Funko - Q2 2023

Transcript

Operator (participant)

Ladies and gentlemen, good afternoon, and welcome to Funko's 2023 Second Quarter Financial Results Conference Call. 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 production of this call and whole or in parts is not permitted without written authorization from the company. As a reminder, this call is pre-recorded. I will now turn the call over to Funko's new head of Investor Relations, Rob Cassidy. Please proceed.

Rob Cassidy (Head of Investor Relations)

Hello, everyone, thank you for joining us today to discuss Funko's 2023 second quarter financial results. On the call are Mike Lunsford, our recently appointed Interim Chief Executive Officer, and Steve Nave, the company's Chief Financial Officer and Chief Operating Officer. This call is being broadcast live at investor.funko.com. A playback will be available for at least one year on the company's website. I want to remind everyone that during the course of this call, management's discussion will include forward-looking information.

These statements represent our best judgment about the company's future results and performance as of today. Our actual results are subject to many risks and uncertainties that may differ materially from those stated or implied, including those discussed in our earnings release. Additional information concerning factors that could cause actual results to differ materially is contained in our most recent SEC reports.

In addition, during the course of this call, we refer to non-GAAP financial measures that are not prepared in accordance with US generally accepted accounting principles and may be different from non-GAAP financial measures used by other companies. Investors are encouraged to review Funko's press release, announcing its 2023 second quarter financial results for the company's reasons for presenting non-GAAP financial measures.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures is also attached to the company's earnings press release issued earlier today. I will now turn the call over to Steve. Thanks, Rob, and welcome to Funko, by the way. Good afternoon, everybody, and thanks for joining us today. In the second quarter, net sales were $240 million, and adjusted EBITDA was a loss of approximately $8 million.

Both metrics were within the guidance ranges we previously provided for this quarter. Our second quarter performance was impacted by ongoing inventory destocking by our larger wholesale customers. We anticipate this softness will continue in the second half of the year. Accordingly, we have lowered our full-year guidance. I'll discuss guidance in more detail later in the call. With that brief overview, I'd like to introduce everyone to Mike Lunsford to give you more color. Mike was recently named interim CEO.

He's an experienced CEO and has served as interim CEO for two other public companies. He's been a member of Funko's board for the last five years, so he is very familiar with the company, its operations, and its challenges. Mike, go ahead.

Mike Lunsford (Interim CEO)

Good afternoon, everyone. As Steve just said, I was recently appointed interim CEO upon Brian's departure from the role. Brian remains actively engaged as both a member of the company's board and as Funko's greatest evangelist, though he is currently taking some time away from the day-to-day to re-energize. We plan to launch the search for a permanent CEO this quarter. The board, with help from an executive recruiting firm, will conduct a thorough search, including both internal and external candidates.

As for me, I love Funko and have been a fan of the company, brand, and team for years, and I'm excited for the opportunity to lead the transition. We are not in a holding period. I have a mandate from the board to quickly reshape Funko, to regain its nimbleness, to return to growth, and to be meaningfully more profitable.

I'm highly confident we will do all three in short order. I'm very familiar with the talented senior leadership team from my five years on the board. This familiarity has allowed us to rapidly reset our strategy for achieving long-term profitable growth. We've already started to execute that strategy. For Funko, the foundation of any strategy must start with the brand and our fans, who count on us to deliver fun, pop culture products that serve as avatars, memories, art, fashion, and most importantly, identity.

Very few brands have such a deep connection with the customer's identity as we do. It is an honor and one that we must constantly strive to earn and maintain. Delight them while running an efficient business underneath. We believe there is no end to the upside in Funko.

Despite the expected second half retail softness that Steve called out earlier, we believe our brand is as strong as ever. We say this based on the strength of sales of our e-commerce site, up 19% year-over-year, and in our retail stores, up 10% year-over-year, and the enthusiasm of our customers and fans we witnessed at San Diego Comic-Con and our Funko Fundays event two weeks ago. E-commerce revenue generated from San Diego Comic-Con product releases was up more than 50% versus last year and drove our biggest week ever of e-commerce sales.

