Funko, Inc. Q1 FY2023 Earnings Call

Good afternoon. And welcome to Funko’s Conference Call to discuss Financial Results for the First Quarter of 2023. At this time, all participants are in a listen only mode. Later, we will conduct the question-and-answer session and instructions will follow at that time. As a reminder, this call is being recorded. I'll now turn the call over to Ben Avenia-Tapper, Director of Investor Relations, to get started. Please proceed.

Thank you, and good afternoon. With us on the call today are Brian Mariotti, Chief Executive Officer; and Steve Nave, Chief Operating Officer and 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 and today’s earnings press release. In addition, we will refer to non-GAAP financial measures during the discussion. Reconciliations to their most directly comparable US 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'll now turn the call over to Brian.

Good afternoon. And thank you for joining us today. It's been a productive quarter at Funko and we're excited to update you on all the ongoing progress we have made. While our priority continues to be improving our operations, we haven't lost sight of all the opportunities we have to continue to grow the brand. I'm pleased to report that we are ahead of schedule with respect to cost reductions and operational improvements as we've made remarkable strides across the business. Top line results came in at the high end of our guidance and our strong performance on the operating initiatives drove our Q1 adjusted EBITDA outperformance by more than $30 million. Steve will provide additional details on the progress we have made on all of our operating initiatives shortly. Enthusiasm for the brand remains high despite a challenging retail climate. Between our exceptional direct-to-consumer growth, the strong performance of our recent product launches, and the early success of our newest commercial partnership with Fanatics, we remain confident in the ongoing passion and loyalty of our fans. I'll start with D2C, which grew 61% year-over-year and now represents approximately 17% of net sales. Our D2C growth continues to eclipse the e-commerce industry's single-digit growth rate and highlights the power of our brand. This channel is important for several reasons. First, the strength of our D2C business represents a very strong indication of our fans’ continued enthusiasm for the brand. In the channel where we control inventory levels and product newness, demand is at an all-time high. Our data suggests that among avid collectors, many purchases that may have occurred at a retail partner in the past are migrating to funko.com. Our D2C performance also highlights the strength and effectiveness of our new website launched in Q1. During the quarter, we transitioned to a new e-commerce platform, Salesforce, which allowed us to upgrade the front and back end of our website, including our order management system that now provides for a more seamless customer experience. We have now improved functionality, better analytics, and tighter integration across our sites. In turn, this has more than doubled our conversion rates from search, increased our cross-selling between Funko and loungefly.com more than seven-fold, and driven a double-digit increase in order values among other metrics. Further, our D2C channel has always been an important avenue for monetizing our convention presence, and the new site is helping us capture the strong demand we are seeing from our fans. At WonderCon, our first convention of 2023, our new site helped us to more than double e-commerce revenue associated with the event compared to last year. And it's not just our e-commerce that's outperforming. In our two brick-and-mortar stores in Hollywood and Everett, net sales grew 41% year-over-year, driven by nearly a 50% increase in traffic. While we can't make up for all the lost retail opportunity, we are continuing to see extraordinary growth in the channels we do control. Beyond the strength of D2C, there are several other indications of the enduring enthusiasm of our fans. In Q1, we launched a new line of miniature collectibles called Bidi Pop!, which has been one of the most successful product launches in our history. This product not only resonates with our core collector but taps into the broader miniature collectibles trend to bring new fans into the brand. The convenient size, product quality, and diversity among licensed partners give us confidence in the future for this promising new form factor. The positive reception to Bidi Pop! reinforces our confidence in upcoming programs this year, with one of the most exciting being the online launch of POP! Yourself. This product, which allows you to create your very own fully customized Pop!, is already the number one product in both of our brick-and-mortar stores and is easily our most anticipated launch to date. POP! Yourself not only resonates with our core fans but also introduces a new customer to Funko through the lens of gift-giving. In addition to our funko.com launch, we'll be introducing a broadened assortment of personalization elements and accessories, including seasonal elements to personalize your Pop! throughout the year and limited edition opportunities tied to relevant pop culture trends and events. We expect to bring POP! Yourself to a much larger audience later this year, and we're only getting started on maximizing this opportunity. Finally, I'm thrilled to be able to share our newest strategic partnership. In Q1, we went live on a key partnership with Fanatics. This is a major step for Funko as we prioritize and activate against the sports side of pop culture. We've already seen success with the launch of our limited edition Kansas City Chief's Super Bowl Gold Four Pack, and currently have Funko and Loungefly products on fanatics.com. We look forward to the expansion of our partnership with the upcoming NFL and NBA seasons. Fanatics is the undisputed leader in the critical sports category, and we're excited to continue to deepen this relationship as they expand their collectible footprint. As we detailed, 2023 is a year for us to focus on operations. We have made great progress on all fronts. While we have made the deliberate decision to scale back and push out some longer-term opportunities, we have continued to deliver the uniquely Funko products and experiences that have been so fundamental to our long history of success. While Funko’s success built on fan enthusiasm has shown remarkable resilience to the volatility in a broader market, we are not immune to external factors in the short term. Based on what we're hearing from our retail partners, we are taking a more cautious approach to the second half of this year, which is reflected in our updated full-year top-line guidance. While we managed through the macro uncertainty, we believe we are off to a great start for the year. We are making excellent progress on the operations front and have multiple launches and a partnership we believe will be instrumental in driving growth well into the future. As always, we remain deeply focused on delivering long-term value creation for the company and our shareholders. Now I'll turn it over to Steve to provide more details on the financial and operating results of the quarter.

