Funko Inc (FNKO) 2018 Q2 法說會逐字稿

Good afternoon and welcome to Funko's conference call to discuss financial results for the second quarter 2018.

(Operator Instructions) As a reminder, this conference is being recorded.

On the call today from management are Brian Mariotti, Chief Executive Officer; and Russell Nickel, Chief Financial Officer.

I will turn the call over to Mr. Nickel to get started.

Please go ahead, sir.

Thank you, and good afternoon.

A press release covering the company's second quarter 2018 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 customer trends, growth, momentum and investment initiatives, collaboration and license relationships, 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 Factor sections of our Form 10-K for the fiscal year 2017 and our other filings with the SEC.

Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligations to update them.

Please also note, that we will be referring to certain non-GAAP financial measures on today's call, such as EBITDA, adjusted EBITDA, adjusted pro forma net income, adjusted pro forma earnings per diluted share and net debt, which we believe may be important to investors to assess our operating performance.

Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and in the Investor Relations section on our website at funko.com.

I will now turn the call over to Brian.

Thanks, and good afternoon, everyone.

Funko had another terrific quarter as we once again delivered strong top and bottom line results with continued positive momentum across the business.

Year-over-year, sales in the quarter increased 32% to $138.7 million.

Gross margin increased 120 basis points to 38.2%, income from operations was up 125% to $9.1 million and adjusted EBITDA increased 12% to $19.9 million in the quarter.

We believe our financial results are a reflection of our unique business model and differentiated products, which we believe are increasingly resonating with consumers around the globe.

We have established Funko as a pop culture platform with our Pop!

brand being seen as a unique form factor that pop culture fans instantly recognize and which is a medium for the expression of a wide range of properties.

We think of it as the Funkoverse, a world in which properties as diverse as the Golden Girls, Marvel, Harry Potter and Fortnite can coexist in a world of pop culture merchandise.

Our broad offering of licensed consumer products and collectibles continue to appeal to a wide array of fans across age, gender and income groups.

We are constantly leveraging our portfolio of more than 1,000 licensed properties to develop a steady stream of new products that we sell to a variety of retailers and channels and directly to consumers.

Our platform allows us to continually put out new products based on a steady stream of content.

Think of us as an index fund of popular culture and entertainment.

We don't have to be the one coming up with the hit ideas.

And although we don't bet heavily on just 1 or 2, we believe that based on our expertise we can better predict what hot properties will be.

And when something does get hot, we're usually the first ones to go to the IP holder and ask for a license.

Because we can bring product to the market so quickly, we are often the go-to-partner for products based on movies, TV shows, sports, music, books, video games, Internet sensations.

Just last month, we had another successful San Diego Comic-Con, and CNET posted a story with the headline "At Comic-Con 2018, Funko reigns as the unofficial king of pop culture." Once again, demand to get into our booth was extremely high.

For the second straight year, we held a lottery for our fans to get access into our booth.

Each year, we create exclusive products to be sold at Comic-Con.

And we make some of these products available through our retail partners.

This year, we created the same number of exclusive products as last year, yet our sell-through at our retailers was up over 30%.

Our annual fun days party this year at Comic-Con was a collaboration with Netflix and the cast of Stranger Things.

We put 1,500 tickets on sale through our website and they sold out in approximately 30 seconds.

So any way you look at it, we had a fantastic Comic-Con.

Let me review the 3 prongs of our growth strategy.

One, content, where we capitalize on the ever-growing range of IP; two, product, where we continually release new products and expand into new product categories; and third, distribution, where we were adding new retailers and growing our sales within existing retailers, both domestically and internationally.

On the content side, we continue to acquire new licenses in properties that provide us with new business opportunities and continue to fuel our growth.

In the second quarter, we increased the number of active properties sold by 26% and our sales per active property increased by 5%.

The top 10 performing properties in the second quarter of 2018 were Harry Potter, Deadpool, Avengers: Infinity War, Stranger Things, Disney Classic, Rick and Morty, Overwatch, Han Solo movie, It and Incredibles 2. It is interesting to note how much change there is among our top 20 properties each quarter.

Of the top 20 properties in the second quarter of this year, nearly half were not in the top 20 a year ago and some didn't even exist a year ago.

Although we have products tied to hit movies and TV shows, we are not a hit-driven company.

In the second quarter of 2018, no single property accounted for more than 6% of our sales and our top 10 properties accounted for only 38% of our total sales.

In Q2, about 45% of our sales came from evergreen properties, that catalog content that is not tied to a current movie, video game or TV show.

We are also very excited about 2 new licenses that we recently announced, Pokémon and Fortnite.

