Earnings Call Transcript - FNKO Q3 2021

Operator, Operator

Good afternoon. And welcome to Funko's Conference Call to discuss Financial Results for the Third Quarter of 2021. 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. Please be advised that reproduction of this call in whole or in part is not permitted without written authorization from the company. As a reminder, this call is being recorded. I will now turn the call over to Ben Avenia-Tapper, Director of Investor Relations to get started. Please proceed.

Ben Avenia-Tapper, Director of Investor Relations

Thank you, and good afternoon. With us on the call today are Brian Mariotti, Chief Executive Officer; Andrew Perlmutter; 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 highlighted during the call, important factors that may affect our future results are described in our most recent SEC reports and today's earnings release. 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.

Andrew Perlmutter, CEO

Good afternoon, everyone, and thank you for joining us today. I am thrilled to report another record quarter with demand for Funko products as high as we've ever seen. Funko continues its strong performance and exceeded expectations for the quarter, despite ongoing supply chain disruption and rising freight costs. Growth was broad-based and spanned across geographies, brands, product categories, and channels. Recovering our specialty channel domestically and in Europe continues to provide a tremendous lift, while strong growth in the mass market channel, including third-party e-commerce, exceeded expectations. Because of our excellent third-quarter results and exceptional demand, we are raising our net sales guidance for the year. Throughout the Funko portfolio, we're developing products that resonate with our fans while continuing to expand our categories and fan base. We've extended our flagship pop brand beyond figures in the entertainment and collectible aisle into soft lines and accessories. We've also broadened our figure lineup beyond the pop brand and into the toy aisle with top-selling action figures like our new Turbo Man figure. We're not only expanding our shelf space with these moves; we're also continuing to broaden our fan base. Loungefly is a great example of this consistent growth mindset. We acquired Loungefly in late 2017 when it was generating less than $20 million in annual revenue, a figure we nearly doubled in Q3 of 2021 alone. Today, we successfully executed against our geographic expansion initiative, and Softline is now our fastest growing category internationally. Domestically, we continue to see strong performance aided by the reopening of retail as well as new channel partnerships and best-in-class product design. Our direct-to-consumer channel is another great example and is driving growth across product categories and geographies, delivering another quarter of exceptional growth and reaching 11% of total net sales. DTC continues to be a critical driver of our success, both domestically and through Funko Europe.com. Our digital and logistical improvements in conversion, fulfillment, and user experience yielded excellent results. On funko.com, for instance, sessions, transactions per user, and conversion rates were all up more than 40% year-over-year. Funko Europe.com, which we launched last year, has nearly tripled the number of sessions with similar operational improvements to our domestic site. It's worth noting that we achieved this success in the same quarter that our wholesale business generated strong double-digit growth, exceeding expectations and demonstrating the viability and sustainability of our multi-channel approach. In our core pop platform, we continue to extend the brand with excellent results, whether it's the rapid sellout of our pop die-cast line or our extremely popular ornament partnership with Hallmark. These examples illustrate the tremendous potential of a platform built around fandom and pop culture. Our efforts go beyond the pop brand, including the launch of our gold action figure line targeting sports and music fan bases, which was rolled out to the mass market in September and has been met with similar enthusiasm. In fact, our target growth areas for content, sports, music, and anime each increased more than 50% in the third quarter. I also want to call out the streaming show Squid Game, which launched on September 17 and soon became a global sensation. In typical Funko fashion, we were the first to sign a licensing agreement and using our world-class speed to market to launch a figure lineup for presale with a full set of pop vinyl figures mere weeks after the show was released. It should come as no surprise that our posts announcing these figures were the highest performing social media posts across all of our channels in Funko’s history. Through the pop vinyl platform and our other form factors, Funko is once again proving to be an authority in our industry, connecting fans to their favorite properties at the speed of pop culture. Within our games business, the titles we launched at the end of Q2 are gaining significant traction. We grew games by strong double digits, led by the mass market channel and particularly strong results in third-party online retailers. This traction in mass market reflects our successful efforts to move into additional aisles with expanded shelf space at some of our largest retail partners. On the collectible games front, we launched Battle World series 2, which generated excellent early results. With this success, we look forward to expanding our collectible games portfolio in the future. Finally, in our youth collectibles business, we had an excellent quarter in action figures with Five Nights at Freddy's, as well as the very popular Turbo Man, which was one of our top-selling items for this fall. Additionally, we launched Snapsies series two at all our mass market partners as we continue to extend our fan base. We delivered these achievements while we also proactively managed supply chain disruptions throughout the quarter, and as a result, exceeded expectations. Let me touch on some of the factors that drove the outperformance. The majority of our products are not seasonal in nature. The best examples of this are our evergreen products, which were again, 65% of net sales in Q3 2021. With that said, in those product categories where we do have higher seasonal exposure, we've made sure to prioritize items as appropriate, such as our advent calendars and products that are more likely to be gifted, including our games. Throughout the quarter, we were in a position to take additional shelf space left open by competitors who found themselves without product due to supply chain disruptions, given the challenges of the container shortage and higher freight costs. We managed to partially offset these headwinds by balancing our traditional freight arrangements with additional container space. We've been proactive in addressing COVID-related factory stoppages in Southeast Asia. In Vietnam, in particular, our products are produced across multiple factories spread throughout the country. This allowed us to shift production to less affected areas when disruptions did occur in a region. Today, we are expanding that regional diversity even further to stay ahead of possible disruptions in the future. Before I turn the call over to Brian, I'll reiterate that the demand for the Funko brand has never been stronger. This is evident in our third-quarter results and our increased guidance. At the same time, we've been proactively managing the supply chain challenges that are facing many across a wide array of sectors and industries. Our employees, our partners, and our fans all deserve tremendous thanks for making this possible. Now I'll turn the call over to Brian to discuss some of the ways we have and will continue to drive these outstanding results.

