Funko: The Final Phase Of Its Downturn

seekingalpha05-02

Funko is a well-known company that sells vinyl figures, with a portfolio of over 1,500 licenses.The company has a strong fan base and a high percentage of repeat customers, making it an attractive ...

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Get published, earn money, and unlock exclusive SA Premium access. Click here to find out more  kipgodi Thesis Funko  is a company with a very recognizable brand that sets them apart from their competitors. The pop culture is continuously expanding, allowing the company to launch new products onto the market. The company not only has customers, it has a lot of fans. Funko has created a great brand and culture. Although its core product is very inexpensive, Funko has acquired other brands with higher margins to which it can pass on to its customers. But now the company is facing some challenges. Despite this, although having a conservative view, in my opinion, Funko is a good buy option due to its business and the current valuation of the company. Viewing this as a turnaround case, Funko encountered difficulties due to its poor management of growth. 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Get published, earn money, and unlock exclusive SA Premium access. Click here to find out more » kipgodi Thesis Funko (NASDAQ:FNKO) is a company with a very recognizable brand that sets them apart from their competitors. The pop culture is continuously expanding, allowing the company to launch new products onto the market. The company not only has customers, it has a lot of fans. Funko has created a great brand and culture. Although its core product is very inexpensive, Funko has acquired other brands with higher margins to which it can pass on to its customers. But now the company is facing some challenges. Despite this, although having a conservative view, in my opinion, Funko is a good buy option due to its business and the current valuation of the company. Viewing this as a turnaround case, Funko encountered difficulties due to its poor management of growth. However, the company has since addressed most of its challenges with a fresh perspective. Moats Starting with the thesis, Funko is a company that, among other things, sells vinyl figures. These figures, known as Funko Pop!, have a very recognizable shape, so these are very well-known collectibles. But more importantly, its portfolio of more than 1,500 licenses, which include movies, series, sports, anime, and music. The company's slogan is 'everyone is a fan of something, so Funko aims to have something for every fan.' Funko has something that everyone looks at when analyzing a company, a very recognizable product. Approximately 36% of its customers are collectors and dedicated fans of Funko. And the other 30% are enthusiasts of the license. These enthusiasts find in Funko a way to express their love for a film or an artist, and these people don't want any figure they want a Funko Pop. They have a product with personality and are cheap. This makes most brands prefer to work with Funko over competitors. Among Funko's competitors, we can find Nendoroid, Minimates, Neca, and Cosbaby. All these are big moats for the company. Only about one-third of the clients are collectors, which is interesting because the other two-thirds are individuals who purchase more for the licensed characters, which enables the company to generate recurring revenue through the continuous release of popular series or new, famous artists' figures. Another important part of the company is its M&A strategy. In addition to the Funko brand, the company owns Loungefly and Mondo, which serve as good examples of its strategy. Loungefly mainly sells backpacks priced around $80, while Mondo sells figures that can cost over $200. So, different from Funko whose Pop! figures are sold for about $15, Loungefly and Mondo enjoy higher profit margins. Furthermore, when Funko acquires these types of companies, they can leverage its extensive portfolio of licenses to create products and utilize Funko's distribution chain. Loungefly has multiplied its revenues more than 12 times since Funko acquired it in 2017, making a lot of people collect these backpacks showing the ability to create collectible products by the Funko team. Additionally, Funko seeks that the acquired company possesses prominent technology and knowledge in its niche. One of the most important aspects is that these brands are showcased to the entire Funko audience. Currently, Funko has more than 3 million followers on Instagram, more than 1 million on Twitter, and 660K on TikTok. Moreover, it is noteworthy that there are many YouTube channels with millions of subscribers and hundreds of thousands of views that exclusively focus on Funko Pop!, and their collections, for example, FunkoPat with almost 2 million subscribers on YouTube, or Top Pops with nearly 3 million subscribers. Loungefly has more than one million followers on Instagram, while Mondo has about 300K. This is an important intangible asset that many investors overlook. This is something that differentiates Funko from its