Our collaborations with the Pokémon company and Epic Games, respectively, are a testament to our strong relationship with great licensors, both new and established, who trust us to deliver their popular characters to their large fan bases.

We believe the property holders value our relationship because we can help them reach a broader base of fans.

We are very excited about the opportunity we see for these 2 properties, one of which has been popular for more than 20 years and another a relative newcomer that has taken the world by storm.

We see Pokémon as a great addition to our stable of our evergreen properties.

For 2018, we are planning a small rollout with a limited distribution to one retailer and look forward to an expanded relationship with Pokémon in 2019.

Fortnite is an immensely popular video game property that is relatively new and growing.

And we're excited as the property appeals to a broad demographic.

Even though we just recently announced the license, we expect that our speed-to-market advantage will allow us to have the product in the market in the fourth quarter of 2018.

I'll also point out another video game collaboration that underscores the strength of Pop!

brand.

In Q2, Microsoft announced the development of Gears Pop!, a new mobile game that combines its Gears of War game franchise with our look and feel where the characters in the game are Pop!-ified.

To us the most obvious example of something like this in the video game world is the series of video games based on the LEGO figures.

We are also very pleased with the response to our video shorts produced in our Funko Animation Studios.

Our licensing partners are increasingly interested in working with us by having their properties featured in our video shorts.

Our preorders often increase when we link video with new product offerings, which validates our decision to invest more in the production of short-form video content.

In all of 2017, our video shorts generated approximately 40 million views worldwide.

And in 2018, they've already generated over 90 million views with approximately 54 million views in the second quarter alone.

On the product side, we are very pleased with our results and we saw significant growth across categories in the second quarter with a 31% increase in figures and a 42% increase in apparel, accessories and others.

Within the figure categories, our worldwide sales of Pop!

Vinyl figures were up 33% in year 8. Beyond Pop!, we continue to broaden our offerings of figures.

We launched Vnyl.

last year, which continues to do well.

And more recently, we launched 5 Star, which are figures with several points of articulation allowing for more pose-ability and storytelling.

We continue to diversify our product assortment through category expansion.

With some retailers and many consumers, our Pop!

figures serve as an introduction to our product offerings.

Pop!

allows us to get on the shelves.

And when retailers see the velocity of the sales and the diversity of the SKUs and properties, it often inspires them to let us set up a Pop!

culture section in the store.

In essence, there are many retailers globally that want to get into the business of pop culture and Funko enables them to do just that.

As you are aware, the Loungefly acquisition provided us with the opportunity to expand into adjacent categories such as apparel and accessories, including handbags and backpacks, in addition to home accessories.

Since the acquisition, we've been working to improve alignment between Loungefly and the rest of Funko for a more coordinated assortment creating a robust pop culture statement across a wider array of properties in a more timely manner.

I will finish off our product overview by calling attention to our launch of FunkO's and Pop!

PEZ.

FunkO's is our take on cereal meets pop culture and collectables, which recently hit specialty stores.

Each box includes a miniature figure and the initial wave features more than a dozen pop culture properties, including Batman, Cuphead, It, Friday The 13th, the Golden Girls and many others.

To be clear, we're not going to be paying slotting fees to muscle our way into the cereal aisle at a supermarket.

This is just another way for us to leverage our relationship with major entertainment property holders to create a fun product that the fans of those properties will like.

FunkO's are merchandised as part of our in-store fun culture, pop culture destinations as well as being part of at-aisle opportunities.

Another great example of our take on consumables is the Pop!

PEZ, a collaboration between Funko and PEZ.

This is just another way that fans connect with these properties through our designs.

The response to both FunkO's and Pop!

PEZ has been very strong and the early sell-through has been very good.

On the distribution side, U.S. and international retailers continue to look to us to offer a growing assortment of curated products that resonate with their consumers.

In the second quarter, our U.S. sales increased 33% as we continue to benefit from expanded shelf space with many of our existing retailers.

Some retailers have allowed us to expand into multiple departments beyond the toy aisle, including Target, where we've already expanded, and Walmart, where we are in the process of expanding.

We remain excited about the continued growth opportunities in our U.S. business, and we are working closer than ever with our retail partners to better capitalize on the continued proliferation of content.

We have just begun working with third-party merchandisers to manage shelf placement, which has some cost but should improve sell-through and in stocks.

While we continue to see strong growth through traditional retail channels, our sell-through on online retailers has also seen strong growth.

Year-to-date, our sales through third-party e-commerce sites are up over 75%, more than twice our overall growth rate.

And third-party e-commerce sales account for a growing portion of our total sales.

Internationally, sales outside the U.S. have increased by 32%, driven by growing demand for our products combined with increased globalization of content.

