Earnings Call Transcript - FNKO Q3 2020

Operator, Operator

Good afternoon and welcome to Funko's conference call to discuss financial results for the third quarter of twenty twenty. At this time, all participants are in 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 authorization from the company. As a reminder, this call is being recorded. I will now turn the call over to Andrew Harless, Manager of Investor Relations, to get started. Please proceed.

Andrew Harless, Manager of Investor Relations

Thank you. Good afternoon. With me today are Brian Mariotti, Chief Executive Officer; Andrew Perlmutter, President; and Jennifer Jung, Chief Financial Officer. A press release covering the company's third quarter twenty twenty financial results was issued this afternoon and is available on our investor relations website. Before we begin, I need to remind you that management's remarks in this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially, as indicated by these forward-looking statements. The results are influenced by various important factors discussed in the risk factors section of our Form 10-K and 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. You'll be referring to certain financial measures on today's call, including adjusted EBITDA and adjusted EBITDA margin, which we believe may be important to investors for assessing our operating performance. A reconciliation of these financial measures to the most directly comparable financial measures will be included in our earnings release. Additionally, we've prepared a visual presentation for investors to consult and follow along with the discussion, which can be accessed on our investor relations website. Now, I'll turn the call over to Brian.

Brian Mariotti, CEO

Thank you for joining the call today, and I hope that everyone is staying safe and healthy. Before I jump in, I'd like to thank the entire Funko team for their tireless efforts, which have allowed us to deliver a solid quarter highlighted by revenue above our expectations and improved profitability versus a year ago. During this dynamic time, our teams are ensuring that we continue to innovate and connect with our fans while making progress against our four key growth initiatives. In the third quarter, we delivered net sales of 191 million and strong gross margins while maintaining prudent cost control. Our adjusted EBITDA margin was eighteen point nine percent, a 70 basis point increase year over year. We also continue to strengthen our balance sheet and increase our liquidity position, which improved over 50 percent compared to last year to 170 million. From a top-line perspective, there are numerous positive indicators across the business, and we believe Funko is well-positioned heading into the fourth quarter of twenty twenty-one. Despite the pandemic headwinds and virtually zero theatrical releases, we drove strong consumer engagement and demand in Q3. Notably, Evergreen products represented 70 percent of our revenue, demonstrating our ability to connect with fans through nostalgic and beloved characters across multiple genres, underscoring that Funko is not reliant on new tentpole movies to deliver products our fans love. We continue to outperform and see strong demand within the domestic mass market and third-party e-commerce channels, both of which grew over 15 percent compared to the prior year. More and more consumers are turning to Funko.com for their pop culture products. In the quarter, we saw sales driven by our own e-commerce platform grow by triple digits as the investments we've made begin to pay dividends. We're seeing positive consumer response in many of our new launch games. For instance, this week, Funko Games had over 10 titles on Amazon's top 100 hot new releases for games and accessories. Lastly, fan engagement with Funko remains strong, highlighted by the tremendous participation we saw in our last virtual con during October. More on that shortly. Now let's turn to our third-quarter performance and our expectations for the balance of the year. Region and channel mix continue to be primary drivers of our top-line performance in the corporate environment. Our U.S. business declined four percent in the quarter, reflecting a slower recovery within our specialty channel but was partially offset by strength in our third-party e-commerce, mass market, and direct consumer channels. Strong consumer demand drove outperformances within our domestic third-party e-commerce and mass retailers. Growth in these channels is attributed to strength in our core collection of products, as well as our expanded game offerings. As the third quarter progressed, we began to see modest improvements in trends within the specialty channel, driven by store openings and retailers shifting their inventory to e-commerce sites. Additionally, we see ongoing momentum in our direct consumer channel, which nearly doubled in Q3, driven by increases in our own e-commerce site, which reported another quarter of triple-digit growth. In terms of our international performance, as expected, recovery in Europe has been more gradual than in the U.S. due to our customer base in the region being heavily weighted towards specialty channels. During Q3, COVID headwinds persisted in both India and Latin America, while Oceania and Canada performed better than the U.S. Looking forward, we expect continued pressure in the European region in Q4 as a result of new restrictions that briefly took effect in multiple countries. We are navigating the macro uncertainty by operating and planning our business conservatively. As always, we are laser-focused on innovating and delighting our fans. Equally important, we remain nimble so that we are prepared to manage through potential closures within the U.S. and international markets. We currently expect Q4 net sales to decline 10 to 8 percent, which reflects almost $20 million or eight points of pressure due to new restrictions and closures across Europe. Despite the global uncertain environment surrounding potential pandemic restrictions, we anticipate strong performance within our domestic mass market, third-party e-commerce, and U.S. channels, offset by continued softness in the European region and U.S. specialty channel. Importantly, we feel confident about Funko's positioning heading into the holiday season, where we will have our most diverse product offering in the market yet. This is enabling us to expand our relationship with key retail customers, partnering with them to deliver an expanded product offering that includes Funko games and youth collectibles. Meanwhile, we expect to drive consumers to our e-commerce sites through creative marketing programs supported by a broad product offering. The investments we are making in our digital capabilities and B2C fulfillment leave us well prepared to meet anticipated demand, even in today's highly dynamic environment. We continue to observe fans actively engage and seek out Funko products both in-store and online. As I previously mentioned, just a few weeks ago, we wrapped up our Funko virtual con in conjunction with New York City Comic-Con, and we couldn't be more enthusiastic about the level of engagement and passion from the Funko family. Not only did we see our engagement levels triple compared to last year's in-person Comic-Con, but we also managed to drive higher sell-through of Comic-Con items at our retail partners. The widespread love for pop culture we have witnessed over many years has been unwavering through the pandemic, as consumers and mega fans continue to engage and create communities around their favorite properties and content. We are confident that Funko is positioned to drive growth as we diversify our business across new product categories, geographies, and channels. We are consistently working to bring new fans into the Funko ecosystem by leveraging our innovative culture to create new products and secure new licenses. This year has certainly presented unique challenges for everyone. I want to express my gratitude to the entire Funko team for helping us bring joy to our fans, along with thanks to our partners, fans, and shareholders for their continued support. I hope everyone has a wonderful, safe holiday season this year. I will now turn the call over to Andrew to discuss our strategic initiatives.

