Is This Pop Culture Merchandiser Worth Investing in?

In this podcast, Motley Fool senior analyst Jason Moser discusses:

• Starbucks (SBUX 0.93%) becoming the latest U.S. business to exit Russia.
• VMware (VMW) shares popping 20% on reports it will be acquired by Broadcom (AVGO -3.49%).
• The chances more companies with deep pockets will start buying companies at lower valuations.

Motley Fool analysts Nick Sciple and Asit Sharma take a closer look at Funko (FNKO 4.77%) and share some of the reasons they're feeling bullish about this pop culture company that is perhaps best known for bobbleheads.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 23, 2022.

Chris Hill: [MUSIC] A week ago when McDonald's announced it's leaving Russia and we asked who's next, today we got the answer, Motley Fool Money starts now. [MUSIC] I'm Chris Hill and I'm joined by Motley Fool Senior Analyst Jason Moser. Happy Monday.

Jason Moser: Hey. Happy Monday indeed.

Chris Hill: We have a Merger Monday ask story we're going to get to vote. Let's start with Starbucks. The coffee chain announced this morning it is leaving Russia and will no longer have any kind of brand presence there. Starbucks committed to paying its Russian workers for six months and helping them transition in new jobs. But from a financial standpoint, Jason, this is not going to have as big an impact as what we talked about last week with McDonald's because for Starbucks, it's a smaller store count and a smaller percentage of their annual revenue.

Jason Moser: Yeah, you're right. I think Starbucks was the example that we used when we were talking about McDonald's recently and thinking, is there another restaurant that will follow suit? Starbucks seemed like an obvious candidate, just giving them a chance to maybe weigh exactly what the reaction to McDonald's actions ultimately was. To me, this makes a lot of sense, following McDonald's lead, generally speaking right there, just look at this they figured, like we said, do you say worth the squeeze. When you look at Starbucks' presence in Russia, this is going to have a negligible impact on the business. I think it's something less than one percent of the company's overall revenue. Remember, when we were talking about McDonald's before, McDonald's in Russia where franchisees operate only 15 percent of the Russian locations the company owned, the rest when you look at Starbucks' presence there, that's all licensed locations.

This is not one of those situations where the company actually owns these stores, but again, less than one percent of revenue, it seems like a very easy decision to make when you look at the big picture. Generally speaking, I think most of the free world is quite opposed to what Russia is doing and rightly so, and so this is, I think, an opportunity for companies to take a little bit of a step back, assess not only where they're doing business and what makes the most sense from an economic perspective, but also what makes the most sense from just their core values perspective. I think with McDonald's, we talked about one of the core values there, being integrity and just doing the right thing, and Starbucks clearly a business that has been built on that type of framework as well. To me, this is a decision that it just feels like a no-brainer. They had suspended operations, I think, since March there, and this is really just putting a stamp on the envelope, so to speak.

Chris Hill: Where do you suppose the bar is now for businesses like McDonald's and Starbucks when thinking about entering new markets? I'm just thinking five years down the line or something, hopefully what's happening in Ukraine is long past the rearview mirror. Maybe someone else is in-charge instead of Vladimir Putin, and they're trying to woo the McDonald's and the Starbucks of the world back like no, no it's going to be better this time around. [LAUGHTER] Does it put these businesses a little bit more in the driver's seat in terms of terms that they can dictate or is that just negligible?

Jason Moser: I feel like it definitely puts the businesses in the driver's seat. They've shown that they don't need to do business there if they don't want to. It certainly depends on the location and perhaps the business and where they source whatever they are sourcing. But for the most part, I think this really is just a testament to the businesses holding more leverage in this case. They can say, "Hey listen, we just prefer to do business in a place that's going to stay on for the things that we stand for." It ultimately boils down to determining that line. This is a very easy line, I think for the most part, this is a very debatable issue.

