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Monday, January 20, 2020

Funko - Quick Flip Ok, Not Long Term Investment

At $15.6/share and 12x PE, Funko (FNKO) is cheap enough that I wouldn't mind buying it for a quick flip. But I do not see this as an investment to hold for the long run. This article explains why. (hint: one of the themes I have been exploring is an "overfit" between a firm's competitive advantages and its markets)


Funko make pop culture figures like these.

Contrary to what you might think, Funko's target audience is not children.
Our demographic is a 35-year-old, 50% male 50% female who is buying our products for themselves, not for other people, for no special occasion. And I said that could not be more -- any further from who is in the toy aisle buying a present for a kid for their birthday party or for Christmas. 

Regardless, Funko's product is an affordable luxury. No one NEEDS this stuff. But they just want it. I'm not sure I'd call it a fad - the big headed style is a niche that has always existed, even before Funko - but revenue growth clearly has a large cyclical component to it and can easily fizzle out.

What's more interesting is Funko's value proposition to IP owners. Funko helps them keep contents relevant, in view at stores and in conversations. Often the contents are hit driven and content owners want to keep the conversation going between hits. An example would be Marvel superhero movies. Marvel built a franchise of inter-related characters, but there's significant downtime in between movie releases. Funko figures is one of many ways to keep those characters in consumer mindshare.



Barrier to Entry

Making pop culture figures is obviously not rocket science. Nevertheless, there are some barrier to entry and I'll list them out.
  • Relationship with content owners. This is not easy for anyone to come in and replace.
  • Process advantages. Funko have a group of creative people who are great at detecting pop culture trends and come out with product quickly.
  • Retail distribution relationships. 

Funko's Place In IP Monetization Chain

I would say relationship with content owners is the most important one. In the grand scheme of things though, Funko is just one small part of the content monetization value chain.

Below is a little diagram I drew up.



IP is at the bottom of everything. The second layer in the diagram shows monetization schemes such as movies, theme parks, toys, T-shirts..etc. In this example, Disney (inside the dotted line) owns various IP and produces movies and theme parks, but outsources the production of toys and t-shirts to third parties. Funko (and Hasbro and others) monetizes for Disney in the toy category, and has relationship with distributors and retailers.

Who has negotiating leverage here? I would say it's clearly the content owner and not Funko, since 1) Funko's products are not the only to monetize IP,  2) it's often a minor revenue stream for content owners.

Perhaps due to this lack of bargaining power, Funko's licenses are usually not exclusive even within the toy category (for example Hasbro and Funko both have Mandalorian products). This further dilutes Funko's bargaining power.

I can also easily think of scenarios where, in order to access the hottest character licenses, Funko has to pay for a bundle that includes far less marketable characters. Effectively they would have to pay premium for what they want.

In short, Funko's relationship with content owners enables its business model, but will also limit its upside in terms of margins.


Process Advantages

As far as process advantages go, here are a few excerpts from transcripts that stood out to me:
  • Low start up cost
  • Absolutely. So for us to develop a new SKU, it really costs us between $5,000 and $7,500, which means I really only have to sell about 2,500 units or so in order to just break even. And that gives us a lot of flexibility to look at niche properties, niche licenses that we can go after and then see how they resonate. It allows us to be very authentic, which is important to us in terms of connecting with that end consumer and casting that wide range.
  • And a great example of that is we saw some tailwinds or whisperings around Bob Ross a year or so ago. And so we called up the licensor and said hey, we want to sign up the license. It was a $5,000 minimum guarantee. The licensor is like, well, how many units do you think you are going to sell? And we were like, well, it's really hard for us to sell fewer than 20,000 to 30,000 of anything that we put out there.
  • We announced it; it caught fire from a social media perspective. It ended up with an end cap at Target. And before the product was even manufactured, we had presold something like 600,000 or 650,000 units.
  • Agility
    • (regarding Game of Thrones) That was on a Sunday night. By Wednesday, we had that item digitally sculpted and colorized and were pre-selling it online and sold several hundreds of thousands of units to fans. And everyone said, oh, you must have known that was coming. We had no idea.

Low startup costs and agility both reinforce Funko's long tail of minor/niche characters; and as such they are inter-related.

The low startup costs (and thus low breakeven) means Funko has the flexibility to experiment with new ideas and take risks. Agility means if said idea does not work, Funko can quickly shift to another idea, keeping its opportunity costs low. Both helps Funko cover maximal ground with minimal monetary and opportunity costs - important if your market is long-tailed in nature.

Agility also ties in to relationship with IP owners as well as distributors. After all, putting out a product in 3 days requires high degree of coordination - both upstream and downstream.

So it seems Funko's process advantages are highly suitable for its specific market. Not only that, they are related to other moats, which makes the sum greater than its parts and thus hard to duplicate.



Conclusion - Investor Perspective

The questions is how scalable these advantages are beyond the niche of pop culture figures. If these figures turns out to be a fad and consumer interests fizzle out..would Funko be able to take these resources and processes and do well in another market? Is there even another market that fits so well to Funko's advantages? What would that be? Clothes? Bags? Games? Fashion?

If yes, the stock could be a multi-bagger. If not, the stock will languish in mediocrity. For now, I think it's the latter.

Funko clearly has competitive advantages that will allow it to dominate its particular niche. But 1) the sustainability of this niche is questionable, 2) the IP relationships weigh on margins, and 3) the competitive advantages are so tailored to the specific market that I'm not sure they can scale to another market easily.

Funko is still growing fast (the company plans to more than double its EBITDA in a few years). But it is unlikely to get a high multiple for reasons above.

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