Andrew Perlmutter, President

Thanks, Brian. In the third quarter, we made good progress against our key strategies to drive growth and diversification. As a reminder, these include building upon our core business, further diversifying our product portfolio, expanding our international reach, and increasing the share of our business through our own direct-to-consumer channels. First, maximizing the core pop culture business. This includes creating fun and nostalgic programs focused on Evergreen properties and expanding our consumer base through underpenetrated content genres. Evergreen properties represented 70 percent of the business in the quarter, compared to 58 percent last year, and on a daily basis, grew three percent compared to last Q3. Additionally, nine out of our top ten properties were evergreen in the quarter. We continue to see strong demand with mainstay properties such as Harry Potter, Marvel Comics, Pokémon, DC Comics, Disney, and Star Wars. Notably, 'The Nightmare Before Christmas', our fourth largest property, thrived through strong retail programs, including pop bottle advent calendars and games. Marvel X-Men, our tenth largest property, primarily benefitted from a retail program commemorating X-Men films over the past 20 years, along with the inclusion of X-Men characters in our Marvel Zombies program, which featured pop vinyl and a collector retail box. Another property, 'Back to the Future', just outside our top 10, succeeded with a broad selection of products, including vinyl figures, games, apparel, bags, pins, and accessories. We will continue to emphasize a strong mix of evergreen content going forward and create exciting retail programs. Strategy number two involves driving category diversification by leveraging our innovative culture to launch new products and reach new consumers. In the third quarter, we saw strong performance from our non-secure products, largely due to our expanded game offerings, as well as our long-planned items. Within the games, we launched 'Marvel Battleworld: Mystery of the Fantasy Stone' late in Q2, targeting a younger demographic and combining micro-collectibles, cards, and gaming. Notably, we observed stronger than anticipated consumer demand for these products, which resulted in us chasing replenishments throughout Q3. We believe we are now in a good inventory position for the upcoming holidays. While we initially lost Marvel Battleworld at Target in the U.S., we have since expanded to other key mass e-commerce, specialty, and drug partners around the globe. We are thrilled about the positive market response to this line and look forward to expanding it in 2021. We're also seeing positive traction with additional game offerings this year, with many of our key titles appearing on top new release lists and receiving favorable reactions from both consumers and retailers. Although our board game category currently represents a small portion of our overall business, we plan to enhance our offerings in the coming years and believe it will significantly contribute to our growth long-term. Additionally, we observed exceptionally strong momentum with our collectible products, which grew 25 percent compared to last year, driven by demand on our website and at wholesale, where retailers chased orders that were postponed from Q2. The resiliency of the collectible brand highlights the importance of maintaining a diverse product lineup at retail and online to continue engaging fans in the Funko ecosystem. For Q4, we are excited about our new non-licensed collectible line leveraging Funko's patent-pending Snappin' Match technology, allowing kids to create custom characters with each purchase. This line exemplifies how Funko can use creativity and innovation in the collectible category to target a new consumer demographic. Moving on to our third focus area, international expansion. As Brian mentioned, the pandemic has been a headwind for our international business. However, we believe significant growth potential exists in overseas markets, and we are confident that Funko is well-positioned to capitalize on this when macro conditions improve, particularly in Latin America and Canada. The recent launch of FunkoEurope.com will provide us with an additional growth lever, broadening our relationship with fans across the region. This leads me to our fourth area of strategic focus: the expansion of our direct-to-consumer business. We have made substantial progress in growing this channel in 2020 by investing in our digital and fulfillment capabilities. As Brian highlighted, our direct-to-consumer channel nearly doubled in the quarter, significantly aided by momentum in our e-commerce sites, which grew more than 150 percent. The investments we made earlier in the year to enhance our product offerings and improve customer experience are proving beneficial on Funko.com. We will continue to strategically invest within the business to reach new consumers. As noted, we strategically launched Funko Europe last month, approximately 18 to 24 months ahead of schedule. This decision was made to fast track this opportunity in light of the current environment, and I commend the team for executing this initiative ahead of schedule. Currently, we are shipping to the UK, Ireland, and Spain, with plans to expand to Germany, France, and Italy by year-end, and additional countries set to come online in 2021. While we are excited about the substantial progress made on the digital front, we acknowledge more work is needed to build our e-commerce platform. Our focus remains on enhancing our site to better the customer journey and experience, as well as investing in our digital platform to ensure business scale alongside demand amidst this dynamic environment. We are committed to executing strategies that best position the business for 2021 and beyond. I will now turn the call over to Jennifer to cover our financial performance.