As planned, we invested in the ERP system and rolled out a 3PL operation in Europe during the second quarter to improve our visibility and scale.

As so often happens with these system rollouts, we have had a few issues, which we're working through.

We anticipated this, which is why we pulled forward some sales into the first quarter.

In part because we pulled forward these sales, European sales were up over 170% in the first quarter and 38% in the second quarter for a total increase of 93% in the first half.

These system implementations are critical to our ability to grow and scale to meet the increasing demand in Europe.

And we plan to continue making investments in our international markets to build the infrastructure that will support what we believe will be meaningful growth for years to come.

We are still under-indexed in the number of markets such as Latin America, Canada and Asia where we believe we have long-term growth opportunities.

These investments will include areas such as sales, operations, systems, and logistics and are factored into our guidance.

So in summary, we are very pleased with our performance this quarter, the underlying trends in the business and the progress we continue to make against each of our growth strategies.

Based off the continued strength of the first half of the year, we are raising sales and adjusted EBITDA guidance for fiscal 2018, which Russell will discuss in more detail.

Before I end, I would like to thank our entire team, licensors and retail partners for their continued support that has contributed to our success to date and will drive our success going forward.

As always, a special thanks to our amazing and engaging fan base whose passion and excitement is what motivates us each and every day.

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

Thanks, Brian, and good afternoon, everyone.

Our strong second quarter results were broad-based with continued positive underlying trends.

Net sales in the quarter increased 32% to $138.7 million and were driven primarily by the continued expansion of products and properties within our portfolio.

In the quarter, the number of active properties increased 26% to 510, and net sales per active property increased 5% to $272,000.

On a geographical basis, net sales in the United States increased 33% to $97.1 million and net sales to all foreign countries increased 32% to $41.6 million.

As expected, with the implementation of a new ERP system in the U.K., and the rollout of the 3PL operation in mainland Europe, sales and operations were impacted, which is why we proactively pulled forward the approximately $5 million in shipments into Q1.

On a product category basis, net sales of figures increased 31% to $114.5 million, and net sales of other products such as bags, accessories, apparel and homewares increased 42% to $24.2 million.

We saw continued strength with our Pop!

brand with sales of Pop!

Vinyl figures increasing 33% on a global basis.

We believe it is noteworthy that in its 8th year, our largest brand, Pop!

Vinyl figures was up 34% in the U.S., which is our most mature market, indicating just how much the brand is able to be refreshed and kept relevant by infusing it with new content.

Our sales growth through e-commerce channels, which includes online-only retailers as well as some of our e-commerce divisions of our brick-and-mortar retailers, continues to outpace our total sales growth.

We saw third-party e-commerce sales on a global basis grow 63% year-over-year during the second quarter and these sales accounted for 16% of our total sales in Q2 of this year compared to 13% in Q2 of last year.

Please note that some of our retailers buy from us in a way that doesn't separate out the e-commerce portion so the actual e-commerce total as a percent of sales is likely somewhat higher than the figures I just cited.

The point here is that e-commerce is a growing and increasingly important part of our business, and we expect to see strong growth continue from this channel.

Gross margin, which excludes depreciation and amortization, increased 120 basis points to 38.2%, driven by more favorable product cost in Europe, which includes a positive impact of the inventory step up from the prior year acquisitions and which more than offset higher royalty expenses due to the mix of properties sold within the quarter.

In the quarter, selling, general and administrative expenses increased 33% to $34.2 million from the prior year.

The majority of the increase was driven by growth in the business as well as incremental investments associated with strategic initiatives, including our direct distribution model in Europe and other international markets, our Loungefly operations and Funko Animation Studios.

Looking at the company as a whole, the biggest areas of increase were personnel and commission expenses, which increased $5.9 million and were driven by the build-out of our sales, operating and administrative teams worldwide, and facilities and rent, which increased $1.7 million, primarily from new facilities in Europe at Loungefly and at Funko Animation Studios.

Depreciation and amortization expense in Q2 increased 27% from the prior year to $9.7 million.

The majority of the $2.1 million increase was from higher depreciations on mold and tooling costs as we continue to expand our product offering and our leasehold improvements at our corporate offices and warehouse facilities.

Net interest expense decreased 27% to $5.6 million from $7.7 million in the second quarter of 2017 due to lower debt levels and lowered rates obtained from our lenders in Q1 of this year.

As a result of these factors, adjusted pro forma net income improved to $3.5 million, compared to $1.6 million in Q2 of 2017.

Adjusted pro forma earnings per diluted share was $0.07 and adjusted EBITDA increased 12% to $19.9 million.

