Funko Inc (FNKO) 2017 Q3 法說會逐字稿

Greetings and welcome to the Funko third quarter 2017 earnings conference call. At this time all participants are in a listen only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Russell Nickel. Please go ahead.

Thank you and good afternoon. A press release covering the Company's third quarter 2017 financial results was issued this afternoon and a copy of that press release can be found in the Investor Relations section on the Company's website.

Management's remarks on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These may include statements regarding our business goals, plans, abilities and opportunities, industry and consumer trends, growth momentum and investment initiatives, consumer engagement and brand awareness, acquisitions and related expenses and anticipated financial performance. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the risk factors sections in our filings with the SEC and our quarterly report on Form 10-Q that is expected to be filed today or tomorrow with the SEC. Any forward-looking statements made on this call represent our views only as of today and we undertake no obligation to update them.

Please also note that we will be referencing to certain non-GAAP financial measures on today's call such as EBITDA and adjusted EBITDA. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release in the Investor Relations section of our website at Funko.com.

I will now turn the call over to Brian.

Thanks and good afternoon, everyone. It's good to be holding our first earnings call as a public company. We are pleased with our third-quarter results and the underlying trends in the business. We are executing against our strategic initiatives by growing our sales, expanding our product portfolio, extending our distribution footprint, building a direct sales model in Europe and making infrastructure investments to support future growth. In the third quarter, sales increased 21% to $143 million from the continued expansion of our product portfolio and gross margin increased 170 basis points to 40.9%, primarily from higher product margins in Europe.

We believe these results are a testament to the unique business we have built to meet the growing consumer demand for licensed pop culture products around the world. We have spent 12 years amassing a broad portfolio of licenses, creating unique and stylized looks that are proprietary to Funko and building a world-class supply chain. Our products are fun, whimsical and sold at accessible price points. They appeal to women, men, girls and boys as well as collectors, enthusiasts and everyday consumers. Our differentiated consumer base is reflected by the fact that our average age of our end consumer is 35 years old and nearly 51% of these consumers are female. Our business is made up of a diversified mix of thousands of licenses and properties that are sold across a wide array of products and retailers. No single property or North American retailer accounted for more than 10% of our sales for the third quarter of 2017. We are continuously updating our properties and our product mix to reflect what's trending in pop culture.

Our speed to market is a distinct advantage and we can take a product from concept to shelf in as little as 70 days. These attributes make Funko unique and a leader in the market for licensed pop culture products.

We believe the worldwide market for our products is in the early stages of development. Content is everywhere and it's resonating globally in real time. Video games, movies, television shows, music and sports are more popular than ever and consumers are spending more time interacting with the content. Just like a football fan shows his affinity for his favorite team by wearing a jersey, fans of pop culture content are looking for ways to do the same thing. Our stylized products connect consumers with content in a way that is unique to Funko. We believe we are very well-positioned to benefit as the global demand for licensed products continues to grow.

One of our key initiatives this year has been expanding our presence in Europe. We have been selling in Europe for several years through a distributor, Underground Toys, and believe there is a significant opportunity to grow this market. After looking at different options, we acquired Underground Toys in January and began investing in a direct distribution model. Our proof point of success in the US has provided a blueprint for rapid expansion in Europe and we now have a platform in place. With more retailers in the US and Europe looking to offer a fuller assortment of products, we have been making investments to broaden our apparel and our accessories capabilities. Loungefly was a company that we had long admired. Similar to Funko, they are design-focused, make fantastic stylized products at accessible prices and have a key number of licenses, including Disney, Marvel, Star Wars, Sanrio and Pokemon. We knew that Loungefly was a great strategic fit. They are a perfect complement to our business and allow us to offer a more curated assortment of products. We are extending Loungefly's products in new retailers and channels of distribution, signing new licenses and broadening our product offering in accessories.