Jennifer Jung, CFO

Thanks, Andrew, and good afternoon, everyone. As noted, Q3 came in better than anticipated. Across the company, net sales declined 14 percent but came in ahead of our initial expectations. Gross margins improved, and we maintained strong cost controls. Our actions allowed us to improve profitability, increase cash flow, and maintain a strong liquidity position throughout the quarter. Q3 net sales were 191 million, reflecting the ongoing impact of COVID-19 within specific channels and regions. The outperformance relative to our expectations primarily results from strength in the U.S. within third-party e-commerce, the mass market, and our direct-to-consumer channels. We had 715 active properties in Q3, a 14 percent increase from the prior year. Net sales per active property reached $257,000 for the quarter, down 25 percent compared to last year, influenced by pandemic pressures. The ten top-performing properties included 'The Mandalorian', 'Harry Potter', 'Marvel Comics', 'The Nightmare Before Christmas', 'DC Comics', 'Disney Classics', 'Star Wars Classics', 'Dragon Ball', and 'Marvel's X-Men'. Third quarter net sales in the U.S. decreased four percent, primarily due to ongoing softness in specialty channels, which was partially offset by strength in third-party e-commerce, mass markets, and our direct-to-consumer channels. International sales dropped 34 percent, reflecting the ongoing effects of COVID-19 on overseas markets, especially in Europe. In terms of product category performance, sales of figures decreased 18 percent to 145 million. Other sales decreased just one percent to 46 million, benefiting from landslide branded items that grew 25 percent during the quarter. Furthermore, sales of our branded products were down 16 percent in accordance with overall business performance. Q3 gross margins were 38.6 percent, a 30 basis point increase year over year, primarily due to improved product margins resulting from a higher percentage of direct-to-consumer sales, partially offset by increased shipping-related expenses tied to a higher mix of orders fulfilled from our distribution centers versus direct shipments from our factories. In Q4, we anticipate gross margins will remain approximately flat compared to 37.1 percent last year, excluding a one-time inventory write-down in 2019. This expectation reflects benefits from higher direct-to-consumer sales offset by regional impacts. Q3 net income came in at 41 million, down 11 million versus the prior year, with lower than expected costs during the quarter influenced by timing in hiring, marketing spend, and other administrative costs. Looking ahead to Q4, we expect SG&A expenses to decline in the mid to high single digits compared to a year ago, reflecting cost-saving actions we have implemented this year. On a sequential basis compared to Q3, we anticipate slight increases due to higher fulfillment costs and marketing expenses to support the holiday and new product initiatives. Strong gross margin performance and better-than-expected adjusted EBITDA enabled us to achieve improved profitability for the quarter, with adjusted EBITDA coming in at 36 million, representing an adjusted EBITDA margin of 18.9 percent, a 70 basis point increase from the previous year. On the balance sheet, we concluded the third quarter with total liquidity of 107 million, which comprised 32 million of cash and cash equivalents and 75 million available under our revolver. We repaid all outstanding borrowings under our line of credit during the quarter. Total debt, net of unamortized discount, stood at 208 million, down 12 percent compared to last year. Inventory totals 73 million, a 23 percent decrease year over year. The business generated strong cash flow from operations amounting to 28 million in Q3, marking an 87 percent increase year over year. Using cash flow from operations, we returned 60 million. As we progress towards year-end, we continue to plan conservatively given the dynamic environment. Considering the current landscape, as Brian mentioned earlier, we expect Q4 net sales to decline 10 to 8 percent compared to last year, particularly accounting for nearly 20 million or eight points of pressure arising from European restrictions. Additional or prolonged closures could further impact performance in the quarter. While uncertainty persists, we are taking the necessary steps to remain agile and ensure the long-term success of the business. We appreciate your time this afternoon. Now, Brian, Andrew, and I would be glad to take questions.

