Funko, Inc.

Good afternoon and welcome to Funco's conference call to discuss financial results for the first quarter of 2023. At this time, all participants are in a 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 authorisation from the company. As a reminder, this call is being recorded. I will now turn the call over to Ben Abinia-Tapper, Director of Investor Relations, to get started. Please proceed.

Thank you and good afternoon. With us on the call today are Brian Mariotti, Chief Executive Officer, and Steve Knave, Chief Financial Officer and Chief Operating Officer. Before we begin, I'd like to remind everyone that during the course of this conference call, management will discuss forecasts, targets, and other forward-looking statements regarding the company and its financial results. While these statements represent our best current judgment about future results and performance as of today, our actual results are subject to many risks and uncertainties that could cause actual results to differ materially from what we expect. In addition to any risks that we highlight during the call, important factors that may affect our future results are described in our most recent SEC reports and today's earnings press release. In addition, We will refer to non-GAAP financial measures during the discussion. Reconciliations to their most directly comparable U.S. GAAP financial measures and supplemental financial information can be found in the earnings press release in 8K that we released earlier today. All of these items, plus a visual presentation that investors can consult to follow along with this discussion, are available on our investor relations website, investor.fungo.com.

I will now turn the call over to Brian. Good afternoon, and thank you for joining us today. It's been a productive quarter at Funko, and we're excited to update you on all the ongoing progress we have made. While our priority continues to be improving our operations, we haven't lost sight of all the opportunities we have to continue to grow the brand. I'm pleased to report that we are ahead of schedule with respect to cost reductions and operational improvements, as we've made remarkable strides across the business. Top line results came in at the high end of our guidance, and our strong performance on the operating initiatives drove our Q1 adjusted EBITDA outperformance by more than $30 million. Steve will provide additional details on the progress we've made on all of our operating initiatives shortly. Enthusiasm for the brand remains high despite a challenging retail climate. Between our exceptional direct-to-consumer growth, the strong performance of our recent product launches, and the early success of our newest commercial partnership with Fanatecs, we remain confident in the ongoing passion and loyalty of our fans. I'll start with D2C, which grew 61% year over year and now represents approximately 17% of net sales. Our D2C growth continues to eclipse the e-commerce industry's single-digit growth rate and highlights the power of our brand. This channel is important for several reasons. First, the strength of our D2C business represents a very strong indication of our fans' continued enthusiasm for the brand. In the channel which we control inventory levels and product newness, demand is at an all-time high. Our data suggests that among avid collectors, many purchases that may have occurred at a retail partner in the past are migrating to Funko.com. Our D2T performance also highlights the strength and effectiveness of our new website, Lost in Q1. During the quarter, we transitioned to a new e-commerce platform, Salesforce, which allowed us to upgrade the front and back end of our website, including our order management system that now provides for a more seamless customer experience. We have now improved functionality, better analytics, and a tighter integration across our sites. In turn, this has more than doubled our conversion rates from search, increased our cross-selling between Funko and LoungeFly.com more than sevenfold, and driven a double-digit increase in order values amongst other metrics. Further, our D2C channel has always been an important avenue for monetizing our convention presence, and the new site is helping us capture the strong demand we're seeing from our fans. At WonderCon, our first convention of 2023, our new site helped us more than double e-commerce revenue associated with the event compared to last year. And it's not just our e-commerce that's outperforming. In our two brick and mortar stores in Hollywood and in Everett, net sales grew 41% year over year, driven by nearly 50% increase in traffic, While we can't make up for all the lost retail opportunity, we are continuing to see extraordinary growth in the channels we do control. Beyond the strength of D2C, there are several other indications of the enduring enthusiasm of our fans. In Q1, we launched a new line of miniature collectibles called Biddy Pop, and it's been one of the most successful product launches in our history. This product not only resonates with our core collector, but taps the broader miniature collectibles trend to bring new fans into the brand. The convenient size, product quality, and diversity in licensing partners gives us the confidence in the future for this promising new form factor. The positive reception to Biddy Pop reinforces our confidence in upcoming programs this year, with one of the most exciting being the online launch of Pop Yourself. This product, which allows you to create your very own fully customized pop, is already the number one product in both of our brick-and-mortar stores, and it's easily our most anticipated launch to date. Pop Yourself not only resonates with our core fans, but also introduces a new customer to Funko through the lens of gift-giving. In addition to our Funko.com launch, we will be introducing a new broadened assortment of personalization elements and accessories, including seasonal elements, to personalize your pop throughout the year and limited edition opportunities tied to the relevant pop culture trends and events. We expect to bring Pop Yourself to a much larger audience later this year, and we're only getting started on maximizing this opportunity. Finally, I'm thrilled to be able to share our newest strategic partnership. In Q1, we went live on a key partnership with Fanatics. This is a major step for Funko as we prioritize and activate against the sports side of pop culture. We've already seen success with the launch of our limited edition Kansas City Chiefs Super Bowl Gold 4-pack and currently have Funko and LoungeSide products on Fanatics.com. We look forward to the expansion of our partnership with upcoming NFL and NBA seasons. Fanatics is the undisputed leader in the critical sports category, and we're excited to continue to deepen this relationship as they expand their collectibles footprint. As we detailed, 2023 is a year for us to focus on operations. We have made great progress on all fronts. While we have made the deliberate decision to scale back and push out some longer-term opportunities, we have continued to deliver the uniquely Funko products and experiences that have been so fundamental to our long history of success. While Funko's success, built on fanthusiasm, has shown a remarkable resilience to the volatility in the broader market, we are not immune to external factors in the short term. Based on what we're hearing from our retail partners, we are taking a more cautious approach to the second half of this year, which is reflected in our updated full-year top-line guidance. While we manage through the macro uncertainty, we believe we are off to a great start for the year. We are making excellent progress on the operations front and have multiple launches and a partnership we believe will be instrumental in driving growth well into the future. As always, we remain deeply focused on delivering long-term value creation for the company and our shareholders. Now I'll turn it over to Steve to provide more details on the financial and operating results of the quarter. Thanks, Brian.