I think that when you get in to the more debatable issues, that's when it becomes a trickier decision, and that's something that remains to be seen. But for the most part, I think, ultimately this puts the leadership of these countries on notice, the companies are going to say, "Listen, we're going to do business in countries that stand for this, that do this, that take these types of actions," and they ultimately, I think have the power whereas as opposed to the countries, particularly with leadership such as Russia and Putin today, it's just a very easy decision for most companies to say, "No, we don't really want to deal with you, you are way more trouble than you're worth," and until things change materially and sustainably, I think that's really one of the bigger point is that you need to be able to see a sustainable change. Not something that's just superficial, but something that's really more in-depth, and meaningful, and longer-lasting.

Chris Hill: Cloud computing business. VMware is reportedly in talks to be acquired by chipmaker Broadcom. The talks are ongoing, so we don't know what terms may be involved here, whether it's all cash or stock or a mix. That information not being available, however, is not stopping some investors because shares of VMware are up 20 percent on these reports. I guess we will see hopefully, in the coming days, if not weeks, whether or not this actually goes through. You and I were talking right before we started recording. Broadcom has grown in part through acquisition, so it is very much in the company's DNA in that sense. Maybe not that surprising that they would go after VMware.

Jason Moser: No, this does feel like it would be a complementary deal if they're able to pull it off. Broadcom being more of a semiconductor oriented business to your point there on growth via acquisitions. Broadcom certainly has grown via acquisitions over the last several years. You look at the business today, they have $43.5 billion in goodwill on the balance sheet, and that's basically doubled over the last five years. Ultimately, goodwill is just essentially overpaying for acquisitions. You're making acquisitions that represents what you pay beyond a fair deal, so to speak, about acquisition. Oftentimes we'll see companies over time, they'll write down a lot of that goodwill and that we can discuss that, debate that for another time. But ultimately, as you see that goodwill number continue to creep up, you have to, at least, keep an eye on that, because you start asking the question, is the company making good acquisitions? Is the company paying fair prices for these acquisitions?

With $43.5 billion of goodwill on the balance sheet, it's at least worth considering that, hey, maybe at some point Broadcom is going to write down some of that goodwill. Who knows, maybe they're making great acquisitions we'll have to wait and see. This to me, it seems like it could be actually a pretty good acquisition if it's able to happen. VMware, being a company that's more focused on becoming a multi-Cloud leader, they're focused more on the Cloud computing market opportunity, and that's something where Broadcom could really benefit. Multi-Cloud is ultimately just, it's that Cloud computing where an organization just utilizes a combination of Clouds, whether it's two or more public Clouds or private Clouds, a combination of public and private or Edge floods. It's ultimately bringing all of those Cloud resources together for their customers.

You look at how this has worked out for VMware and it's so far so good, the company is moving more and more toward a SaaS model, which is something we've seen a bit that's been obviously a big trend over the past several years. If you look at the breakdown of the fiscal year 2022 revenue, you had about 25 percent of the business' revenue, which was from licensing, 50 percent from servicing, and then 25 percent from SaaS, that's Software-as-a-Service. It continues to become more and more of a subscription in servicing that subscription model, and I think that's ultimately a good thing.

Given the direction the world is headed, given the tailwinds in the Cloud computing space, I absolutely understand Broadcom's interest here. It probably is not a bad time to consider doing a deal like this given where valuations are right now because if you hadn't heard, of course, we're in the middle of a bear market. [LAUGHTER] It's having a bit of an impact on some stock prices not all, but most. [laughs] So it's distinctly possible they could end up getting VMware for a very respectable price along with the fact that now that VMware, there was this big Dell relationship where Dell recently spun-off its VMware stake last November, so there's a little bit of uncertainty that's been resolved there. Maybe that's why this interest really is developing now. So yes, it remains to be seen whether this deal actually happens or not, but it does feel like it would be a complementary one for Broadcom, and I guess really then it just depends on what price they are willing to pay.

Chris Hill: Before I let you go, let's broaden this out a little bit. There are a lot of companies that, from a market cap standpoint, are less expensive than they were six months ago. There are also a lot of companies out there with cash on the balance sheet. Do you think we could be entering a period over the next 3-6 months where we see more deal-making going on, more acquisitions. It is not lost on me that there are no names attached to these reports. There are no analyst, there are no executives. I trust the reporting. If Reuters and CNBC are reporting this, I take them at their word. But it just makes me wonder if we're going to see this scenario play out multiple times over the next 3-6 months.

