Funko, Inc.

Good afternoon, and welcome to Funko's conference call to discuss financial results for the third quarter of 2020. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. Please be advised that reproduction of this call in whole or in part is not permitted without written authorization from the company. As a reminder, this call is being recorded. I will now turn the call over to Andrew Harless, Manager of Investor Relations, to get started.

Please proceed. Thank you, and good afternoon. With us on the call today for management are Brian Mariotti, Chief Executive Officer, Andrew Perlmutter, President, and Jennifer Fall Young, Chief Financial Officer. A press release covering the company's third quarter 2020 financial results was issued this afternoon and is available on our investor relations website, investor.funco.com. Before we begin, I need to remind you that management's remarks in this call make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the risk factors section of our Form 10-Q, the three-month edit September 30, 2020, and our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligations to update them. We will be referring to certain non-GAAP financial measures on today's call, such as adjusted EBITDA and adjusted EBITDA margin, which we believe Thank you for joining the call today, and I hope that everyone is staying safe and healthy.

Before I jump in, I'd like to thank the entire Funko team for their tireless efforts, which has allowed us to deliver a solid quarter highlighted by revenue above our expectations and improved profitability versus a year ago. During this dynamic time, our teams are ensuring that we will continue to innovate and connect with our fans while making progress against our four key growth initiatives. In the third quarter, we delivered net sales of $191 million and strong gross margins while maintaining prudent cost control. This drove adjusted EBITDA margins of 18.9% up 70 basis points over a year-over-year basis. We also continued to strengthen our balance sheet and increased our liquidity position over 50% compared to last year to $107 million. From a top-line perspective, there are a number of positive indicators across the business, and we believe Funko is well-positioned heading into the fourth quarter and 2021. In the face of pandemic headwinds and virtually zero theatrical releases, we drilled strong consumer engagement and demand in Q3. Some noteworthy call-outs. One, Evergreen products represented 70% of our revenue. This demonstrates our ability to connect with fans through nostalgic and beloved characters across multiple genres and underscores that Funko is not reliant on new tempo movies to deliver products our fans love. Two, we continue to outperform and see strong demand within the domestic mass market and third-party e-commerce channels in the quarter, both of which grew over 15% compared to prior years. Three, more and more consumers are turning to Funko.com and LoungeLight.com for their pop culture products. In the quarter, we saw sales driven by our own e-commerce platforms again grow by over triple digits as the investments we have made into our platforms and capabilities begin to pay dividends. Four, we are seeing positive consumer response to many of our new launch games. For instance, this week, Funko Games had over 10 titles on Amazon's top 100 hot new releases for the games and accessories category. And lastly, fan engagement with Funko remains strong, highlighted by the tremendous participation we saw in our last virtual con during October. More on this shortly. Now let's turn to third quarter performance and our expectations for the balance of the year. Regent and Channel Mix continue to be primary drivers for our top-line performance in the COVID environment. Our U.S. business declined 4% in the quarter, reflecting a slower recovery within our specialty channel, which was partially offset by strength in our third-party e-commerce, mass market, and direct-to-consumer channels. As I mentioned previously, strong consumer demand drove overperformance within our domestic third-party e-commerce