As Brian said, we're well on the way to delivering the operational improvements necessary to support Funko's future growth. To provide greater transparency on our performance, I'll share additional context around the operating initiatives we discussed last quarter as I walk you through our first quarter results. I'll also provide an update on our outlook for the second quarter and the full year. In March, we described multiple steps we are taking to drive between $150 and $180 million in annualized improvements to our financial profile. I'm pleased to report that we've made great progress across the board. I'll start with our efforts to improve our gross margin. Last quarter, we described the container rental charges we were paying, which peaked at just over $100,000 per day. This was our most immediate action item, and I'm pleased to report that as of the end of the quarter, we've eliminated all excess containers. We were able to accomplish this work much more quickly than we originally anticipated. The introduction of a price increase on our exclusive products is the second gross margin letter we've been focused on. In Q1, we successfully wrapped up negotiations on this action with our retail partners, and we are on track to receive the full benefit of this pricing action by the third quarter of this year. Finally, we've made strides in our efforts to drive efficiency in our product costs. We've instituted a competitive bidding process with our manufacturers and are currently implementing design cost tracking and reduction initiatives. Turning to our operating expenses, we've been similarly successful in reducing the rate of SG&A increase, particularly with the U.S. fulfillment costs in our Arizona distribution center. Within our U.S. distribution center, we've rebalanced our staffing levels, introduced more efficient shift scheduling, improved process flaws, and added other fundamental improvements that have driven a substantial bottom line beat in the first quarter. Importantly, these steps are also designed to ensure a more stable foundation for our logistics as we roll out our new warehouse management system this summer. Finally, we completed a 10% workforce reduction that we announced last quarter. This action was done thoughtfully to enable us to remain well-positioned to execute on current and future growth initiatives. I'll now provide the financial results for the first quarter. In the first quarter, we delivered net sales of $252 million at the top end of our guidance rate. As Brian mentioned, our direct-to-consumer channel grew 61% to $42 million. Our wholesale business was lowered by 26% year-over-year at $210 million due to broad-based cautiousness from retailers around restocking and inventory levels. In the U.S., net sales declined 23% to $178 million, while net sales in Europe grew 4% to $59 million. In our other international regions, which faced many of the same retail headwinds, net sales declined 23% to $15 million. On a category basis, our core collectible brands net sales decreased 23% to $183 million. The Loungefly brand grew 4% to $52 million, while other brands, which includes Toys, Games, and Mondo, declined 13% to $16 million. First quarter gross margin was 20%, which included the write-down of approximately $30 million in inventory in the quarter. Excluding the inventory write-down, adjusted gross margin would have been approximately 32% or 400 basis points ahead of expectations. This outperformance was a combination of savings and product margin and container rental fees, as well as favorable freight and shipping rates. Moving on to operating expenses, SG&A was $100 million, a sequential improvement, and approximately $15 million ahead of our expectations. due to the progress we've made on driving fulfillment efficiencies. While macro retail caution has had an impact across our brands and geographies, the progress on our operating improvement initiatives has allowed us to significantly outperform our previous Q1 adjusted EBITDA guidance. For the first quarter, adjusted EBITDA was negative $14 million, more than $30 million ahead of expectations. Finally, adjusted diluted loss per share was $0.49. Turning to the balance sheet, we ended the quarter with $35 million of cash on hand and total debt of about $310 million. We remain confident in our cash forecast and believe we have ample liquidity to navigate the year. Inventory at quarter end totaled $192 million, a decrease of 22% sequentially, but still an increase of 19% year over year. We expect to continue to make progress on improving our inventory levels throughout this year. Now onto guidance for the second quarter and the full year. For the second quarter, we expect net sales of between $240 and $260 million. We expect sequential gross margin improvement relative to the first quarter adjusted gross margin. We expect SG&A to come in roughly in line with that of the first quarter. and we expect adjusted EBITDA for the quarter to be a loss of 10 million to break even. Finally, we expect adjusted net loss of 24 million to a loss of 16 million based on a blended tax rate of 25%. On a per share basis, we expect a loss of 45 cents to a loss of 30 cents based on a weighted average diluted share count of 52.2 million shares. For the full year 2023, Reflecting the uncertainty around multiple macro factors, including retail confidence, we now expect year-over-year net sales to decline by between 5% and 10%, which is a reduction to the previous guidance we provided last quarter. Despite the expected decline in our net sales outlook, we are raising the midpoint of our adjusted EBITDA outlook and now expect adjusted EBITDA between $65 and $75 million. Q1 represented a great first step in our operational reset. We remain confident in our ability to right-size our business for the current climate as we continue to build a solid financial foundation for the long term. Before I turn things over to the operator for Q&A, I'd like to take a minute to recognize the incredible hard work and dedication of our people. The improvements we've driven in the business so far this year are a testament to the scrappiness and the willpower of all of our employees. We still have a lot of work to do, but my confidence and our ability to deliver against the improvements we've yet to tackle goes up every day as I see how our teams are coming together with the singular mission of improving our financial profile. So with that said, thank you so much for your time today, and we'll now turn it over to the operator for Q&A.

