Business context and reporting period
Funko, Inc. designs and sells licensed pop-culture products, including Core Collectibles, Loungefly and other products. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2022; comparisons are with the corresponding 2021 periods. Funko reports as one operating segment.
Financial performance and liquidity
| Metric | Q3 2022 | Q3 2021 | Nine months 2022 | Nine months 2021 |
|---|---|---|---|---|
| Net sales | $365.6m | $267.7m | $989.7m | $693.0m |
| Gross margin, excluding D&A | 35.0% | 36.0% | 34.3% | 38.5% |
| Operating income | $17.4m | $26.2m | $46.1m | $70.3m |
| Net income | $11.1m | $18.4m | $41.5m | $50.4m |
| Net income attributable to Funko, Inc. | $9.6m | $11.9m | $34.2m | $32.2m |
| Diluted EPS | $0.19 | $0.28 | $0.73 | $0.80 |
| Adjusted EBITDA (non-GAAP) | $35.7m | $40.2m | $103.7m | $111.0m |
Quarterly sales rose 36.6%, but operating income fell 33.6% and net income fell 39.3%; nine-month sales rose 42.8%, while operating income fell to $46.1m from $70.3m. Q3 and nine-month gross margins contracted as product costs increased and, year to date, freight and shipping costs also weighed on margins. Higher selling, general and administrative expenses contributed to lower operating profit.
For the nine months, operating cash flow was negative $64.7m, versus positive $78.8m in 2021. Investing used $60.1m, principally for property, equipment, tooling and molds, plus the Mondo acquisition; financing provided $66.8m, including a $90.0m revolver draw. Cash fell to $25.1m from $83.6m at December 31, 2021. Working capital was $141.8m, down from $167.6m.
At September 30, cash was $25.1m; debt carrying value was approximately $250.2m, comprising $90.0m drawn on the revolver and $160.2m of term debt net of discount. The $215.0m revolving facility had $125.0m available. Funko reported compliance with its debt covenants. Inventory was $265.8m, compared with $166.4m at year-end 2021. The company reported a $117.6m deferred tax asset and a $112.7m Tax Receivable Agreement obligation, including accrued interest.
Material changes and management commentary
- Q3 sales growth was driven mainly by distributors and mass-market retailers. Loungefly sales increased 57.3% year over year; Core Collectible sales increased 33.7%. For the nine months, Loungefly grew 88.2% and Core Collectibles 34.8%.
- Q3 gross margin was 35.0%, down 1.0 percentage point; nine-month margin was 34.3%, down 4.2 points. Management cited higher product costs and, year to date, elevated freight costs amid supply-chain constraints. Funko said earlier price increases took full effect in 2022 and it expected to broaden price increases more comprehensively in 2023.
- SG&A increased 63.5% in Q3 and 56.0% year to date, including higher personnel, warehouse transition, marketing, facilities and professional costs. Management expected personnel costs to remain elevated through at least year-end 2022 and ERP consulting costs to remain elevated as implementation steps continued into 2023.
- The nine-month income tax benefit included an $11.0m discrete benefit from releasing a valuation allowance. This helped keep nine-month net income attributable to Funko above the prior-year level, despite a decline in consolidated net income.
- Funko acquired Mondo in June 2022 for preliminary consideration of $14.0m; the purchase-price allocation remained preliminary. On October 6, 2022, after the reporting date, Funko acquired the remaining TokenWave interests for cash and stock.
Outlook, risks and contingencies
No specific revenue or earnings guidance is provided in the filing. Management said it believed available liquidity would support operations, growth, planned capital expenditures and public-company costs for at least 12 months, while cautioning that operating cash flow and revolver availability might prove insufficient and additional financing might be needed. The company cited inflation, rising interest rates, economic uncertainty and COVID-related disruption as potential pressures on cash generation and covenant compliance. Its business is seasonal, with historically more than half of annual sales in the third and fourth quarters.
Key risks include fast-changing consumer and pop-culture demand; dependence on third-party licenses, manufacturers and retailers; inventory and supply-chain management; inflation and freight costs; foreign-exchange exposure; and debt and financing needs. The top ten licensors represented about 76% of nine-month sales, with Disney-owned Disney, Lucasfilm and Marvel together representing about 46%. Inventory had risen 89% from the prior-year period, which Funko attributed primarily to the timing of receipts and processing challenges at its new consolidated U.S. distribution center; the filing also cites elevated in-transit inventory and freight costs.
Funko disclosed material weaknesses in internal control over financial reporting, including deficiencies in IT user-access and segregation-of-duties controls and in monitoring controls. Management concluded disclosure controls were not effective at September 30, 2022 and expected remediation efforts to continue into 2023, with no assurance on completion timing. Legal matters include securities and derivative actions; the Ferreira settlement had preliminary court approval, and the company said its cost was covered by D&O insurance. The filing also reports a $17.2m reserve for ongoing and future royalty audits and a $0.8m contingent liability for potential U.S. customs penalties; any additional penalties could exceed that recorded amount.
Important facts for investors to verify
- Whether sales growth can translate into improved margins and operating cash flow as product, freight and operating costs evolve.
- Whether the elevated inventory can be processed and sold without material markdowns, write-downs or further working-capital strain.
- Cash needs, revolver usage, interest-rate exposure and continued compliance with debt covenants, including the effect of the negative nine-month operating cash flow.
- Progress and effectiveness of remediation for the disclosed internal-control material weaknesses.
- Final Mondo purchase accounting, integration results, and the terms and effect of the post-quarter TokenWave acquisition.
- Developments in pending litigation, royalty audits and the customs matter, including potential costs beyond recorded reserves.