climate broadly. As some of these factors, including inflation could impact consumer spending or further disrupt supply chains, we are monitoring the environment closely. While we are confident in our ability to deliver sustainable long-term growth and manage through disruption, significant deterioration in the macroeconomic climate would impact our operations. Acknowledging these factors and on the strength of the first half, we now expect fiscal 2022 revenue between $1.3 billion and $1.35 billion and adjusted earnings per share of $1.88 to $1.99. Moving into the second half, we will continue to execute against our key strategic growth initiatives, innovate within the core, diversify our revenue base, grow our direct-to-consumer business and expand international operations. We look forward to providing updates as the year unfolds. Before I close, I would like to announce our investor event, which we are holding on September 13 in New York. We will be sharing some additional depth on our businesses and providing details around our three-year roadmap to sustain double-digit growth and margin expansion. We look forward to seeing many of you there. I'd like to thank our incredible fans, partners and employees for their continued support and belief in the Funko brand. With that, I'll turn the call over to Jen to take you through the financials.

Thanks, Andrew, and good afternoon, everyone. We are pleased to report a record second quarter for net sales with growth of 34% over the prior year. Our results were broad-based with strength across our brand categories, geographies and channels. The outperformance was primarily driven by continued strength within our Loungefly brand, domestic mass market wholesale and our own direct-to-consumer channel. Net sales in the U.S. increased 42% to $231 million, while net sales in Europe grew 22% to $63 million and other international net sales increased 1% to $21 million. On a brand category basis, core collectible brands net sales grew 21% to $233 million driven by continued innovation in the category with new form factors like our Pop! die-cast lineup and new figures, including our Popsies and Soda lines. The Loungefly brand more than doubled its net sales for the second consecutive quarter to $70 million reflecting our successful effort to increase revenue per SKU while shifting product mix to our more iconic and high-value items. We've broadened our partner brands and we continue to open new retail relationships. Importantly, we have established ourselves as a category leader in fan communication and engagement. Among our other brands, which includes Toys and Games as well as Digital, net sales grew 12% to $13 million. Our Loungefly and other brands now constitute 26% of net sales, up from 19% in the second quarter of 2021 and a strong proof point of the effectiveness of our investments to diversify our revenue base. Moving down the P&L, first quarter gross margin was 33%, a decrease of 640 basis points versus Q2 2021, primarily due to supply chain cost inflation. As a reminder, we rely on the spot market for trans-ocean freight. Last year, this resulted in higher freight rates hitting our P&L somewhat later than some of our peers. Conversely, as we described last quarter, although rates are beginning to improve, we saw little benefit in Q2 2022. Relative to the first quarter of 2022, margins declined 260 basis points, partially due to product mix as emerging brands were a large share of total revenue in Q2 versus Q1. SG&A for the quarter was $83 million or 26% of net sales. In Q2, we saw elevated expenses related to the relocation of our distribution center from Everett to Buckeye, Arizona as well as our ERP project. Regarding our ERP, we recently made the difficult decision to delay the remaining steps until 2023. There are a number of factors that contributed to this decision but ultimately we did not want to impair the momentum that we have today by shifting to a platform that we felt wasn't yet fully ready to support our business. We plan to have more details for you around our 2023 implementation plans on our Q3 call in November. Adjusted EBITDA was $32 million with an adjusted EBITDA margin of 10% reflecting the elevated freight rates, product mix and infrastructure spending. We remain on track to deliver full year adjusted EBITDA margins consistent with 2021 results, but acknowledge that a significant deterioration in the macroeconomic environment or less than anticipated stability in freight rates could temper margin expansion in the second half of the year. Wrapping up the P&L, adjusted diluted earnings per share were $0.26. Turning to the balance sheet, we ended the quarter with $56 million of cash and cash equivalents and $30 million of remaining availability under our revolver, representing total liquidity of $86 million. We ended the quarter with total debt of $235 million, up 32% compared to Q2 of last year, as we leveraged our revolver for near term infrastructure investments. Inventory at quarter end totaled $234 million as shipping delays begin to subside. While our inventory levels are up year-over-year, we believe the inventory is generally high quality and leaves us well positioned to meet our consumer demand and support our strong second half growth forecast. Now to the guidance for 2022, which assumes we don't experience further congestion to the supply chain or a significant deterioration in consumer demand due to macroeconomic factors. We are raising our full year net sales target to between $1.3 billion and $1.35 billion, reflecting our $25 million outperformance in the second quarter. For full year adjusted EBITDA margins, we continue to target a margin consistent with 2021. We expect adjusted net income of $101.8 million to $107.3 million based on a blended tax rate of 25% and adjusted earnings per diluted share of $1.88 to $1.99 based on the weighted average diluted share count at $54.1 million. We appreciate your time this afternoon. Now, Andrew and I would be glad to take your questions.