Operator, Operator

At this time, we will be conducting our question and answer session. In order to ask a question, please press star, then the number one on your telephone keypad. Your first question comes from the line of Erinn Murphy with Piper Sandler. Your line is open.

Erinn Murphy, Analyst

Great. Thank you. And good afternoon. I guess my first question is just around what you're currently seeing in Europe and maybe what exactly is embedded in the 20 million dollar headwind that you're seeing about X number of weeks across certain countries. And then as you think about spring 2021, are any of the retailers in Europe starting to cancel orders?

Brian Mariotti, CEO

You know, Jennifer, do you want to start with that? I can add on.

Jennifer Jung, CFO

Absolutely. Hey, Erin, how are you? Yeah, so you know, as we've been talking with our European business partners, what we're really seeing is that the shutdown came very quickly and very swiftly. We have modeled into our forecast based on what we are seeing across the board. Restrictions on openings have been significant across several countries, affecting what can be sold. So it's a substantial hit to the quarter based on the current business model.

Brian Mariotti, CEO

Yeah, I'll add a little color here. No one is able to definitively forecast anything for spring of next year. We are operating under the assumption that some retailers will be able to start shipping again as early as December 2nd in some countries, that are currently shut down for the 30-day period. We're doing everything possible to mitigate the impacts of the possible shutdown, in addition to maintaining our own e-commerce direct-to-consumer platform.

Erinn Murphy, Analyst

That's helpful. And then just to that latter point on the European dot com opportunity, can you just help us understand what percentage of the overall U.S. mix is that? Is that the right benchmark to use to project how significant the European dot com business could become over time?

Jennifer Jung, CFO

Yeah, our entire direct-to-consumer business represented eight percent of the overall business in the quarter, including our two stores. As we look at the European site, it was just launched, I think, two weeks ago, and we will be opening up more countries over the course of the quarter. We do expect that to expand, but it's still a relatively small portion of the business. That said, as Andrew mentioned earlier, this is a major priority, and we will continue to invest in this initiative to grow it internationally and domestically.

Erinn Murphy, Analyst

My last question is just regarding how you've effectively leveraged evergreen content in light of new releases. What is your level of confidence in continuing this evergreen success? And how do you feel about the new release schedule for 2021? Thank you.

Brian Mariotti, CEO

Thank you, Erin. Either today or as of Monday, we've seen changes. Over the last couple of years, we've gained a lot of confidence. If you look at Harry Potter, it's been our number one license for the past four years. Evergreen properties dominate our sales, with nine out of the top ten being evergreen in nature lately. We've learned to focus on creating interesting retail stories and products based on evergreen content, which we expect to continue doing in the years ahead. In 2021, we anticipate a much stronger content lineup in the first half than what we had in twenty twenty, which was limited due to the pandemic and lack of new content, aside from 'The Mandalorian'. We are doing exceptionally well despite constraints.