and mass retailers. Growth in these channels is attributed to strength within our core collectible products, as well as our expanded game and lounge-fly offerings. As the third quarter progressed, we began to see modest improvements in trends within the specialty channel, driven by store reopenings and retailers shipping their inventory to their e-commerce sites. Additionally, we are seeing ongoing momentum in our direct-to-consumer channel, which nearly doubled in Q3, driven by an increase in our own e-commerce sites, which had another quarter of triple-digit growth. Our D2C business represented 8% of our sales in Q3, up from 4% a year ago. Turning now to our international performance, as expected, Bunco's recovery in Europe has been more gradual than the U.S., given that our customer base in the region is more heavily weighted to the specialty channel. During Q3, COVID headwinds persisted in both EMEA and LATAM, with Oceana and Canada regions performing well, better than the U.S., in fact. Looking forward, we expect to see continued pressure in the European region in Q4 as a result of new COVID restrictions that recently took effect in multiple countries. We are navigating the macro uncertainty by operating and planning our business conservatively. As always, we are laser focused on innovating and delighting our fans. Equally important, we are remaining nimble so that we are prepared to manage through potential closures within the U.S. and international markets. Currently, we expect Q4 net sales to decline 10% to 8%, which includes almost 20 million or eight points of pressure related to new restrictions and closures throughout Europe. Notwithstanding the global uncertainty around potential pandemic restrictions, we expect to see strong performance within our domestic mass market, third-party e-commerce, and B2C channels, offset by continued softness within the European region and U.S. specialty channels. Importantly, we feel good about Funko's positioning heading into the holiday season, when we will have our most diverse product offering in the market yet. This is enabling us to expand our relationship with key retail customers as we partner with them to deliver an expanded product offering, which includes Funko games and youth collectibles. At the same time, we expect to drive consumers to our own e-commerce sites through creative marketing programs supported by a broad product offering. The investments we have been making in our own digital capabilities and B2C fulfillment leave us well prepared to meet the anticipated demand. Even in today's highly dynamic environment, we are continuing to see fans actively engage and seek out Funko products in-store and online. As I previously mentioned, just a few weeks ago, we wrapped up our Funko Virtual Con in conjunction with New York City Comic Con. and could not be more enthusiastic about the level of engagement and passion we received from the Funco family. Not only did we see our engagement levels triple compared to last year's in-person Comic-Con, but we were also able to drive higher sell-through of Comic-Con items at our retail partners. The broad-based love of pop culture we have been witnessing for many years now has not diminished due to the pandemic. Consumers and mega fans alike are continuing to view, engage, and create communities around their favorite properties, content, and teams. Over the long term, we are confident that Funko is positioned to drive growth as we continue to diversify our business across new product categories, geographies, and channels. We are continuously working to bring new fans into the Funko ecosystem by harnessing our innovative culture to create new products and leverage new licenses. This year has certainly come with a unique set of challenges for everyone. I want to again give my thanks and appreciation to the entire Funko team for helping us bring joy to our fans. Also, thank you partners, fans, and shareholders for your continued support. I hope everyone has a wonderful and safe holiday season and New Year's. Now I turn the call over to Andrew to discuss our strategic initiatives.

