What, indeed, does Funko need before its shares can really soar? My headline phrase may seem disingenuous given that Funko, Inc.'s (NASDAQ:FNKO) stock has appreciated nearly 170% since the company's November 2017 initial public offering, due mostly to investor appreciation of Funko's double-digit sales growth over the last few quarters. The performance of FNKO shares is more striking considering a 40% plunge on the ticker's first day of trading. 

However, for its stock to appreciate over the long term, the Everett, Washington-headquartered pop-culture-related product marketer needs to elevate one component in its business model: It needs to generate greater operating leverage. That is, Funko needs to expand its margins, either through higher sales or improved profitability. Evidence suggests that simply scaling revenue won't be enough for it to achieve this task on its own.

Funko product display beside life-sized Godzilla figure in Funko headquarters.

Retail display at Funko headquarters. Image source: Funko, Inc. 

Royalties: the crux of Funko's model, but a hurdle as well

As we discussed in the previous article in this two-part series, Funko's business consists of creating products from trending pop-culture "properties." The company obtains intellectual property rights primarily from the movie, TV, and video-game industries to create properties, and it sells vinyl figures, apparel, tchotchkes, handbags, and backpacks within each property platform.

Obtaining rights isn't free, of course. Licensing costs typically manifest as agreements to pay royalties to intellectual property holders based on a percentage of sales. Most agreements require minimum guaranteed royalties to be paid in advance.

Royalty payments have averaged roughly 15% of sales for Funko over the last few years. The expense Funko incurs for royalties is recorded in its cost of sales. Other major costs of sales include production costs (manufacturing is outsourced through production and supply chains located in Mexico, China, and Vietnam) and shipping costs. 

Funko's royalty expenses are both the key driver of the overall business and a margin hurdle that must be met every quarter. Royalty expense combined with product and shipping costs to generate a total cost of sales of 62.2% in the first two quarters of 2018. The resulting gross margin of 37.8% represented an improvement of 160 basis points against the prior-year quarter. For a company that outsources production, a near 38% gross margin is acceptable, though not stellar.

A rapidly ascending top line isn't enough to lift profits

Of course, if revenue expands fast enough, a middling gross margin becomes less of a concern, as growth in sales brings incremental profits beyond a fixed-cost base. Funko derives revenue from both a recurring line-up of "evergreen classics" (i.e., properties like Harry Potter, Star Wars, and classic Disney movies) and trending pop-culture phenomena (recent movie releases, new video games, TV shows with current content, and other recent pop-culture properties). Evergreen classics tend to comprise 40% to 50% of revenue in a given quarter.

Trending properties, then, push the company's growth, and as of late, Funko's most current properties have enjoyed wide customer demand. In the first six months of the year, sales have increased 35% year over year to $276 million. Higher sales accompanied by slightly better gross margin were enough to pull Funko into a $1.3 million profit on a GAAP basis during the period, versus a loss of $10.2 million in the first six months of 2017.

These two factors of climbing revenue and slightly better gross margins haven't moved the company's economic needle substantially, though. In the past two years, Funko's net profit margin has dropped from the mid single-digits (nearly 6% in 2016) to less than 1% in 2017.

This is due to selling, general, and administrative expenses, which have climbed in tandem with sales, nullifying the operating leverage the top line might have provided. Higher operating expenses reflect the integration costs of recent acquisitions. In 2017, Funko purchased southern California-based licensed handbag and fashion accessories marketer Loungefly, as well as U.K.-headquartered animation company Evil T.V. (now renamed Funko Animation Studios). 

Both businesses fit within Funko's core competencies. Loungefly's product line boasts prominent handbag and backpack licenses including the Disney, Star Wars, and Marvel labels. Before its acquisition, Evil T.V. collaborated with Funko on animated videos featuring Marvel Universe characters.

As Funko Animation Studios, the subsidiary now produces video shorts that have proven to be extremely popular among vinyl product collectors. Management points out that the millions of views garnered by each short help drive new product sales, and licensing partners are beginning to express interest in having their products featured within these videos.

An opportunity also lies within Funko Animation Studios to explore in-house property creation. Products that Funko can create from scratch, market through its widely watched video series, and sell via retail partners would prove to be one of the strongest margin expansion tools available, as the company would save the 15% in royalties it pays on current product sales.

While they present an initial margin drag, over time, the investments in Loungefly and Funko Animation Studios, along with ongoing business optimization initiatives (such as a recent shift to a direct distribution model in Europe to meet increasing consumer demand), should help push operating leverage higher.

Investors intrigued by this newly public company should track its investments outside of the core licensing business over the next few quarters (and years) to understand its opportunities for significant margin expansion. Finding operating leverage is the necessary key for Funko to truly soar over the long term.

Asit Sharma has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Walt Disney, which owns the intellectual property licensing rights for Marvel and Star Wars. The Motley Fool has a disclosure policy.