Touching on a few balance sheet highlights.

We ended the second quarter with net debt of $237.6 million compared to $226.2 million at the end of 2017 and $326.3 million at June 30, 2017.

Inventory was down to $63.6 million versus $79.1 million at year-end 2017, but up 10% compared to $58 million on June 30, 2017.

It's worth noting that this increase year-over-year was much less than our sales growth and recall that inventory at the end of the first quarter was up 40% over the prior year, which was more than the corresponding sales increase.

For the first half of the year, our sales are up 35% compared to the first half of last year and inventory at midyear is just 10% above last year.

As we've said previously, the fast fashion nature of our business and the shift to a more just-in-time inventory model by some of our larger retailers has shifted some inventory burden onto our balance sheet.

We continue to work with our large retail partners to improve in stock and inventory productivity levels at retail and are investing in systems and processes that we believe will help us improve our inventory turns over time.

Turning to our 2018 outlook.

We are raising our guidance given our strong first half performance.

We now expect net sales of $620 million to $630 million compared to prior guidance of $595 million to $615 million; adjusted EBITDA of $104 million to $112 million compared to prior guidance of $100 million to $110 million and adjusted pro forma earnings per diluted share of $0.60 to $0.70, which assumes a blended corporate tax rate of 25% and a weighted average diluted share count of 53 million shares.

The assumed share count is 1.9 million shares higher than our prior guidance due to the recent incentive stock grants and the impact of the increase in the stock price since the beginning of the year on the treasury method of EPS calculation.

This compares to our prior guidance of adjusted pro forma earnings per diluted share of $0.60 to $0.71.

Looking at the quarterly sales progression for the second half of the year, we continue to expect our year-over-year sales growth to decelerate on a sequential basis as the year progresses.

The biggest factors influencing these are: the comparison against Q4 of 2017 when the acquisition of Underground Toys caused sales to increase; the fact that the first half of 2018 saw a greater year-over-year sales increase from the pipeline fill at new retailers, primarily in Europe; and the second half of 2017 benefited from the addition of Loungefly sales, which was acquired in June 2017 and has now been anniversaried.

We will continue to make investments in key areas of the business to position us for long-term sustainable growth.

Along those lines, we expect the rate of investments to decelerate as the year progresses and anticipate that we will begin to leverage operating expenses late in 2018 and into 2019.

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

(Operator Instructions) Our first question is coming from the line of Steph Wissink with Jefferies.

We have 2 questions.

The first one, Russell, for you is just on the third-party fulfillment partner, the company you are using to help with retail level restocks.

Can you just help us know where that flows through the P&L?

Is that a cost of goods expense or does that hit you in the SG&A line?

And how should we think about the terminal value of that over time, do you -- is it a contract over the course of years or is it based on performance stipulations?

How should we think about that agreement?

So it hits in the SG&A.

It's part of our sales and general administrative expense, it's a sales expense.

And then it is a contract over a 3-month period of time that will then turn into a month-to-month.

Okay, that's super helpful.

And then the second question is just with respect to leverage on the business.

I think you mentioned in your closing remarks, kind of operating expense leverage in the back half of '18 and into '19.

Are you seeing any areas within the business today where you're seeing signs of some of that early leverage, and maybe if you could just help us pointing those out.

And where we should start to see the leverage first as we get to the back half of '18 and then how you see it progressing into '19?

Yes.

I mean, I think ultimately, if I'm understanding your question, it's going to come from the sales and general administrative expense.

First and foremost, with the headcount.

Really since we were acquired in 2018, we've been making substantial investments in personnel on a worldwide global basis, including the acquisitions that we made throughout the course of last year.

So I think you're going to see leverage really coming from headcount going forward.

Okay.

Great.

Then the last one for us is just with respect to, Brian, your comments on the amount of velocity in the portfolio of top selling properties.

Do you think you could just talk a little bit about some of those that tend to be evergreen?

How we should think about the evergreen contribution over the course of the next maybe 6 to 12 months?

Do you expect it to kind of stay in that 45% to 50% ratio?

Yes, Steph.

It has been amazing how consistent it has been over the last 7 years.

40% to 45% always seems to hit.

I think, what did we end up?

45% in Q2.

And if you look at our top 10, Potter was 1 and Disney Classic was 5. So just 2 great examples of how we can take something -- the Disney Classic one is a great example.

We built a huge program around Hercules, which just -- there was no anniversary, there was no rhyme or reason why we built a program around that specific movie, but it resonated, it took off and the numbers were fantastic.

So, we believe that the track record over the last 7 years speaks really loudly in terms of evergreen content.

