Funko, Inc. — Q3 2019 Form 10-Q
Business context and reporting period
Funko designs, sources and distributes licensed pop-culture products. This unaudited quarterly report covers the three and nine months ended September 30, 2019; comparisons are with the corresponding 2018 periods. Funko reports as one operating segment. Figures below are in millions of dollars except per-share data.
Financial performance
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net sales | $223.3 | $176.9 | $581.6 | $452.8 |
| Gross margin, excluding D&A | 38.3% | 38.4% | 37.8% | 37.8% |
| Operating income | $22.6 | $16.6 | $52.5 | $32.0 |
| Net income | $15.5 | $7.6 | $34.1 | $9.5 |
| Net income attributable to Funko, Inc. | $8.6 | $1.6 | $16.0 | $2.2 |
| Diluted EPS | $0.25 | $0.06 | $0.50 | $0.09 |
| Adjusted EBITDA (non-GAAP) | $40.6 | $33.9 | $97.3 | $70.4 |
Q3 sales increased 26.2% year over year; nine-month sales increased 28.4%. Management attributed growth to more active licensed properties and strong U.S. and European demand. Nine-month active properties increased 22.8% to 737, while average sales per active property rose 4.6%. International sales grew faster than U.S. sales in both periods.
Operating income rose 35.9% in Q3 and 63.8% over nine months. Net income attributable to Funko increased 450.3% in Q3 and 613.7% for the nine-month period, from comparatively low prior-year amounts. Lower interest expense supported the improvement: it fell 37.0% in Q3 and 33.5% year to date. Q3 gross margin edged down, mainly due to higher Loungefly duties; nine-month gross margin was unchanged, with lower license, royalty and freight costs offsetting higher duties. SG&A included $2.9 million of customs-investigation-related costs in Q3 and year to date. Adjusted EBITDA is non-GAAP and includes management-selected adjustments; it should not be treated as a substitute for GAAP results or cash flow.
Cash flow, debt and liquidity
- Nine-month cash flow: Operating activities provided $63.0 million, versus $21.4 million in 2018. Investing used $33.5 million, including $27.2 million of property and equipment purchases and $6.4 million of net acquisition cash outflow. Financing used $30.8 million, including $22.9 million of distributions to continuing equity owners and $8.8 million of term-loan repayments. Cash increased by only $0.006 million to $13.5 million.
- Balance sheet at September 30, 2019: Current assets were $285.0 million and current liabilities $165.8 million; reported working capital was $119.1 million. Cash was $13.5 million, receivables $163.1 million and inventory $94.3 million.
- Debt: Term-loan principal was $223.3 million and revolver borrowings were $18.5 million. Carrying value of total debt was $237.7 million, net of debt issuance costs and discount. The revolving facility was increased to $75 million in February 2019. A September amendment extended facility maturity to September 23, 2024 and reduced interest margins by 0.75 percentage points. The company reported covenant compliance at quarter-end.
- Other obligations: Operating lease liabilities were $70.6 million. The Tax Receivable Agreement liability, including accrued interest, was $65.4 million, up from $6.8 million at December 31, 2018; $4.4 million was classified as current.
Management said available liquidity was expected to fund operations, growth plans and planned capital expenditures for at least the next 12 months, but cautioned that future cash flow or revolver availability may prove insufficient and additional financing may be needed.
Material changes, outlook and risks
- Customs duties and financial-statement revisions: Funko identified approximately $7.8 million of historical Loungefly customs-duty underpayments and paid that amount to U.S. Customs in July 2019. The company said $6.3 million related to previously issued statements. It concluded the identified errors were not material to prior periods individually or in aggregate, but cumulative correction would have been material to the second-quarter 2019 statement of operations; prior-period figures were revised. Potential penalties were estimated at $0.2 million to $1.0 million, with $0.5 million accrued. The filing says the company was not aware of a government investigation as of the report date.
- Internal controls: Management identified a material weakness concerning controls over the completeness and accuracy of customs-duty calculations at Loungefly. Disclosure controls were deemed ineffective as of September 30, 2019. Planned remediation includes customs procedures, training and periodic compliance reviews; remediation was not reported as complete.
- Growth and costs: Other-product sales grew, supported by Loungefly and softlines, and the company began expanding into board games through its February acquisition of Forrest-Pruzan Creative. The acquired business’s results through September 30 were not material. Growth investments in personnel and facilities increased SG&A.
- Guidance and seasonality: The filing text does not provide a clear numerical earnings or revenue forecast. Management noted that active-property counts and sales per property can fluctuate with pop-culture trends. Historically, more than half of annual sales occur in Q3 and Q4 as customers build holiday inventory.
- Key risks and contingencies: Funko depends on licensed intellectual property, third-party manufacturers and retail customers; its top ten licensors represented about 76% of nine-month sales, and Disney-affiliated licensors about 38%. Other risks include rapid shifts in consumer demand, tariffs and foreign-exchange movements, inventory management, debt and restrictive covenants, and the substantial Tax Receivable Agreement obligation. Securities class-action litigation remained pending: the state action was dismissed with leave to amend, an amended complaint was filed October 3, 2019, and Funko intended to seek dismissal; a related federal action was stayed.
Most important facts for investors to verify
- Progress and effectiveness of customs-duty control remediation, and any U.S. Customs investigation, penalties or further costs.
- The effect of the prior-period revisions and the accuracy of subsequent financial reporting.
- Whether sales growth can continue without gross-margin deterioration as duties, product mix and licensing costs change.
- Cash generation, seasonal working-capital needs, debt covenant headroom and the capacity to meet debt, lease and Tax Receivable Agreement obligations.
- Potential dilution from continuing-equity-owner unit redemptions, equity compensation or future securities offerings, and developments in the securities litigation.