Brian Mariotti, CEO

Thanks, Andrew. I'll start by echoing Andrew's word of thanks. The global supply chain has seen unprecedented disruption this year and the fact that we are able to report the kind of third-quarter results we did, despite those challenges, is a testament to our employees and our loyal fans. We have an amazing community at Funko, and I couldn't be more proud. As I look to transition into my new role as Chief Creative Officer in January, I've been highly focused on continuing to elevate our level of fan interaction and bringing innovative new products to market that have been such a hallmark of our success. This effort is our focus on developing events that are monetizable and consistent with Funko's trademark, one-of-a-kind fan engagement. Throughout the pandemic, we've proven our ability to develop these events at any point on the calendar and in any form factor, including virtual and hybrid formats. This capability was an important factor in our ability to deliver such a strong third quarter amid unprecedented supply chain headwinds. I'll share a few events that highlight that dynamic. I'll start with our celebration of Batman Day. While perhaps not a traditional holiday on every calendar, our ability to generate genuine excitement through fan engagement drove this to be our single largest non-conventional sales day on record at funko.com. In fact, between our Alice In Wonderland event in July, FunKon in August, and our Batman takeover in September, we created three brand new events this quarter representing the top three largest sales days for our direct-to-consumer and e-commerce channels. We also recently announced our full-scale virtual event taking place in early December. These highly successful virtual events highlight new products, drive awareness to our retail partners and our own B2C channels, and engage our fans with exciting new content. Our versatility allows us to operate unconstrained by seasonality, so we can truly engage with and delight our fans with fresh content and amazing new pop culture products year-round. We're also excited to participate in this year's Macy's Thanksgiving Day Parade with a gigantic balloon featuring Funko’s pop interpretation of the character Grogu, effectively known as Baby Yoda. This balloon character from the Star Wars series, The Mandalorian, streaming only on Disney+, will soar 41 feet in the air on Thanksgiving Day. This massive brand moment will allow us to reach millions of families and new pop culture fans as we simultaneously release a limited edition collectible line based on the balloon that'll be available only on funko.com. Finally, I want to share some of the milestones we've achieved in our Digital Pop! NFT business. Today, we've had four major drops as well as several small events. The response so far has been truly outstanding. Each of our drops sold out in minutes and all of them have been massively oversubscribed with tens of thousands of fans in the queue. We've also demonstrated our ability to generate enthusiasm across a range of licensed peers. As we said, when we first announced our entry into the NFT market, we are in for the long term. That said, today, I can confidently say we are well on our way. The rest of the calendar is built out for the year and the licensing landscape continues to gain traction. We've also recently announced, in partnership with TokenWave, the opening of our new digital marketplace, Droppp.io. Droppp.io will be greatly more accessible with a user-friendly interface as we build our visual products business. I'll reiterate that this is still a very early stage market, but we're incredibly encouraged by what we've seen so far. Let me conclude by reminding everyone that when you hear from us again next year for our Q4 call, you'll be hearing from Andrew as CEO as he takes over in January. We are thrilled to have Andrew taking the reins. He's done an excellent job guiding our strategy in his time with Funko, and I have absolute confidence in his ability to continue that in this new role. In conjunction with Andrew assuming the role of CEO, I will be moving to the role of Chief Creative Officer. I will be primarily focused on product creation and innovation, expanding engagement and our digital pop business while continuing to investigate other potential organic and acquisitive needs to accelerate our growth and expand our addressable markets. With our continued partnership and the amazing work of the Funko team, I am confident in our ability to unlock Funko's potential as we look forward to our next phase of growth. We've had an excellent year-to-date and we're excited to close out the year with some of the great products and programs we have in store. I will now turn the call over to Jen to take you through the financials and 2021's expectations.

