Funko Inc (FNKO) 2018 Q4 法說會逐字稿

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

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

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

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

Please go ahead, sir.

Thank you, and good afternoon.

A press release covering the company's fourth quarter and full year 2018 financial results was issued this afternoon and a copy of that press release can be found in the Investor Relations section of 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, expectations regarding 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-Q for the third quarter 2018 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 note that we will be referring to certain non-GAAP financial measures on today's call such as EBITDA, adjusted EBITDA, adjusted EBITDA margin, 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 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.

We have also prepared a visual presentation that investors can consult to follow along with this discussion, and it can be accessed in the Investor Relations section of our website.

I will now turn the call over to Brian.

Good afternoon, and thank you for joining us.

On the call with me are Russell Nickel, our CFO; and also Andrew Perlmutter, our President.

Funko just announced another great quarter that kept a fantastic 2018.

Net sales in Q4 were up 38% to $233 million and that put our full year sales at $686 million, up 33% over 2017, which greatly exceeded our expectations.

Our top line growth has significantly exceeded the growth targets we set when we went public in late 2017.

We are seeing stronger-than-expected demand for our products and the property that they represent, both domestically and internationally.

In fact, our 2018 sales exceeded the 2019 sales consensus estimate established immediately after our IPO.

We have beaten and/or raised guidance every quarter since we went public, and we are even more bullish for 2019, guiding to 18% to 20% top line growth year-over-year.

We're going to review many of the ways in which 2018 was a phenomenal year, but here are some highlights.

We completed our first full year as a public company with the stock far outperforming in the broader markets and the traditional toy companies in the year.

We made sales to thousands of new stores and markets all over the world, and so our domestic business grow 30% and our international sales rise 58%.

We successfully integrated 3 acquisitions that we made in 2017, including Loungefly, which more than doubled their sales.

And we refinanced our credit facility, slashing our interest cost, producing an annualized cash savings of over $6 million per year going forward.

Andrew and Russel are going to take you through more of the details of our Q4 performance and our growth expectations.

But I want to start by telling you that not only that our sales exceed our own optimistic estimates, but demand for our products was so strong that it strained some of our operations.

We consciously made spending decisions to achieve growth and expand our reach in the market as a whole, knowing it would depress our margins in the near term.

As you might expect, meeting this stronger-than-expected demand required us to incur additional cost.

It also strained our fulfillment capabilities, both domestically and in Europe, which led to significant increase in customer noncompliance chargebacks during the quarter.

Both of these factors impacted our margins, but allowed us to fulfill our customers' demand, and more importantly, satisfy our fans.

I want to emphasize that none of the actions we took in Q4 were the result of unusual discounting on our part or a sign of slacking demand.

Quite to the contrary, through the entire quarter, demand for our products exceeded our expectations and our plans.

We see so much opportunity to enlarge our market that we plan to pursue sales growth aggressively again in 2019.

We're not managing for margin percentage, we're managing for continuing to dominate and enlarge this market.

We intend to be disciplined about the investments we make, but we also intend to make those that we believe are needed for the long-term growth opportunities in front of us.

It was this mindset that enabled us to increase our sales 150% over 3 years from $274 million in 2015 to $686 million last year.

Keeping up with this kind of growth is challenging, but we have shown our willingness and commitment to do so intelligently, and that will continue.

Licensors continue to look to Funko first as a way to connect their IP with their fan base.

Retailers on a global basis are looking to us to continue to drive traffic and engage with their customers and our fans.

To capture this high global demand that we are seeing and address some of the pressure points in 2018, we are planning to invest further in diversifying our product offerings, creating new avenues through which our fans can experience pop culture, most notably the expansion into the board game category with the acquisition of Forrest-Pruzan Creative, which Andrew will discuss later.

Our brand, including opening a retailtainment store in Hollywood, given the overwhelming success of our HQ store in Everett, Washington and continuing to enhance our branding and brand placement of retail.

Our direct-to-consumer strategy, including continuing to enhance and expand our e-commerce capabilities and our planning capabilities, including refining our internal go-to-market strategy and process.

And finally, our fulfillment capability, including improving our distribution network in the U.K. as well as systems and processes in both the U.S. and U.K.

As I said earlier, our approach to 2019 is to go for the growth even more aggressively.

We are guiding 18% to 20% sales growth this year, higher than the midteens growth rate for 2019 that Wall Street is currently projecting.

This higher growth guidance comes on top of sales that came in much higher than expected last year.

So we're not only raising the growth target, we're doing it on top of a higher base.

Our ability to guide to a higher level of growth in 2019 is a function of several factors.

We see the increased momentum behind the Funko brand on a global basis.

Our growth last year showed us we are -- where there are even more opportunities in front of us, including more international opportunities, growing our space with the existing retailers, more product categories we can expand into that connect people to what it is that they are a fan of.