Jason Moser: It feels it should. It feels logic dictates that it should. I don't think it's going to be something where the obvious suspects are the acquirers. I don't think it's something where your Alphabets, and your Amazons, and your Microsofts, Microsoft is in the middle of trying to wrap up this Activision Blizzard deal, but for the most part, I feel those are the companies that are really under the microscope of regulators right now. Maybe there is this lower level echelon. Just that next step below, like your Broadcom's of the world, where they could get away with something like this without necessarily getting right there on regulators radars there.

It does feel it's something that should happen because you're right. Valuations have come down considerably. We live in a world right now where it feels every single headline is bad. [laughs] It really does feel that way. It just feels there's so much bad news out there right now that any spate of good news could really turn things around. It does feel there should be more interest in making some deals happen right now, particularly for those mid large cap companies that aren't necessarily on the radar of regulators. They have the financial resources, they have the wherewithal to get these deals done, and they don't necessarily have to worry about being on regulators radars. It'll definitely be interesting to see how the remainder of this year shakes out because if these market conditions persisted, and it feels they will at least for a little while, it definitely feels we can we can hear more news like this. [MUSIC]

Chris Hill: Jason Moser, thanks so much for being here.

Jason Moser: Thank you. [MUSIC]

Chris Hill: Enough talk about companies involved in Cloud computing and semiconductor chips. Can I interest you in a publicly traded business based on selling vinyl figurines? No, really. Nick Sciple and Asit Sharma are taking a closer look at Funko. Some fundamental reasons they're feeling bullish about bobbleheads and what a new investor group could mean for the company.

Nick Sciple: Welcome everybody. I'm Motley Fool Canada analyst Nick Sciple and I'm here today to talk about why Funko could be a fun company for your portfolio. Joining me to help me do that is Motley Fool analyst, Asit Sharma. Asit, how is it going?

Asit Sharma: Great, Nick. Good to see you and chat with you after a long time.

Nick Sciple: It's been a long time since we've been together in podcast land. It's great to be back here with you and we've got a fun company to talk about today. Funko. If folks aren't familiar with the company, you've probably seen their Funko pop [inaudible] , action figures, figurines in stores. Whether it's a bookstore or Target, or a place like GameStop, they're all over the place. They are one of the biggest pop culture merchandise providers, really, in the world. Asit, for folks who aren't familiar with Funko, what do they do?

Asit Sharma: I like to think of Funko as a company that bridges the physical and digital divide. Some stuff that we experience first digitally, so movies, music, and video games, bringing that into collectible format with their vinyl pop figures, their bobblehead figurines, and an array of other merchandise which includes backpacks, key chains, you name it. This is a company that has very deep partnerships with big intellectual property giants like Disney, Netflix, Warner Brothers, Activision Blizzard. They basically licensed the right to intellectual property and turnout these figurines, which they didn't distribute through big-box retailers, through their own direct commerce channel, and for their products like backpacks through stores and you can even buy them at Disney, which is a big part of this business.

Nick Sciple: Loungefly has been a growing part Funko's business. It's actually up to 16 percent of the business, up over 100 percent year-over-year in the most recent quarter, which is helping diversify the company's revenue. Traditionally, those Funko pop vinyl figures that you mentioned really drove the vast majority of the business and they still drive over half of the business today. Historically, there's been some concern just given that dependence on those Funko pop products and that being a single-product company that perhaps there's a little bit of a risk of Funko being a fad. However, they put up some really impressive growth numbers, Asit. What do you make of that potential fad risk, the dependence on the pop products and maybe prospects for diversification moving into the future?

Asit Sharma: Yeah. I think this is fair criticism of the company, even today if you look at their most recent quarter, their core collectible items make up about 2/3 of revenue. But as you mentioned, Nick, they've got now a good part of their business which comes from an acquisition they made of a company based in the UK, which is Loungefly, what we've been mentioning. They've got some other revenue streams that branch all the way into NFT sales, although no one should hang their hat on that as investment thesis. Call it gravy if they make that more significant part of the business.