Thanks, Brian. In the third quarter, we made good progress against our key strategies to drive growth and diversification. As a reminder, these include building upon our core business, further diversifying our product portfolio, expanding our international reach and increasing the share of our business through our own direct-to-consumer channels. First, maximizing the core pop culture business. This includes creating fun and nostalgic programs with a heightened focus on evergreen properties, as well as expanding our consumer base by growing under-penetrated content genres. Evergreen properties in the quarter made up 70% of the business compared to 58% last year, and on a dollar basis grew 3% compared to last Q3. Additionally, nine out of our top ten properties were evergreen in the quarter. We continue to see strong demand with mainstay properties such as Harry Potter, Marvel Comics, Pokemon, DC Comics, Disney, and Star Wars. Some other notable programs in the quarter were The Nightmare Before Christmas, which was our fourth largest property and was driven by strong retail programs that included Pop Vinyl, Advent Calendars, and games, Marvel X-Men, The 10th largest property was primarily driven by a retail program commemorating X-Men in films over the past 20 years, as well as the inclusion of X-Men characters in our Marvel Zombies program that included pop vinyl and a collector retail box. Back to the Future, which was just outside our top 10, saw success through a broad selection of products, including pop vinyl, board games, apparel, bags, pins, and accessories. We will continue to focus on having a strong mix of evergreen content going forward and creating fun and nostalgic programs at retail. Additionally, we intend to place emphasis on expanding the anime, music, and sports genre by broadening our license base and product offering. Strategy number two, driving category diversification by harnessing our innovative culture to launch new products and reach new consumers. During the third quarter, we saw strong performance of our non-figure products, primarily due to the performance of our expanded game offerings, as well as our lounge flight items. Within games, we launched Marvel Battle World, Mystery of the Thanos Stone, late in Q2, which targets a younger demographic and combines micro-collectibles, cards, and gaming. Of note, we saw stronger than anticipated consumer demand for these products, which resulted in a low in-stock position that had us chasing replenishment throughout Q3. We believe we are now in a good inventory position at retail for the holidays. While we initially launched Marvel Battleworld at Target in the U.S., we have now expanded to other key mass e-commerce specialty and drug partners around the world. We could not be more excited about the positive reaction we are seeing from the market on this line and look forward to expanding it in 2021. We are seeing good traction with the additional game offerings we launched this year. Many of our key titles appearing on top new release lists and generating positive response from both consumers and retailers. While our board game category is currently a small piece of the overall pie, we plan to expand our offerings in the coming years and believe it will become a meaningful contributor to our business over the long term. Also in the quarter, we saw exceptionally strong momentum with our Loungefly products, which grew 25% compared to last year. This strength was driven by demand on Loungefly's website and at wholesale, where retailers chased orders they had pushed out from Q2. The resiliency and performance of the Loungefly brand demonstrates the importance of having a diverse product statement at retail and online to continue bringing fans into the Funco ecosystem. For Q4, we are very excited about the launch of Snapsies, our new non-licensed youth collectible line that utilizes Funco's patent-pending snap and match technology to allow kids to create a custom character with each snap. This line is a great example of how Funko can utilize its creativity and innovation within the collectible category to target a new consumer. Going forward, we will continue to invest and expand within games, soft lines, and youth collectibles category to ensure we are offering fans across the world an increasingly diverse portfolio of items. Now moving on to our third area of focus, international expansion. As you heard from Brian, the pandemic has been a headwind to our international business. That said, we believe there is a significant amount of growth potential in overseas markets and feel confident that Funco is well positioned to capture this when macro conditions begin to improve, particularly across AMAIA, Latin America, and Canada. We expect the recent launch of FunkoEurope.com to provide us with an additional growth lever as well as another method to expand our reach and broaden our relationship with fans across the region. That leads me to our fourth area of strategic focus, the expansion of our direct-to-consumer business. We have made significant strides growing this channel in 2020 by investing in our digital and fulfillment capabilities. As Brian mentioned, our D2C channel almost doubled in the quarter from led by ongoing momentum on our e-commerce sites, which grew more than 150%. The investments we made earlier in the year to expand our product offering and improve the customer experience are bearing fruit on Funko.com. We are continuing to strategically invest within the business to reach new consumers. As I just mentioned, we strategically launched FunkoEurope.com last month, approximately 18 to 24 months ahead of schedule. We made the strategic decision to fast track this opportunity in light of the current environment, and the team did a tremendous job getting this across the finish line ahead of schedule. Currently, we are shipping to the UK, Ireland, and Spain, and expect to expand to Germany, France, and Italy by the end of the year with additional countries coming online in 2021. While we are pleased with the substantial progress we made on the digital front, there's still more work to be done as we continue to build out our e-commerce platform. We plan to continue to enhance our site to further strengthen the customer journey and experience, as well as invest in our digital platform to ensure we can scale the business alongside demand. Despite the dynamic environment we've seen this year, we've stayed focused on executing against the strategies that we believe will best position the business for 2021 and beyond. I will now turn the call over to Jen to take you through the financials.