We feel that based off the Potter strength the last 3 years, last 2 big Star Wars movies, Episode VII and Episode VIII, we've outsold with Star Wars: Classic in both those years.

I don't think we see anything changing.

A continued dedication to making sure that we take everything that's topical and hot and trendy and leverage against it and then fill in all the cracks with the evergreen content.

So yes, we see no change in that model going forward.

The next question is coming from the line of Mike Swartz with SunTrust Robinson Humphrey.

Brian, just a question for you around proprietary properties, non-royalty bearing.

I think you said longer term this is one of your strategies to grow the business.

Can you give us a sense of maybe how big those proprietary properties are now and maybe do you have a target in mind longer term?

No, look, Mike, great question.

It's certainly something that's a focus for us.

Wetmore Forest is our first true series of characters where there is some storytelling elements behind and there's an actual process on how to bring these things to market.

It's still relatively small.

We have had over the years some of Funko's own creations in our Pop!

line and our Spastik Plastik line.

Both of those have done very, very well, but this is still very small and less than a percent of our business right now.

But I think it's something important when you have 85 to 90 world class artists sitting at our headquarters, they all have voices, they all have ideas.

They oftentimes take their work home with them and come up with great characters that we would be foolish not to leverage those ideas and those concepts.

So I think you're just going see a greater amount of time dedicated to looking at opportunities in developing our own IP.

We still view our lines like Pop!

and Dorbz and Rock Candy and Vynl.

and 5 Star as kind of our own IP layered over our licensors' IP.

But certainly when it comes to these new proprietary designs, it's definitely a way for us to incubate new lines and bring them into specialty and grow them accordingly.

And then just second question.

With regards to the new Fortnite and Pokémon partnerships that you announced during the quarter.

Could you help us understand, maybe, was that predicated in your prior guidance and maybe how much of that went into the guidance raise that you're announcing tonight?

No, it wasn't.

I mean, it just Funko being Funko.

Our -- obviously, we identified Fortnite quite a while ago and worked very, very hard.

We'd probably tell you the we're the first ones to approach them on the license.

These things take a little bit of time.

But no, they did not factor into our guidance previous to this call.

They did.

We were anticipating having those licenses in the guidance that we had have given.

Yes.

Going forward.

Going forward.

Look, I think it's one of those things that -- the idea how Funko operates is absolutely going to be finger on the pulse of everything that moves pop culture.

And when we put out our guidance even at the beginning of last year -- or tail end of last year, we're always anticipating that we're going to pick up whatever is next, it's new and it's hot and that's just part of our strategy always going forward.

Our next question is coming from the line of Erinn Murphy with Piper Jaffray.

I guess, first I would love a little bit more detail behind North America; it was very strong dollar growth.

And I recognize you had a bit of easier comparison year-over-year.

But if could you just maybe update us on how the progress with Walmart's repositioning in terms of where you are showcasing product in the store.

I know you talked a bit on Target, but then are there any new accounts that you're starting to work with in a little bit more of a forward fashion in the quarter?

That's a good question, Erinn.

First and foremost, those are fantastic numbers considering the Walmart migration from one area to another that's going to happen in tail end of Q3.

So we're obviously very excited about our North America growth.

Obviously, we are seeing a significant amount of increase in our third-party e-commerce business.

And obviously, there's a couple of major retailers that are e-tailers that have done phenomenally well over the last couple of years, and they're growing exponentially for us.

Again it's the same model, just coming out with additional shelf space to create programs, whether it'd be at Hot Topic or BoxLunch or FYE or GameStop or Walmart or Target, just trying to find interesting ways to put out pop culture statements.

But I definitely think that considering where we are at for the first 2 quarters and knowing the transition from Walmart into we think a much bigger space come Q3, we're excited what North America looks like going forward.

Okay.

That's helpful.

And then on Europe, you talked a bit about the European implementation during the quarter.

It sounds like you had some hiccups; a lot of those were anticipated, though.

As we look into the back half, how should we think about the international growth from here?

Does it start to stabilize in kind of where the most recent quarter was?

Does it pick up a little bit?

Just any help on kind of where you're at with working through some of the system implementation?

Yes.

So I mean, with any ERP system that anybody's going through there are going to be hiccups, they were anticipated, there was process as well as technology just -- it was a lot of process change for the organization.

So as we work through this, we're seeing tremendous demand throughout Europe and really the rest of the world.

Over the rest of the year or for the year, I should say, that we still are anticipating that 45% to 50% growth rate for Europe and then 18% to 20% for the rest of the world.

So you are going to start to see because -- you are going to start to see in Europe in particular, growth really normalize around where we were at the -- where we were in Q2.