We have a massive army of licenses combined with diversity of product lines and a fast-fashion approach to getting them into the marketplace at lightning speed.

Add to this, the constant proliferation of new content from movie studios, TV studios, streaming services like Netflix, video game publishers, new sports stars, music icons and our growing library of evergreen content, all leading to a growing base of properties that we can leverage.

2019 is looking like an A+ content year, including an above-average number of big tentpole entertainment properties such as Captain Marvel, Avengers and Game, Toy Story 4, Frozen 2 and Star Wars Episode 9.

In TV, we have new seasons of Game of Thrones, Stranger Things and Rick and Morty.

And in the video game area, we have a full year of Fortnite in 2019 as well as Kingdom Hearts and the continued strength of Overwatch.

We're also seeing great traction with sports and music as a part of our offering.

Among the new products we released just before Toy Fair New York, the top sellers in Amazon pre sales were BTS and Post Malone.

And Michael Jordan and Lebron James special edition Pop!

Vinyls.

Since Funko creates a large portion of retail programs in some of the top retailers around the world, our ability to create programs with many different types of products is an opportunity we did enjoy a few years back.

Retailers look to us to help create demand and drive traffic by giving us expanded placement with different product categories.

This position is a significant reason why we've been able to drive our high sales growth and why we're excited about the opportunities in front of us.

In summary, we had a great year and a terrific fourth quarter.

Our strong performance in Q4 and the full year validates the power of the Funko brand and the market we believe we have created and continue to expand.

We expect the investments we are making to improve our operations and enlarge the market to pay off nicely in 2019 and beyond.

Before I end, I want to thank our entire team, licensors, 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 every day.

With that, I will now turn the call over to Andrew Perlmutter, our President.

Andrew?

Thank you, Brian.

As Brian said, we're coming off a better-than-expected fourth quarter, which caps off a terrific year for Funko.

I'm going to focus my comments on what we did last year to drive sales growth and what we're doing this year to keep the momentum going.

In 2018, our growth was balanced and came from multiple sources, including an expanded base of properties, new product categories, sales growth at existing retailers and continued expansion and growth of our international retailer network.

We had significant growth in the U.S. and internationally, and all of our international markets showed growth.

We expect these factors to continue to be key drivers of our growth over time.

The cornerstone of our growth is the continued expansion of entertainment content across properties.

In Q4, we sold against 583 active properties, which was up 34% from Q4 2017.

As we said before, we expect this number to grow over time as the proliferation of content continues and we broaden our license portfolio.

In the fourth quarter, not only did we increase the number of active properties, 34%, but we were also able to grow the sales per active property by 3%.

Our business is not dependent just on newly released content.

In Q4, our top 10 best-selling properties were as usual a mixture of new properties and evergreen and accounted for about 38% of sales in the quarter, around the same percentage as last year.

Those top 10 properties in the quarter were: Fortnite, which accounted for about 12% of sales; Harry Potter, Avengers: Infinity War, Marvel Studio's tenth anniversary; Stranger Things; Overwatch; Star Wars Classic; Mickey Mouse; Dragon Ball Z and The Nightmare Before Christmas.

The fact that Fortnite, which the Washington Post called the biggest pop culture phenomenon of 2018, accounted for only 12% of our Q4 sales and 5% for the year, showcases how Funko is like an index fund of pop culture.

The property is important, but it's just one of many in our portfolio.

Evergreen properties accounted for about 46% of our sales in Q4 and 47% for the full year.

Again, this shows that we are not reliant on a small number of hits nor we reliant on only new content.

As we say, everyone is a fan of something.

And as we expand our offerings, we would expect to attract new fans into the Funko verse.

Since our founding in 1998, the backbone of our sales has been our Figure business, and we continue to see strong growth in that category, even as we continue to expand into new categories.

Growth sales of Figures overall, including Pop!

Vinyl were up 38% for fourth quarter and 33% for the year, right in line with our overall top line growth.

For the year, Figures accounted for 82% of total sales, the same as in 2017.

Our figure line for platform Pop!

Vinyl is in its ninth year and was up 48% in the fourth quarter and almost 39% for the year.

Our growth sales of other products grew 37% for both the quarter and the year, with our fastest-growing categories outside of Figures being apparel, bags, wallets and accessories, all of which grew faster in 2018 in our total sales.

Funko's customer diversification continues to be one of our key strengths.

No single customer accounted for more than 9% of our total sales in either Q4 or the full year.

On the digital side, we continue to grow third-party e-commerce sales at a substantial rate, which supports the facts that our products resonate online.

Our third-party e-comm sales were up 31% during the fourth quarter compared to last year and accounted for nearly 17% of our total sales.

For the full year, e-commerce sales were up nearly 45% and accounted for 15% of our total sales.

As we continue to improve and grow our B2C business, we expect to see some gains in 2019.