Jennifer Fall Jung, CFO

Thanks, Brian, and good afternoon, everyone. We're pleased to report record third-quarter results highlighted by net sales growth of 40% over the prior year, reflecting very strong third quarter demand and broad-based strength across our products, categories, geographies, and channels. The outperformance of our expectations was primarily driven by domestic wholesale outperformance in part due to a shift to FOB for some of our larger accounts. All comparisons are to the third quarter of 2020, unless otherwise stated. Net sales in the U.S. increased 36% to $191 million, while net sales in Europe grew 66% to $59 million. Our other international markets increased 19% to $18 million, with growth in all regions. The number of active properties in Q3 increased 13% to 806. Net sales per active property were $332,000 in the quarter, an increase of 24%. For a list of our top performing properties in the quarter, please see our accompanying earnings presentation. On a product category basis, Q3 net sales in figures, including action figures, grew 42% to $206 million, with pop branded products increasing 41%. Non-figure product sales increased 34% to $62 million, primarily driven by the Loungefly brand, which grew 36% with strong contributions from games and plush. Third-quarter gross margin was 36%, a decrease of 260 basis points versus Q3 2020 due to freight expense. We managed to partially offset the freight inflation through improved global product margins in the quarter, as well as careful expense management throughout the organization. We currently forecast that supply chain disruptions will result in a 2021 gross margin slightly below our 2020 level. We expect this headwind to remain through at least the first half of next year. SG&A for the quarter was $60 million or 22.4% of sales, representing a 90 basis point sequential improvement over Q2, exceeding expectations. Regarding the P&L, adjusted EBITDA increased to $40 million with an adjusted EBITDA margin of 15%, also above expectations. Our outperformance was due to our proactive efforts to delay some marketing spend to align with product availability. Finally, adjusted diluted earnings per share were $0.39. Turning to the balance sheet and cash flow, we ended the quarter with $93 million of cash and cash equivalents and $100 million of availability under our revolver, representing total liquidity of $193 million. We ended the quarter with total debt of $178 million, down 7% compared to Q3 of last year. Inventory at quarter end totaled $141 million, up 94% relative to sales growth of 40%. Roughly 60% of our inventory was in transit as total transit times have increased significantly compared to pre-pandemic levels. The business generated operating cash flow of $79 million year-to-date. As we previously discussed, we expect supply chain disruptions to continue throughout the rest of the year and at least into the first half of 2022. While this will continue to put pressure on gross margin, we are actively managing our operations to ensure we can meet as much demand as possible without jeopardizing profitability. With that context for full year 2021, we are raising our top-line outlook at the midpoint of the range by approximately $45 million with anticipated net sales now expected to be in the range of $950 million to $975 million. We expect gross margin for the year to be slightly below 2020 levels, including a sequential decline of approximately 300 basis points for the fourth quarter due to elevated freight expenses from the supply chain disruptions. We expect fourth-quarter SG&A to increase mid to high single digits sequentially, reflecting higher sales volume, as well as catch-up on some marketing spend that shifted from Q3. For the full year, adjusted EBITDA margin is expected to be in the range of 14% to 14.5%, representing an increase of 200 basis points at the midpoint compared to 2020. We expect adjusted net income to be $64.4 million to $70.4 million based on a blended tax rate of 25% and adjusted earnings per diluted share of $1.20 to $1.31 based on a weighted average diluted share count of 53.9 million. We appreciate your time this afternoon. Now Brian, Andrew, and I will be glad to take your questions.