These are some risks behind Funko, and I'll say this company has some other risks behind it that traditionally have made it a hard investment to really entertain. But those are falling away one-by-one. First, it had a very large debt load about five years ago. If you look at their net income on the books going all the way back to say, 2017, just the interest expense on their debt took out a big chunk of their earnings. They gradually paid down the debt to more reasonable levels, so it's not affecting their income statement as much and it's not quite the existential threat on their solvency or liquidity than it was in the past. Also, they had a big private equity investor, Acon investments, that at one point owned about 69 percent of this company. Over time that private equity group, which is actually pretty helpful in helping this company grow its business and diversify.

They've sold off their shares bit by bit. We're going to talk about this last buyer that's come to buy shares from Acon in just a moment here. But also want to mention they didn't have a wide enough distribution footprint. Management made the push to get into stores like Walmart and Target and to push their products globally. Another thing is they just really didn't have a great cost structure on the bottom line. But here you look today, they've just moved into a million square foot distribution center, not their headquarters, but their distribution operation. All fronts, this company is looking a lot more investable and I think it is an interesting play. But Nick, what about these most recent investments? So Acon is now selling most of its shares to another group, which is made up of some pretty interesting players.

Nick Sciple: Yeah, Asit. So if you look at the company today, some really promising growth numbers, 58 percent revenue growth year-over-year in 2021 of free cash flow, positive business, a business that's put some of those debt concerns behind it. And then again, you had this significant private equity investor, this overhang that we talked about sometimes when you have these large investors, well, on the same day that Funko reported its first quarter earnings, it reported that Acon was going to sell about 80 percent of its stake, a stake equivalent to 25 percent of Funko's business to an investment consortium led by, among others, The Chernin Group, which is led by Peter Chernin, a private equity investor that's invested in companies in the past like Barstool Sports and other member of that investment consortium was former Disney CEO Bob Iger, someone who probably knows a thing or two about the IP licensing business. And then lastly, Rich Paul, who is LeBron James' sports agent as well as significant super agent in the sports business. Since you had those investors buying a quarter of the company at $21 a share. If you look at where the company is trading today, it's about $19 a share, so we saw a little bit of value out there. It looks like these private equity folks did too. Then not only that, these are folks you could argue, can create potential additional value on top of just the value they recognized in the market at 21.

Asit Sharma: Yeah, I agree, Nick. This isn't your group of financial buyers who are just in there to see if they can squeeze some more out of the bottom line. These are pretty forceful personalities in the business world. They want to bring their talent and their bona fides to bear here with Funko, and they are also extremely well connected people who are used to the power of picking up the phone and getting deals done. I want to point out another investor who is actually not an individual but a company that's part of this consortium, which is eBay. eBay is now an investor in Funko, and the two companies have a new partnership where there will be a nice secondary market for Funko's products on eBay. The two companies will collaborate to create new products. Now, we didn't mentioned that one of the really fun parts of Funko is the fact that these collectibles can often rise in value. So having a secondary market on eBay only makes the whole proposition more valuable, although I should mention in the same breath, Funko's aim is to have products that are affordable to everyone. But what do you think about all these big hitters coming in, Nick? Do you think they will be able to add some juice to this revenue picture and help with some really great creation of IP or might this be just a little hype here?

Nick Sciple: Well, whether it's hype or not, it's something we'll have to find out, what results they produce. I will say I tend to follow the stuff that The Chernin Group does in the past. Again, Barstool Sports investment, they were really transformational in getting that company up to scale. They also have some other investments in the IP space Crunchyroll, Goldin Auctions which is just another kind of collectibles business. Obviously, Bob Iger, Disney, a huge driver of that side of the business. So I think there's lots of value to be created here as well. Then there's some pie in the sky stuff I'll mention. It's not something that I would build into the thesis or anything like that, but if you look back, I think it's 2019, there were some rumors that Warner Media was going to produce a Funko movie using the Funko IP, in the vein of what you've seen with the Transformers Movie or the Lego Movie or the Trolls Movie, that sort of thing.