As a reminder, we acquired Underground Toys in January 2017.

We began to ramp up those sales.

And now in Q3 and Q4, we're going to be seeing -- comping that ramped up channel fill and growth.

And so that's why you're seeing the overall growth rate in the second half of the year normalize around the 38%.

Okay.

That's helpful.

My last question is for Brian again.

You talked about in your prepared remarks just really strong engagement you're seeing with these video shorts.

How do you think about like monetizing and the fact that you're getting 90 million views kind of in this year-to-date period?

How do you monetize that over time and what are the opportunities that you guys are working on?

It's a great question.

I think the one thing we've done is obviously -- for our strategy for the second half of this year and all of 2019, it can be really simple.

We're going to look at all of the big programs, the big beats, whether it's television or movies, for example, Avengers: Infinity War, Frozen 2, Star Wars Episode 9. That content is going to basically coexist along with these big retail programs.

What we see in that is an ability to take that content and have our retail partners share it on their websites, in stores like a lot of stores are doing in Europe.

And add on a final slide to the animation where they're showing their exclusive content.

The way to monetize this is just purely simple.

The videos are so engaging and they get so many viral views that we're exposing people to these really cute whimsical products that may have not seen them before.

We also see that social media increases sometimes fivefold when we put the video content in versus just pictures and sometimes up to a threefold increase in preorders.

So we obviously acquired Funko Animation Studios for a reason.

We love the ability to kind of grow that business and now give them an ability to align with our big opportunities for retail.

And then also to continue to incubate the Wetmore Forest and some of our lines like Vynl.

and 5 Star where we can use that medium as well to basically garner more attention to some of our newer product lines.

Our next question is coming from the line of Mike Ng with Goldman Sachs.

I just have a few.

First, could you just talk about what your expected revenue contribution is from Pokémon and Fortnite in 2019?

And can you help us understand the thought process behind having a limited release in 2018 with only one retailer?

And also did you consider pursuing a master toy license for Fortnite ?

Mike, all good questions.

Russell's saying least over $10 on the Fortnite business.

So we know it's going to be above $10.

Let's start with a bunch of those questions.

One, look, we explored a lot of different opportunities with Fortnite.

But I think where we ended up is where we thought we would have the best chance to succeed, which is really what is truly in our core, which is fun, whimsical pop culture products that aim for all 4 quadrants, adults and boys and girls.

So I think we're really happy with where we landed with that.

And obviously, we think that there is going to be a great business to be had with those guys over the years to come.

Pokémon.

it's been a long time in coming.

We've been working with them for a very long time trying to obtain a license.

We finally got it and it's a slow burn.

It's going to be just with 1 retailer this year.

But we obviously feel like there's been dialogue to increase what we'll be making in 2019.

So I think that both of those licenses are -- obviously, we're very excited, but we're also tempering expectations for 2018 based on the limited amount of Pokémon products and obviously Fortnite setting in fourth quarter alone, but really glad that both those are part of our new stable.

I would just add a couple of things.

One, again, as we look at 2019, as we expect and as we look, we are not a hit-driven organization.

Typically, no individual property accounts for more than 10%.

Again, the Fortnite, the Pokémon, Harry Potter, these are licenses -- these are things that we do.

This is in the very core DNA of what Funko is.

And so it's just an opportunity to continue to put out products around properties that people are a fan of.

And just to clarify, we have been in long conversations with both Pokémon and Fortnite going out through the course of really most of 2018 and so when we provided that earlier guidance for the year as overall, we were anticipating these licenses or licenses similar to these.

Okay.

Great.

And you mentioned that Target has already expanded some shelf space for Funko and Walmart is in the process of doing that as well.

I was just wondering, could you just elaborate on that a little bit?

When is that happening and what is Walmart actually doing?

Yes.

So Walmart is migrating, primarily, from the toy department over to the DVD entertainment department.

And that's going to be a shift that closely mirrors the success we've had over the last couple of years with Target.

We're excited about that, that's going to afford us more shelf space with them certainly than what we had in the toy department.

And I think that is -- it's basically a way to continue to grow the business.

Some of our properties are going to still stay in line like Five Nights at Freddy's where they're much more toy-etic with Walmart and also with Target.

Target's just continuing -- we're just continuing to garner shelf space in a lot of different areas and continuing to grow the business with a lot of different adjacent categories as well with apparel and accessories and the Loungefly categories.

And we continue to control a little bit more shelf space with Target because our products are working with such velocity.

So obviously, both of those retail partners we're very excited about the second half of the year and going forward.

But I think it's a really big win for us with Walmart to see the migration of the more collectible products moving to the DVD entertainment section.