Ultimately, our goal is to make our products available and accessible wherever and whenever our fans want them.

As part of the company's strategy, to make our products accessible and build out our customer experience, we are excited that we have redesigned our beta app, and we'll be relaunching it with the most up-to-date Funko products past and present.

This mobile app was developed in response to our fans' feedback.

It brings tools to the community so they can explore the most extensive Funko catalog of products, track their collections and find which retail partners carry the items they are searching for.

We expect this redesigned app to launch in the next few months.

To start 2019, Funko has already had a busy trade show season, attending Toy Fairs in Hong Kong, London, Nuremberg and New York.

We leverage these events to announce new products, create points of engagement with our fans and meet with retail partners.

As we announced over 150 new products at the start of Toy Fair, many of those products quickly rose to the top of the best-selling list in Amazon's toys and games action figure category.

As we said, we also use these shows to engage with our fans.

Over the 4 days of Toy Fair, we had over 4 million engagements and made over 70 million fan impressions on social media.

As we continue to strengthen our brand globally, we are also continuing to expand our social media reach in the following.

At the end of 2018, we had over 3.5 million followers across Facebook, Twitter, Instagram and YouTube.

And on YouTube, our videos amassed over 100 million views.

Before I turn the call over to Russell, let me say a few words about our recently announced acquisition of Forrest-Pruzan Creative.

Forrest-Pruzan is one of the board game industry's most experienced and highly respected design and development groups.

Their business has historically been designing games, they are licensed to other companies such as Hasbro, Mattel, Spin Master, Ravensburger and Asmodee, just to name a few.

FPC designed and partnered with Ravensburger to publish Villainous, which won the 2018 Game of the Year award.

The highest award a game can receive within our industry.

Forrest-Pruzan's revenue has traditionally been driven of licensing royalties with their publishing partners.

FPC owns the underlying design and has over 500 designs in our current catalog.

Going forward, we will be developing games under the Funko Games brand and have access to this catalog of games designs.

Our focus in the near term will be to bring the Pop!

brand to the board game aisle.

But our plan is to broaden the offering over time.

The board game category is substantially larger than the action figure category, and with over 20 years of board game experience, the former FPC team will lead the charge into this completely new stream of revenue for Funko.

With this acquisition, Funko Games will bring board gamers into the Funko verse where they will discover the broad offering of other products that we have.

We believe that aligning this new category and combing with our expertise of pop culture and the diversity of our 1,100 licensed properties further solidifies our position as the leading pop culture solution for licensors, retailers and consumers.

We deliver pop culture to our fans and board games as another avenue in which people can experience their favorite properties.

We see this as the perfect fit.

While I'm excited about this move, we don't expect it to have any material impact on top or bottom line results this year.

We think that over time, this will prove to be a low-risk, high-reward move that will contribute to our future growth.

I now turn the call over to Russell to discuss our financial results.

Thanks, Andrew, and good afternoon, everyone.

As was the case throughout 2018, our strong fourth quarter results were broad based and reflected a number of positive underlying trends.

Net sales in the quarter increased 37.6% to $233.2 million and were driven by strong and balanced global demand for our products across the higher number of properties.

On a geographical basis, in the fourth quarter, net sales in the United States increased 29.8% to $158.8 million, and net sales internationally increased 57.8% to $74.5 million.

As you recall, earlier in the year, we implemented a new ERP system in the U.K. and rolled out a 3PL operation in Mainland Europe to support the growth.

These investments helped us achieve growth in net sales in Europe of 37% in the fourth quarter over the prior year.

But we believe that this growth was still constrained by some system limitations and the capacity of our fulfillment network in the U.K., given the higher-than-expected demand.

On a product category basis, in the fourth quarter, net sales of Figures increased 37.9% to $188.3 million, and net sales of other products such as bags, accessories, apparel and homewares increased 36.6% to $45 million in the quarter.

As Andrew noted, sales in the quarter of Pop!

Vinyl figures increased 48% on a global basis over the prior year.

And as a brand, Pop!

was up 52% over the prior year.

Gross margin, which excludes depreciation and amortization, decreased 260 basis points from Q4 of last year to 36.7%.

As we communicated after the third quarter, gross margins in the third and fourth quarter of 2017 were atypically high, and we knew at the time that margins would be lower year-over-year in the second half of 2018 due primarily to price reductions we took in Europe at the start of 2018 to streamline pricing across markets as well as a significant shift towards more FOB sales, which while neutral to operating income, do result in a lower gross margin percentage.

There were a number of other factors that adversely impacted gross margins in Q4, most having to do with the higher-than-expected demand driving decisions and the actions we took during the quarter in order to better serve our customers and fans.

Before detailing some of these factors, I want to stress, as did Brian, that the gross margin reduction was not at all the result of a higher promotional support, price discounting or a reduction in demand.