In addition, we are leveraging our combined talents across our portfolio of properties. Loungefly products have traditionally been sold in the US at boutique, specialty and department stores and we believe there is a significant new door opportunity in the mass and international channels. Target began carrying Loungefly products for the first time in October and we are seeing a growing affinity in the market for licensed contemporary fashion accessories.

Finally, we are investing in ways to drive consumer engagement and brand awareness. We have upgraded our web and e-commerce platforms and recently launched a redesigned website. In August, we opened a 17,000 square foot flagship retail store at our new headquarters in Everett, Washington. The new store was opened to showcase our full assortment of products in a unique merchandising setting for the full benefit of our retail and licensing partners, fans and employees.

With video becoming an increasingly important medium of communication, we made the decision to acquire A Large Evil Corporation. This is a fantastically creative studio that is producing the majority of our animated product videos for several years. With the closing of the acquisition, we will be changing the name to Funko Animation Studios and bringing this function in-house. While the acquisition is not material from a financial standpoint, we see huge potential to promote our brands and products globally through the creation of more original video content.

In summary, we are pleased with our third-quarter results and progress of our strategic initiatives. We are executing the business in line with our plans and are delivering against our internal targets. We are excited about our positioning in the industry today and the opportunities ahead of us. As a public company, we know it's important to execute and deliver. We believe we are doing that and feel good about the underlying trends and momentum of our business.

In closing, I would like to thank everyone at Funko as well as our board members, our shareholders, for their dedication and support. Funko sits at the epicenter of a worldwide emerging market for licensed pop culture merchandise and we see many long-term opportunities as the industry continues to grow and develop.

I will now turn the call over to Russell to take you through the third-quarter financial highlights in more detail.

Thanks, Brian, and good afternoon, everyone. Net sales increased 21% to $142.8 million, driven primarily by the continued expansion of products and properties in our portfolio. In the third quarter, the number of active properties increased 26.6% to 400 and the average sales per active property remained relatively flat at just over $400,000. On a geographical basis, net sales in the United States increased 6.5% to $104 million and the net sales to all foreign countries increased 91.3% to $39 million.

On a product category basis, net sales of figures increased 21.8% to $115 million and net sales of other products increased 17.8% to $28 million.

Gross margin, which excludes depreciation and amortization, increased 170 basis points to 40.9%. The increase was driven by higher product margins in Europe as a result of our move to a direct distribution model through the acquisition of our European distributor. This was partially offset by higher royalty expenses from a mix of properties sold in the quarter and higher freight and shipping costs.

Selling, general and administrative expenses increased 73.9% to $32.5 million. The increase was driven by additional expenses related to the continued growth in business as well as the impacts from recent strategic acquisitions and investments in key areas such as product development, supply chain and infrastructure, both domestically and in Europe. Additionally, we continued to invest in our digital and direct-to-consumer initiatives. The biggest areas of increase were personnel expenses, which increased $6.5 million; bad debt expense, which increased $2.3 million; advertising, marketing and commission expenses, which increased $1.8 million; and facilities and blend, which increased $1.3 million. Depreciation and amortization expense increased 39% to $8.4 million, primarily from higher depreciation levels in the areas of tooling and molds and leasehold improvements, as well as higher amortization of intangible assets from the Underground Toys and Loungefly acquisitions.

Net interest expense was $9.1 million versus $4.2 million in the third quarter last year. The higher net interest was driven by increased borrowings over the past year. Subsequent to the end of the quarter, we reduced our debt by $123 million. As a result of all of these factors, our third-quarter net income, EBITDA and adjusted EBITDA were $8.3 million, $25.8 million and $27 million respectively.

Touching on a few balance sheet highlights, we ended the third quarter with net debt of $348 million. Inventory was $79 million versus $44 million at the end of 2016. Included in our inventory at the end of the third quarter was approximately $28 million of inventory related to our new European operations as well as Loungefly. This accounted for more than 80% of the overall increase in inventory.

