Funko, Inc. — Form 10-Q Summary
Business context and reporting period
Quarter ended September 30, 2017; comparisons are with the three and nine months ended September 30, 2016. Funko, Inc. was formed to complete its November 2017 IPO and had no operating activity through quarter-end. The operating results below are those of Funko Acquisition Holdings, L.L.C. (FAH, LLC) and subsidiaries, which conducted the business before the IPO. Funko designs, sources, and distributes licensed pop-culture products.
Key financial metrics
Amounts are in millions of dollars unless noted. Gross margin excludes depreciation and amortization.
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net sales | $142.8 | $118.0 | $346.6 | $294.3 |
| Gross margin | 40.9% | 39.2% | 38.1% | 32.9% |
| Income from operations | $17.3 | $21.4 | $22.8 | $23.2 |
| Net income (loss) | $8.3 | $17.2 | $(1.9) | $11.1 |
| Adjusted EBITDA, non-GAAP | $27.0 | $31.0 | $58.3 | $66.6 |
- Q3 revenue grew 21.0%; nine-month revenue grew 17.8%. Foreign sales increased 91.3% in Q3 and 79.3% for nine months, primarily reflecting the Underground Toys acquisition. U.S. sales grew 6.5% and 4.6%, respectively.
- Gross margin improved, but higher operating costs and interest expense weighed on earnings. SG&A rose 73.9% in Q3 and 49.5% year to date; interest expense rose 116.1% and 96.7%, respectively.
- Cash from operations was $10.4 million for the first nine months, versus cash used of $3.7 million in 2016. Investing used $54.7 million, including $26.3 million of property and equipment purchases and acquisition spending. Financing provided $45.9 million; cash increased $1.5 million to $7.7 million.
- At September 30, cash was $7.7 million and working capital was $12.2 million, compared with $6.2 million and $54.9 million at December 31, 2016. The filing attributes the working-capital decline in part to higher current debt.
- At September 30, debt included $61.7 million drawn on the revolving facility, $20.0 million of subordinated notes, and term loans. Total debt carrying value, net of issuance costs, was $286.7 million; current portion was $37.6 million. The company reported compliance with debt covenants.
Material changes and unusual items
- Q3 active properties increased 26.6% to 400; the nine-month count increased 37.2% to 468. Nine-month average sales per active property declined to $0.7 million from $0.9 million.
- Gross-margin gains reflected the absence of much of the prior-year acquisition inventory step-up, improved Funko UK margins, and lower weighted-average royalty rates. Q3 gains also reflected stronger European product margins, partly offset by royalties and freight costs.
- SG&A increases included personnel, professional fees, marketing, facilities, and investment in direct-to-consumer initiatives. The company expected additional public-company costs.
- Acquisitions: Underground Toys assets were acquired in January 2017 and Loungefly in June 2017. Purchase price allocations remained preliminary and could change materially. Loungefly contributed $7.1 million of post-acquisition sales and $0.8 million net income; Funko UK contributed $56.4 million of nine-month sales and a $1.9 million net loss.
- On November 6, 2017, Funko completed an IPO of 10,416,666 Class A shares at $12.00, receiving approximately $116.4 million net. Proceeds and cash on hand repaid $20.9 million of subordinated notes, $46.1 million of Term Loan B debt, and $55.6 million drawn on the revolver. The filing reports a $5.1 million debt-extinguishment loss related to the Term Loan B repayment. The IPO proceeds were fully used for these purposes.
Outlook, risks, and contingencies
- No numerical earnings or revenue guidance is provided. Management said liquidity and capital sources should fund operations, growth, planned capital expenditures, and public-company costs for at least 12 months, while warning that future cash flows or revolver availability may not be sufficient.
- Management describes moderate seasonality; historically, more than half of annual sales occur in the third and fourth quarters as retailers stock for the holidays. Rapid product and pop-culture shifts may increase volatility.
- Key business risks include short-term, non-automatically-renewable licenses; concentration in licensed properties and the Pop! brand; retailer and distributor dependence; inventory forecasting; third-party manufacturing and supply-chain disruption; international, currency, and Brexit-related exposure; and leverage and interest costs.
- The top ten licensors generated approximately 70% of nine-month sales; Disney, Lucasfilm, and Marvel together accounted for approximately 31%. GameStop represented approximately 12% of sales. Toys “R” Us, which filed for Chapter 11 in September 2017, represented approximately 3.6% of nine-month sales.
- The post-IPO Tax Receivable Agreement generally requires Funko to pay Continuing Equity Owners 85% of specified tax benefits realized or deemed realized; management expects payments could be significant. Continuing Equity Owners may redeem FAH, LLC units for cash or Class A shares, at the company’s election.
- A putative securities class action was filed November 16, 2017, alleging misleading IPO disclosures. The company intends to defend the claims and stated potential liability was not then probable or reasonably estimable. Other ordinary-course legal matters are also disclosed.
- Management reported disclosure controls and procedures were effective. The company is an emerging growth company and a controlled company, and relies on certain Nasdaq governance exemptions.
Important facts for investors to verify
- Reconcile post-IPO debt balances and interest costs after repayment of the subordinated notes, Term Loan B, and revolver; assess remaining Term Loan A obligations and covenant headroom.
- Monitor operating cash conversion, inventory growth, receivables and reserves, and the ability to fund seasonal working capital and capital expenditures.
- Track whether revenue growth and gross-margin gains persist as product mix, license royalties, freight costs, and acquisition effects change.
- Review final acquisition purchase accounting, integration performance, and the profitability of Funko UK and Loungefly.
- Assess exposure to major licensors and retailers, license renewal terms, royalty-audit reserves, and the potential effects of retailer distress, including Toys “R” Us.
- Evaluate the costs and cash-flow effects of the Tax Receivable Agreement, unit redemptions, public-company expenses, the IPO-related litigation, and subsequent acquisitions.