Quite the contrary, it was the higher-than-expected demand that triggered us to incur many of these additional costs.

This increased demand resulted in higher shipping and freight costs.

At the request of some retailers, we airfreighted some of our Fortnite products in order to get products on the shelf as fast as possible.

These costs were typically passed through to our customers and did not cost us gross profit dollars.

But they did negatively impact our gross margin percentage.

Also, given the higher demand and volume, we incurred considerably higher customer noncompliance chargebacks than we have historically.

Customer noncompliance chargebacks arise when we fall short in adhering to our customers' fulfillment requirements.

For instance, missing a shipping window, failure to provide an advance ship notice or placing the shipping label in the wrong place on the carton.

It is likely that if we had slowed down on our shipping, we would have been able to avoid or minimize some of these chargebacks.

But we made the decision not to slow shipments so as to better supply our customers and, ultimately, our end consumers.

We are working both internally and with our customers to mitigate these charges in the future.

Finally, late in the quarter, one of our customers, HMV in the U.K., declared bankruptcy.

Consistent with our revenue recognition policy, we did not recognize any revenue on shipments made within the fourth quarter, even though the full COGS are being recognized.

This bankruptcy cost us about $1 million on the gross profit line and an additional $800,000 in bad debt reserve, which was recorded in SG&A.

Over time, we continue to expect to be able to get gross margins higher than the levels we are seeing now.

But we do not intend to sacrifice long-term growth opportunities in order to do so.

As we exited the fourth quarter, our channel inventory remained in a very good position heading into the new year.

And in the quarter, sell-through at the retailers where we can measure this, was up about 10% over 2017 and up 15% in the second half of the year.

In the quarter, selling, general and administrative expenses increased 20% to $45 million from the prior year.

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

As we had indicated last quarter, we are starting to see leverage against our operating expenses.

As a percent of net sales, SG&A expenses were 19.3% in the quarter compared to 22.1% in the fourth quarter of last year and an improvement of 280 basis points.

Of all of our major SG&A expense items, the only ones that were not lower as a percent of net sales in the fourth quarter compared to last year were stock compensation expense and facilities and rent, which reflects the continued expansion of our operations to support future growth.

Depreciation and amortization expense in Q4 increased 11% from the prior year to $10.2 million.

The majority of the $1 million increase was from higher depreciation on mold and tooling cost as we continued to expand our product offerings as well as our leasehold improvements at our corporate offices and warehouse facilities.

Our reported operating income in Q4 was $30.5 million, up 57.3% from the $19.4 million we reported last year.

Despite the investments we have made to grow the business and despite the lower gross margin in the fourth quarter, operating margin as a percent of sales was 13.1% in the quarter of 2018 compared to 11.4% in Q4 of 2017.

Net interest expense decreased 34% to $4.5 million from $6.9 million in the fourth quarter of 2017.

This was due to lowered interest rates obtained from our lenders in the first quarter of 2018 and again, in the fourth quarter after we refinanced our debt.

As a result of these factors and even with the negative impact from the HMV bankruptcy, adjusted pro forma net income was up 127% to $22.5 million compared to $9.9 million in Q4 2017.

Adjusted pro forma earnings per diluted share was $0.44 compared to $0.20 in the fourth quarter of 2017.

Adjusted EBITDA increased 42% to $44.8 million.

This represents a 19.2% adjusted EBITDA margin, which increased 50 basis points over Q4 of 2017.

Again, despite the reduction in gross margin and increase in investments we have made in the business, we are, again, achieving adjusted EBITDA leverage.

Touching on a few balance sheet highlights, we ended the fourth quarter with net debt of $233.8 million compared to $226.1 million at the end of 2017.

Inventory at year-end was $86.6 million versus $79.1 million at year-end 2017, an increase of only 10%, despite sales being up 38% in Q4 and up 33% for the year.

Without going through all the detail for the full year, I will summarize certain key metrics for fiscal 2018, all of which can be found in our press release.

Net sales in 2018 were $686.1 million, up 33% compared to $516.1 million in 2017.

Adjusted pro forma net income was $41.5 million in 2018, up 138% compared to $17.4 million in 2017.

Adjusted pro forma earnings per diluted share were $0.82 in 2018, up 141% compared to 2017.

And adjusted EBITDA in 2018 was $116.2 million, up 29% versus $89.9 million in 2017.

Turning to our outlook for 2019, we expect net sales of approximately $810 million to $825 million, or an increase of approximately 18% to 20%.

Adjusted EBITDA of approximately $133 million to $143 million, which will be approximately 17% of net sales, relatively consistent with our performance in 2018, even as we make the investments Brian alluded to earlier to accelerate our growth.

And adjusted pro forma earnings per diluted share in a range of $1.05 to $1.15, which assumes a blended corporate tax rate of 25% and a weighted average diluted share count of 53.5 million shares.