competition, the culture that they have created around its brands. Funko has a lot of fans, which can be moved to businesses with higher margins like Loungefly and Mondo. Company Overview- March 2024 Future Of The Company Funko is currently facing challenges, so it is making some changes in the structure of the company to increase its profitability. Among the main actions taken by the company are the simplification of its business. Most of the revenues come from the Pop! brand, which is a low-value product. In 2021 and 2022 the company diversified to new products like board games and plushies; therefore the company had a lot of inventory (it increased 174% in 2021 and 48% in 2022). Coupled with the significant revenue growth experienced by Funko in 2021 (57% increase) and 2022 (28.5% increase), this has led to increased complexity in inventory management and associated costs. A problem that the management can't handle, resulting in the need to write off approximately $30 million worth of inventory in 2023. Now Funko is working on improving its distribution chain by lowering inventory levels, implementing a new Warehouse Management System with a lean startup mind, and reducing its workforce. However, I've noticed that the company regularly posts new job openings on LinkedIn across various departments, which I see as a positive sign of growth. In line with this simplification, the company is reducing its line of products, focusing on the best Funko products. On its Investor Day in September 2022, the company said that it wanted to expand into new categories, but now the strategy has changed. This doesn't mean that Funko doesn't want to diversify its line of products, but the company is trying to focus on Pop!, Loungefly, and Mondo. And with Pop! Funko wants to increase the quality of its main product, enter deeper into new verticals like Anime or sports, and make a strategic diversification to other related products like Pop! Yourself or Bitty Pop, which are different from other lines that the business launched in the past, it has had a better reception from the fans of Funko. For example, the company entered 2021 the NFT business that today continues creating DigitalPop!, connecting the digital world with the physical world with a good strategy that creates a profitable revenue line for the company. Also, it is important the international expansion because around 68% of total revenues are generated in the USA, so the company has a great path to expand its business in other countries and areas like Scandinavia, Eastern Europe, and Asia. For example, recently, in January 2024 Funko announced that its board games distribution and assets (inventory and its two studios) had been sold to the game company Goliath. An interesting move from Funko in its strategy of simplification, which generates an initial amount of cash and royalty payment for the use of the Funko brand, able the company to be present in another market without risk. In my opinion, all of the information presented above is interesting because the company quickly has changed its strategy, focusing on what is working. Most of Funko's clients want Pop! figures, not board games or other product lines, so the company is engaging in a more rational diversification with a different mindset. I think that this strategic change could lead to improved margins in the future, thanks to the improvements in the main product and a more efficient distribution chain. Problems The company, apart from the actual financial complications, had different problems that made Funko one of the worst IPOs in history. One was its complex business structure. Because the public company didn't have any operations it only participated in a company called FAH, LLC, which owns FHL (100%), and FHL owns Funko, LLC (100%), which is the company with real operations. Funko was created in 2017 with the purpose of making the IPO. In 2018, Funko only owned about 48.3% of FAH, LLC, which means that if the operating company (FAH) generates $1 of EPS, a shareholder in Funko only receives $0.48. This makes the investment in Funko less attractive. However, in the 10-K of 2023, Funko reported that they own 94.9% of FAH, increasing from the 77.3% that they owned on 31 December 2021. Another problem that justified its bad IPO is that most of Funko's revenues come from Disney licenses, so if Disney increases the royalty or leaves working with the company, Funko could have a lot of problems. Funko, as I said before, has built a good brand with a lot of fans. And most companies want to work with Funko; in fact, there hasn't been any problem between Funko and a license. Disney continues to have a high weight in Funko's revenues, but the company is much more diversified than in 2018. For example, in 2018, its top 10 properties accounted for 38% of total sales, with its first property accounting for about 7% of total sales in most quarters. In 2022 and 2023, the top 10 properties accounted for a number closer to 30%, with the first property accounting for about 5% and 6% of sales. Although Disney represented about 33% of total sales in 2017 and in 2023 it represented 