Should Investors Buy the Dip in Funko Stock?

Funko's (FNKO 7.88%) stock is definitely in a funk. Shares of the pop culture collectibles maker sank 59% to a two-year low on Nov. 4 after the company posted its third-quarter report. Revenue rose 37% year over year to $365.6 million, beating analysts' estimates by $46 million. However, its adjusted net income fell 28% to $15.1 million, or $0.28 per share, and missed the consensus forecast by $0.22.

Funko's outlook also disappointed investors. For the full year, the company expects revenue to rise 25%-29% and adjusted EPS to decline 33%-40%. Wall Street had expected revenue to increase 29% and EPS to increase 35%. Funko's sales are still rising, but its steep profit declines raised bright red flags. Is this dip worth buying, or is it a falling knife that investors should avoid?

Image source: Getty Images.

How fast is Funko growing?

Funko is best known for its Pop vinyl and bobblehead figures, which are based on a wide range of pop culture franchises. These figures, along with its newer Soda, Vinyl Gold, and Popsies brands, make up its Core Collectible segment, which generated 77% of its third-quarter sales.

Funko generated another 17% of its revenue from its Loungefly subsidiary, which sells licensed pop culture bags and fashion accessories, while the remaining 6% came from its other smaller brands. Here's how those three core businesses fared over the past three quarters.

Data source: Funko. YOY = Year-over-year.

The midpoint of Funko's full-year guidance implies its revenue will decline 5% year over year in the fourth quarter, compared to its 48% growth in the fourth quarter of 2021. It attributed that slowdown to macroeconomic headwinds (which likely curbed the consumer's appetite for bobbleheads and other pop culture collectibles), supply chain problems that kept its inventory levels elevated, and less demand from major retailers as they grappled with their own rising inventories.

Why are Funko's profits plunging?

As Funko's revenue growth slows to a crawl, its margins are contracting. Its gross margin rose 230 basis points sequentially to 35% in the third quarter, but that still fell 100 basis points from a year ago. Its adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margin also declined 30 basis points sequentially and dropped 520 basis points year over year to 9.8%. For the full year, it expects its adjusted EBITDA margin to stay in the "high single digits" -- which would represent a severe contraction from its adjusted EBITDA margins of 14.6% in 2021 and 10.2% in 2020.

Funko mainly blames that compression on the supply chain challenges and elevated freight costs. It's trying to offset that pressure by outsourcing its production to lower-cost facilities across Asia and implementing its first price hike in five years, but the latter tactic could easily backfire as inflation throttles discretionary purchases.

That turnaround strategy is also based on the notion that the market's demand for Funko's flagship Pop products isn't merely a passing fad. Unfortunately, its soft guidance for the holiday quarter suggests its figurines could still eventually suffer the same fate as the Beanie Babies.

Even Funko's management doesn't seem too confident in that strategy. During the conference call, CFO Jennifer Fall Jung admitted it "might have to do a little bit [of] discounting" because it knows that "inventory is tight across our retailers in the back half the year" -- yet she still expected the price hikes to take "full effect by early to mid-2023." Those mixed messages suggest that even Funko isn't quite sure where its gross margins will actually land in 2023 and beyond.

Is Funko a value stock or a falling knife?

Funko's stock now trades at just four times forward earnings and 0.3 times next year's sales, but those expectations are pegged to analysts' expectations, which will likely shrink after its latest earnings report. By comparison, Hasbro and Mattel -- which are much larger but also dealing with slower consumer spending -- trade at 11 and 10 times forward earnings, respectively.

Therefore, Funko's stock could easily double from these levels if its growth rates stabilize. Unfortunately, it doesn't seem like Funko will regain its momentum anytime soon. Its revenue growth is decelerating, its margins are crumbling, and its main turnaround strategy is to raise its prices as consumers grapple with record inflation. Funko might eventually be a good takeover target for Hasbro, Mattel, or other toy makers -- but it could still fall a lot further before potential suitors show up.