As Brian said, we will be investing in a number of areas to support further growth opportunities.

Some of these investments are being made ahead of the expected revenue benefits, and some of the spending will produce near-term benefits.

Areas of investment spending include our acquisition of Forrest-Pruzan Creative, which positions us well in the board game category.

Given the response to our store in Everett, Washington, we are opening an additional retail store in Hollywood, which we see as a way to get further exposure for the Funko brand and connect with our fans.

We will see preopening expenses in 2019, ahead of the revenue benefit that is expected once the store opens in later this year.

Continued and expanded use of third-party merchandisers, which helped us in Q4.

We can expect the pretty quick payback on this spending as they help to keep the content on the shelf fresh and relevant.

Expansion and consolidation of our distribution network in Europe, particularly in the U.K., which will help us realize greater revenues in this important market.

Our sales and our ability to on-board new customers in 2018 were somewhat constrained, and we expect these investments to start paying off in 2020.

And of course, we are continuing to invest in our sales and operations team in order to enhance growth and improve our efficiency.

These steps will cost us, but they are a big part of why we are confident in raising our sales growth guidance to 18% to 20%.

A final comment about guidance for 2019.

Please recall that in 2018, as we prepared for the rollout of our ERP in Europe, we consciously pulled forward approximately $5 million in sales into Q1 from Q2.

We won't have that same pull forward this year.

So our growth in the first quarter could be somewhat less than the full year growth rate.

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

(Operator Instructions) Our first question comes from the line of Erinn Murphy with Piper Jaffray.

I guess my first question for the team, maybe it's actually probably most appropriate for Russell.

On the guidance of 18% to 20% for the year, I recognize you have the comparability in Q1.

But really curious more for the balance of the year, how should we think about the run rate between the U.S. and international?

And then, particularly, on the U.S., if you could just touch upon what you saw in the fourth quarter with respect to Walmart that was a very, very strong Q4 number for the U.S. Just curious what you're seeing with extensions there.

Yes.

In regards to the growth that we're seeing or expecting in 2019, domestically, we're expecting about 10% growth -- 10% to 15% growth coming out of the -- in the domestic markets, and then really the rest of the markets coming making up the rest, with really strong growth continuing in Europe for an overall balance.

And regarding to Walmart, I'd let Andrew to take that question.

Yes.

So the Walmart -- the rollout was successful.

We saw very strong compliance within the chain with the new collectibles section.

As far as setup was concerned and sell-through followed, we had several very strong programs with them in Q4.

And I believe that they are seeing the opportunity, and we expect that to grow in 2019.

Okay, that's helpful.

And then just on the gross margin, just going back to some of the comments throughout the prepared remarks.

I guess 2 questions.

First, is anything structurally changed outside of your doing from FOB more in Europe?

And I guess, you have some pricing changes there, but from getting back to 39% or getting there over time suggests that was obviously what we thought about the IPO time.

I'm curious if there is anything that you think is truly structural.

And then, the second piece is, in the release and I think on the transcript, you also talked about royalty.

Is that mix or is there any specific renegotiations that are happening with some of your key partners that would continue to hinder the gross margin rate?

No.

So -- in regards to the gross margin, I'll take that one first.

It was largely mix that drove the difference between Q4 of last year and this year.

There is no change in our renegotiations with our licensors that should have an impact.

So it's really being driven by mix.

In regards to the structural changes, there is, again, nothing structural.

The changes in pricing that we referenced really relates to what we talked about in Q3 and Q4 of last year.

And then on the call last year, after having bought Underground Toys, we gave back some of that margin at the beginning of this year really at the very end of Q4 of 2017 to more streamline and align pricing on a global basis.

And then, obviously, there is the shift as more retailers want our products and want our products sooner, they are moving and shifting to increased percentage of their buys coming out directly from our factory.

So coming out of FOB, which, again, has no real impact on our operating leverage, but it's a shift between gross margin percentage and SG&A.

Okay.

And then I guess, just for the year, then as you think about 2019, I mean, should be just kind of remodeling this kind of march forward from where you ended Q4?

Or is there any other kind of thoughts about how we should be thinking about even just first half, second half for the GM?

No.

I'm saying -- we're not, again, with the opportunities and the growth opportunities we see in front of us.

The fact that retailers frequently want us to airfreight in product on their behalf.

Those dollars flow through, we charge -- flow those through, and so those are negative from a gross margin percentage, but they don't impact our gross profit.

We're not guiding to a specific.

If you had to have me, I'll probably hold it around the same lines of what we saw this year, knowing that there are opportunities that might impact that over the course of the year.

Again, we're focused on the long-term growth and healthy growth of the business.

Okay.

And then maybe just last question, big picture for Brian.

When you said out at the IPO, this was kind of the longer-term aspirations were $1 billion in sales, and next year is starting off not too far from that.