Thanks, Brian. As Brian said, we're well on the way to delivering the operational improvements necessary to support Funko’s future growth. To provide greater transparency on our performance, I'll share additional context around the operating initiatives we discussed last quarter as I walk you through our first quarter results. I'll also provide an update on our outlook for the second quarter and the full year. In March, we described multiple steps we are taking to drive between $150 million and $180 million in annualized improvements to our financial profile. I'm pleased to report that we've made great progress across the board. I'll start with our efforts to improve our gross margin. Last quarter, we described the container rental charges we were paying, which peaked at just over $100,000 per day. This was our most immediate action item, and I'm pleased to report that as of the end of the quarter, we've eliminated all excess containers. We were able to accomplish this work much more quickly than we originally anticipated. The introduction of a price increase on our exclusive products is the second gross margin lever we've been focused on. In Q1, we successfully wrapped up negotiations on this action with our retail partners, and we are on track to receive the full benefit of this pricing action by the third quarter of this year. Finally, we've made strides on our efforts to drive efficiency in our product costs. We've instituted a competitive bidding process with our manufacturers and are currently implementing design, cost tracking, and reduction initiatives. Turning to our operating expenses. We've been similarly successful in reducing the rate of SG&A increase, particularly with the US fulfillment costs in our Arizona distribution center. Within our US distribution center, we have rebalanced our staffing levels, introduced more efficient shift scheduling, improved process flaws, and added other fundamental improvements that have driven a substantial bottom-line beat in the first quarter. Importantly, these steps are also designed to ensure a more stable foundation for our logistics as we roll out our new warehouse management system this summer. Finally, we completed a 10% workforce reduction that we announced last quarter. This action was done thoughtfully to enable us to remain well positioned to execute on current and future growth initiatives. I'll now provide the financial results for the first quarter. In the first quarter, we delivered net sales of $252 million at the top end of our guidance range. As Brian mentioned, our direct-to-consumer channel grew 61% to $42 million. Our wholesale business was lower by 26% year-over-year at $210 million due to broad-based cautiousness from retailers around restocking and inventory levels. In the US, net sales declined 23% to $178 million, while net sales in Europe grew 4% to $59 million. In our other international regions, which faced many of the same retail headwinds, net sales declined 23% to $15 million. On a category basis, our core collectible brands’ net sales decreased 23% to $183 million. The Loungefly brand grew 4% to $52 million, while other brands, which includes toys, games, and Mondo, declined 13% to $16 million. First quarter gross margin was 20%, which included the write-down of approximately $30 million in inventory in the quarter. Excluding the inventory write-down, adjusted gross margin would have been approximately 32% or 400 basis points ahead of expectations. This outperformance was a combination of savings in product margin and container rental fees as well as favorable freight and shipping rates. Moving on to operating expenses. SG&A was $100 million, a sequential improvement and approximately $15 million ahead of our expectations due to the progress we have made on driving fulfillment efficiencies. While macro retail caution has had an impact across our brands and geographies, the progress on our operating improvement initiatives has allowed us to significantly outperform our previous Q1 adjusted EBITDA guidance. For the first quarter, adjusted EBITDA was negative $14 million, more than $30 million ahead of expectations. Finally, adjusted diluted loss per share was $0.49. Turning to the balance sheet. We ended the quarter with $35 million of cash on hand and total debt of about $310 million. We remain confident in our cash forecast and believe we have ample liquidity to navigate the year. Inventory at quarter end totaled $192 million, a decrease of 22% sequentially but still an increase of 19% year-over-year. We expect to continue to make progress on improving our inventory levels throughout this year. Now on to guidance for the second quarter and the full year. For the second quarter, we expect net sales of between $240 million and $260 million. We expect sequential gross margin improvement relative to the first quarter adjusted gross margin. We expect SG&A to come in roughly inline with that of the first quarter. And we expect adjusted EBITDA for the quarter to be a loss of $10 million to breakeven. Finally, we expect adjusted net loss of $24 million to a loss of $16 million based on a blended tax rate of 25%. On a per share basis, we expect a loss of $0.45 to a loss of $0.30 based on a weighted average diluted share count of 52.2 million shares. For the full year 2023, reflecting the uncertainty around multiple macro factors, including retail confidence, we now expect year-over-year net sales to decline by between 5% and 10%, which is a reduction to the previous guidance we provided last quarter. Despite the expected decline in our net sales outlook, we are raising the midpoint of our adjusted EBITDA outlook and now expect adjusted EBITDA of between $65 million and $75 million. Q1 represented a great first step in our operational reset. We remain confident in our ability to rightsize our business for the current climate as we continue to build a solid financial foundation for the long term. Before I turn things over to the operator for Q&A, I'd like to take a minute to recognize the incredible hard work and dedication of our people. The improvements we've driven into the business so far this year are a testament to the scrappiness and willpower of all our employees. We still have a lot of work to do, but my confidence in our ability to deliver against the improvements we've yet to tackle goes up every day as I see how our teams are coming together with the singular mission of improving our financial profile. So with that said, thank you so much for your time today, and we'll now turn it over to the operator for Q&A.