I'll also add that at the event, we soft launched the next generation of Pop Yourself, which generated tremendous buzz. We expect to launch the product later this month on our e-commerce site, which will enable millions of fans and customers to pop themselves....

A strong brand isn't enough. Our fans and our partners demand that we be quick to market, responsive to rapidly changing pop culture, nimble and creative in our product designs, and operationally excellent. Over the past two years, we lost sight of the importance of these competencies, and as a result, the number of product lines and SKUs that we have produced has grown rapidly, bringing too much complexity to the business with too little return. We believe that the best path forward for Funko is to focus our energy on fewer product lines and fewer SKUs.

Using a data-driven and strategically informed approach, we are taking out products that were not adding significantly to the top line and not helping the bottom line. Our plan is to reduce our product lines by 30% plus and our SKUs by a similar amount.

This simplification and focus will result in a leaner company, which is the driving factor behind the reduction in workforce that we enacted last week. This new, more focused approach does not mean we will stop innovating. It does mean that we will put more effort behind key value-driving initiatives and choose those initiatives using hard data and thoughtful planning. Our new Pop Yourself is a great example.

It is a logical brand extension and one that leverages our D2C channel first, which is an environment we can control. Over the longer run, we expect that the product will add licensed content for accessorizing, and that will create a new wholesale opportunity at brand-specific locations.

It is a return to the basic flywheel that powers our business: delight our fans, go back to the license holders with new opportunities, then bring new content to our wholesale partners and further delight our fans. To keep the flywheel spinning, we are returning to our roots as a fast-moving, entrepreneurial disruptor that knows the dollars we spend must perform.

This strategy and approach will inform everything we do going forward by focusing on the fans and our unmatched brand, by running the business like a lean startup, rejecting complexity, by focusing on fewer products done extremely well, by investing in areas we can control, measure, and grow profitably, and that are central to or strategically aligned with our most productive businesses, and by keeping the flywheel turning. What does all this mean from a financial viewpoint?

While we are not yet prepared to provide a formal outlook for next year, I'll share a few of the quantifiable reasons we are optimistic about our strategy and the moves we have made and will continue to make as we reshape the company. First, we anticipate a return to more normalized purchasing levels by our wholesale customers once inventories are right-sized. Second, we expect to see a meaningful benefit to our gross margins from the annualization of price increases, factory cost savings, and normalized freight costs.

Third, we'll see the full annualized benefit of the operational improvements and cost reductions we have been implementing throughout this year. Finally, the strategy we are pursuing to focus on generating additional revenues from our more profitable business lines will, for the most part, be implemented by year-end. With that, I'll turn the call back over to Steve to cover our detailed financial results and guidance.

Steve Nave (CFO and COO)

Thanks, Mike. Before diving into the financials, I'd like to update you on the progress we've made on the first round of operational improvements and cost reductions that we put in place earlier this year, which will generate annualized cost savings of between $155 to 185 million.

Some of the major elements of that plan included the significant reduction of inventory earlier in the year, which helped us eliminate certain storage costs and improve the efficiency of our primary US distribution center. The completion of a 10% workforce reduction in April, the renegotiation of key freight and logistics contracts across our supply chain, and numerous operational changes to reduce our fulfillment cost per unit.

We also went live last month with our new temporary warehouse management system, which is a key component of our efforts to drive financial efficiencies in our primary US distribution center. By the way, this was a Herculean cross-functional effort, so I'd like to take a second to recognize all the Funkonians out there who were involved in this complicated systems implementation.

Turning to our second quarter financial results, net sales were $240 million, which included wholesale channel sales of $200.5 million, and direct-to-consumer sales, which includes sales from our e-commerce sites and our three retail stores of $39.5 million. Gross margin was 29.2%, which was below our expectations. This was primarily driven by two factors.

One, the mix of our sales for the quarter included a higher-than-anticipated percentage of inventory that was received back when freight costs were much higher, resulting in higher amortization of capitalized inbound freight costs than we expected. Two, customer order cancellations during the quarter resulted in a formulaic increase in our inventory obsolescence reserve.

