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Small-Cap Confidential
Undiscovered stocks that can make you rich

Cabot Small Cap Confidential 265

This month we’re jumping into a little-known company that makes and sells pop culture products.

It’s sort of an odd duck, but when you dig below the surface you find compelling products and interesting market exposures, including to the nascent Non-Fungible Token (NFT) market, which has exploded in trading value over the last year.

Revenue growth is above 30%, and the chart is strong.

Enjoy!

Cabot Small Cap Confidential 265

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The Big Idea
I’m not the biggest pop culture guy out there. But I do have an affinity for certain movies, shows and sports teams that have struck a chord, or played a special role in my life.

This is likely true for everybody out there, to varying degrees.

Some people express their fandom through hats, tee-shirts, flags, backpacks, stickers, whatever. Some people take it to the next level and name kids and pets after their idols.

Wherever you fall on the fandom spectrum, the point is that pop culture has evolved into a huge part of life for most of the world. The proliferation of streaming content has only fed into this cycle. Even shows that are way out of date, like Seinfeld and Friends, are now available at the touch of a button. Nostalgia is real.

If we trust the numbers, the global licensed pop culture products industry is worth nearly $300 billion. That’s a mind-boggling number. But it doesn’t seem out of the realm of possibility given how influential pop culture products, and references to the content behind them, has become.

Some of this is being driven by social media, some by professional sports, some by conventions like Comic Con and some simply by people trying to entertain themselves and others by messing around.

Point is, it’s big market.

Today we’re investing in a small cap company that’s a pure play bet on pop culture. It has a seemingly stable business right now that leverages the popularity of content from providers that include Disney, Netflix, HBO, the NFL and more.

The future sounds even more intriguing as in-house content creators launch new products, and the company expands into the Non-Fungible Token (NFT) arena this month.

It’s an interesting story. And equally important, growth is terrific (30%+ this year) and the chart looks great.

The Company
Funko (FNKO) is a pop culture consumer products company that makes figures and other products that give people a chance to showcase their fandom for their favorite TV shows, movies, video games, musicians, and sports teams.

FNKO Product Categories

The majority of sales – 80% in the most recent quarter – come from sales of figures, while bags, wallets, apparel, accessories, board games, plush, homewares and other products make up the remaining 20%. The company has a market cap of $1.3 billion.

Funko has also recently entered the Non-Fungible Token (NFT) market through the acquisition of TokenHead, a leading mobile app and website for showcasing and tracking NFT holdings (10 million NFTs displayed, 100,000 visits per day).

This is an emerging market that could be huge given the recent growth trajectory of NFTs, which saw $250 million in value traded in all of 2020, then roughly $2 billion just in the first quarter of 2021. It will be interesting to see how Funko brings its pop culture physical products into the digital realm. Pricing will start at around $10, with products launching weekly, starting this month. Get ready speculators!

There is more variety in Funko’s product lineup than a cursory glance at its website suggests. This is due to an expansive license portfolio that includes a variety of content providers, including Disney, HBO, LucasFilm, Marvel, Netflix, Pokémon, the NFL, Epic Games, Blizzard Entertainment, Warner Bros and more. The more you click around the deeper you venture down the rabbit hole.

FNKO properties

In recent quarters the more productive selling properties (i.e. products from a show, movie, game, etc.) include Star Wars, Harry Potter, Marvel, Disney, The Office, Pokémon, Seinfeld and DC. In Q1 2021 Star Wars: The Mandalorian was the top property, generating 4% of sales.

Recently, a lineup of Seinfeld collectibles landed. The web launch says, “They’re real, and they’re spectacular!” Those of you that remember the show will know what that line is all about.

FNKO Seinfeld

The company says its products are whimsical, fun, and unique. Its tagline, “Something for Everyone,” speaks to the truth that everybody out there is a fan of something and would enjoy a little token to connect them with whatever that something is.

Most products are not expensive, ranging from $5 to $15 new. That said, some do get up there, especially when demand is high and supply is constrained. This is done intentionally in some cases to create a scarcity premium.

Some products have proven to be great investments. There is a growing secondary market on platforms including ebay, StockX and GOAT. Some Pop! figures on these sites are selling for well above $1,000, with some approaching $4,000.

