Funko: Buy The Dip

For the first time in many quarters, Funko (FNKO), the maker of pop-culture toys best known for its line of Pop! figurines, has taken a leg down after reporting earnings. Despite topping Wall Street's expectations on both the top and bottom line in Q3, Funko's decision to hold its guidance exactly the same (and not even take in Q3's beats) dramatically hurt the stock, sending shares down ~15% since earnings:

Funko is now more than 45% below its all-time highs notched in September, and has virtually wiped out its year-to-date gains - even though in my view, we've learned nothing negative about the business save for the fact that Funko may have a single quarter with a difficult compare coming up. In my view, it's a great time to review the bullish case for this fantastic, high-margin maker of pop culture icons.

The company's recent expansions are another reason to invest in Funko. Recall that the company just recently launched a Funko Games division that has recently rolled out its first board game, Funkoverse. Here's some qualitative commentary from CEO Brian Marotti on the traction for that game on the Q3 earnings call:

As I mentioned earlier, within the quarter we began shipping Funkoverse, which is our first foray in the board games. Funkoverse is a great example of us creating new and exciting ways for fans to connect their favorite characters and properties, and combining our own IP with licensed content. While it's still at early days, we are very excited about the initial reaction that we have received from retailers and from our consumers. We plan to continue to invest and grow the board game business in 2020 with the release of additional Funkoverse offerings as well as licensed and non-licensed games."

In my view, it's premature to be worried about Funko's future growth. Investors have a great chance to pick up shares of a growth stock at discounted prices: per Yahoo Finance, consensus estimates are projecting EPS of $1.45 for next year (+18% y/y versus consensus estimates of $1.23 this year), indicating that Funko currently trades at a

forward P/E ratio of 10.6x -

which, for a company that just grew EPS at 41% y/y in Q3, is quite modest. I believe Funko is worth at least

15x forward P/E,

implying a

price

of $22

and 44% upside from current levels.

Impressive growth so far - don't read too much into the future

In Q3, Funko grew revenues to $222.3 million, up 26% y/y. This is two points stronger than the $219.4 million (+24% y/y) that Wall Street expected:

Figure 1. Funko revenue trendsSource: Funko Q3 earnings deck

What I continue to find impressive about Funko's growth, however, is that its mix of top properties is ever shifting. Bears' biggest argument against Funko is that it's too prone to fads - but in my view, Funko's continuously changing roster of top properties defies that argument.

Figure 2. Funko top propertiesSource: Funko Q3 earnings deck

As seen in the snapshot above, Funko's strongest-selling property in Q3 wasHarry Potter.By all intents and purposes, Harry Potter is effectively a "stale" franchise. Unlike many of Funko's other top properties, the last Harry Potter movie,The Crimes of Grindelwald, was released a year ago (to poor reviews) - while the last book was released many years ago. The Harry Potter "hype" is effectively over - yet Funko has still managed to make Harry Potter its top-grossing property in Q3, demonstrating its ability to monetize even older brands. Several other Top 10 properties, like the Nightmare Before Christmas and Frozen 2, are nowhere to be found on prior lists - indicating that Funko is continuously able to generate fresh growth from new content.

Funko has also made large strides with distribution and reach this quarter. Per CEO Marotti's commentary on the earnings call:

Another major factor of our growth strategy continues to be broadening our base of retailers domestically and around the world. Our partnerships with our diverse set of retailers is one of our key strength. Domestically, we continue to grow within our existing channels by expanding shelf space and finding new placement opportunities with our retailer stores.

Our U.S. mass market channel grew over 65% in the quarter driven by Pop! Vinyl and the expansion of additional product categories such as apparel, games, bags and wallets. Additionally, we continue to drive traffic in stores and online. Our worldwide sales to third-party e-commerce retailers increased over 50% in the quarter. Internationally, we continue to expand our distribution and bring on new retailers. One of the major drivers of international growth continues to be the European region. Our growth in Europe was over 60% in the quarter and is up 40% year-to-date."

Based on the strength of both Funko's product and its distribution reach, it's premature to be bearish on the company's growth. What investors are worried about is the fact that Funko maintained its full-year revenue outlook of $840-$850 million for the year, implying $258.4-$268.4 million in revenues for the fourth quarter:

Figure 3. Funko guidance updateSource: Funko Q3 earnings deck

This represents a rather grim growth rate of 11-16% y/y over 4Q18 revenues of $232.2 million. Funko is citing optical headwinds in Q4 due to a strong Fortnite launch last year:

The lion's share of the basics that we have with Fortnite was right out of the gate and it was early Q4 of last year. It's a massive number. I mean there is no doubt about it. But we are also pleasantly surprised at how it's evolved into a very consistent stable basis, since all that pent-up demand and interest in that product in Q4 of 2018."

This doesn't mean, however, that Funko can't return to >20% y/y growth once it moves past a single quarter with a tough compare. Funko also typically exceeds its own guidance, which prevents us from taking its literal guidance too seriously.

Strong bottom-line performance

Aside from strong top-line performance, Funko has also generated tremendous earnings growth:

Figure 4. Funko earnings trends

Source: Funko Q3 earnings deck

As seen in the chart above, Funko retained high gross margins of 38.3%, falling only 10bps due to higher import taxes on the recently-acquired Loungefly brand (which focuses on accessories like backpacks and purses).

Operating income, however, jumped 36% y/y to $22.6 million, and gained

70bps

of operating margin leverage - despite the fact that Funko invested heavily in sales and marketing, as well as inventory, in the third quarter. The company has also boosted its headcount in global planning operations, as well as expanded its office and warehouse facilities. In spite of this, Funko still managed to boost its operating margin.

Similarly, Adjusted EPS also soared 41% y/y to $0.38, beating Wall Street's expectations of $0.32 with 19% upside. Given that Funko has grown earnings at a >2x pace over the current year, it's also difficult to believe that Funko will only generate 18% EPS growth in FY20, which is what current consensus implies.

Key takeaways

There's a lot to like about Funko, especially at its new lower price. This is a company that has a "Midas touch" on virtually every pop culture brand that ever existed, even turning older franchises like Harry Potter into big revenue generators. Greater scale has also allowed Funko to expand its margins, which in turn has resulted into robust earnings growth in the year-to-date.

It's true that as Funko laps strong launches like Fortnite as well as some of its 2019 acquisitions, we may see decelerating growth in FY20. But this alone shouldn't push Funko into a discounted, <11x forward P/E valuation. Stay long here and buy the dip.

Disclosure:

I am/we are long FNKO.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.