SG&A expenses were $85.6 million, which was significantly better than we expected and an improvement of $14.4 million over the preceding quarter, driven by efficiencies in our distribution centers and very tight expense control. Adjusted net loss was $22.3 million, equal to $0.43 per share, which was within our guidance range for the quarter. Finally, adjusted EBITDA was a loss of $7.6 million, also within the guidance.

I also want to note that in the second quarter, due to a technical accounting requirement, we established a full valuation allowance against the company's deferred tax asset of $138.1 million, offset by an adjustment to our tax receivable agreement liability of $99.6 million. The net effect of which was a non-cash charge of $38.5 million.

This charge does not affect adjusted EBITDA, and despite the technical accounting requirement to record the impairment of our deferred tax asset, we believe we'll be able to utilize the deferred tax asset in the future. Turning to our balance sheet, at the end of the quarter, cash and cash equivalents totaled $36.8 million. Total debt was approximately $305 million.

This includes the amount outstanding under the company's term loan facility, net of unamortized discounts, revolving line of credit, and our equipment finance loan. Inventory was $187.3 million, which was down significantly from $246.4 million at 31 December 2022, and down slightly from $191.6 million at the end of the first quarter.

As Mike discussed, we are rationalizing our product lines to better focus on the products and businesses that are most productive for us, improve our inventory management, and drive further efficiencies throughout the organization. As a result of this sharper, more deliberate focus, we implemented an additional reduction in our workforce last week. This second larger workforce reduction affected approximately 180 positions, which corresponds to a 17% reduction of our non-variable workforce.

The annualized cost savings related to this second workforce reduction is approximately $20 million. Combined with the earlier workforce reduction, we've now reduced our non-variable workforce this year by 23%, resulting in total annualized cost savings of approximately $30 million. In addition to the $20 million in savings from last week's workforce reduction, we've identified another $18 million in non-headcount-related annualized cost savings, for a total of approximately $38 million of annualized cost savings.

Related to the most recent workforce reduction, we expect to record non-recurring severance and related charges of approximately $2 million in the third quarter. Cost savings related to the product rationalization are expected to occur gradually over time. It is important to point out that we are being strategic and deliberate with where and how we've cut costs.

Our plan is to continue to invest in product development, just with more focus and financial discipline. Turning to our outlook for the full year, we have lowered our guidance and now expect net sales of between $1.05 billion and $1.12 billion, down from our previous guidance of $1.19 to 1.26 billion. Adjusted EBITDA of between $20 million and $30 million, down from $65 to 75 million, driven by the drop in sales, partially offset by further expense reductions. For the third quarter, we expect to see a much improved overall financial performance compared to the second quarter.

Our expectation is based on, among other things, historically higher sales in the holiday season, combined with the positive impact of the cost reductions and operational improvements we've implemented.

Our outlook for the third quarter is as follows: Net sales of between $280 million and $310 million. Gross margin increasing meaningfully from second quarter. SG&A, as a percent of net sales, improving sequentially from the second quarter as well. Adjusted net loss of $5 million or $0.10 a share to $1 million or $0.03 a share.

Finally, we expect adjusted EBITDA of between $14 million and $19 million. That's it for me. Mike, back to you. In closing, in a challenging retail environment, we believe we are taking the correct actions to navigate the near-term challenges and also set ourselves up for profitable long-term growth. We are early in the refactoring process, but we believe our financial performance next year will be significantly better than in 2023. The actions we have taken and continue to take strengthen our business and lay the foundation for a more profitable future. I will now turn it over to the operator for Q&A.

Operator (participant)

Thank you. Ladies and gentlemen, if you'd like to ask a question, please press star followed by one on your phone keypad now. When preparing to ask your question, please ensure your phone is muted locally. We have our first question comes from Linda Bolton Weiser from D.A. Davidson. Linda, your line is now open.