As a reminder, we did not begin selling direct in Europe or acquire Loungefly until after the first of the year so the December 31, 2016 balance sheet did not contain any inventory related to those two businesses. Subsequent to the end of the third quarter, we repaid $123 million of debt, which included the full principal and interest balances on our subordinated promissory notes, term loan B facility and revolving credit facility. In connection with the repayment of our term loan B debt, we incurred a $5.1 million write-off of the unamortized discount that will be recorded as a loss on extinguishment of debt in the fourth quarter.

Turning to guidance, for the fourth quarter of 2017 we are expecting net sales of $144 million to $149 million and adjusted EBITDA of $28.5 million to $31 million. Given the timing of the IPO, we decided to provide fourth-quarter guidance today. In the future, and beginning with our 2017 year-end results, we intend to provide guidance for the full-year outlook on the business. As a reminder, we will begin reporting net income per diluted share in the fourth quarter, which is expected to be calculated using a tax rate of approximately 39% and a diluted share count of approximately 49 million shares.

I would now like to turn the call back over to the operator to start the Q&A session.

Thank you. At this time, we will be accepting conducting the question-and-answer session. (Operator Instructions).

Mike Ling, Goldman Sachs.

Great. Thank you for the question. We saw a strong q-on-q rebound in revenue growth in the third quarter. Can you just talk a little bit about the key drivers of growth in the quarter, whether that's from a content perspective or events perspective, such as Comic Con or the new headquarters/retail store opening?

And as a follow-up to that, could you break out how much of that growth was organic versus acquisition? Thanks.

Yes, Michael. Thank you for the question. We always like to talk about our business model and our philosophy of diversity of licenses, diversity of products, diversity of price points. We had some great key drivers in Q3 == Harry Potter; Stranger Things from TV; Five Nights at Freddy's, which is our first master toy license; Rick and Morty, which is our second master toy license; Game of Thrones; Overwatch from the videogame world; Star Wars; and Marvel really were prime drivers in that quarter. But again, look at the diversity of the licenses and the different areas they come from. I think that's a really big part of our overall third-quarter success.

Russell, did you want to take the second part of the question?

Sure. We do not break out revenues from Underground Toys or Loungefly. What we are focused on is expanding our product portfolio and our distribution footprint. So we have looked at acquisitions from small tuck-in opportunities where we've had an existing relationship, which is how we came to acquire Underground Toys. We've leveraged that relationship and taken a direct relationship selling only our products within Europe and then leveraging Loungefly from a product portfolio across our own distribution channel.

Great, thanks. Maybe just one follow-up and I'll get back in the queue. But could you talk about a little bit about the Toys "R" Us bankruptcy and the impact that may have had on 3Q results as well as the status of your relationship with that retailer today? Thank you.

Yes, Michael, I'll add some topline color and then turn it over to Russell. Look, we are big fans of Toys "R" Us as a long-time partner. Over the last year they were less than 3.5% of our overall business --- not a significant amount but again, a true partner in every sense of the way.

I'll turn it over to Russell for the rest of that.

Yes, so as Brian referenced, they have been a good partner to ours. We have been having ongoing conversations since they filed for bankruptcy. We have resumed shipping to them and will do so in a prudent manner going forward.

Rafe Jadrosich, Bank of America Merrill Lynch.

Hi. Good afternoon. Thanks for taking my questions. Brian, I was hoping you could talk a little bit about your expectation for the topline growth rate over the next few years, you think longer term. And then can you lay out a few of the key drivers behind that growth? Just any color you can give about what the key drivers would be by channel, geography or category going forward?

Thank you, Rafe, for the question. Look, I'll tell you that as we have given guidance, we still believe it's midteens? As far as the overall growth we're going to continue to play by the Funko playbook we've had for the last 12 years -- diversity of licenses, videogames, television, movies, anime, theatrical and then the one that we're so proud of is evergreen content, which is any kind of content that is not tied to a current movie, videogame or TV show, which on average for the last 6 years has been 40% to 45% of our business. We believe those drivers are going to be the recipe for our success going forward.

