Funko, Inc. (NASDAQ:FNKO) Q4 2022 Earnings Call Transcript

Funko, Inc. (NASDAQ:FNKO) Q4 2022 Earnings Call Transcript March 1, 2023

Operator: Good afternoon, and welcome to Funko’s conference call to discuss financial results for the fourth quarter of 2022. Please be advised that reproduction of this call in whole or in part is not permitted without written authorization from the company. And as a reminder, this call is being recorded. I would now turn the call over to Ben Avenia-Tapper, Director of Investor Relations, to get started. Please proceed.

Ben Avenia-Tapper: Thank you, and good afternoon. With us on the call today are Brian Mariotti, Chief Executive Officer; and Steve Nave, newly appointed Chief Operating Officer and Chief Financial 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 the most directly comparable U.S. GAAP financial measures and supplemental financial information can be found in the earnings press release and 8-K that we released earlier today. All these items, plus a visual presentation that investors can consult to follow along with this discussion are available on our Investor Relations website, investor.funko.com. I will turn the call over to Brian.

Brian Mariotti: Good afternoon, and thank you, everyone, for joining us today. As most of you know, this is my first earnings call as I step back into the role of CEO in December. I’d like to use this call to provide an update for the important work that is underway at Funko. I want to first emphasize that I step back into the role of CEO because I fully believe in the power of the Funko brand and its potential, but also recognize significant operational issues confront us. Our first priority is a reset of our operations, which we are addressing with urgency, but it won’t happen overnight. Recognizing our current situation, I think it’s important to understand how we got here. Since we IPO-ed approximately 5 years ago, we’ve more than doubled our revenue.

We have taken a nascent direct-to-consumer business and growth of 15% of total revenue this past quarter. We’ve expanded into multiple neuteography and we’ve added amazing new brands for our pop-culture platform. This rapid growth brought challenges that we are now addressing. Our history proves that we can deliver reliable, profitable growth. But to do so, we will need to reset our operational foundation. With that context, let’s turn to the results for the quarter. Demand for our brands is stronger than ever, but we’re still early in our operational reset. Looking at our financial results for the fourth quarter, net sales were $333 million, down 1% year-over-year, wrapping up the year in which we grew 29% year-over-year. In our direct-to-consumer business, the channel we have most control over, we grew 37% year-over-year.

And on the wholesale side, while we don’t typically comment on point of sales trends, wholesale sell-through has been very encouraging. In Q4, we posted double-digit POS growth, well ahead of NPD estimates of flat growth for the broader industry over the same period. While demand remains strong, our fourth quarter profitability was heavily impacted by our operational challenges. Adjusted EBITDA was a loss of $6 million and adjusted EPS was a negative $0.35. It was clear on our last earnings call that the business and our operations hit an inflection point, a combination of macro factors and Funko-specific issues have disrupted our financial and operating performance to an unacceptable degree. We’ll share more details on our financial results shortly, but I want to spend this time discussing the important work that’s underway and how we’re going to get our operations back on track.

Our Board and our management team are deeply focused on execution and unlocking the potential of Funko’s unique value proposition. To begin, we have strengthened our leadership team. Steve Nave, who is with me on today’s call, joined us in early December in interim operations consulting capacity. We announced that today, Steve will serve as both the new Chief Financial Officer and Chief Operating Officer. Steve brings a wealth of expertise spanning retail, consumer and e-commerce industries. He served as CFO, COO and CEO of Walmart.com where he is responsible for all aspects of a multibillion-dollar e-commerce business. More recently, Steve was the CEO of new — brand, a multi-channel retail. We are thrilled to have Steve on board. We made good progress in aligning the finance and operations side of the business, and that’s exactly why Steve will be serving in both capacity as CFO and COO.

Allowing Steve to oversee both functions, we believe we’ll be better positioned for him to drive that alignment as we work across the organization to improve efficiencies and ultimately, our financial results. Our efficiency improvements fall into 3 categories, gross margin initiatives, fulfillment cost reductions and other SG&A savings. These actions are well underway, but 2023 is still very much a year to operationally reset. Once completed, we believe these actions will save us between $150 million and $180 million annually. Our first category of focus to improve execution is on the gross margin line. Here, we have 2 primary levers: price and product costs, which, together, we expect to contribute approximately $60 million to $70 million in annualized adjusted EBITDA.

Last quarter, we discussed extending our price increases to include our exclusive product line. The resection has been encouraging, and we believe our products remain curly at an affordable price range for our customers. We are also driving down our product costs with the introduction of a more competitive bidding process from our vendors and a more comprehensive assessment of cost throughout the product development life cycle. The second and third categories include addressing our fulfillment obstacles and reducing other SG&A spending. Since the pandemic, we’ve added approximately $85 million in annual fulfillment expenses despite similar overall throughput in our distribution center. The mix of the business has changed since 2021. But by focusing on the execution, we can replan a significant portion of that spending increase.