Okay.

And my last question is just on taxes.

You mentioned there is a 25% corporate tax rate.

If I remember correctly, I think the cash tax rate, if you include the tax distribution to members, is a bit higher.

Can you just give us your latest thoughts on what that cash tax rate would be including those tax distributions?

And what was the free cash flow in the quarter post-tax distributions to members?

Yes.

As it relates to the tax distribution, our LLC agreement has the cash tax distribution going out at 42.9% of the allocated taxable income.

That is a reduction obviously with the changes in the tax law.

As far as the free cash flow in the quarter, I don't have that in front of me and I'd have to get back to you on that.

Our next question is coming from the line of Christopher Horvers with JP Morgan.

So a couple of follow-up questions there.

Trying to put some guardrails around Fortnite and Pokémon.

If you look back, I think, Five Nights at Freddy's was $60 million in 2016 and I know you talk about, historically, not more than 10% of sales is one platform, but that exceeded 10%.

And clearly, those 2 brands are much more recognizable globally as you mentioned.

So, why wouldn't each one of those brands as we think about on a full run rate exceed that $60 million from -- that you saw with Five Nights at Freddy's in 2016?

Chris, I think it's a good analogy you're using.

And I think that Fortnite is an interesting property.

The game is based on skins.

And they're not necessarily based on characters, like in Overwatch they have defined characters with defined personalities and there's an actual attachment to those characters.

So I think everybody is going in with a ton of hope that Fortnite is the next great property.

We believe in it, we love it, we love the character skins.

But it's one of those things that's just going to have to prove itself out.

Obviously, we think there is going to be good business there, but can it be phenomenal business?

I don't think we're ready yet to make that jump or leap yet, because we certainly didn't see that with Five Nights at Freddy's either.

It's one of those things that just took off.

Pokémon is still going to be a -- it's going to have a cadence to how we release products.

I mean, we're obviously just a few products in '18, there is going to be -- we're going to grow off of that in '19 and we're just going to have to see.

But I can tell you right now that you can definitely count on us not releasing 10, 20, 30, 40 SKUs of Pokémon in 2019.

I think it's going to be more of a definite jump from '18 to '19, but we're not going to be releasing the free world supply of Pokémon.

We're going into that relationship gradually.

We're excited about that relationship.

So I think both of those, you could think that these could be epic numbers.

I think certainly with Fortnite that there is definitely a possibility there in '19.

But we're just going kind of play it by ear, put out great products, monitor it.

If we see something that looks like it's really starting to resonate, I mean obviously, we'll keep you guys in the loop.

One of the other big differences, Chris, is you also have to recognize that Five Nights at Freddy's was really a master toy license and really our first foray into a master toy license.

So we had a much broader array of product categories that we could produce against that we don't have either Fortnite or Pokémon.

And to follow up, Brian.

So it sounds like you are -- if you had to say, just magnitude, how much bigger do you think the Fortnite potential is versus say a Pokémon, at like a full Pokémon run rate understanding that you're going to bleed this out over time?

I don't know.

I wish I did.

I wish I could tell you.

I think Pokémon is going to be a very, very strong license as we continue to grow the breadth of SKUs there.

Fortnite, look, there is going to be some competition in the space.

I think Russell's point is really well spoken.

As a master toy license you're afforded more things like with Five Nights at Freddy's than we will be with just being one of their partners.

But I can tell you right now, the good news about us and as we continue to grow as a company, get smarter about doing business is we get monitor the sell-through.

And when you monitor that sell-through on a week-to-week basis with our top 15, 20 customers, we're going to get a really good read on how Fortnite is resonating.

And we believe we might be the first guys out with product in the 3-dimensional form for fourth quarter.

We're definitely going to be able to take that those lessons learned, those sell-throughs and begin to formulate what 2019 look would like with Fortnite.

Well if my son's Fortnite playing is any indication, then this should be a huge, huge hit.

And just a couple of follow-ups.

So can you talk about -- Russell, can you talk about how large Underground Toys and Loungefly were in the back half of last year, dollars-wise?

Dollar-wise.

I have to get back to you on specific numbers.

Overall, Loungefly, when we acquired them they were doing about $20 million a year in business for the year.

So it would be as we were ramping that up, it would probably be in the $10 million range.

And then Underground Toys, we saw a ramp -- there was a strong growth really in the second half of the year.

So we were looking at probably about $50 million or $60 million in revenue coming from Underground Toys or really I should say Funko U.K. in the second half of the year last year.

Okay.

And then last one.

You talked about -- I think in the last call you talked about 39% gross margin as sort of the long-term stable target.

You are below that.