Then as you just --- I know it's early and holiday. Can you just talk about kind of the early trends for your holiday sellthrough rates? And then just discuss the order book and what the retailer inventory levels are like.

Yes, great question. Definitely we are in a better inventory position with our top 10 customers year over year than we were last year. The sellthrough rate is also up considerably year over year from 2017 to 2016. I think those two factors alone are really strong and they are going to fuel, with again the diversity of licenses, a really strong fourth quarter for us.

So when you say the sellthrough rate is up, so it's accelerated in 2017 over 2016?

That's correct.

Against the higher base.

Correct.

Okay and then the final question is can you just give a little bit of color about how you think about balancing driving growth with the Funko pop product longer-term while still maintaining exclusivity in the markets so that the product doesn't become overdistributed?

No, I think all of our product platforms have a common thought process behind it. We're taking our own IP, our own unique style, look and feel and layering it over all this wonderful content that we have such a diverse portfolio from. You know, year six in pop, we're still up double digits so the category continues to grow. I always give the same example --- action figures have been around for 75, 80 years, plush has been around for nearly 90 years, bobbleheads have been around for almost 100 years. We truly believe that we are building platforms to lever against with new content year after year after year to keep those products fresh and we're going to continue to protect the brand integrity of each of those product lines that we've built.

Great. Thanks for all the color.

Erinn Murphy, Piper Jaffray.

Great, thanks. Good afternoon. I guess I wanted to start with the US side of the business, the growth rate being up in the mid-6% range. Could you just talk a little bit more about kind of the composition of that growth between the direct-to-consumer side of your business versus some of the digital kind of pure plays you have initiatives with and then the traditional I guess department store mass channel?

Yes, Erinn, thank you for the question. Yes, we will start with direct to consumer. Our focus in 2018 is certainly going to be helping our brick and mortar retail partners establish a better e-commerce strategy with Funko products. We do believe overall our products are channel-agnostic. It's one of the strengths of the Company. In addition to that, we are continuing to offer gradually more and more products on our direct-to-consumer Funkoshop.com website.

So that's that. The digital strategy is very interesting. We invested obviously in 2017 in providing digital licensed products through -- across a great range of licenses and portfolio. We are excited about bringing in a different demographic. One of the measurements we use is that of the downloaded digital product, 60% of those people have never bought a Funko product to date. So we are definitely engaging a different consumer base.

Traditional --- obviously there's just a ton of white space. One great example of a case study is Target, with our relationship with Netflix as a global hardlines partner. Target wanted a 4-foot section of Stranger Things between the Funko products and the Loungefly products. We set 4 foot of Stranger Things product in fall in all 1,700 Targets and it's done phenomenally well. So there are going to be instances where we're the only company to go to that has this large portfolio of different products across a very wide licensing base and I think that's going to continue to provide a ton of opportunities in brick and mortar for years to come.

Okay and then maybe Brian, if you could just expound a little bit more on your strategy with Europe, now that you have effectively gone direct kind of in the year to date period. What markets, if you've done more work, represent the largest opportunities and then how are you thinking also there about some of the digital potential partners?

Great question. Look, I think the exciting thing about this is Underground Toys over the last five years being our distributor has done a wonderful job of laying the groundwork. They have phenomenal licenser relationships. They have begun to lay the groundwork starting with the pop vinyl figures in all the markets. What we managed to do with the acquisition is to put a face and use some of the blueprint success that we had in North America and have that direct connection with the retail partners.

It's gone phenomenal. We've absolutely exceeded our expectations. We are excited about the growth. We are working very, very hard on the backend of what Funko Europe is right now. I'm learning to be more productive at the warehouse. That has continued to be a focus with IT. But as far as the future is concerned, that has been the focus. I think digital in Europe is a little bit --- we're not quite there yet on how that's going to roll out but the focus is definitely we continue that success in the brick and mortar and also the backend for our business there.