Thanks, Andrew, and good afternoon, everyone. As noted, Q3 came in better than anticipated across the P&L. Net sales declined 14% ahead of our initial expectations, gross margin improved, and we maintained strong cost controls. Our actions allowed us to improve profitability, increase cash flow, and maintain a strong liquidity position throughout the quarter. Q3 net sales of $191 million largely reflect the ongoing impact of COVID-19 within specific channels and regions. The outperformance relative to our expectations is primarily attributable to strength in the U.S. within third-party e-commerce, mass markets, and D2C channels. The number of active properties in Q3 was 715, which increased 14% from prior year. Net sales per active property were $267,000 on the quarter, down 25% compared to last year, reflecting the pressure on net sales from the pandemic in the quarter. The top 10 performing properties were The Mandalorian, Harry Potter, Marvel Comics, The Nightmare Before Christmas, Pokemon, DC Comics, Disney Classic, Star Wars Classic, Dragon Ball Z, and Marvel's X-Men. Third quarter net sales in the U.S. decreased 4%, reflecting the continued softness in specialty channels, which was partially offset by strength in third-party e-commerce, mass markets, and our own DVC channels. International sales decreased 34%, reflecting the ongoing effects of COVID-19 on overseas markets within the quarter, particularly in Europe. On a product category basis, Q3 net sales of figures were down 18% to 145 million. Other sales decreased just 1% to 46 million, reflecting strength in lounge five branded items, which grew 25% in the quarter. Additionally, sales of our pop branded products were down 16% in the quarter, in line with the total business performance. Third quarter gross margins came in at 38.6% of 30 basis points versus a year ago. The increase primarily reflects improved product margin due to higher percentage of DTC sales in the quarter. This is partially offset by an increase in shipping-related expenses related to a higher mix of orders being fulfilled out of our distribution centers versus direct shipments from our factories. In Q4, we anticipate gross margins will be approximately flat compared to 37.1% last year, which excludes the one-time inventory write-down in 2019. This expectation reflects a benefit from higher D2C sales offset by region and channel mix. SG&A in the quarter came in at $41 million, down $11 million versus the prior year. Lower than expected costs in the quarter were partially timing-related within hiring, marketing spend, and other administrative costs. Looking at Q4, we anticipate that SG&A dollars will decline in the mid to high single digits compared to a year ago as a result of the cost-cutting actions we've taken this year. On a sequential basis compared to Q3, We anticipate that SG&A dollars will be up due to increased fulfillment costs, marketing spend to support holiday and new product initiatives, as well as other administrative costs. Turning now to profitability, our strong gross margin performance and better than expected SG&A enabled us to deliver improved profitability in the quarter. Adjusted EBITDA came in at $36 million, which represents an adjusted EBITDA margin of 18.9% at 70 basis points from last year. Looking at the balance sheet, we ended the third quarter with total liquidity of $107 million, which consisted of $32 million of cash and cash equivalents and $75 million of availability under our revolver, as we repaid all outstanding borrowings under our line of credit during the quarter. Total debt, net of unamortized discounts, was $208 million, down 12% compared to last year. Inventory totaled $73 million, down 23% versus a year ago. the business generated strong cash flow from operations of $28 million in Q3, an increase of 87% from a year ago. Year-to-date cash flow from operations was $60 million. As we look at the balance of the year, we continue to plan conservatively given the dynamic environment. Considering the current landscape, as Brian mentioned, we expect Q4 net sales to be down 10% to 8% compared to last year. As a reminder, this includes almost $20 million, or eight points, of pressure coming from Q3 European restrictions. Additional or prolonged closures could further impact performance in the quarter. While uncertainty persists, we are taking the steps needed to remain agile and best position the business for the long term. We appreciate your time this afternoon. Now, Brian, Andrew, and I would be glad to take questions.

