Description

A stupid sounding company name/bobble head dolls/worst IPO in 17 years/class action lawsuit/microcap/”Up C” Structure/debt on the balance sheet.  Ugh! Run Away! Just hearing those things should have most investors ignoring this company. They have. That being said, Funko presents a compelling opportunity which is not easily appreciated.  

Investment Summary

Funko is a compelling opportunity as investors remain skeptical of the sustainability of their business, and some near term fears over the Toys R Us liquidation.  We feel the company is significantly undervalued and believe the shares to be worth $15/ share, nearly double from here.

Business Description

Headquartered in Everett, Washington, Funko is a leading pop culture consumer products company. Funko designs, sources and distributes licensed pop culture products across multiple categories, including vinyl figures, action toys, plush, apparel, housewares and accessories for consumers who seek tangible ways to connect with their favorite pop culture brands and characters. 

A Passing Fad or a Durable Business Model?

Beanie Babies, Cabbage Patch Dolls, Fidget Spinners.  Fads come and go and they create enormous excitement and big ramp in sales.  But then after awhile, saturation occurs, consumer tastes change and sales become a small fraction of what they once were.  Funko has clearly demonstrated enormous sales growth which suggest its products are a fad. However, we believe that the products sold by Funko piggyback on a much broader and deeper secular trend in media and entertainment.

Pop Culture is evolving and growing

One of the toughest concepts for investors to embrace in Funko is that the company is not a “one trick pony”.  About 60% of the company revenues comes from the sales of its Pop! Vinyl product line. They are similar in appearance to bobble heads (see below)

With the proliferation and growth of digital entertainment content, such as Youtube, Netflix, Amazon, Facebook, multiplayer video games, there is a huge pool of entertainment properties for consumers, and consumers are embracing and are following their favorite brands more than ever.  Consumers can watch at home, on mobile devices any time of the day. They can follow their favorite shows or characters on Facebook, Twitter and Instagram. Following your favorite character or brand has never been easier or more socially acceptable. The collectibles market today is much more than geeks collecting batman figures.  It is much more mainstream.

Not One Brand-Funko Leverages Broad Entertainment Content

Another misconception about Funko is that this is not just about the Funko brand.  Funko leverages content across hundreds of brands through licensing contracts. Therefore its products don’t rely on one branded product to survive such as other toy properties, such at Barbie, Cabbage Patch, GI Joe etc.

Proven Expertise in Speed to Market

One of the keys to Funko’s success is their ability to get the right products to market in a short time frame.  This is a key differentiator for the business. Due to its in-house capabilities, including design and prototyping, as well as significant leverage with 3rd party manufacturers, Funko is able to get products to market quicker than other competitors.  They have the ability to get a concept to a store shelf (virtual or bricks and mortar) in 70 days. This allows them to capture changing current events quickly and it helps avoid keeping large amounts of inventory in stock.

No Brainer for Licensors

Many licensors don’t have the interest or resources to pursue selling figurines for their developed content.  It is not their core competency. However, by partnering with Funko, they not only 1) receive cash (Funko pays licensors around 15% royalties on sales), but  they 2) further bolster their existing brand following and bring in new followers.  

Growth Opportunities

1. Funko should benefit from additional shelf space from existing retailers due the recent success.

2. International Expansion.  Funko products are underselling outside the US.  While Funko generated only about 20% of its sales outside the US, its content partners generate 40% of its traditional merchandise outside the US, and 80% of movie receipts outside the US.  

3. New domestic distribution channels.  Funko has recently begun programs modestly with some drugstore and grocery store chains.  But there is huge opportunity to grow.

4. E-commerce or selling direct.  Currently Funko is generating just 6% of sales direct to consumer.  

5. New Licenses/New Products.  Though hard to forecast the growth from a new license partner can be substantial.  

IPO Disaster

It was a perfect storm of destruction that took the price down to these levels.  Initial price talk was $14-16/share, it ended up pricing at $12/ share and closed at $7.07, or over 50% down from its original price talk.  One of the reasons, was due to simply poor investment banking. But Funko was also subject to a hit piece during its IPO from the Bloomberg Gadfly entitled “Funko Extends its Playtime to Accounting-IPO Prospectus gives a lesson in Make Believe.  

https://www.bloomberg.com/gadfly/articles/2017-11-02/funko-ipo-maker-of-dolls-extends-playtime-to-accounting

The article as you can see is very cursory and takes shots at proforma one time costs, such as acquisition and corporate headquarters buildout.  It is very common for private companies to have proforma adjustments for an IPO. I agree that you shouldn’t take every adjustment that a company makes in their proforma financials.  But I think this article took adjustments that were somewhat normal, and had fun with them to an exaggerated effect with fun puns like “fun house accounting”. The net result was a total IPO disaster that Funko is fighting out of.

Financial Snapshot

Valuation

Currently shares trade at about 6.1X 2018 EBITDA, and 5.1X 2019 EBITDA.  Our target price for the company is $15/share which is about 8X 2019 EBITDA.

The closest comp in the space is Spinmaster  (TOY CN) in our opinion. Like Funko, it is a smaller growth oriented toy manufacturer.  It trades for about 12X EBITDA.

The UP C Structure

While not the key driver of value for the company, it is worth pointing out the the company came public as an Up C structure which is designed to reduce taxes for both the private owners prior to the IPO and the company to a lesser degree.  While this writeup will not go into the details of the cash flow and tax structure of this arrangement, simply put, the company will make cash payments back to the private equity owners and in return, they will be able to shield itself from future taxable taxes that it would have had to pay.  Essentially, the company creates a deferred tax asset on the balance sheet. The upshot of this I believe has created additional noise to the detriment of valuation.

Risks

-Dependence on the content of other companies’ brands.  Funko is susceptible to the changing popularity of its customers’ brands.  What might be hot one year might be not hot the next year. That being said Funko has relationships with over 125 content owners and has a library of over 1000 licensed products.   It largest relationships are with Warner Brothers, Marvel, Disney and Lucasfilm. Funko has never lost a license.

-Royalty rates.  Funko May have to pay higher royalty rates for more popular content.

-Brick and mortar traffic decline.  Currently approximately 80% of revenue is generated by physical store retailers.  32% of sales were made to specialty retail such as Gamestop, Hot Topic etc. While another 18% of sales are made to mass retail such as Walmart, Target etc.  One risk that should be kept in mind is that approximately 3% of sales is made to Toys R Us which is closing down.

-Sourcing and raw materials.  While Funko has demonstrated its adept ability in sourcing products quickly and efficiently, it is still subject to moving prices in labor and resin prices in Asia. Currently Funko sources about 50% of product from Vietnam and Funko is hedged in the berm term from resin fluctuation.

Catalysts

Execution of company estimates.  Because the IPO was such a bust, there is a low bar set for Funko.  Simply demonstrating that this is a real business that can be predictable will bolster the valuation of the company.

New major license agreement.

Acquisition by a larger toy company.  Funko is one of the few exceptions to an otherwise tougher environment for toy companies.  

Catalyst

Execution of guidance.  A show me story will improve multiple.

Acquisition by larger toy manufacturer missing out on figurine pop culture secular trend.