Thank you. If you would like to ask a question, please press star followed by one on your telephone keypad. If you choose to withdraw your question, please press star, followed by two. When preparing to ask your question, please ensure your phone is unmuted locally. Our first question today goes to Andrew Urquitz of Jefferies. Andrew, please go ahead. Your line is open.

Hey, thanks, guys. Let me ask a couple questions. I guess the first one, just kind of on the Q1 results, you talked about the storage costs effectively going away faster than you anticipated. Is that because you were able to move inventory faster quicker, the ERP system, warehouse system got rolled out faster. Just kind of curious what allowed you to clear that out more quickly.

Yeah. Hey, Andrew, this is Steve. Good question. We were able to get out of it more quickly than we anticipated because I don't remember if we brought this up on the last call. We did acquire some short-term expansion space in Arizona, not too far from our Buckeye facility, where we were able to start staging inventory to get the containers emptied and returned. And without getting into too much of the puts and takes of that process, we also were able to find a third-party agent willing to accept the trailers on behalf of the carriers, because the carriers would only take so much back at a time, which is kind of ridiculous because they're charging us rent, but that's the way it works. So we found a third-party agent agent that can receive containers back on behalf of the carriers and that immediately stops the per diem charges that we were seeing. I think you also mentioned ERP and WMS. Those projects are not done. So ERP, just as a reminder to everybody, we're not really investing much in ERP this year. We're singularly focused on the warehouse management system. That is definitely on track, looking to launch that in the first week of July. So we should see some further efficiencies after that. And then, honestly, Andrew, I forgot the other part of your question. So feel free.

No, no, no. That answered it. I appreciate the additional color. And then just kind of switching to just a little bit more color on, I guess, the back half change and revenue guide. Is that just purely retailers wanting less? Is that – it sounded like you mentioned – A couple of initiatives were pushed out, so was that a part of it? And what kind of contribution do you think DTC will have by the end of the year, if you can share that? Thank you, guys.