38%, and therefore there is still a risk. Financial analysis Funko's 10K Regarding its financials, the income statement highlights the impressive growth of the company, passing from $686M in revenue in 2018 to $1,322M in revenue in 2022. But in terms of margins, everything went well until 2021, a gross margin of about 37%, an EBIT margin closer to 10%, and a net income margin of 4.6%. However, the increases in transportation costs and the inflation in 2022 showed a hidden problem at Funko, its inventory management. And also a main product which is a low-value product with difficulties in passing the increment in costs to the customer. Funko 10K In 2022, the gross margin fell to 32.8%, and the SG&A expenses grew 63% which resulted in a negative EBIT. While other companies faced challenges with increased financial costs in 2022, Funko encountered operational issues despite a revenue growth of 28.5%. In 2023 revenues went down about 17%, mainly due to the simplification of the business with the elimination of non-profitable lines, but the revenues are up about 6% compared to 2021. While cost of sales decreased by 14%, SG&A expenses only decreased by 5%, resulting in an EBIT loss of $103M, compared to the negative EBIT of $12M in 2022. But this isn't too worrying due to the improvement in Q4 (more details in the next section). Funko 10K However, it's worth noting the dilution that has occurred since 2020, with a growth in the number of shares of about 40% over three years. This is due to the corporate structure I mentioned earlier. The part of FAH that isn't owned by Funko is owned by directors of the company, who can convert their shares in FAH for Funko shares. This conversion explains the dilution. About the balance sheet, it's worth noting that its inventory decreased by about 50%, due to its simplification strategy and improvement in the distribution network. Therefore, the DIO has been reduced from 101 days to 57 days. The working capital has been reduced to half in one year, so the WC turnover has increased from 8x in 2022 to 20x in 2023, an amazing improvement. Most of the accounts at the assets have been lowered but the intangibles and goodwill have maintained their values, so the weight of these accounts in the total assets has increased from 28% of total assets in 2022 to 37% in 2023. Which obviously provides some risk. Its long-term debt has lowered and only increases in the short term due to a line of credit. And in the next months, thanks to the cash received for its sale of the board games division, Funko is going to reduce debt. In the cash flow statement, it's worth noting how in 2023 Funko had a positive operating cash flow, in contrast to the negative operating cash flow of 2022. This difference, despite the lower net income, is due to the reduction of inventory. Although the CAPEX in 2023 was higher than the operating cash flow. However, when calculating the free cash flow to the firm (FCFF), it was positive in 2023, whereas it was negative in 2022 due to the high negative operating cash flow. The same situation applies to the FCFE. So, in terms of cash flow generation, the situation is better than in 2022, despite what is shown in the P&L, and probably it will improve in the next years, thanks to all the changes made in the company. Also, it highlights how the company has had better cash generation than its net income, so it has high-quality earnings. Own calculation To sum up, Funko didn't have great margins because most of its revenues come from Pop! line, which is a cheap product where part of the margin is allocated to the IP owner. But the company has maintained a lower debt level, which prevented this negative situation from worsening in the last years. Moreover, the cash flow generation of the company was very strong. And now the company has implemented improvements in its working capital management that are reflected in the 2023 results. Q4-23 Commentary In the last quarter of 2023, the company highlights the important change in the operating face of Funko, with workforce reduction and elimination of unprofitable product lines. As a result of this cost reduction plan, the company increased its gross margin in the last quarter from 28.3% in Q4-22 to 37.6%. Also, the company is waiting to increase its margin due to the increase in the DTC channel, which saw a 30% increase in sales from Q4-22. Funko showed its capacity to create amazing products like Pop! Yourself, which is a product with a high margin, and Bitty Pop!, both lines well received by the customers. Furthermore, Funko is seeking to launch exclusive products like Project Fred 01, which was launched in March 2024, these exclusive products produce a high margin due to their price ($295 vs. $15 average Funko Pop!) and not only using traditional licenses but also using viral moments like Jason Kelce to create a Pop! Funko Q4-24 Earnings call Therefore, Funko is leaving the idea of being a growth company to find more profitable growth with fewer SKUs focusing on the fans and its areas of expertise, all with a financial discipline and long-term view. The company seems to be in the final phase