Combined, we expect fulfillment savings and other SG&A reductions to add $90 million to $110 million in annualized adjusted EBITDA. The first action addresses the efficiency of our distribution center. We’re implementing a warehouse management system that we believe will dramatically improve our cost to fulfill. This system is expected to be up and running this summer. The second fulfillment improvement action is addressing our elevated inventory levels. We are beyond the intended capacity of our Arizona-based distribution center. The volume is restricting our distribution centers throughput and incurring incremental container rental charges. By eliminating this inventory, which we expect to do in the first half of this year, we expect that will both reduce SG&A spending expenses and improve our gross margin by saving on incremental container rental targets.

Finally, we are taking steps to reduce operating expenses across the board, including a workforce reduction of approximately 10%, tighter marketing spend, and other cost reduction actions to ensure our spending is aligned with our top line results. These changes are on-going, and we are focused on executing on all these initiatives with a high degree of urgency. We expect the margins in the first half of the year for me under significant pressure. However, by the second half of the year, we expect the combination of gross margin initiatives, improved fulfillment and reduced SG&A spending to return for our adjusted EBITDA margins to double digits. 2023 is a year for us to focus on operations. Most of that work is already underway and will continue throughout the first half of the year.

Many of our retail partners have been very tentative in their post-holiday restocking, and we expect that to weigh in on first half However, as already noted, demand and sell-through remain strong. We expect a robust second half rebound in the content calendar. These factors give us confidence in top line performance in the second half. That sales trend, coupled with the bulk of our operational improvements coming in the first half, we expect our results to improve in the second half of the year. I look forward to updating you on the progress along the way. While we are heavily focused on execution, we have not lost sight of opportunities to grow our core business through new collaborations, adjacent product categories, new direct-to-consumer experiences and new geographies.

These opportunities are exciting and expected to help grow our bets. Today, however, operational improvements are the most important. Our execution here will help us to ensure we’re well positioned to win in these new growth opportunities in the future. We know that 2023 will be a year to reset, but I’m confident we will come out of this a stronger Funko from top to bottom. These steps will allow us to regain our operating leverage as we accelerate growth in the near future and deliver long-term value creation for the company and our shareholders. Now let’s turn it over to Steve to provide more details on the financial results of the quarter.

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Steve Nave: Thanks, Brian. Hey, everyone. It’s nice to meet you. I look forward to future conversations with each of you. I’m super excited about this business and helping to unlock Funko’s potential. I look forward to getting to know you all over the coming quarters as we continue on the operational and financial initiatives we have underway. Now jumping into the results. In the fourth quarter, we delivered net sales of $333 million, down 1% over the prior year. Our direct-to-consumer channel grew 37% to $49 million driven by very well-received events, including Black Friday and Cyber Monday. The strong performance in our direct-to-consumer business was offset by slower sell-in on the wholesale side. Wholesale declined 6% to $284 million as we manage through a period of muted destocking across most of our retail partners.

In the U.S., net sales declined 5% to $241 million, while net sales in Europe were relatively flat at $64 million. Other international net sales increased 45% from $28 million with double-digit growth in all of our emerging geographies. On a brand category basis, net sales in our core collectible brands declined 7% to $244 million, on lower evergreen content, as we prioritize more time-sensitive current content in light of our constrained logistics. The Loungefly brand grew 31% to $71 million, bringing the full year growth to 68% year-over-year as the brand saw strong demand. Among our other brands, which include poise and gains in our digital products, net sales declined 13% to $18 million as the on-going strength of our digital collectibles was offset by fulfillment challenges in our games business.

Turning to margin and expenses. Fourth quarter gross margin was 28%, well below our expectations due to multiple factors, including container rental charges and, to a lesser extent, chargebacks. These 2 factors reduced gross profit by approximately $15 million. While freights do continue to improve, this was offset by container rental charges incurred when capacity constraints within our distribution center prevented us from unloading containers. As Brian discussed, we believe that our on-going inventory management practices, combined with our lower product costs and increased pricing will allow us to get back to our historical margin range in the second half of this year. Moving on to operating expenses. We experienced significant headwinds due to constrained logistics.

SG&A was $139 million, which includes a onetime $33 million non-cash charge for the write-down of capitalized costs related to a pivot in our ERP deployment strategy. In addition, there was approximately $3 million in incremental labor and third-party fulfillment expenses. For the fourth quarter, adjusted EBITDA was negative $6 million, due to container rental charges, chargebacks and additional fulfillment expenses, all of which we are addressing in the first half of this year. Finally, adjusted diluted loss per share was $0.35. Turning to the balance sheet. We ended the quarter with $19 million of cash on hand. We ended the quarter with total debt of $246 million. Today, we announced an amended credit agreement which provides us with additional room under our financial covenants as we implement this year’s cost savings initiatives.

Please refer to our 10-K filing for additional details. Inventory at quarter end totaled $246 million, up 48% year-over-year. As Brian previously mentioned, we’ve conducted an exhaustive analysis of our fulfillment network and have decided to reduce our inventory levels to improve our overall cost to fulfill by managing our inventory to the proper efficient operating capacity of our U.S. distribution center. We expect this action to result in an inventory write-down in the first half of between $30 million and $36 million. Before I move on to our guidance, I’ll note that we’ve all been incredibly focused on identifying and addressing opportunities for improvement. We believe that executing on our initiatives will position us to drive sustained long-term shareholder value.