I could see with folks like Bob Iger, and The Chernin Group has actually been involved in the movie production business as well, those folks get involved, maybe that makes that type of optionality more likely. But in any event, you have really smart savvy investors that know a thing or two about the IP licensing business that have recognized Funko as a smart place to put their money in. Listen, The Chernin Group is a private equity company, they're in the business of making money, they're not buying it just to be flashy. To the extent, it's hype, they put real dollars buying this, trying to make real money. So I think these folks are smart, and listen, I thought the stock was attractive even before that investment took place. It's always nice to get a little bit of confirmation bias too.

Asit Sharma: Yeah, this is a company that looked like a value stock before and still does in some ways, even though it's had a nice pop there's a pun for you who are fans of the company. A nice pop after the announcement with the first-quarter earnings that you mentioned. I'll also say too that this is a fun type of private equity investment because while you do have that PE angle, which is all about making the money, there's a lot of creative energy here. For Funko, that's like oxygen for this company, they spent the last several years figuring out their distribution, getting their costs under control, getting that distribution that I talked about. Now, it's time to capitalize on creative ideas and partnerships they can build. I think all this is good. Any risks to the investment thesis that you see, Nick?

Nick Sciple: Well, one of the big ones is they don't own the IP. To a certain extent, whether it's Loungefly or Funko pops, they own the design for the bag, they don't own the IP that's going in to creating those products. The relationships they have with those other parties are foundational to the business. Maintaining those relationships is always going to be a key. That's one risk that pops to mind for me. What about you, Asit?

Asit Sharma: I see a lot of the risks that I worried over in the past to slowly melt it away. I talked about the balance sheet risks and the fact that they were controlled by this other group and that gradually diminished. Now the replacement group looks pretty capable, will help revenue and earnings as well. But in the near-term, you could see a little bit of deceleration from this very nice pace of revenue growth they've been enjoying. If we go into recession, that obviously hits that consumer discretionary spend. Some would argue that because Funko's products are very accessible, maybe they don't lose that much.

Maybe people choose to buy some Funko collectibles after they've been forced to stay home and not take that vacation because of inflation. That's yet to be seen, but that's a near-term risk. Longer-term is to ever present risk that people will just change the way they consume their pop culture. For the longest time, Funko has benefited from what they call Evergreen Properties. Properties like Star Wars, Harry Potter, the NFL, these deals that enable them to keep churning out products that never go out of style. It could be that in the future, the younger-generation moves to more digital products for collectibles. But here again, we mentioned they are getting a toehold in the NFT markets. So at least they'll be able to maybe compensate if that risk of the physical product does become more prominent in the coming years.

Nick Sciple: Yeah, I will say one thing if you look at the consumer and potential slowdowns as a result of consumer weakening. One of the areas that I think about that's probably a place that's a big demand driver for this type of fandom based pop culture content is Comic Cons and those types of conventions, if you think about it, San Diego Comic Con is the biggest one that's been canceled the past two years. While there are some headwinds when it comes to inflation, potentially weakening consumer. There are some tailwinds when it comes to reopening and then some of these traditional demand drivers for these types of collectible products opening backup.

Asit Sharma: So before we leave, Nick, I've hinted at this, but I'll ask it as if I didn't know. Do you or anyone in your family own any Funko products?

Nick Sciple: Yes. So we don't own any of the Funko pop figurines, but we own three or four of the Funko Loungefly bags. We've got a Marie one from the Aristocats, and we've also got ones with the little mice from Cinderella. Whenever we go on hikes in the park or actually went to Disneyland, Paris a month or two ago, those bags come with us. So yeah, we represent a little bit.

Asit Sharma: Awesome, yeah, I have some in my house as well. Now, I personally don't own any products, but my three sons love their bobblehead Star Wars product. Especially my oldest, he collected a few after he went to college. My two younger sons took his passport photo [MUSIC] and taped it on the front of the bobblehead doll. You can't see it now, because we're taping and this is a radio-type show, but I'm showing it to Nick. When we walk by, we tap the top of the bobblehead now, almost like, "Hey, call home." 

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.