of its downturn, showing an improvement in its gross margin and implementing a better strategy. Additionally, in the last quarter, Steven Nave, the former CFO, announced that he is leaving the company. Nave commented that this decision was because he did the job he was hired to do, improve Funko's finances, and, also, because working in Funko meant traveling from Minnesota, where he lives, to Seattle every week. Therefore, this isn't a cause for concern. The new CFO is Yves LePendeven, who formulated the 2024 plan and has significant experience working at Funko since 2019. Additionally, the new Funko CEO will be announced in Q2-2024. Valuation Finally, regarding valuation, Table 1 displays my estimations for Funko's FCFF (Free Cash Flow to Firm). I believe I have been conservative in my estimations, projecting negative EBIT for this year and 2025. I don't expect high growth in revenues, but I expect a margin improvement in the next years due to its focus on high-margin products and fewer SKUs. Although Funko has a good fan base, outside the USA it isn't very well-known. Funko has the ability to create collectible lines and there are M&A opportunities. So, the growth could be better in the future. As well, while in 2019 Funko achieved a 7.65% FCFF margin, I projected a 4.35% margin for 2028. Own calculation With a WACC of 8.5%, assuming a 6.08% after-tax cost of debt and a cost of equity of 11.02% (beta of 1.07, risk-free rate of 4.6%, and risk-premium of 6%), along with a terminal growth rate of 2.5%, the value per share is shown in Table 2. Now, my value per share of Funko is about $8, almost 40% higher than the actual price of the company. And, as I said later, I was conservative in my assumptions. Funko is a good turnaround candidate. Own calculation Table 3 shows a sensitivity analysis using the revenue growth and EBITDA margin. In the conservative and optimistic cases, the growth and margin are one percent lower and higher respectively compared to the base case. This illustrates that if the growth is higher than expected, but the margin is lower, the value of Funko exceeds its actual price. If the revenue growth and EBITDA margin exceed my estimations, the value of the company is more than twice the actual price. This scenario is achievable for the company, as it projects an FCFF margin in 2028 of about 5.33%. This is in contrast with the 7% in 2019 and 6% in 2021. Own calculation The graph of Funko's price can show a bad situation, but the company is starting to show good advances in its recovery. Based on a conservative valuation, the target price for Funko is about $8, with a margin of safety of about 40%. When I was observing the price declines I was nervous, but when I see the valuation and understand what I own, I am more at ease. Currently, there is high volatility in the market, which refuses to acknowledge small stocks, creating an opportunity to own Funko stock with a free cash flow yield of above 4%. Risks But obviously, there are risks in the thesis. Funko is facing some challenges. The company has experienced two years of losses. So, the recovery could be slower, or in the worst case, the company could go bankrupt. Although, I think that the probabilities of this scenario are very low. The company depends on its ability to gain licenses; there could be some licensors that don't want to work with Funko, which can limit the company's business. Additionally, there is a risk if the licensors increase the royalty payments. So, the business of Funko largely depends on external entities. Also, Funko needs to be flexible and quick to adapt to new pop waves and trends, and select the correct licenses because if the sales are lower than expected, the company couldn't afford the minimum royalty payment. Another important factor to consider is that the company works with independent workshops in Vietnam, China, and Mexico that manufacture its products, so the company is very sensitive to the price of maritime transportation, which can absorb all the margin, as occurred in 2022. Furthermore, most of its revenues come from wholesale, so Funko needs to have a good relationship with these vendors because if someone doesn't want to work with Funko, the company could encounter problems. Additionally, there is a risk of the product being rejected by consumers. Its main product is too cheap, so people can become bored of it, leading to a decline like Beanie Babies, although this is a different story. Conclusion  To sum up, Funko has a great product with a big fan base. The product is difficult to replicate by its competitors because customers specifically desire a Funko Pop!. The company has suffered a lot in the last two years, resulting in its stock being undervalued. However, as we have seen, the company is starting to recover. This offers a 40% upside with a real possibility of increasing by more than 100%. It is a good option for a turnaround because the company is facing problems, which I think will be fully resolved in the near future; the market is pricing the company in a very pessimistic scenario.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2432641500"}