FNKO Secondary Market

Looking through the Funko app I see certain products selling for around $10,000. Clockwork Orange – Glow, which was released in 2012, has earned the “vaulted” status and has a trending value of $13,300!

FNKO App

Many of Funko’s products aren’t exactly my cup of tea. But some are. Truth be told I’ve found a number of items that I want to buy. I “may” be swayed by the value being placed on some of these collections! If one of my kids comes home from a party with a Funko figure I’ll be like, don’t play with it we’ve got to preserve it in perfect condition! (joking).

In seriousness, beyond the obvious thrill of speculating on four-inch-tall plastic figures, there are some that I really do want.

I mean, a Lloyd Christmas (Jim Carrey from Dumb and Dumber) or Michael Scott (Steve Carell from The Office) keychain for five bucks? Yes please. I guess they really do have something for everyone.

FNKO D&D

Funko’s work with a wide variety of content providers clearly gives them extensive likeability from a huge swath of potential consumers. These partnerships mean content providers are incentivized to see Funko succeed. The more consumers connecting with Funko the more that connect with the providers’ content, and visa-versa. It’s a win-win for companies that live and die based on their ability to create and monetize pop culture trends.

Funko’s reach appears to be growing nicely. The company’s Twitter handle, @OriginalFunko, ended 2020 with over one million followers. As of March 2021 the Funko App has roughly 450,000 monthly active users (MAUs), up from around 150,000 two years ago (when an app relaunch occurred). App downloads grew more than 50% in April (the latest available data), according to Sensor Tower, a month in which Funko.com web traffic was up 60% (it was up nearly 100% in March).

In short, the trend seems up.

Products & Brands
Funko currently has two product categories: Figures and Other.

Figures
The first, Figures, are self-explanatory. These stylized vinyl, blind-packed miniatures and action figures combine pop culture licensed properties with Funko’s distinctive designs to create figures with appeal to a wide variety of consumers, at an affordable price. They are around four inches tall. Proprietary figure brands that are licensed include Pop!, Mystery Minis and Funko Soda. Non-licensed brands (designed in house) include Snapsies and Paka Paka.

Other
Funko’s Other category includes stylized fashion accessories (bags, backpacks, wallets) apparel (hats, t-shirts, etc.), board games, plush products, accessories (keychains, pens, pins) and homeware (drinkware, etc.).

Here are a few notes on Funko’s three best-selling brands.

Pop!
Pop! was introduced in 2010 and generated 76% of 2020 revenue. These stylized figures are typically around four inches tall and are characterized by a rounded square head, no mouth, and a simple nose. They’re kind of weird looking, but also kind of neat.

Loungefly
Loungefly is a fashion accessory brand that Funko acquired in 2017. It makes items such as handbags, backpacks, wallets, clothing and more. Products can be seen on Funko’s DTC website, loungefly.com. Loungefly generated 13% of 2020 revenue, up from 6% in 2018.

Funko
The Funko brand includes a growing variety of items across both figures and accessories, including Funko Games, Funko action figures, Funko Soda and Funko Plush.

Growth Initiatives
Further Diversify Revenue Mix/Category Expansion: Funko continues to diversify its revenue mix by growing in under-represented categories, including games and toys (nearly $90 billion market), and products centered around sports, music and anime. Efforts to attract a younger demographic could also increase the company’s presence on resale platforms, including StockX and GOAT. Some Pop! figures on these sites are selling for well above $1,000, with some approaching $4,000.

Launch NFT Market Through TokenHead Acquisition: In April 2021 Funko took a majority stake in TokenWave, the developer of TokenHead, a leading mobile app and website for showcasing and tracking Non-Fungible Token (NFT) tokens. The strategy here is to expand Funko’s pop culture platform to the digital realm. Initial NFT offerings will launch this month (June), with a unique property introduced each week starting at $9.99. Products will be sold on the WAX platform (a newish, leading decentralized wallet on the blockchain), which provides verifiable authenticity. This is a long-term growth initiative, and I don’t expect eye popping growth right off the bat. However, the potential here is large as the NFT market grows (went from $250 million in 2020 to $2 billion in the first quarter of 2021). More to come on this as it rolls out.