I'm curious how you're thinking about the bigger opportunities longer term to drive above that and you've referenced sport and music and some of these categories you're just starting to see some great traction, kind of what gets you beyond the $1 billion?

Yes, no, I think Andrew's experience and work in helping us acquire Forrest-Pruzan is certainly our first stake in the ground of a category that's much larger than the action figure category and has significant growth above what the toy sector is doing right now.

We think that's a new stream of revenue.

We think our war chest of licenses, our industry expertise, our global distribution and a partner with almost 20 years' experience dealing with the Asmodees and the Hasbros and the Mattels and the Spin Masters on game creation, we think that's one of the revenue stakes that we're going to be able to grow and get pushed past that $1 billion.

We've made some comments that we are working on some of our own IP and how that's going to go into the toy aisle.

And we think that there is definitely an opportunity to scale down with our own IP and our creative team of 150 world-class artists to recognize some revenue in categories that are much younger than what we traditionally play in much like the Five Nights at Freddy's licenses and the demographic that, that reaches.

So that's another -- we think another avenue that's going to help us push past $1 billion in our future.

So there's a couple of other things we're working on that I'm not really yet prepared to talk about.

But those are 2 big ones that we feel like are going to, over time, get us to the next level as a company.

Our next question comes from the line of Stephanie Wissink with Jefferies.

Just a follow-up on one of Erinn's questions.

I'm curious if you can talk a little bit about the new retailers that you're seeing coming off the trade shows also in the sports category.

And then Brian, one for you, just more mechanics.

So as we think about 2019 and all the content, should we think about the number of new properties slowing a bit and the dollars per property going up?

Just again, mechanically, how should we think about property growth versus dollar per property in 2019?

Let me take that.

Yes, thanks, Steph.

I'll take the second question first.

Yes, I think there is -- it is an interesting year for us because the content is so good.

And so yes, you could potentially see us not leverage as many unique properties because of how -- we're dealing with A+ content as what we say we're not hit driven, and we had something that was a big movie that we can anniversary in a quarter, we'll make it up with 2, 3, 4, 10 properties.

So I think there could be -- it'll interesting to see how the year shakes out.

But there could be a potential to actually make less and lever against less property this year because of the strong content.

Repeat the first question, though, I'm not sure I exactly understood that one.

Erinn has asked about music and games -- excuse me, music and sports.

And I think you're opening some new retail channels with some of the…

Oh, yes, yes, yes, absolutely.

Yes, Steph, look, I think that Foot Locker and Fanatics are 2 great examples of retail partners that desperately wanted to get into the business of pop culture.

Obviously, Fanatics being an e-tailer.

Geographical concerns, traditionally with the sports, goes away on an e-commerce platform.

So that's been something we've seen.

And we've seen some amazing success, I think, both Pop Foot Locker and Fanatics websites crashed on Lebron and Michael Jordan exclusives that we gave them.

Pop Foot Locker is really happy with their basic 2 quarters for the sales in our category and how they are leveraging our everyday pop culture content to align with.

Sometimes, Nike activations or Adidas activations, and we're seeing a parallel consumer that the sneaker had that is crossing over into our pop culture world.

They already had that collecting bug in their DNA.

So 2 great retailers, 2 new retailers for us that we're continuing to expand with both music and sports.

Final one for us.

It's just on the acquisition of Forrest-Pruzan.

Does that come with any owned IP that you're looking to exploit down the road?

Or is it more of a platform acquisition around the gaming and gaming development?

That's a great -- it's a good question.

They actually have over 500 pieces of IP or what you'll hear me refer to as game engines in their catalog.

These are games that they've either created, had in the market at one time and brought back.

And it's not necessarily the game, it's the engine that drives the game.

So the mechanics of it, and they brought it back, or there is an equally large catalog of games that they've created, but they haven't found the right home for yet.

And so these are all opportunities for us to explore as we move forward.

That said, we are developing new game engines with them out of the gates.

So we're excited about both of those avenues.

Yes, I think the library helps us with a fast turnaround when it comes to something that's pop culture that we need to get in the marketplace immediately, but there is definitely a strategy of have -- using that library plus creating our own.

Our next question comes from the line of Michael Swartz with SunTrust Robinson Humphrey.

Russell, maybe start with you.

You outlined a number of items in the quarter that kind of weighed on gross margin.

So I was just trying to get a sense of maybe the magnitude of some of those, whether it was the chargebacks or some of the elevated costs related to expedited shipping.

Yes, again, I want to highlight that most of these were driven by demand or related to demand exceeding the expectations, including even the elevated shipping, which again, was largely at the request of retailers that wanted us to air shipping.

Again, 0 impact from a gross profit percentage but negative gross margin.

I won't get into the detail in terms of the overall impacts of each one.