At this time, we will be conducting our question and answer session. In order to ask a question, please press star then the number one on your telephone keypad. Your first question comes from the line of Erin Murphy with Piper Sandler. Erin, your line is open.

Great. Thank you and good afternoon. I guess my first question is just around what you're currently seeing in Europe and maybe what exactly is embedded in the $20 million headwind that you're seeing at that X number of weeks across certain countries. And then as you think about spring 2021, are any of the retailers in Europe starting to cancel orders?

Yeah, Jen, you want to start with that? I can add in.

Absolutely. Hey, Erin, how are you? Yeah, so, you know, as we've, you know, been talking with the European business partners, what we're really seeing is that the shutdown came very quick and very swift. And we have modeled in to our forecast based on what we are seeing across the board. There has been, you know, a lot amongst several countries, there have been not only restrictions on openings, but also in terms of what can be sold. So it's a pretty big hit to the quarter just based on what we're seeing currently within the business model.

Yeah, also they add a little color. No one obviously is canceling anything for spring of next year. And we are still working with the assumption with some of the retailers that we will be able to start shipping again as early as December 2nd on some of the countries that are shut down for the 30-day shutdown. So we're doing everything we possibly can to mitigate the possible shutdown for 30 days, in addition to obviously having our own e-commerce direct-to-consumer platform up and running.

Okay, that's helpful. And then maybe just to that latter point on the European.com opportunity, can you just help us think about at least the US.com business? What percent of the overall US mix is that? And is that like the right benchmark to use of how big the European.com business could be, at least as a mixed percentage over time?

Yeah, our entire DSC business represented 8% of the business over the quarter. that does include our two stores. As we think about go forward, we just launched, I think we're two weeks in with our European site. And over the course of the quarter, we will be opening up more countries. So we do expect that to grow, but it's still a pretty small part of the business. That being said, as Andrew mentioned in his remarks, this is a major priority and we will continue to invest in this initiative to continue to grow it as an overall piece of the business on both sides, both internationally and domestically.

And then just my last question is just you guys have done a really good job in the absence of new releases, just leveraging that evergreen content. So I guess the question is for Brian, what is your confidence level that you can kind of keep this evergreen engine going? And then how do you feel about the new release schedule for 2021? Thank you.

Yeah, thanks, Aaron. I mean, as of today or as of Monday, let me change it again. You know, we are, you know, I think the last couple of years gives us a lot of confidence. If you look at Harry Potter, it's been the number one license we've had over the last four years combined, and it's evergreen. So you look at the last quarter and this quarter, nine of the top ten have been evergreen in nature. We've always said the one time we kind of got away from that mix was It came back to bite us, which was Q4 of 19 when we were too heavy in Star Wars F9 and too heavy in Frozen 2. So, you know, I think the ability to just continually find interesting retail stories and products with evergreen content. is going to continue to go very strong for us for the next couple years. I think the lesson learned in Q4 will keep us always hungry to make sure we're developing these great evergreen properties and building really cool retail programs around that. And then you layer in, we think a really strong content year next year. And I think, you know, I think there's still some There's some liquidity in that and some fluidity in that in the first half of the year, but it's still much stronger than what we have in 2020. 2020 was as bare as it's got, and considering a global pandemic and almost no new content besides The Mandalorian, I think we've done exceptionally well.

Great. Thank you for that.

Your next question comes from the line of Steph Withink with Jefferies. Steph, your line is open. Good afternoon.

This is Ashley Helgens on for staff. Thanks for taking our question. To start, we were wondering if you could update us or give a little bit more color on the GAINS initiative given the strength in the category year to date, and then any space allocation changes or new distribution we should know about. Thanks.

I can jump in on that one if you guys want to talk a little bit about the GAINS business. So our games plan is going, you know, according to plan, we are increasing our shelf space with our retail partners. You know, as I mentioned on the call, it's still a pretty small piece of the overall pie. But that being said, we are seeing growth. We are seeing additional shelf space at our retailers. We're seeing a tremendous reaction from our online e-commerce partners. You know, one of the fun ways to track that is by, you know, looking at all the lists that they have on Amazon. I referenced that on my talking points. And so, yeah, we're really excited about it. We're excited about it both at retail and at e-com as well. And so we continue to grow it. I think that, you know, it's a fresh take on the category. The category is doing very well, as you pointed out. It's perfect for, you know, when people are spending more time at home. You know, better for some categories than others. Party games, obviously, is, you know, is taking a little bit of a hit because of the people getting together around the table. But, you know, the strategy category and a lot of the other categories are doing really well. So we're excited about it. We've seen a lot of success this year, and we look forward to building on that in the years to come.

Great. Thanks. And then just, yeah, my next question, just any space allocation changes we should know about or new distribution we should be factoring in our models?

