Funko, Inc. — Q2 2019 Form 10-Q
Business context and reporting period. Funko designs, sources and distributes licensed pop-culture consumer products. This unaudited report covers the quarter and six months ended June 30, 2019; amounts below are in millions except per-share data. Funko consolidates FAH, LLC, with a portion of earnings attributable to non-controlling interests.
Key financial metrics
| Metric | Q2 2019 | Q2 2018 | First half 2019 | First half 2018 |
|---|---|---|---|---|
| Net sales | $191.2 | $138.7 | $358.3 | $275.9 |
| Income from operations | $17.1 | $8.7 | $29.8 | $15.4 |
| Net income | $11.4 | $0.3 | $18.6 | $2.0 |
| Net income attributable to Funko, Inc. | $5.1 | $0.1 | $7.3 | $0.7 |
| Diluted Class A EPS | $0.16 | $0.00 | $0.24 | $0.03 |
| Gross margin, excluding depreciation and amortization | 37.2% | 38.1% | 37.6% | 37.6% |
| Adjusted EBITDA, non-GAAP | $31.4 | $19.5 | $56.7 | $36.5 |
For the six months ended June 30, operating cash flow was $48.0, investing cash outflow was $18.1, and financing cash outflow was $23.7; cash increased $6.0 to $19.5. Capital expenditures were $11.7, and net cash paid for the Forrest-Pruzan acquisition was $6.4.
At June 30, cash was $19.5 and working capital was $114.4, compared with $13.5 and $117.4 at December 31, 2018. Current assets were $243.6 and current liabilities $129.2. Debt was reported at $241.3 net of unamortized discount, comprising $222.0 of term debt net of issuance costs and $19.3 drawn on the revolving facility. The term loan matures in October 2023; the company reported compliance with its debt covenants.
Material changes versus prior comparable periods
- Q2 sales grew 37.8%; first-half sales grew 29.8%. Management attributed growth to more active licensed properties and stronger sales across product categories and regions. International sales rose 64.7% in Q2 and 40.8% in the first half.
- Q2 gross margin declined 0.9 percentage points, primarily due to higher inventory reserves, partly offset by improved product costs and lower licensing and royalty costs as a share of sales. First-half gross margin was unchanged year over year; 2018 included $1.8 of costs related to Toys “R” Us shipments for which no revenue was recognized.
- Interest expense fell 32.6% in Q2 and 31.8% in the first half, which management attributed to lower rates under the new credit facilities. First-half operating cash flow increased from $22.1 to $48.0.
- Funko acquired Forrest-Pruzan Creative, a board-game studio, in February for stated total consideration of approximately $11.9, including cash, shares and deferred/held-back consideration. Its post-acquisition operating results were not material.
- Funko adopted lease accounting on January 1, 2019. At June 30 it reported $41.8 of operating lease right-of-use assets and $49.0 of lease liabilities.
Outlook, commentary, risks and unusual items
- Outlook and liquidity: No specific revenue or earnings guidance is provided in the filing. Management said available sources of liquidity were expected to fund operations, growth plans, capital expenditures and public-company costs for at least 12 months, while cautioning that future cash flows and revolver availability may not be sufficient. The business is seasonal: historically, more than half of annual sales occur in the third and fourth quarters.
- Customs-duty underpayment: Funko identified approximately $7.8 of Loungefly customs-duty underpayments for May 2014 through June 2019, including $6.3 related to previously issued financial statements, and paid $7.8 to U.S. Customs in July 2019. It recorded a $0.5 liability for potential penalties within an estimated range of $0.2 to $1.0. The filing says prior-period errors were individually and collectively immaterial for those periods, but cumulative correction would have been material to Q2 2019; comparative statements were revised for these and other identified errors. The revisions did not affect reported cash flows.
- Controls: Management concluded disclosure controls were ineffective as of June 30, 2019 due to a material weakness concerning controls over the completeness and accuracy of customs-duty calculations at Loungefly. The weakness also existed at December 31, 2018 and March 31, 2019, revising prior effectiveness conclusions. Management described planned remediation, including formal customs procedures, training and periodic compliance reviews.
- Litigation: On August 2, 2019, after quarter-end, a consolidated state securities case was dismissed with leave to amend. A separate federal securities class action remained pending; management said liability was not then probable or reasonably estimable. Ordinary-course claims also exist.
- Business and financing risks: Licensed products and consumer trends are central to performance; the top ten licensors accounted for about 73% of first-half sales, Disney, Lucasfilm and Marvel together about 36%, and Pop!-branded products about 82%. Other disclosed exposures include inventory obsolescence, retail/customer concentration, third-party manufacturing and supply-chain disruption, tariffs and foreign exchange, debt covenants, and obligations under the Tax Receivable Agreement. Funko reported a $35.9 total Tax Receivable Agreement obligation, including accrued interest, at June 30.
- Capital structure: Continuing equity owners may redeem FAH, LLC units for cash or Class A shares, at the company’s election, potentially affecting liquidity or dilution. The preliminary shelf registration statement would permit up to $100.0 of company securities offerings if declared effective; the filing does not state that an offering had been completed.
Important facts for investors to verify
- Whether the customs-duty review is complete, whether further penalties or remedial costs arise, and whether the identified control weakness is remediated.
- Whether sales growth, inventory reserves and gross margins hold up through the seasonally important second half of the year.
- Debt principal, covenant headroom and actual revolver availability, as well as cash requirements for scheduled debt service and lease obligations.
- The timing and amount of Tax Receivable Agreement payments and unit redemptions, including potential cash use or share dilution.
- Developments in the pending federal securities litigation and any amended state complaint.
- Whether the preliminary shelf registration becomes effective and whether Funko or selling shareholders use it.