Operator, Operator

Your next question comes from the line of Steve Wissink with Jefferies. Your line is open.

Unidentified Analyst, Analyst

Good afternoon, this is actually in for Steve. Thanks for taking our question. To start, we were hoping you could update us on the games initiatives given the strength in the category today, and any basic allocation changes or new distribution you can share with us. Thanks.

Andrew Perlmutter, President

I can jump in on that one. Our game plan is proceeding as expected, and we are increasing our shelf space with retail partners. As I mentioned during the call, it's still a relatively small part of our overall business, but we are witnessing growth and gaining additional shelf space with retailers. We are receiving a tremendous positive reaction from our online e-commerce partners. A fun way to track progress is through Amazon listings, which I noted earlier. It's exciting on both retail and e-commerce fronts, and we continue to grow. This is a fresh take on a category that is doing well, especially while consumers are spending more time at home. Certain categories, like party games, are somewhat affected but overall, the strategy works well for us.

Unidentified Analyst, Analyst

Great, thanks. So are there any distribution changes rather than just allocation changes? Anything noteworthy?

Brian Mariotti, CEO

I don't think there’s anything particularly noteworthy at this point. We are witnessing additional space allocations from our retailers for our products, as mentioned previously. We're eagerly anticipating our upcoming larger-scale launch, occurring in Q4 across Europe, recently initiated at Tesco. We're looking forward to seeing how it performs. Overall, we're garnering more interest as time passes, which provides a bullish outlook.

Operator, Operator

Your next question comes from the line of Alex Perry with Bank of America. Alex, your line is open.

Alex Perry, Analyst

Thanks for taking my question. Some other retailers in the space have noted a differing cadence to the holiday season this year, with extended promotional timelines. Could you provide your outlook on any possible promotional environment you might expect?

Jennifer Jung, CFO

As we enter the holiday season, we're currently feeling very optimistic despite the pressures observed in the European business. Within our core business in the U.S., we see positive signs. Our guidance indicated we expect a decline of 10 to 8 percent, which includes an eight-point impact from our performance in Europe. We remain bullish about prospects for Q4 domestically, anticipating strong business growth during the quarter due to the promotional dynamics in play. Our overall operations in the U.S. remain robust.

Alex Perry, Analyst

Perfect, and just a second question—how have you seen trends progress within your specialty channel? It seems there has been some sequential improvement in that area. Furthermore, any insights on how demand recapture is taking place from specialty channels within your own e-commerce business?

Brian Mariotti, CEO

I can start with that. Stores are gradually reopening, although foot traffic is considerably down in malls. Some of our retail partners are adopting curbside pickup, while others are restricted regarding capacity. Each partner adopts a slightly different approach. We're beginning to see a rebound in foot traffic and are excited about the rising orders leading into the holiday season. Our direct-to-consumer journey likely mirrors what the mall experience will evolve into post-pandemic. We're optimistic about our products being channel agnostic—they're adaptable across retailers. We are definitely sensing an improved situation in specialty relative to a few months ago.

Operator, Operator

Your next question comes from the line of Tami Zakaria with J.P. Morgan. Your line is open.

Tami Zakaria, Analyst

Hi, thank you very much. My first question is, have you witnessed any fluctuations in demand within the U.S. market as COVID cases have spiked in some areas?

Brian Mariotti, CEO

Not domestically, no. We have seen no fluctuations whatsoever. In fact, demand is stronger than ever, and we remain focused on getting product out of the warehouse swiftly, directly into the hands of retailers and our fans.

Tami Zakaria, Analyst

Understood, and can you remind me of the size of the landslide business relative to the overall pop segment?

Brian Mariotti, CEO

Would you like to take that, Jennifer?

Jennifer Jung, CFO

Sure. Our landslide segment is continuously growing, and we are confident about its position. It still remains sub-20 percent of our total business, but it has increased by around 50 percent in terms of percentage penetration, placing it in the mid-teens relative to overall business.

Tami Zakaria, Analyst

Great, very helpful. One last question: I believe you guided for mid-to-high single-digit growth. Is that guidance inclusive of DTC or just excluding it?

Jennifer Jung, CFO

That guidance pertains to our core business, excluding DTC.

Tami Zakaria, Analyst

Got it. Thank you so much.

Jennifer Jung, CFO

Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. On behalf of Funko, we appreciate your participation. You may now disconnect.