But in total, if you'd kind of pro forma it and you back those out, then frankly, our gross margins really were -- really would have been in line with where they were in the third quarter.

Great, that's helpful.

And then a lot of the investments that you outlined for the year ahead seemed to be more on kind of the distribution or retail side of things.

I guess, it begs the question, as far as just manufacturing capacity and your ability to meet that -- the demand from that standpoint.

Are there any limitations or capacity constraints you're running up against just in terms of the manufacturing?

No, not, absolutely not.

We have 11 unique factories.

We are making a shift into a greater percentage each and every year into Vietnam versus China.

But we both have -- we represent a good 80% to 100% of all those factories' capacities.

But we are probably only at about 50% to 60% of what we're able to produce on a month-to-month basis within those factories.

So there is a ton of bandwidth for us to continue to grow.

And there is no shortage of factories that we are now digging into that are coming to us with the slowdown in toys and asking us so they can be a part of our manufacturing team.

So that will not be any kind of issue at all.

Our next question comes from the line of Michael Ng with Goldman Sachs.

I have two.

My first question is, could you just talk a little bit about your optimism about the board game category and the acquisition of Forrest-Pruzan?

Is this like a category where you see a lot of potential underlying growth?

Or do you think there is a lack of compelling innovation creating some opportunities for market share gains or both?

And then, do you see this as a marketing tool for the Funko brand?

Or will board games be profitable in of its own right?

I can take that one, it's Andrew.

Yes, I would say that it is definitely going to be profitable for Funko to get into this space.

That being said, I will say that there is a tremendous amount of opportunity in both the innovation side, which we believe, we're going to bring to the game aisle.

But as importantly as the innovation side is, we believe we're going to disrupt this category by approaching it in a very nontraditional way similar to how we've approached the Figure business.

That's one of the reasons why we're most excited about getting into this category.

And we think that there is tremendous opportunity ahead.

Great.

And then my second question is just about the U.S. sell-through.

And I think you said it was up 10% in the quarter, selling was up 30%.

Could you just help reconcile some of the gap there?

Was it just the function of Walmart stocking up and then expanding shelf space.

And I guess, do you expect sell-through to accelerate in 2019?

So it's a great question.

So I will remind you, we get sell-through data from about 15 of our top customers in the U.S. So it's not all of our top customers.

We did have a couple of customers that, one, like Walmart, that stocked up as they moved into a new retail store.

We often saw some e-commerce platforms that change their buying habits.

Also in order to -- because they just were beginning -- they're beginning to understand what pop culture and what our products specifically can mean to them.

And so they started to increase their overall buy.

I won't say for the retailers that report to us, it's important to note that the sell-through, which was up about 10%, but their channel inventory was up only 8%.

So we're seeing a very strong correlation between the sell-through and the levels of inventory that they're carrying, which is why we're seeing a healthy level.

And we feel good about the channel inventory as a whole going into 2019.

Okay, great.

And maybe one last one for Brian, if I could.

Brian, could you just comment on what you're seeing in terms of Fortnite demand as we start off 2019, particularly with Apex Legends kind of creeping up?

And any comments about a potential license there.

I just won a lot of money in Vegas.

There'd be an Apex Legends question that came up.

So happy to do that.

Daddy's got to sell some money.

So anyways, look, Fortnite continues to be stronger, we're monitoring this sell-through.

It is doing extremely well.

It's a bigger retailers.

And that's interesting for us, but we kind of thought that's how it's going to be.

We think a full year and continued trust in partnership with that because it's going to be a meaningful license for us.

With that said, obviously, Apex is on a run rate that is on par with what Fortnite did last year as far as interest and adoption, and like anything else, will give you the party line.

Anything that's moving a needle in pop culture, we're on top of, we're having dialogues with.

And this is just part of our business model, so certainly aware of that property.

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

So in terms of Forrest-Pruzan, can you talk about what proportion of your current library of licenses would be transferable to Games?

Yes.

I would say that we've had conversations with a large number of our current licenses.

So far, every license that we've talked to has been very enthusiastic about this new avenue of product diversification.

And so to give you a specific percentage, probably wouldn't be fair at this juncture, I can just tell you.

But the adoption rate has been extremely high and as we expected.

Okay.

And a couple of housekeeping questions.

Perhaps, CapEx in the quarter and your expectations for the year.

And then also your expectations for equity compensation for the year.

Yes.

So CapEx was in line with what we're expecting for the fourth quarter, and you'll see that as it comes out next -- when we file our K. As it relates to CapEx for next year with the addition of the Hollywood store, we will see a little bump in -- or increase in CapEx spend next year as we continued to invest.

And then also you'll see as the stock continues -- with the full year of the stock rants and things in line, we are expected to see approximately about $10 million in stock compensation expense recognized from a GAAP perspective next year.

Okay, great.

And maybe one last question.