Operator Instructions. Our first question today comes from Stephanie Wissink with Jefferies. Stephanie, please go ahead.

Thank you. Good day, everyone. We have two questions for you. Jen, the first is on inventory. Just to give you a chance to talk a little bit more about where the inventory resides? How much of it is related to the DC relocation? How much might be in transit? If you could just dimensionalize inventory for us that would be appreciated?

Great. Hey, Seth. How are you? Regarding inventory, we encountered a lot of delays in Q4 that carried over into Q1 due to supply chain congestion. You might see some of that continue into Q2 as well. However, as we look toward the second half of the year, we believe our inventory is in a very healthy position, and we are ready to achieve our goals for that period. It has mainly been about managing through the congestion we've experienced so far. We are beginning to see transit times decrease and delivery dates becoming more reliable than they were earlier in the year. There is still a significant amount of inventory in transit, but we are focused on getting that into the distribution center and delivering it to our customers.

All right. That's great. And then Andrew one for you is just on your big growth drivers, innovation, diversification, direct-to-consumer international. If you had to think about where you would force rank any of those more than the other. Is there something that is outperforming your expectation within those four drivers? Or do you look at them almost equally as power drivers of the business?

Thank you for the question, Seth. We have each of our initiatives organized into separate categories, making it challenging to prioritize the four key drivers. However, we are dedicating significant resources to our direct-to-consumer business, which we are enthusiastic about growing and expanding. Recently, we experienced our largest sales days ever at San Diego Comic-Con, marking a thrilling moment in our direct-to-consumer history. Additionally, we are seeing impressive growth from our acquisitions like Mondo and Loungefly. Our focus on product diversification is ongoing, and it's difficult to choose just one initiative to prioritize, as they all contribute significantly to each respective area. I hope that answers your question.

It does. Thank you. Very helpful. Thanks.

Our next question comes from Linda Bolton Weiser with D.A. Davidson. Linda, please go ahead.

Yes. Hello. So, the toy companies, which I know you're not exactly the same thing, but they reported quite high shipment growth in the first half because they were sort of refilling inventory levels in the channel. So the POS was actually kind of lower than their shipment growth. Do you think that's what is, is that what was going on with you in the first half like in the U.S., where you sort of reselling channels or is your high growth just purely a reflection of the high consumption growth?

Yes, I'm doing well, thank you. As you remember, that significant growth was mainly due to Q4 sales being pushed into Q1. That's the primary source of that growth. We are optimistic about our Q2 growth as well. It's important to note that there has been a slight price increase, which we have started to see take effect. However, we are confident in managing our inventory alongside our retail partners and the current stock levels.

And also on the cost side, you talked about pushing out this ERP initiative into 2023. Does that mean there's going to be less associated SG&A cost in 2022?

No. And that's actually a great question. There'll be puts and takes about 2022. We will still continue to work on the initiatives throughout the year, so the run rate will continue, but there's other offsetting factors to that. So we don't see it as a major headwind in 2022 so far, but we feel good we made the right decision for the business to not have business interruption as we go into the holiday season.

Okay. And then I'm just kind of curious about your cash flow. I mean, you had a really, really high level of free cash flow during the pandemic in 2020. And then 2021 was too strong, but down. I'm just kind of wondering in 2022, do you have any sense for whether, like, your cash flow can be up or down year-over-year? I'm just concerned if you develop this trend of declining cash flow and how that might look?

That's a great question. What you're seeing is a few key factors affecting our cash flow. We had significant expenses related to getting our distribution center operational and moving inventory between our facilities in Everett and Buckeye. Additionally, we faced challenges with inventory management this year. We also saw a substantial influx of inventory in the fourth quarter and the first quarter. Despite these cash outflows, we expect cash flow to improve in the second half of the year. We've worked with our banks to utilize an accordion feature in our debt agreement, which will allow us to access additional cash that will reflect on our balance sheet.