Linda Bolton Weiser (Managing Director)

Yes, hello. So I guess my first question is about your kind of performance at retail. We've heard a lot of, you know, toy companies and other durable goods companies have said that they're done with their inventory reduction at retail, like, things are in much better shape. I'm wondering, what's the difference for you, and how is your POS trending in brick-and-mortar like Walmart and Target versus, like, your own stores? Like, why is that POS seemingly so different?

Steve Nave (CFO and COO)

Hey, Linda. Steve, good to hear from you. On your, on your first question, what I would say, and I don't wanna get too excited about this yet, is we are starting to see a little bit of a shift. We're starting to see some of the bigger replenishment orders that we would have expected from some of our larger retail partners.

I don't want to look at that and say that's a, that's a trend yet, 'cause it's literally just starting to happen, probably over the last 30 days or so. You know, that gives us quite a bit of optimism, but what I would tell you is, we're planning the back half of the year from an inventory perspective, a little bit different than what we've done in the past.

What we've done in the past, is we've always wanted to make sure that we were in stock for our retail partners. This time around, we're willing to let a little bit of sales... to leave a little bit of sales on the table if things really rebound, so that we don't end up in a, in another inventory position like we were at the end of last year. You know, we're... we've actually adjusted our buys accordingly, based on what our, what our new projections are for the back half of the year. It's a little bit... I mean, we, we will always have the ability to chase some inventory, but it's kind of...

For us, it's a little bit set, and I don't want to say set in stone, but we've deliberately managed our new buys for the back half of the year down. Which means at some point, conceivably, we might not have enough inventory to meet demand if it really does rebound.

Again, it's early in that process, but it is what we are seeing just over the last probably 30 days, has been pretty encouraging. On the POS side, so we're continuing to see POS data, and just a reminder to everybody, Linda, I know you know this, but a reminder for everybody, we don't have POS data for everybody, but we do for the, you know, the big retail partners. We don't have them for specialty partners, which are a good chunk of our business.

On the bigger retail partner side, our, our sell through is better than our sell in, just like it's been pretty much all year. It's also, we're also seeing sell through start to go up a little bit more. You know, I the, the difference between, you know, what's going on with our own, with our wholesale retail partners versus our own retail stores, is literally that these guys are just managing their inventories down.

We do think, you know, we saw some releases for some other, some other, you know, toy-related companies recently. It all seemed very encouraging about what they're seeing. It's just, you know, trying to be conservative and practical, it's just too early for us to kind of make that bet.

Linda Bolton Weiser (Managing Director)

Okay, thank you. That's very helpful. Can I also ask about your SKU reductions and the plans there? I'm trying to understand, are you going to, like, utilize fewer licenses each period? Instead of having, like, 900 active licenses in a period, maybe it's gonna be, you know, you know, 600 or something. Is it that, or is it more that you're going to just reduce the number of different items under each property that you're, that you're marketing?

Steve Nave (CFO and COO)

It's much more the latter, not the former. I'll give you an example. Like, we have, like, Marvel licenses that do really, really well for us, but we've expanded those products under that, that license to include key chains, and lanyards, and things like that. I'm not, I'm not, I'm not, I'm not officially saying that we're getting out of those specific SKUs, but those are the kinds of things we're looking at to cut back on. It's not a licensing cutback, it's more a product cutback.

Linda Bolton Weiser (Managing Director)

Gotcha, that makes sense. You made it sound like these things that are being cut are not too significant to the top line, but, but nevertheless, I, I would think there'd be some sales, lessening, you know, shrinkage of sales because of reduction in SKUs. Do you have any estimate what that could be?

Mike Lunsford (Interim CEO)

I think that would be very small. It's certainly included in the forecast that we've or the guidance that we've provided here. The, the large majority of our revenue comes from a very small number of product lines and SKUs, and those aren't being impacted, and the shelf space that gets freed up by eliminating some of these more tertiary product lines, will actually, I think, drive volume in these more core products.

Linda Bolton Weiser (Managing Director)

Okay. And just, can I ask about, your, your, your cash flow? It, it actually was, was really good in the quarter. I mean, you had positive operating cash flow, from what I can tell, and so that is really good. You mentioned there will be $2 million of severance expense coming, but is there anything unusual in the cash flows in the quarter that would not be repeatable? Anything that was unusually positive that won't repeat itself?