However, these initiatives will take time and in some cases, several quarters. As a result, we don’t expect adjusted EBITDA to be positive until the second half of 2023, but to improve sequentially throughout the year as these initiatives take hold. For the first quarter, we expect revenue of between $225 million and $255 million, excluding our anticipated inventory write-down, we expect gross margin to be slightly below this past quarter and improved sequentially throughout the year as our inventory actions, pricing and product costing efforts take hold. We expect SG&A to be sequentially lower by approximately $25 million. Adjusted EBITDA for the quarter is expected to be between negative $50 million and negative $45 million, returning to positive territory in the second half of 2023.

We expect adjusted net loss of negative $53 million to negative $48 million based on a blended tax rate of 25%. And adjusted loss per diluted share of negative $1 to negative $0.90 based on a weighted average diluted share count of 52.3 million. For the full year, as gross and operating margins improved, we expect year-over-year revenue growth between 0% and 5%. We expect adjusted EBITDA for the year to be between $50 million and $75 million with effectively all of that coming in the second half of the year. We’ve made steady progress, and there’s still much more to do. We’ve identified initiatives to capture between $150 million and $180 million in annualized adjusted EBITDA. The next two quarters will see us rebuild a stronger foundation for Funko, and we are confident it will produce meaningful benefit in the second half and into 2024 and beyond.

We appreciate your time this afternoon. Now I’ll turn it back over to Brian.

Brian Mariotti: Thank you, Steve. In closing, we remain very encouraged by the strong support and demand we continue to see from our devoted advance. As I’ve said, we recognize our results are not where we want them to be, and we are working with urgency to take operational steps we need to deliver margin improvement and drive a long-term shareholder value. We are confident in our ability to execute. Thank you for the time today, and I will now turn it over to the operator for Q&A.

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Q&A Session

Operator: Thank you. The first question on the line comes from Alexander Perry from Bank of America Merrill Lynch. Please go ahead. Your line is open.

Alexander Perry: Hi, thanks for taking my question. I guess just first, sort of is there any indication on when the operational headwinds from the lack of the warehouse management software at the new DC will be behind us? And then I guess the obvious question is, how much of a drag on sales, gross margin, SG&A, is that this year? So like if we sort of exclude the operational headwinds, what would the guidance have been? You mentioned some pretty positive color about wholesale POS being up double-digit percent in the quarter. Is that the type of growth rate that 2023 sort of would be if it weren’t for the operational issues you guys are facing? Thanks.

Steve Nave: Sure. Hey, this is Steve. I’ll take the first cut at this. On your first set of questions around the operational efficiency initiatives that we have underway, it’s going to kind of come in kind of phased throughout the year. For example, we’re already taking action on the inventory, and we’re already seeing some efficiency gains from that, although we’re not done with that work yet. We are starting to see some benefit there. We’ve already started to see these container rental charges that we’ve been incurring as we basically cut those in half as of a couple of days ago. So we’re seeing that benefit already. And that benefit is going to continue to get bigger and bigger as we work through the inventory. On the systems side, which is really the biggest hamstring in our U.S. distribution, we expect to have a warehouse management system in place this summer.

And normally in a systems implementation like that, it takes 45, 60 days to fully burn in and work out the kinks. But we’re confident that after that burn-in period, we’ll see some really nice efficiency, especially on the variable labor side of fulfillment.

Alexander Perry: Great. That’s really helpful. And then I guess just on the sort of 2 follow-up questions. Can you give us a little more color on the anticipated inventory write-down? Was this due to sort of lower wholesale reorders? Or is it primarily just the logistics issue, which didn’t allow you to unload the containers? And then my last question is what sort of led to the decision to not go through with the ERP implementation and take the charge in the quarter? Thanks.

Steve Nave: Sure. On the inventory, it’s purely an operating thing. The products are good, but the facility was running at over 100% capacity when it needs to run around 80% capacity to be as efficient as we’d like it to be. And we were incurring all these kind of storage costs, both in terms of the container rentals as well as some off-site storage that we had to procure in the fall of last year and then another temporary one that we’ve had to put in place a few weeks ago. So the inventory reduction is purely in order to be able to operate more efficiently and save a lot of money on storage costs. We work that trade-off through pretty tightly to understand that takes a hit to get rid of that inventory, but we’re very confident of the payback that we’re going to get as a result of being — just being more efficient and saving on storage costs.

On the ERP question, so it’s a little bit of an involved answer. We figured out in early part of this year, let’s call it, January, that we were not going to be on time with the launch of the ERP that was scheduled to happen this summer. And unfortunately, the warehouse management system for the Buckeye facility would have been tied to the launch of the ERP. So we took a look at the landscape, other system solutions that were out there that maybe we could implement much more quickly, including the ERP that we run very successfully in our EMEA business. And basically made the decision that we could move forward, invest less money in a pivot in the strategy than it would have cost to complete the original strategy. And the side benefit is it gives us the ability to actually launch a warehouse management system in advance this summer.