Okay. That's it for me. Thank you so much.

Thanks, Linda.

Operator Instructions. Our next question comes from Megan Alexander with JPMorgan. Please go ahead, Megan.

Hi. Thanks very much for taking our question. I just wanted to start on the macro. You clearly called out a lot of the factors weighing on consumer sentiment. I just was hoping you could elaborate on that. Are you seeing any change in retail order trends or the end consumer holding off a bit? Or is it more just an acknowledgment that the consumer is under pressure and therefore you're just being prudent. It does seem like the latter, I just wanted to clarify.

I'll take it. Jenn, you can chime in. It's really the latter. I think that, I’d say that we don't really have a crystal ball. So if something turns in the back half of the year, I think that's why we're pointing that out. Obviously, there is pressure on the consumer. We're aware of that. Our retail partners are aware of that. So I think we're just being cautiously sort of just cautious about it as we really know what the back half of the year holds. Jen, you want to add anything to that?

Yeah. I would just add similar to what we saw during the pandemic, we would see some positive signs and then the economy would shut down again. So at this point, we don't have a crystal ball. We want to make sure we're being prudent.

Got it. That's helpful. And then maybe a follow-up quickly for you, Jen, on the gross margin. You did mention that it makes sense you're not seeing a benefit ad soon, but can you talk a little bit about the gross margin outlook for the back half? Maybe any commentary on cadence and are we going to start to see some relief from ocean freight?

Yes, that's a great question. In the second half of the year, you will notice an increase as we move from Q3 into Q4, which is not typically our usual pattern. However, we anticipate some relief in shipping costs in Q4 compared to Q3, so we've factored in a modest improvement. While we are observing a decline in prices, it's important to remember that the inventory we sold in Q3 was purchased at higher rates, which is why Q3 won't benefit as much as Q4.

Got it. And can you just remind us, did you use airfreight at all last year? And if so, what's your expectation for airfreight this year?

Minimally, we did not do airfreight. It's, yes, minuscule. We don't have plans at this point.

Okay. Thank you. Very helpful.

Thank you.

We have no further questions. So I'll now hand back to Andrew.

I'd just like to say thank you. I appreciate you jumping on the call today. I think there might be one more question. Can we make sure there's no more questions out there?

Apologies. We have just had another question come through from Gerrick Johnson with BMO Capital Markets. Gerrick, please go ahead.

Thank you, Andrew. Great observation. I wanted to ask about the shipping for the holiday season and whether you've moved anything from the third quarter into the second quarter or from the fourth.

No, we have not.

Okay. All right. And then maybe spreads you had mentioned this before, but your agreement with 10:10 Games and the AAA Game you guys are planning on developing. Can you just tell me a little bit more about that? What kind of deal is this? Is this just a licensing deal? Are you actively building out a studio? Or what's going to happen with 10:10 Games?

Yes, it's a great question. Thank you. And we probably should have mentioned that. There's a lot going on here. So yes, that is a licensing deal. We are not building out a studio. We are partnering with 10:10 Games to work with them to release on brand game that represents Funko and our IP as well as the other IP that they're going to be working with. So it's an outsourced licensing deal. Very excited about it by the way. Our fans. It was debuted at San Diego Comic-Con and it was huge thoughts.

Okay, great. And maybe one more since I have the opportunity. How about the physical games, the board game business? Do you still see that as a growth category as we come out the other side of the pandemic?

Yes, we do. That has been a really great business for us. We continue to grow and work with our retail partners, which you know well. Expanding our presence in the games section of stores to reach a different consumer with a different buying team has been beneficial for us. Some of the relationships we are developing from our early successes are truly exciting. The best is yet to come. We mentioned Disney Kingdomania and are very optimistic about it. I'm also positive about a few other new initiatives we have yet to announce, such as the Ted Lasso Party Game. These are projects we are rolling out, and our fans, along with retailers, are really enjoying this relationship and our expansion into a new part of the store.

Okay, great. Thanks, Andrew.

Thank you.

Operator Instructions. Thank you. At this time, we have no further questions. So, Andrew, I will hand back to you.

All right. Thanks everybody for joining us today. Appreciate it. Thank you to all of our fans and employees and everybody to help make this possible. Appreciate it. Thank you.

Thank you, everyone for joining us today. This concludes our call, and you may now disconnect your lines.