Okay, and then just last for Russell --- don't want to leave you out. A quick kind of clarification on the fourth-quarter guidance, just helping us think about the building blocks. So the revenue it looks like kind of range is from high single digit increase to low double digits. Can you just help us think about --- I mean, that would imply a deceleration in growth rate from Q3. Kind of how are you thinking about the composition US versus international?

Then on gross margin in the fourth quarter, it should still be benefiting from the Underground Toys acquisition. So should we think about kind of that triple digit increase basis point increase in gross margin in Q4 to continue?

So in regards to gross margin, I will take that first. I would assume gross margins will remain in line with our historical trends. We had a strong gross margin in the third quarter. However, I do not necessarily see that those --- or would expect those to continue. You should assume gross margins more in line with our historical trends.

From a fourth-quarter perspective, guidance is in line with our plan and we believe we will continue to execute against our plan.

Steph Wissink, Jefferies.

Thanks. Good afternoon, everyone. I want to focus in on inventory if we could. Russell, could you talk a little bit about just the inventory increase in the quarter? I think up 15% on an adjusted basis relative to your recorded growth. Just talk a little bit about how you're managing inventory.

And if you could just reflect on that with respect to your supply chain comments, your speed-to-market advantage. How should we think about inventory relative to your growth projections? Should you be under, over? What's the balance and how do we think about inventory versus sales growth? Thank you.

Yes, so on a sort of comparable basis, we are in line. We feel that the inventory growth is in line with the growth opportunities, to support the growth opportunities long-term. We continue to focus on our overall inventory management and we see --- there are opportunities for improvements. But I think the 15% to 16% increase is in line with where we think the growth opportunity is in front of us.

All right, and just one follow-up on gross margins. I'm curious if you can talk a little bit longer-term how you're thinking about the portfolio mix by category and how that might evolve over time from a margin mix perspective.

We take a very disciplined approach against our gross margin and across all of our mix of products. Products we get a -- and channels, we obtain a very similar gross margin and therefore we do not anticipate fluctuation depending on overall product mix going forward.

Chris Horvers, JPMorgan.

Thanks. Good afternoon. So first question --- I was wondering if you could talk about the new doors that you've entered in the US. I noticed product in Costco. I noticed --- I think you made an announcement about entering Walgreens. So can you talk a little bit about what's new and where you're headed? Is there a way to break out that US revenue growth based on sort of organic existing recent retail partner growth versus new door expansion?

Yes. Thank you for the question, Chris. Great observations. Yes, this is --- like any other retail channel that we had not entered into, we're going to take a very careful, disciplined approach, protect the brand integrity, make sure we have the right product for the right retail channel. Costco, I think it's a 4-pack of Star Wars. We're going to continue to monitor the sellthrough. It's too early to make a call on that. Walgreens has performed well in a small incubated section that we've done over the last two years. We do believe there's some upside there in 2018 to continue to expand because the sellthrough has been great. The customer reaction to the product has been great. There's been a nice fit there with diversity of products.

So I do think those are two channels that we're excited about the growth. We are doing a small test order in the value channel as well that we will evaluate through fourth quarter and look at again a product that's sub-$5, it's our Pint Sized Heroes product, the right product for the right retail channel, making sure that we have a fit there. Like anything else, protecting that brand integrity is paramount, making sure that these products work, have a fit and have a good positive reaction. So I do believe that that is kind of the new door strategy as we go forward.

Russell, did you want to chime in on the second part of the question?

No, I think you touched on everything.

Great. Appreciate it, Chris.

Drew Crum, Stifel.

Thanks, guys. So first question, Brian. In doing some store checks and listening to Gamestop's earnings call the other week, they're emphasizing this Pokemon Center. I'm wondering if that is in any way is impacting your shelf space, given that this is one of your larger retailers?

Then separate from that, can you remind us of Five Nights at Freddy's what was in the comp? I recall that being a big property in your third quarter last year and I'm curious if that was up year on year or if it was down and how long it remains a headwind.

