Is Funko Stock a Buy After Its 60% Selloff?

Funko (FNKO -0.33%) blew up last week, losing 59.4% of its value in six and a half hours of panicked selling, after the "POP" toymaker reported a big earnings miss and warned that full-year earnings will be less than half what it thought they would be just three months ago. Now that Funko has announced this nearly 60% sale (on its shares), though, doesn't that make Funko stock a bargain?    

A lot of investors thought so on Monday, rushing back into the market to buy Funko stock, driving the share price back up 28.7%.

Funko's drop and pop, explained

But here's the problem with math: When your stock loses 60% of its value, and then gains back 30%, you don't make back half your losses immediately -- because your 60% loss was multiplied by a bigger number, and your 30% gain was multiplied by a much smaller number. Result: As of the beginning of trading Tuesday, Funko shares were still only worth 48% of what they cost investors before earnings on Thursday.

So how bad was Funko's news, exactly? And Funko stock is still down nearly half from what it cost a week ago. Does that mean Funko stock is still a buy, even after Monday's big bounce back?

Before you decide, consider the math.

Funko by the numbers

Funko generated sales of $365.6 million in the third quarter of 2022, up 37% year over year and well ahead of analyst expectations. Unfortunately, the profit margins Funko earned on these revenues underwhelmed, with the result that diluted earnings per share were only $0.19 -- 32% below Q3 2021, and less than half the $0.50 per share profit that Wall Street had envisioned for Funko.    

So what exactly happened to Funko in Q3? That's an excellent question -- and one that analysts asked several times on Funko's earnings call. Various analysts expressed confusion as to what precisely were the "components of the margin" that caused profits to fall apart in the second quarter, and wondered how things got so bad, so fast, since Funko held its last analyst meeting as recently as September. Expressing a sentiment apparently common among investors who thought they had a handle on the business, one analyst complained: "It feels to me a little bit like a bomb has dropped down on my head!"  

Funko's explanations, unfortunately, weren't entirely clear. Gross profit margins at the company, it turns out, slipped only about one percentage point year over year (to 35%), as input costs rose faster than Funko raised prices to offset them. And yet, net profit margins fell nearly four times as much.

According to the company's income statement, the reason appears to be as follows: As sales increased 36% at Funko, and cost of sales (input costs) climbed 38%, Funko's selling, general, and administrative spending surged 63% higher, and interest expense on company debt leaped 74% higher. This all added up to increased pressure on profit margins, which plummeted from 6.9% a year ago to just 3% in Q2 2022.

On top of all that, Funko's share count grew 19% over the past year, spreading out what profits Funko did earn over the past year, over many more shares -- decreasing profits per share as a result.

The future of Funko

The bad news isn't over for Funko just yet. Turning from Q3 performance to guidance for the remainder of the year, Funko cut its sales projections to roughly $1.31 billion -- slightly short of analyst predictions. Worse, in light of the profits shortfall in Q3, and the apparently weaker profit margins to be expected in Q4, Funko now predicts that its earnings for full-year 2022 will be only about $0.90 per share.

That's a full dollar below Wall Street's expectation of $1.90 per share, and also less than half Funko's own previous projection, which had envisioned earnings as high as $1.99 per share.  

Granted, even assuming Funko's new, downbeat assessment is correct, it means the stock is selling for a seemingly cheap 11.3 times current-year earnings. This may tempt investors back into the shares. (Indeed, judging from all the buying going on back on Monday, it seems it already has tempted investors back into the shares.)

With profit margins continuing to deteriorate, however, there seems to be a very real chance that Funko's earnings next year won't be nearly as strong as the earnings it enjoyed earlier this year -- in which case, Funko stock is arguably a whole lot more expensive than it currently appears.

That sounds to me like the very definition of a value trap. Caveat investor.