Yeah. I don't think that there's anything of note. I can tell you that we are seeing, you know, continuing to see additional space allocated to us retailer by retailer. You know, we had mentioned that before. We're growing our space both in by diversifying our categories at retail, but then also just taking over more incremental space within our departments. So that's continuing to happen. And we mentioned the launch of Snapsees, which is obviously incremental space in a completely different department for us. coming out in Q4. Very excited about that. Just launched in Europe at Tesco last, I think, Monday of this week. So, you know, we're excited to see how that goes. And, you know, we're getting more and more interest as the weeks go on. So we're very bullish on that. But, yeah, I mean, that's an incremental space for us as well in the new department of the store. Okay, great. Thanks so much. I'll pass it off to someone else. Thank you.

Your next question comes from the line Alex Perry with Bank of America. Alex, your line is open.

Hello. Thanks for taking my question. Some other retailers in the space have called out sort of a different cadence to holiday this year, you know, sort of extended promotional timeline. Just could you give your outlook on any possible promotional environment to the extent you see one? Thanks. That's my first question on it.

You know, as we enter into the holiday season, you know, right now we're feeling very optimistic despite, you know, some of the pressures that we are seeing in the European business. You know, if you look across just the core business, you know, within the U.S., we are seeing some positive signs. And as we noted in our guidance, you know, with our down 10 to 8 percent, you know, that does include an eight-point hit from the European business. So, We're feeling very bullish as we move into Q4, at least domestically, but we anticipate seeing some really strong business within the quarter. From a promotional perspective, Andrew, feel free to chime in, but we haven't seen necessarily anything different from our perspective. It's been the success of our e-commerce site, our own e-commerce site, as well as mass remains really strong.

Perfect. And then I guess just my second one, can you just give us an update on how you're seeing the trends progress within your specialty channel? It seems like you have seen some sort of sequential improvement there. And then just any comments on how much of the demand recapture you think you're getting from specialty channel customers within your own e-commerce business? Thanks.

I can start. Obviously, you know, doors are opening. Foot traffic is obviously down considerably in the malls. But, you know, some of our retailers are doing curb pickup. Some retailers are limited by how many people could be in the store. A lot of their business is shifting to direct-to-consumer online. So, you know, each one of our partners are taking the strategy a little bit differently, but we are starting to see the foot traffic. We're bound and obviously orders continue to build into the holiday season. So we're very excited about what that means. You know, and again, I think the DTC journey, I mean, it probably mirrors, you know, what the mall experience is going to be post pandemic. I mean, it's going to be different and there's going to be businesses that don't make it. And, you know, we've always felt like our products are channel agnostic. They can flow from, channel-to-channel, retailer-to-retailer if need be. But we're definitely seeing a better situation and specialty than we did a few months ago. Perfect. That's really helpful. Best of luck going forward. Thank you.

Thanks.

Your next question comes from the line of Tammy Zakaria with JP Morgan. Tammy, your line is open.

Hi, thank you so much. My first question is, have you seen any volatility in demand in the U.S. market as COVID cases saw some spikes in some geographies?

Yeah, not domestically, no. We've seen no fluctuations at all. As a matter of fact, demand is stronger than ever, and our focus is getting the products out of the warehouse as quickly as we possibly can into the retailer's hands and into our fans' hands. So, no, nothing domestically.

Got it. And my second question is, can you remind us of the size of the lounge fly business relative to the core pop segment?

Yeah, Jen, you want to take that one?

Yeah, sure. You know, Lentify has continued to grow for us. We feel really good about the position that the business has been. It's still, you know, either sub 20% of the business in total. It's, you know, it's grown from a percentage penetration perspective. It's grown about 50%. So, you know, it's in the mid-teens as a piece of the overall business.

Got it. Super helpful. And one last question. I think you've guided to mid to high single digit growth and SG&A expense. So does that include DNA or just SG&A dollars?

That was an SG&A dollar guidance question. And really what we're talking about is as we're coming off of Q3 and we gear up into Q4, you will see an increase in our SG&A coming off the Q3 quarter.

Got it. So sGNA excluding DNA, that's the guide? Correct. Got it. Okay. Thank you so much.

Thank you. Ladies and gentlemen, this concludes today's conference call. On behalf of Funko, we appreciate your participation. You may now disconnect.