Operator, Operator

Thank you. We will be taking our first question today from Erinn Murphy from Piper Sandler. Erinn, the floor is yours.

Erinn Murphy, Analyst

Great. Thank you. Good morning, or good afternoon, everyone. A couple of questions for me just off the results in the third quarter. Can you just talk about the key drivers of your outperformance maybe by channel? And then secondly, just a little bit more color on the supply chain, Jen, I think you referenced a lot of your inventory is still in transit. I don't know if you can give us kind of a point in time now of inventory balance and just kind of what do you have kind of floating off the coast of the west coast and some of your mitigating factors that you've taken?

Jennifer Fall Jung, CFO

Hey, Erinn, nice to hear from you. Yes, from a growth perspective, it was really across the board. The U.S. grew substantially, and every one of our international channels grew as well. What you saw in May was that this was the first quarter; they now lapsed 2019 levels. They were slightly under in Q2. So, we're just seeing growth really across the board and feeling really positive about where the business is heading. Our demand for our products has never been stronger and our DTC business continues to be on fire as well. So, we've already outpaced our penetration of our DTC business compared to what we thought we would achieve for the year. So it's just very consistent. And you had a second part; I apologize.

Erinn Murphy, Analyst

Yes, that's fine. Just on the supply chain, if you could give us a little bit more color on some of your mitigating factors, what stock you have off the west coast right now, and maybe a case or a point in time for what your inventory looks like right now?

Jennifer Fall Jung, CFO

Yes, so our inventory is up year-over-year, obviously, but as we go into a quarter where sales will be up year-over-year. Our inventory turns in Q3 were the fastest they have been from both an overall perspective, as well as an on-hand perspective compared to the past three quarters. As we're looking forward, this inventory, a couple of things that we're doing, we want to make sure we don't only protect Q4 but also as we get into Q1, as supply chain times have extended. We've been managing both our Q4 as well as our Q1 inventory to make sure we are set up to end the year on a high note, as well as to start 2022 with enough inventory to support our sales. We are seeing, I think everyone is seeing, containers, a lot of containers sitting out in Long Beach, which obviously is a big port for us as well. So we are continuing to work with different carriers across various routes to ensure we can get our inventory here and get it through our distribution center and back out. We've also moved some of our customers to FOB to alleviate some of the congestion within our own supply chain.

Erinn Murphy, Analyst

Got it. And then if I could just add one more question, regarding pricing, we've noticed you've taken pricing up for some of your retailers. Can you just talk about how deep your pricing increases are now? I know you're facing some challenges internationally as you look into next year. Additionally, one for Andrew on Snapsies; we're noticing that product is back in our store checks. Can you talk a little bit more about how the reception has been? Thanks so much.

Jennifer Fall Jung, CFO

Yes, great. Yes, on the pricing, Funko hadn't raised their prices in quite some time. As we started to look into the future and seeing some of the pressures we're facing within the supply chain, we thought now was the right time to work across our retail channels and collaborate with them to raise prices fairly systematically across the board. This is consistent with a planned indiscernible; just a little bit less for international markets. We don't expect to see the full benefit until really later in Q1 of next year and Q2. We wanted to ensure that we partnered with our retailers and gave them time to adjust and focused on future orders. So it was the right time for us to do it, and so far it's been fairly well received, as much as it can be.