Steve Nave (CFO and COO)

I don't know. There, there are no real one-time benefits to cash flow in the quarter. I think what you're seeing is the result of better inventory management. That's a, that's a big part of it. We, we've had... we've, we've, we've started to get better at collections.

I think part of that is managing our AR aging better, and making sure that we get all the payments in on time, just, you know, following up with customers and things like that in a little bit of a different way than we used to. I think it's a little bit of that, which all tells me it's sustainable. It's not one time, and we're gonna continue to be to, to be better at working capital management.

Linda Bolton Weiser (Managing Director)

Can you just clarify on the SG&A guidance for third quarter, do you mean it will be improved sequentially as a ratio or in dollar amounts, it'll be lower? Which, which is it?

Steve Nave (CFO and COO)

Yeah, good question. So, we, what we guided was a percent of sales. The reality is, what happened, there's a, there's a big chunk of the payroll that is variable labor. As the volume increases, so even though we brought our guidance down, we will see sequential improvement in the top line, you know, in the third and fourth quarter. So, the variable labor, specifically in our distribution centers, starts to go up to handle that volume.

So essentially, it wouldn't be unreasonable to assume that our SG&A in just dollars is gonna go up in the third quarter versus the second. I can also tell you the big driver of that, like I mentioned is the variable labor in the warehouses, and cost per unit is going down. You know, the fact that it's gonna go up in dollars is not alarming to us at all because we're managing it as a percent of sales and a fulfillment cost per unit, both of which are improving.

Linda Bolton Weiser (Managing Director)

My final question is, I mean, originally, you were really kind of bullish about getting EBITDA margin back to a double-digit level in the fourth quarter. You know, with the lower guidance, you know, I'm just wondering at the pace of recovery or normalization of margins. Do you see that normalization is gonna be more fully achieved in 2024? Like, getting to a double-digit EBITDA margin, is, is that something you can comment on?

Steve Nave (CFO and COO)

I don't, I don't really wanna get into specifics about next year just because we haven't done the work yet to really put a fine point on it. The theme that you just spoke of is gonna absolutely be true. You're going to see the margin rate continue to improve third quarter, fourth quarter into next year. We'll, we'll, we'll continue to see sequential improvement there. Also keep in mind there are components of our margin, and it's, I know it's the, probably the most frustrating topic, which is the amortization of our capitalized inbound freight.

That's gonna take some time to fully bleed through, to get all of those products that came in at those much higher inbound freight costs, to get those bled through the system, so that then we're only amortizing, like, the new normalized rates that we started to see earlier in the year.

Linda Bolton Weiser (Managing Director)

Okay, thank you. That's it for me.

Steve Nave (CFO and COO)

Thanks, Linda.

Thanks, Linda.

Operator (participant)

Thank you, Linda. As a reminder, ladies and gentlemen, if you'd like to ask any further question, please press star followed by one on your telephone keypad now. With our next question comes from Antares Tobelem from Goldman Sachs. Antares, your line is now open. Hello, Antares, your line is now open.

Steve Nave (CFO and COO)

Operator, let's move on to the next one in case he's got a mute problem or whatever. We'll go back to him.

Operator (participant)

As a further reminder, ladies and gentlemen, if you'd like to ask any further question, please press star followed by one on your telephone keypad now. Antares, your line is now open.

Stephen Laszczyk (VP)

Hey, sorry, this is actually Stephen. I think our lines got switched up. Maybe just one on, on the long-term guidance. I think you previously gave guidance that you were working towards $2 billion of revenue in 2026. I'm curious if this is, is still the North Star for you as a company, or if there's parts of the reorganization or maybe parts of the new strategy that, that might either delay that time frame or change that priority altogether. Any thoughts around that would be helpful?

Steve Nave (CFO and COO)

Sure. I think that's a great question. I'd say it's too early in the process to really respond to that. I think your intuition is right. While that may end up being, we may actually be in that sort of range, I don't think that's the North Star right now. I think the North Star is profitable growth. Let's find the things that really drive the bottom line and focus on those, and that may result in having a lower top-line number in 2026 than we had originally sort of pointed to, but too early to say that. Certainly, what we're targeting in terms of the focus of the company is a little different than it was back then.