International Expansion: Pop culture is a global phenomenon and Funko sees huge opportunity in markets beyond the U.S., which represented 75% of revenue in 2020. Management is particularly focused on Europe (ecommerce site funkoeurope.com launched last October). An exclusive partnership with Bandai was entered in 2020 which allows Funko to distribute anime properties in Japan, the world’s largest anime merchandise market.

Grow DTC Business: Funko has multiple DTC websites (funko.com, funkoeurope.com, loungefly.com) as well as two flagship retail stores to aid its direct-to-consumer sales initiative. Expanded product offerings, features and functionality on all e-commerce sites are incremental positives. While DTC was up huge in Q1 2020 (160%), this channel still only represented 8% of 2020 revenue. There is a lot of room to grow here.

Grow IP Portfolio: While Funko will likely continue to be reliant on licensed content for the foreseeable future it does have an in-house creative team that is growing and pumping out its own content and IP, including products under the Snapsies and Paka Paka product lines, as well as various board game offerings. Expect this trend to continue.

The Business Model
Funko makes and sells a small portion of products that it designs in house. Most sales come from products for which IP is licensed from content creators under two to three-year agreements (typically renewed). Royalty rates paid to licensors are typically around 16%.

Licensed properties (a property is a content title, franchise, or character, like Star Wars, Disney’s Frozen, etc.) typically fall into one of two categories: (1) Classic Evergreen, or (2) Current Releases.

Classic Evergreen properties are based on movies, TV shows, games, etc. that are not tied to new releases. Examples include Star Wars Classic and Harry Potter. Current Releases are properties tied to new movie release, current TV series, etc. Examples include The Mandalorian, Stranger Things and Fortnite.

Typical upfront costs to design a figure run $5K to $7K and it usually takes 70 to 200 days to get something from design to shipping from the factory. Manufacturing is done mainly in Vietnam and China, with some apparel manufacturing and assembly occurring in the U.S., Mexico and Cambodia.

Funko has a varied distribution model. The company has a direct-to-consumer (DTC) channel through its three e-commerce websites. It also sells to specialty retailers, mass market retailers and other ecommerce sites, as well as to a small group of distributors. Key domestic retail partners include Target (TGT), Walmart (WMT), Amazon (AMZN), GameStop (GME) and Hot Topic. International partners include Smyths Toys, ASDA, Tesco, Fnac, Amazon, Micromania and HEO.

The Bottom Line
Funko grew revenue by 33% in 2018 and by 16% (to $795 million) in 2019, when adjusted EPS grew 117% to $0.78. The pandemic was devastating, and double-digit revenue growth evaporated and turned into double-digit revenue contraction as Funko moved through the first half of fiscal 2020. Full-year 2020 revenue of $653 million represented a decline of 18% while adjusted EPS of $0.37 represented a decline of 61%.

The tide finally turned in Q4 fiscal 2020 (ended December) as revenue expanded by 6% to $227 million and EPS jumped 61% to $0.29. In Q1 fiscal 2021 (ended March) results surpassed expectations as revenue jumped 38% to $189 million and EPS grew 700% to $0.24.

Management cited huge Q1 improvements in both the U.S. (up 39%) and Europe (up 55%), with Pop! Branded products growing 33% and sales of Other (non-figure) products growing 52%, driven by Loungefly branded products (up 82%). DTC sales were up 160%, driven by sales from the Funko and Loungefly websites.

Current consensus estimates suggest 2021 revenue will grow 35% to $880 million while EPS should expand nearly 200% to $1.10. This seems low to me. In the Q1 earnings release management raised full-year growth guidance to a range of 33% to 38%. Given how early it is in the year they would be fools not to be somewhat conservative, so I’m expecting growth could surpass 40% this year.

As of March 31, 2021, current debt was $183 million

Risk
Key Retailer Trends Need Continued Improvement: Retailers that Funko sells through are seeing improved foot traffic, however trend needs to continue in order for Funko to hit its 2021 numbers. Evolving trends in shopper traffic could lead to upside or downside to growth estimates (I expect upside).

Reliance on Pop! Branded Products: While Funko is making progress diversifying its revenue mix the majority of current sales still come from Pop! figures (80% in Q1 2021, down from 83% in Q1 2020). Further diversification would reduce risk.