Was there something unique to this quarter or when do you think we build to that gross margin rate?

I think really as I've said, we're going to get to the gross margin rate probably beginning on a steady basis in 2019, early part of 2019.

Part of what drove the lower gross margin this year was just really the property mix of what we sold.

When you look at our top 10, there is a number of properties that have a higher royalty rate.

And so we are trending above that.

Our next question is coming from the line of Gerrick Johnson with BMO Capital Markets.

2 questions.

First, can you talk about the POS or retail sell-through in the second quarter?

And second, maybe a little discussion on the economics of Gears Pop!?

Gerrick, it's Brian.

Thanks for the question.

I can tell you that if you take the anomaly of the business moving from Walmart toys to transitioning over.

We are in the high-teens with sell-through continuing to really be excited about not only the sell-through rate, but the inventory levels of all of our key retail partners.

We're, again, seeing a lot of really, really good trends when it comes to the appetite for the product, the in-stock for the product and the sell-through for the product.

The second question?

Y.

Yes.

As it relates to the Gears Pop!, we are not really anticipating substantial monetization as it relates to that.

The way Microsoft is developing this, they have licensed the Pop!

IP, the Pop!

brand, which really I think just highlights how much that IP, that brand, that platform resonates on a global basis.

But it's not really -- we're not anticipating a lot, but it is a royalty base coming from Microsoft.

The next question is coming from the line of Drew Crum with Stifel.

So Brian, I wonder if you could talk about or characterize the pipeline in terms of new licenses or adding new licenses as you look out over the next several quarters.

Obviously, you added 2 big ones -- or announced 2 big ones back in July.

But how would you characterize the pipeline of new licenses over the next couple of quarters?

Drew, thank you for not asking me a Fortnite question.

We are, obviously, very excited.

Look, I tend to go -- with my geekiness and finger on pop culture, I tend to go by looking at licensing years.

And I would tell you 2017 in my mind was an A-minus, really, really strong licensing year where '18 wasn't as strong, I think it's more of a B, B-plus.

2016 was more like a B, B-minus.

I will tell you that I'm personally excited about what 2019 looks like.

If you look at Frozen 2, Star Wars: Episode 9, the Avengers: Infinity War sequel, Captain Marvel, there are just some -- the Wonder Woman sequel and you add in Stranger Things and finale season of Game of Thrones.

I think you're just looking at a ton of fantastic content going in.

New content is like anything else.

We are -- our finger is on the pulse, our ear is on the ground.

We are always looking for new ways to monetize.

There's a ton of anime licenses that are continuing to do very, very good business.

We continue to back catalog as much stuff as we possibly can.

When it comes to music, K-Pop bands, video games.

We're looking at back catalog stuff for more evergreen content.

We are building programs around.

I think that everything we're interested in, there is some sort of state of negotiation for new licenses.

But also you couple that with the theatrical, the video game and then yes, I think we're very, very excited about what 2018 and 2019 looks like.

Okay.

Very good.

And then you mentioned video games, looks like a very strong slate for the second half of this year.

I would think that at the very least that the increased traffic through GameStop helps your business.

But can you remind us what exposure you have to some of the big titles that are launching on console this Fall.

I wouldn't say exposure.

I think that we're obviously leveraging some of the most popular ones on the planet right now.

Obviously, Overwatch has continued to be a strong license for us for the last couple of years, and we'll continue to grow that relationship.

Obviously, Fortnite.

Fallout 76 is a new title that we're very, very excited about.

Yes, those are the 3 big ones, I think, we're the more excited, we're going to put the most products to.

But like anything else, with looking at sell-through, indications of interest on orders.

We never get ourselves in an over-inventory position when it comes to those video games.

We're really watching the level of interest and the indications of interest to make sure we get those decisions made right.

But those are 3 great ones that we're obviously going to build a lot of business around.

Okay.

I didn't realize you had Bethesda.

That's helpful.

And then just a housekeeping item, Russell.

The -- I know it's small but the D&A picked up sequentially, just below $10 million.

Is that kind of a good quarterly run rate to think about going forward?

Yes.

I think, I think the tick-up is just as we continue to grow and we continue to put out more products, we're continuing to invest in mold and tooling and that's what you're seeing that really -- that's what's really driving that number.

We have reached the end of our question-and-answer session, so I would like to pass the floor back over to Mr. Mariotti for any additional concluding comments.

Thank you for your interest and support of Funko and we look forward to speaking to you guys again in the third quarter earnings, if not sooner.

I hope everybody have a great day.

Thank you.

Ladies and gentlemen, this does conclude today's teleconference.

We thank you for your participation, and you may disconnect your lines at this time.