Stephen Laszczyk (VP)

Got it. That makes sense. Then maybe just on the CEO search, I'm curious what qualities the board is looking for in a replacement for the CEO. On one hand, I can understand how creativity has been a big reason for Funko's success, but on the other hand, I think execution, and maybe operational, you know, how is probably of importance at the time. Just curious how the board thinks we do that.

Mike Lunsford (Interim CEO)

Sure. Good. Another good question. Listen, I think, again, not to, not to answer the same way, but it's still sort of early days there. I think one thing that should give you and everyone else on the call some comfort is that Steve and I are very operationally focused. Right now, that is, that is the main thing to focus on. In some ways, with the following revenue, I would say this is almost a bit of a turnaround.

We want to get through a certain piece of that before we start thinking about the key characteristics of the person, we would bring in. That person will probably be more revenue-oriented, more creative than I am. I can name a, a number of other things, but...

The point being, we have some, we have some near-term things to deal with first. We wouldn't want to pick someone today to deal with those near-term things. We want to pick the person that's right in the long run. Go after the best athlete, go after somebody that fits with this company, someone that understands pop culture.

Could be we have some great internal candidates here, some sitting at the table with me now. I think there will be plenty of people outside interested in this as well. We'll get there, give us a little time on that part, though.

Stephen Laszczyk (VP)

That's good to hear. Then maybe one more, if I could. Just as, as it relates to the workforce reduction, could you maybe talk a little bit about what parts of the business those reductions are being made in? You know, one of the questions we've gotten from, from clients over the last couple of days as, as it relates to this is, how investors can be, you know, confident that the reduction of force and running a leaner org won't amplify, you know, some of the operational issues that have come about over the last couple of quarters? Any color there would be, would be helpful. Thank you.

Mike Lunsford (Interim CEO)

Sure. Let me start there, and then I'm, I'm sure Steve will have something to add. The, the reductions are really in many different groups, many different areas. They're driven by this SKU and product line reduction. First, we, we went through the process of thinking about what we can take out and what work goes with that. You know, that, that starts all the way back in our product development areas and creative and ripples all the way through. To your question about the operation side, which Steve can get into more detail on, this actually will lessen the load for them at some point.

We still have a ton of stuff to work through, obviously, but as we get more focused on a fewer number of products and all of the things that go with that, the back end should benefit even more than the front end.

Steve Nave (CFO and COO)

I don't have much to add to that. That was perfect.

Mike Lunsford (Interim CEO)

That's the first time he's ever said that to me. Just everyone on the call should know that.

Stephen Laszczyk (VP)

Thanks for the, the color there.

Mike Lunsford (Interim CEO)

Just, I want to go back to the previous question, one thing I probably should have mentioned, you, you touched on creative there. Look, Brian is a creative genius, and whoever we get in here, we, we hope that they have that same level of creativity. I'm not as concerned about that, I think, as, as maybe some groups outside of the company are. We have a very deep team here, and credit to Brian for bringing them in, but we have a lot of creative talent here.

Mike Becker is the original founder, is still here, and he comes up with more ideas than we can possibly put on the shelf. I don't think creativity is the issue that we have to deal with today or even in the future. It's how to channel that creativity into profitable products.

Operator (participant)

Thank you. As a reminder, ladies and gentlemen, if you'd like to ask any further question, please press star followed by one on your telephone keypad now. We have no further questions on the line. I will now pass back to the management team for closing remarks.

Mike Lunsford (Interim CEO)

Thank you, operator. Steve and Linda, thank you for the questions. Also, thanks to everyone else for not asking questions. Thank you, everyone, for joining us on the call today. As always, thanks to our fans, employees, and partners for their support. Thank you to our investors and analysts for joining the call and listening in. We look forward to sharing our progress on our next call with all of you. Thank you.

Operator (participant)

Thank you. Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.