Andrew Perlmutter, CEO

Yes, and I can jump in Erinn on the Snapsies thing. Thank you for noticing series two hitting shelves. We're excited to see that hit shelves. We're just thrilled with the traction that we're getting in the new areas of the store that we're working with, whether it be Snapsies or Battle World or the game aisle. We're just happy with the results. So, yes, you're right. Snapsies wave two has hit, and we've also launched an additional product, which was an offshoot of Snapsies called Gems. We're excited about that. We've got really good retailer support on that. We've always said that the girls' toys sector has a tough competitive landscape. So we're somewhat modest in expectations, but you're seeing wave two on the shelf, and we're excited about it. We will continue to support it, and you'll continue to see us support it this holiday season.

Erinn Murphy, Analyst

Thank you so much.

Andrew Perlmutter, CEO

Thanks, Erinn.

Operator, Operator

We'll now move over to Garrett Johnson of BMO. Garrett, please go ahead.

Garrett Johnson, Analyst

Hey, good afternoon. Thank you. I had two questions. One, Vietnam is an area you source quite a bit from. We've always heard that was the worst place to be sourcing. How were you able to mitigate the problems there and get your product to market? That's one. And then this shift to FOB that you talked about for some of your larger accounts, how did that impact the flow of goods? Did you pull some stuff forward or recognize some stuff earlier than you would have last year via the FOB? What percent of your shipments are now core FOB versus last year? Thank you.

Andrew Perlmutter, CEO

So I can start with the FOB question, and then we can dive into Vietnam, it's Andrew, by the way. Sure. We didn't pull orders forward due to the FOB shipments. It was more to help mitigate supply chain disruptions and get products to retailers faster. So where we had historically gone through our domestic warehousing facility, we consulted some of our key partners and said, 'Hey, listen, we can cut down on the time of the supply chain by going directly to you.' Historically, we might have done this a little bit here and there, but the retailers saw the benefit of broadening their selection of products via FOB because they also knew it would cut weeks off of the supply chain, and they were experiencing the same challenges. That being said, we also assumed that some of the large retail partners that we deal with have better access to containers than we do, so that was another motivator for pushing this approach. As for Vietnam, our factories there aren't concentrated in one particular area. This helped us mitigate some of the risks related to factory stoppages that may have come up. We were able to shift production within Vietnam to areas that weren't affected, and that is how we mitigated it. As I mentioned in the script, that's something we're continuing to look at—how do we further diversify geographically to avoid risks like this in the future?

Brian Mariotti, CEO

Yes. We have eight main factories in Vietnam that are spread over a distance of a couple of hundred miles. So, we had only two and a half factories affected by COVID. It was only in the last 45 days that they have been affected. We were able to mitigate some of that by moving molds and production to other factories within different factory groups. I know Nike and some of the textile companies have been more affected than us, but it certainly has not been a massive problem for us. It literally wasn't a problem until about 45 days ago with a couple of COVID breaks. But all those factories now are operating at full capacity again, so, we're in pretty good shape.

Garrett Johnson, Analyst

Okay. Fantastic. Thank you.

Brian Mariotti, CEO

Thank you.

Operator, Operator

Thank you. We'll move over to Linda Bolton Weiser of D.A. Davidson. Linda, the line is yours.

Linda Bolton Weiser, Analyst

Yes. Hi. I have a longer-term question just about your business. I mean, you've recovered very well in the post-pandemic environment and you're growing your sales rapidly. Do you think or do you foresee that you have any major kind of infrastructure spending either on the CapEx side or on the income statement side in the next couple of years, as you continue to grow rapidly, or do you think you can maybe achieve some positive SG&A leverage as you continue to grow? Thanks.

Jennifer Fall Jung, CFO

Hey, Linda, nice to hear from you. This is Jen. Yes, actually that's a great question. I feel like I teed that one up for you. We don't want to comment too much on 2022, but just to provide a little bit of flavor, we do have some infrastructure projects we need to address. Our demand for products has never been stronger. As we look forward to 2022, we're really excited. As we think about where we need to invest in the business, we talked a little bit about in previous calls. We do have an ERP implementation that we are currently working on that is set to be implemented next year; that will be a use of capital. Due to our extensive growth, we will invest in our logistics capabilities and add some additional space. We've taken on some additional leases that will allow us to fulfill the growth we anticipate in the future. So that will be CapEx that you'll see come through more towards 2022 but also some now. Historically, I think our only other large CapEx was the Hollywood store, but those are the two main infrastructure projects as well as our DTC business and the platform that we’re working on there, which will come after our ERP. So, yes, lots of infrastructure in 2022, but all the support profitable growth in the future. We're feeling great about that.

