It's hard to believe that Funko (FNKO), a company that makes bobbleheads, is going public - and they say the IPO market isn't robust! Not only that but the deal is led by Goldman Sachs, JP Morgan and BofA with five other co-managers on the cover. [We have both the FNKO IPO slide deck and roadshow transcript online. Of course, you'll want to read the 282 page S-1 filing so we link to it for your convenience. ;-)]
On the plus side bobbleheads are a pretty good business. Gross margins of 40% and EBITDA margins of 20% are impressive. Funko did $427M in revenues during 2016 with EBITDA of $97M. So the numbers are not bad. Even though this is the type of product that always seems to be on sale in retail channels as in "2 for $10." The company expects September quarter revenues to be just over $142M with net income of $5-6M. EBITDA for the period will be about $24M.
Of course, Funko doesn't position themselves as a bobblehead maker - they are a "purveyor of pop culture" and a "category manager" of the genre for large retailers and content owners. There is some weight to the claim as they have been aggressive and creative in their licensing which has given them the most comprehensive set of products in the category. Their portfolio includes more than 1,000 licensed properties from the very large (Star Wars) to the very niche (Sharknado.) They also have the distribution with all the major retailers - you know the list.
Management also makes the case that pop culture has "entered a new phase" thanks in part to the proliferation of content and social media. Another leg to the growth stool is that geeks are "out of the basement" and into the mainstream. This is a tougher claim to back up. It is clear that the CEO, Brian Mariotti, and the team at FNKO are intensely focused on the category and have built execution capability to develop and manage thousands of products. Their supply chain is at the point where they can go from design to store shelves in three or four months which in this industry is fast. In some cases, they claim to be able to do it in 70 days. Product development is done in a matter of days and the upfront costs for a new design are less than $10,000. Revenue is very diversified both by content provider and channel. FNKO also has a good deal of "long tail" product that isn't tied to a current release of a new movie, show or game.
The toughest problem in looking at FNKO is what kind of multiple to ascribe to the business. The numbers suggest that this isn't a "fad" business but their claims of sustainability will be tested in the next year or two. We've seen something very much like Funko with JAKKS Pacific (NASDAQ: JAKK). As the chart illustrates the bullish case on JAKK didn't go well at all. This category is definitely good for content owners who get free licensing revenue but it's less clear it's good for the guys in the middle.
If we take FNKO at face value and use their long-term business model of "mid-teens" revenue growth and plug it into or QuickIV formula it can get us to a $30 stock. The company will carry some debt and a dual-class share structure. Here are a few factors that are hard to take into account and might suggest a little extra caution:
- At some point channels for this type of product get full. The company has benefited from a wind behind their back as new channels come on line. Right now they are still enjoying that internationally. However at some point this tail wind will stall and could become a drag on growth. We've seen it before and it's typical of retail product growth companies like LA Gear, Crocs, etc.
- Funko is making acquisitions and diversifying out of bobbleheads. This is a new area and not one that management has proven ability to execute yet. So far the acquisitions have been small but they could grow once the company has a "public currency."
- As the company increases product lines, SKUs and adds inventory the operational risk increases. Depending on the terms of their retail distribution agreements this can result in some negative "surprises" when inventory comes back.
- Channel conflict isn't an issue now but the company notes that more customers are coming to Funko.com to find and purchase these items. The Funko products are very conducive to retail point of sale because of their impulsive and discretionary nature but if Funko.com starts to grow rapidly it could eat into other channels. A more partner-oriented online channel solution might be a better idea.
In conclusion, the stock at the IPO price is reasonable but we're a little concerned about how future growth will play out and what kind of valuation investors will give a stock like FNKO. This is a business that has created more disappointments than super returns. JAKK is only one piece of roadkill on the highway.
We'll have this on our watch list but probably not in our portfolio for now.
The management team is likable and serious about the business but it might not be enough. Paraphrasing Warren Buffett - "better to own a mediocre management team in a great business than a great management team in a mediocre business."