Yeah, Andrew, Brian, I can start. You know, I think obviously DTC is one of the levers we're able to pull when we have a very conservative retail buying environment right now. Everybody's afraid of having too much inventory, and And so we've been able to, we can continue to ship goods to our data scene to basically, you know, move revenue from one source to another, obviously, in a more profitable manner. So that part of it we're still pretty excited about.

Yeah, I would just add on to that. The sales drop that we just guided is a reaction to what we're seeing kind of at the macro level. It's not like a bunch of our customers have come back and said, we're not going to buy all this stuff. It's just more looking at macro, having conversations with our retail partners about the second quarter and just trying to get their mood on inventory levels and things like that. So we feel like bringing the sales down was the prudent thing to do because of just the uncertainty going on kind of out there on the retail landscape.

Got it. Thanks for the color and good job on the execution so far. This looks great. Awesome.

Thank you.

Thank you. The next question goes to Linda Bolton-Weiser of DA Davidson. Linda, please go ahead. Your line is open.

Yes. Hello. So I was wondering if you could just comment on the channel, the regular brick and mortar channel inventory levels and how things stand kind of among the bigger box retailers versus the specialty retailers out there and what the current situation is.

Yeah, sure. Hey Linda, it's good to hear from you. Um, so what we're seeing with the larger retailers and I'm sure, you know, in other consumer products companies, um, you're probably hearing the same thing is that a lot of the larger retailers are just taking a peanut butter approach right now to inventory management. and reducing inventory across all categories, and we're definitely not immune to that. As you can imagine, I've got really good contacts in the retail industry, and I'm hearing the same thing from everybody that I talk to, that we want more of your product, but we're facing a, you know, a top-down mandate to reduce inventory by X percent, and it's hitting everybody. So I think that that's definitely part of it. Now, the good news is eventually they're going to run out of stock. uh so sell through is is obviously still better than sell in at some point the sell-in those those curves are going to have to cross and they're going to have to start restocking and you know we've got checked out with a number of customers and they're all kind of anecdotally saying yeah that we will definitely have to be upping our replenishment game here in the not too distant future okay and then um

I think you said that Loungefly was up 4% in the quarter. That's different from the other kind of categories of products. Why was Loungefly so much better than just the other pop figures?

You know, I think, Linda, you know, it's Brian here. Obviously, we've diversified over the last couple years since we've owned. We've diversified the retail mix and some of the channel mix. They continue to excel in D2C. Some of their partners, we don't have a ton of partners compared to Funko, but the ones they do are doing very, very well. The parks are doing very well, especially. We've opened up some new doors like Spencer's that is performing extremely well for us. So I think we're just seeing more of an opening of new retail partners that want to participate and allow us by brand. And that's kind of offsetting some of the maybe just smaller customers who are having credit issues or just, you know, Their products aren't as moving as fast as we'd hoped. The new doors, the additional doors are really helping LoungeFly. And this is ahead of a really exciting time for them with the new doggy fashion that's coming in the summertime and also our stationary line that's launching in the fall. And then following it up with a really big unisex offering for all of our bags and apparel and accessories. in Q1 of 24, it's good to see that they still have momentum going in a really tough macro environment in terms of retail. So, we're pretty excited. And again, the D2C channel is just one of those great levers we're able to pull as we can move products from one channel to another. Okay.

And then, can you just remind me, did you have any target for your own inventory by the end of 2023. Do you have a target for that?

Not that we've shared, no.

Okay. All right. That's all for me. Thanks very much.

Thanks, Linda. Thanks, Linda.

Thank you. As a reminder, if you would like to ask a question, please press star, followed by one on your telephone keypad. And the next question goes to Jeric Johnson of BMO. Jeric, please go ahead. Your line is open.

Hi, thank you. Steve, I'd like to take Linda's question and go a little bit more granular. Can you share with us a channel inventory, you know, quarter to quarter and year over year and quantify that and then perhaps bifurcate it between mass and specialty?

That's probably not something that I can answer on this call. We can follow up on that.

But yeah, going there granular on this call, I'm not equipped to do that right now. Apologies. Okay. All right. Thanks, Henry.

Thank you. We have no further questions. I'll now hand the call back to Brian for any closing comments.

Thank you very much, guys, for joining us on this earnings call, and we look forward to talking to you guys in the future. Thanks, everyone.

Thank you. This now concludes today's call. Thank you so much for joining. You may now disconnect your lines.