Loss Of License: Funko is highly reliant on licensing deals. Loss of key partners, or pressure on terms in the form of higher royalties paid out, could pressure margins and EPS.

Competition/Knock-Off Products: Brand recognition is important with Funko’s products, but that’s not to say knock-offs couldn’t eat into sales.

Failure To Anticipate Pop Culture Trends: Clearly Funko management needs to keep an ear to the ground to pick up on what’s likely to be hot sellers every quarter, and try to avoid flops.

Supply Chain Constraints: Thus far management has said supply chains are functioning fine, but things could change depending on how the global reopening progresses.

Competition
Funko competes with many other toy, board game and fashion accessory companies, both foreign and domestic. A few notable publicly traded competitors include Mattel (MAT), Hasbro (HAS), Spin Master (TOY.TO, SNMSF) and JAKKS Pacific (JAKK).

The Stock
Trading Volume: FNKO trades an average of 2.7 million shares daily. Heavy days are 5 million or more. Over the last six months there have been six days where volume surpassed 5 million shares, and three of those days were off the charts, one with over 17 million shares exchanging hands and two with over 30 million.

Historical Price: FNKO went public at 12 in November 2017 and got off to a strong start. By mid-September the stock was trading just over 30. It pulled back to just under the IPO price by the end of the year then rallied back over 27 by the end of September 2019. Another pullback came before the pandemic hit, then FNKO was obliterated during the market crash and didn’t stop falling until shares got below 4. The recovery was slow at first – FNKO didn’t get back above 10 until December 2020. After that it began climbing steadily, helped by a breakout above 15 after Q4 2020 results were released on March 11. It has since climbed into the mid-20s. Like a lot of small caps FNKO’s action has been choppy but it has been mostly making a series of higher highs and higher lows and is currently pushing up against its pre-pandemic high near 28.

Valuation & Projected Price Target: FNKO trades with a 2022 PE ratio of 19.5, based on consensus EPS estimates of $1.30. Given the company’s growth in Pop!, expansion into other categories (toys, NFTs, games, etc.) and accelerating revenue and margin growth, the stock should begin to trade at a premium to competitors (it has historically traded at a discount). If the bull thesis continues to play out the stock could trade up to 23x to 25x 2022 consensus estimates in the coming months, implying a target share price range of 30 to 32.5. As we move further along, positive developments should push 2022 EPS estimates up, giving FNKO additional upside potential based purely on valuation.

Buy Range: In the near-term expect to buy in the 22 to 27 range. We’ll likely keep at buy provided FNKO stays above its 50-day line (currently at 22.4). In the coming weeks a breakout above 30 or a breakdown below 20 may cause me to revisit our buy rating

The Next Event: Management is expected to present Q2 2021 results around August 6.

FNKO Company Description

FNKO Financial

FNKO-060221

Updates on Current Recommendations

Stock NameDate BoughtPrice BoughtPrice on 6/2/21ProfitRating
Accolade (ACCD)8/6/20405228%Buy
Arena Pharmaceuticals (ARNA)2/2/18396258%Buy
Avalara (AVLR)2/1/1940129223%Buy
Cerence (CRNC)10/1/2050100101%Hold
Everbridge (EVBG)12/2/1616114637%Buy
Fiverr Intl (FVRR)3/5/2032209546%Hold
Funko (FNKO)New26Buy
Inspire Medical (INSP)10/4/1959171192%Hold Half
Kornit Digital (KRNT)3/4/211021108%Buy
Porch Group (PRCH)1/7/21131836%Buy
Q2 Holdings (QTWO)4/1/162495301%Buy
Repligen (RGEN)11/2/18 and 12/31/1859178201%Buy
Revolve Group, Inc. (RVLV)4/1/21465930%Buy
Sprout Social (SPT)9/3/20367092%Buy
Thunderbird Entertainment
(THBRF, TBRD.V)
5/6/213.84.03%Buy

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.

Glossary
Buy
means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.

Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.


The next Cabot Small-Cap Confidential issue is scheduled for July 1, 2021.

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Chief Investment Strategist: Timothy Lutts
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