I thought I heard you say that increased FOB sales lowered your gross margin in the quarter.

Wouldn't that help your gross margins?

Help me understand how that would lower your gross margin.

We give -- specifically when we sell to retailers from FOB, we're giving a discount off of the top line.

So because we're not -- we're -- they're covering the freight costs, so there is that element.

But there is typically an increase in royalty cost related to it.

So it's decreased in giving -- it's decreased in our gross margin, given the discount that we give.

Our next question comes from the line of Christopher Horvers with JPMorgan.

So it seems like the product category expansion has really accelerated here, I mean, with Loungefly and now with the board game company.

So as you go back to the original plan around the IPO, there was the expansion within existing retailers versus new categories, and there was international.

Obviously, Europe is growing like a weed as well.

But the success of the new categories, and particularly the recent acquisition of Forrest-Pruzan, does it change your sort of thought process on how hard you need to push outside of Europe in the United States?

No, I don't think so.

I think, though, we've looked at rest of the world really strategically, I think we just added 2 people in Latin America from '17 to '18, I think we grew that about 700% with just 2 people and a focus.

So it doesn't change the philosophy that we believe the content resonates on a global basis.

I think what the expanded category success has allowed us to do, it's continued to create wonderful, whimsical programs for our key retail partners and to be able to garner all of the categories within that space instead of having to form some of the stuff out to other manufacturers.

So that's been really the key that we can basically carry a section, whatever the section would be, if it's an '80s retro TV section, if it's a section all about ad figures, we have all the categories necessary to carry that section.

And just getting that expertise in these adjacent categories has really helped us with our retail partners, understandably.

We truly are a one-stop shop for anything and everything that is pop culture.

So it's really paid off.

Even things as whimsical as the serial on the Pop!

PEZ.

Just having some consumables in there are allowing us to delight and surprise the end consumer when they come into these sections.

And then as you -- I know you're going to work a lot on the direct site, funko.com, but obviously that's branded under Funko.

Do you think there is, just philosophically, a lack of a singular destination on the web for fandom-type products?

Obviously, you sell the Amazon, you sell Walmart, you sell the Target.

But there's -- do you think there's need to exist something that's not called funko.com, that you can participate in, that you could perhaps sell some ownership in that can be world web destination for this type of product?

I think we've focused so much time and energy in the last 1.5 years in helping Target to build up target.com and Walmart -- build up walmart.com and see a great success with Amazon growing their business as we've grown our own B2C.

So I don't think we're ever going to see any one retailer definitively own pop culture because it is so vast, and it is so diverse, and when you go back and see like Pop Foot Locker who is really putting a foothold in the music and sports and Fanatics who is putting a foothold into sports.

I think that you're going to see multiple players there.

We just personally have to get better with our search engine capabilities and our marketing and making sure that we continue to garner more and more of that direct-to-consumer sales.

But no, I don't see, unless Andrew has a different opinion.

I don't see any way that anybody can definitively own.

This is just too broad of a category, and now it's too mainstream.

Yes, I would just say -- I would just add on to that, that we have talked to websites that their whole business is around fandom.

And what we have found is that with as little of a focus as funkoshop.com has been for us, the traffic that we generate dwarfs a lot of the other companies out there.

So we would -- and I think that what we're saying is we would rather focus on our third-party partners as well as building funko.com.

Yes.

Got it.

And then -- and just some further model questions for Russell.

Any other cadence commentary around the top line growth?

Obviously, you're not going to let Fortnite, you're not going to let Walmart until the end of the year.

How does sort of that interact with the overall content calendar?

You mentioned a number of the movie franchises coming out.

Any variation in terms of top line growth over the year besides that shift in 1Q and 2Q -- Q2 to 1Q?

Yes, I think the other aspect of it is right now given Fortnite and given the strong demand and also a little bit of the FOB sales that came in the fourth quarter, I think you may also see Q4 being a little just below kind of our annual top line -- or guidance for the full year.

Other than that, I think it's a pretty normal cadence in terms of overall growth.

Then last one for me is, any expectation around the level of debt on the balance sheet?

Do you anticipate a payment to help down, not that you need to, where are you going to keep that level of leverage?

I think we're going to keep and maintain -- I don't think we're going to accelerate any pay down of the debt.

We are getting to a comfortable leverage ratio with our performance.

We've been able to manage and refinance -- manage our interest costs.

We'll continue to evaluate obviously, but our focus right now is continuing to invest in the business, seek the opportunity and be in a position when presented with opportunities such as Forrest-Pruzan to take advantage of the position in the markets that we have created.

Yes, thank you for your interest.

Yes, I just want to say thank you for your interest and support of Funko, and we look forward to speaking to you guys, again, on the first quarter of 2019 earnings, if not sooner.

So thank you very much.

This concludes today's conference.

You may disconnect your lines at this time.

Thank you for your participation.