Funko (NASDAQ:FNKO) took investors on a wild roller coaster ride in 2018. The pop culture collectible maker went public at $12 in late 2017, plunged to $7 on the first trading day, then rallied into the low $30s last September.
However, the subsequent market sell-off erased most of those gains, and Funko now trades just slightly above its IPO price. Let's take a closer look at this beaten-down growth stock to see if it can rally again this year.
What does Funko do?
Funko generates most of its revenue from its Pop! vinyl figurines, which feature a wide variety of characters from comics, video games, TV shows, and movies. The Pop! lineup also includes plush dolls, keychains, T-shirts, and various accessories.
Sales of Funko's Pop! branded products accounted for 76% of its top line during the first nine months of fiscal 2018, compared to 70% a year earlier. The rest of its revenue came from other action figures, figurines, and pop culture products.
During the third quarter, Funko stated that over half of its products were "evergreen", meaning that they aren't tied to a current movie, video game, or TV show. Those products, which include classic characters like Mickey Mouse and Batman, are less likely to burn out than newer franchises. It currently has over 1,000 licensed properties in its portfolio.
Many of Funko's products appeal to adults instead of kids, so it was well-insulated against the slowdown in the traditional toy market that slammed Mattel (NASDAQ:MAT) and Hasbro (NASDAQ:HAS) last year. None of Funko's individual retailers account for over 10% of its year-to-date sales, which insulates it from big bankruptcies like that of Toys R' Us.
How fast is Funko growing?
Funko's revenue rose 24% annually to $177 million last quarter, which beat estimates but represented the company's slowest quarterly growth rate since its IPO. However, Funko's growth still looks much rosier than Mattel and Hasbro's negative sales growth in recent quarters.
Funko's growth was supported by robust demand for its Pop Vinyl figures, which posted more than 25% annual sales growth for seven straight quarters; 24% sales growth in its total figures; and 26% sales growth in its apparel, bags, accessories, and other products, which were boosted by its takeover of fashion accessories maker Loungefly.
During last quarter's conference call, Funko CEO Brian Mariotti attributed most of the company's sales growth to "increased shelf space and stronger sell-through at existing retailers" instead of sales at new retailers.
Funko expects its sales to rise 25%-26% for the full year, which represents an acceleration from its 21% sales growth in 2017. For comparison, analysts expect both Mattel and Hasbro's revenues to decline about 9% this year.
How profitable is Funko?
Funko's sales growth is impressive, but its margins and profitability are less consistent. Last quarter, its gross margin fell 250 basis points annually to 38.4%, mainly due to lower average selling prices in Europe. Its gross profit, buoyed by higher sales growth, rose 16% to $68 million -- but its operating income dipped 3% to $16.8 million (due to $3.7 million in non-recurring items) as its net income fell 2% to $8.1 million.
Funko's reported earnings growth is weighed down by two things. First, it paid its licensing partners an average royalty rate of about 15% over the past three years, compared to single-digit royalty rates for Mattel and Hasbro. This tells us that Funko has much less clout in negotiating lower royalty rates than the bigger toymakers.
Second, Funko accumulated lots of debt as it was passed between private equity firms, and it even borrowed money to pay those owners $98 million in special dividends before its IPO. That's why Funko finished last quarter with nearly $200 million in long-term debt.
Therefore, Funko often highlights the growth of its adjusted EBITDA and adjusted pro forma net income (which exclude a wide range of one-time charges) instead of its GAAP results. Last quarter, its adjusted EBITDA rose 26% to $34.1 million, and its adjusted pro forma net income more than doubled to $13.8 million.
For the full year, Funko expects its adjusted EBITDA to rise 18%-22%, and for its adjusted pro forma EPS to surge 84%-97%. To counter potential tariff headwinds, Funko plans to manufacture 70% of its products outside of China by the end of 2019.
But will Funko sink or swim?
At $14, Funko trades at 20 times the midpoint of its adjusted pro forma EPS forecast this year, which looks cheap relative to its estimated growth rate. Its low enterprise value of about $700 million also makes it a lucrative takeover target for Mattel and Hasbro.
Looking ahead, Funko still has plenty of room for growth with evergreen products like Marvel Classics, hotter franchises like Fortnite, and nostalgic niches like Golden Girls and Bob Ross collectibles. I'm not a fan of Funko's high royalties or debt levels, but I think the positives outweigh the negatives, and that the stock should rebound this year.