Our first question today goes to Andrew Uerkwitz of Jefferies.

Thanks guys for letting me ask a couple questions. I guess the first one, just kind of on the Q1 results, you talked about the storage cost effectively going away faster than you anticipated. Is that because you were able to move inventory quicker, the ERP system warehouse system got rolled out faster? Just kind of curious about what allowed you to clear that out more quickly?

We were able to resolve this issue more quickly than we expected because we acquired some short-term expansion space in Arizona, close to our Buckeye facility, which allowed us to begin staging inventory for unloading and returning containers. Additionally, we found a third-party agent who could accept trailers on behalf of the carriers, as the carriers would only take back a limited amount at a time. This setup helped us avoid the daily charges we were incurring. Regarding the ERP and WMS projects, we are primarily focused on the warehouse management system, which is on track for launch in the first week of July, rather than investing much in the ERP this year. After that launch, we should see further efficiencies. I also forgot the other part of your question, so feel free to…

No, that answered it. I appreciate the additional information. Now, can you provide a bit more insight into the change in revenue guidance for the second half of the year? Is it mainly because retailers are ordering less, or did the delays of some initiatives play a role? Also, what contribution do you anticipate D2C will make by the end of the year, if you can provide that information?

I think obviously D2C is one of the levers we were able to pull when we have a very conservative retail buying environment right now; everybody is afraid of having too much inventory. And so we have been able to continue to shift goods to our D2C to basically move revenue from one source to another obviously in a more profitable manner. So that part of it we feel pretty excited about.

I would just add on to that. The sales drop that we have just guided is a reaction to what we are seeing at the macro level. It's not like a bunch of our customers have come back and said we are not going to buy all this stuff. It's just more looking at macro, having conversations with our retail partners about the second quarter and just trying to gauge their mood on inventory levels and things like that. So we feel like bringing the sales down was the prudent thing to do because of just the uncertainty going on out there in the retail landscape.

Thank you. The next question goes to Linda Bolton-Weiser of D. A. Davidson.

So I was wondering, if you could just comment on the channel, the regular brick-and-mortar channel inventory levels, and how things stand kind of among the bigger box retailers versus the specialty retailers out there, and what the current situation is?

So what we are seeing with the larger retailers and I'm sure in other consumer products companies you are probably hearing the same thing is that a lot of the larger retailers are just taking a peanut butter approach right now to inventory management, and reducing inventory across all categories and we are definitely not immune to that. As we can imagine, I've got really good contacts in the retail industry and I'm hearing the same thing from everybody that I talk to that, we want more of your product, but we are facing a top-down mandate to reduce inventory by a certain percentage and it's hitting everybody. So I think that that's definitely part of it. Now the good news is eventually they are going to run out of stock. So sell-through is obviously still better than sell-in. At some point, the sell-in and sell-through curves are going to cross, and they are going to have to start restocking. And we've checked in with a number of customers and they are all kind of anecdotally saying yes that we will definitely have to be upping our replenishment game here in the not too distant future.

And then I think you said Loungefly was up 4% in the quarter, that's different from the other kind of categories of product. Why was Loungefly so much better than just the other Pop! figures?

We've expanded our offerings over the last couple of years, focusing on retail and channel diversification. The direct-to-consumer segment is performing well, and while we don't have as many partners as Funko, the ones we do have are thriving. Our parks are also doing very well, particularly with new openings like Spencer, which has exceeded our expectations. We're seeing an increase in new retail partners eager to engage with the Loungefly brand, which is helping to balance out challenges from smaller customers facing credit issues or slower product movement. These new partnerships are very beneficial for Loungefly. We're looking forward to an exciting period with upcoming launches, including a new doggy fashion line this summer and a stationery line in the fall, followed by a significant unisex collection of bags, apparel, and accessories in the first quarter of 2024. It's encouraging to see them maintaining momentum in a challenging retail environment. Additionally, the direct-to-consumer channel remains a valuable asset, allowing us to shift products between channels as needed.

And then can you just remind me, did you have any target for your own inventory by the end of 2023, do you have a target for that?

Not that we've shared, no.

And the next question goes to Gerrick Johnson of BMO.

Steve, I'd like to take Linda's question and go a little bit more granular. Can you share with us channel inventory quarter-to-quarter and year-over-year and quantify that, and then perhaps bifurcate it between mass and specialty?

That's probably not something that I can answer on this call. We can follow-up on that. But yes, going that granular on this call, I'm not equipped to that right now.

Thank you. We have no further questions. I'll now hand the call back to Brian for any closing comments.

All right. Thank you very much for joining us on this earnings call, and we look forward to talking to you again in the future.

Thanks everyone.

Thank you. This now concludes today's call. Thank you so much for joining. You may now disconnect your lines.