Linda Bolton Weiser, Analyst

Okay. Thank you. Good luck.

Jennifer Fall Jung, CFO

Thanks, Linda.

Brian Mariotti, CEO

Thank you.

Operator, Operator

Thank you, Linda. We are now moving over to our final question today from Tami Zakaria of JPMorgan. Tami, over to you.

Tami Zakaria, Analyst

Hey everyone. Thank you so much for taking my questions. I have two quick ones. The first one is I wanted to ask you about your gross margin outlook. I think you mentioned the supply chain pressures you expect to persist through at least the first half of next year. So does that mean your gross margin should continue to deleverage in the first half, or do you think your pricing can offset the pressures beyond the fourth quarter?

Jennifer Fall Jung, CFO

Hey, Tami, great to hear from you. Yes, as we noted in our remarks, we do expect we're with everybody else kind of trying to look forward to see when we think those pressures from the supply chain will ease up. All indications are that we do expect it to be a pressure point in the first half of next year. I think we are a little past the spike we saw, and it's starting to flatten out a little bit. As you look at our gross margin, I'll give you a little bit more color on the guidance that we provided for Q4 of this year. We noted that we would see quarter-over-quarter pressure on our gross margin, but keep in mind, for the past few years, our Q4 margin has always come in lower than our Q3 margin. That is cyclical in nature for our business and how we work with our retailers. That is a component of it. While looking forward, we are constantly looking for ways to offset the pressure we see within this quarter; we had about 600 basis points of pressure from the supply chain, but we were able to offset 300 basis points of it through our channel mix, as well as our strong product margins. We will continue to explore ways to mitigate these pressures, and yes, I think the prices will definitely help, but that's likely a bit later in Q1 and more so in Q2.

Tami Zakaria, Analyst

Got it. That's very helpful. If I could squeeze in one last one, I think your DTC business has been exceptional, really strong and a bright spot. As you think more long-term, where do you see the penetration of your DTC business going? Because I think if it keeps growing, it's an inherent tailwind to your gross margin structure. How do you think about your DTC penetration over the next two to three years?

Brian Mariotti, CEO

So we see a ton of opportunity in front of us on our DTC business. We are really focused on the U.S. and EMEA which covers several countries. The truth is there's tremendous opportunity geographically for us to continue to expand. While we haven't disclosed what percentage of the business we're trying to reach with that particular part of our business, your observation is correct. It is performing exceedingly well in the same quarter that we saw our overall wholesale business perform exceedingly well. We're excited that both channels are growing in tandem. We believe the world is at our doorstep regarding growing our DTC, considering that we really serve only two geographic areas right now. We’re excited about a tremendous amount of potential.

Andrew Perlmutter, CEO

Yes. And we are adding investment to that. When we put in the new platform next year, we'll be able to take pre-orders, which is huge. Currently, we're sharing all of our announcements with virtual events and directing them to other retailers, which we support and love, but we'll be able to take pre-orders next fall on that as well. Additionally, we’ll implement customer service improvements and get packages out of the warehouse quicker—customer loyalty and better marketing tools will all come along with the new platform. We're continuing to be mildly obsessed with doing a better job for our customers and fans, and definitely part of our growth strategy is direct to consumer.

Tami Zakaria, Analyst

Got it. Thank you so much.

Jennifer Fall Jung, CFO

Thanks, Tami.

Andrew Perlmutter, CEO

Thank you.

Operator, Operator

Thank you, Tami. At this point, we don't have any further questions registered, so I'd like to hand back to you, Andrew, for any closing remarks.

Andrew Perlmutter, CEO

Thank you all for joining the call today.

Operator, Operator

Thank you. This concludes today's call. You may now disconnect your lines.