Yes, let me answer the first part first and then I'll ask just a clarification on the second part. No, it will not affect us at Gamestop. We've managed to curate an area that we feel is the best way to basically merchandise pop culture products in that store. Again, year-over-year sellthrough in Gamestop is over from 2017 compared to 2016 so we like where we're at with that retailer.

The second part of the question again? Could you repeat that one again?

Five Nights at Freddy's -- if I recall, you launched that in the third quarter last year and I think in your preamble you suggested it was one of the properties that was up or it was a big contributor in the quarter. I want to understand if it was up year on year and how long it remains a headwind as you lap some difficult comparisons?

Yes, look, for us it has been a phenomenal property for us. We've done close to $100 million in wholesale in about 18 months with the property. What's so exciting about that property is we continue to come in with new product categories that we haven't used before as being a master toy licensee. We do believe that the content is ongoing. There was a minigame released yesterday. There is a new release coming out I think very early 2018. As Scott Games continues to release new content we continue to see strong growth. He is still our number-one license in 2017 and it was our number-one license in 2016. Again, I'll point out that the license portfolio is always being as diverse as you possibly can but we're very excited about the ongoing future of what Five Nights at Freddy's means to Funko.

Okay. Very helpful. Then just one last one for Russell. Provide us an update in terms of efforts to refi the term loan A facility and if so, any expected reduction to the interest expense line?

So, as a reminder, obviously we paid down our debt by $125 million with the proceeds of the IPO. We are interested in refinancing our debt and are continuing to evaluate the best course of action, both from a timing and capital structure perspective.

Thanks for the questions, Drew. We appreciate it.

Gerrick Johnson, BMO Capital Markets.

Hey, good afternoon. So I'm looking at your numbers on your press release compared to where you guided us on October 5 and everything seems to line up but what I'm not seeing are those other expenses, the $3 million transaction expense, the $800,000 non-cash comp management fees. Are those excluded from the numbers you presented in the press release?

No. So the other transaction expenses were not added back. They are in SG&A and/or were capitalized as a component of the IPO. Then the other expenses, the add-backs that were referenced are included in the press release, as they should. I would refer you to obviously the reconciliation table if you haven't seen it already.

Okay. Moving on, Toys "R" Us --- on October 5 you told us that you'd have a $4.8 million reserve for bad debt related to Toys "R" Us. I think in your remarks you mentioned that bad debt year over year grew to 2.3. So where's the differential there? Did you get a recovery?

We cannot disclose the nature of our conversations with TRU. We evaluated, as we closed out the quarter, our risk and bad debt exposure across our entire customer base and adjusted our bad debt reserves accordingly. We have taken the appropriate reserves for all customers, including TRU, in the third quarter and that reserve is reflected in our quarterly results.

Okay and sticking with Toys "R" Us, back on October 5 you told us you were lowering your fourth-quarter sales by $5.1 million assuming no shipments to Toys "R" Us. So now that you are shipping to Toys "R" Us, how much of that $5.1 million is coming back into the fourth quarter?

We've provided the guidance on where we think the fourth quarter will end up and we should take that offline if needed.

Okay.

Sorry, Gerrick. I mean, we're not going to comment on an individual retailer from a sales perspective.

Okay. Then can you talk about your channel inventory levels? What do they look like compared to last year and how much larger are your channel inventories? And then if you can discuss sales allowances as a percent of gross sales this year versus last year. Thank you.

I think one way to do it is looking at the top 10 customers year over year from 2016 to 2017. I can tell you across the board, all of them are in a better inventory position. I can't give you an exact number but they are all in a better inventory position this year than they were last year. Obviously we get better at our business. We're able to look at more data on a consistent week-to-week basis than even we were able to do six months ago. So we really feel like we're in a great position. That, coupled with the year-over-year increase in sellthrough, we feel really good about where fourth-quarter is heading.

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the call back over to management for closing remarks.

Yes, thank you guys for your interest and support of Funko and we look forward to speaking to you guys again in the fourth-quarter earnings call next year. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.