Funko, Inc. (FNKO) CEO Brian Mariotti on Q2 2019 Results - Earnings Call Transcript

About: Funko, Inc. (FNKO)
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Earning Call Audio

Funko, Inc. (NASDAQ:FNKO) Q2 2019 Results Conference Call August 8, 2019 4:30 PM ET

Company Participants

Brian Mariotti - Chief Executive Officer

Andrew Perlmutter - President

Russell Nickel - Chief Financial Officer

Conference Call Participants

Alex Perry - Bank of America Merrill Lynch

Drew Crum - Stifel

Christopher Horvers - JPMorgan

Eric Johnson - Piper Jaffray

Steph Wissink - Jefferies


Good afternoon, and welcome to Funko's Conference Call to discuss Financial Results for the Second Quarter of 2019. At this time all participants are in a listen only mode, later we will conduct a question and answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call is being recorded.

On the call today from management are Brian Mariotti, Chief Executive Officer; Andrew Perlmutter, President; and Russell Nickel, Chief Financial Officer.

I will turn the call over to Mr. Nickel to get started. Please go ahead, sir.

Russell Nickel

Thank you, and good afternoon. A press release covering the company's second quarter 2019 financial results was issued this afternoon, and a copy of that press release can be found in the Investor Relations section on the company's website. Management's remarks on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These may include statements regarding our business goals, plans, abilities and opportunities; industry and customer trends; growth, momentum and investment initiatives; collaboration and license relationships; consumer engagement and brand awareness; acquisitions and related expenses; potential tariffs; and anticipated financial performance. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of our Form 10-Q for the quarter ended June 30, 2019, and our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligation to update them.

Please also note that we will be referring to certain non-GAAP financial measures on today's call, such as EBITDA, adjusted EBITDA, adjusted EBITDA margins, adjusted net income, adjusted earnings per diluted share and net debt, which we believe may be important to investors to assess our operating performance. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and in the Investor Relations section on our website at

We have also prepared a visual presentation that investors can consult to follow along with this discussion, and it can be accessed in the Investor Relations section of our website. I will now turn the call over to Brian.

Brian Mariotti

Thanks, and good afternoon, everyone. Funko once again had another terrific quarter, posting growth that exceeded expectations. Given our continued exceptional performance, we are increasing our full year outlook for 2019.

Our net sales were up 38% over Q2 of last year. On a 12-month trailing basis, our net sales were over $0.75 billion, coming in at $768 million, up 31% compared to the 12 -- prior 12-month period. Gross margin came in at 37.2%, and we are on track to achieve full year gross margins of 37.5% even with this latest round of tariff increases.

We believe we are well positioned to withstand potential increases in tariffs, which up to now have mainly affected just our allowance by division, and we are looking at a number of ways to reduce the impact of these tariffs as well.

Our team's strong execution drove excellent performance, allowing us to raise our outlook for the year for sales, adjusted EBITDA and adjusted EPS. And as we've been saying all year, the strong momentum of our business allows us to make disciplined investments to take advantage of the increasing opportunities in front of us. Our future has never looked brighter and I've never been more excited.

The factors that drove our excellent performance in Q2 are familiar: more properties, higher sales per property, more stores in more markets and continued expansion of our product categories. Andrew and Russell will review those details, but what I want to focus on is not the near term but our longer-term vision. What really keeps me excited is how many more opportunities we have ahead of us, and we didn't even see those a year ago. We are constantly finding more and more opportunities for new partnerships, new product categories and new lines of business that, when combined, continue to build Funko brand and gain share globally. You've heard us talk since even before our IPO about our plans to increase the portion of our revenues that come from our own intellectual property. This means so much more than just putting out a physical product based on something we created and having it sit on a retail shelf. This is about recognizing the strength of our brand and the opportunities that it creates for us.

We are working on several initiatives that we believe over time will capitalize on the strength and should continue to produce increasingly profitable sales growth. As Russell will review later in the call, Pop! Vinyl sales were up 34% for the quarter. We believe that our ability to grow Pop! Vinyl, which, by the way, is more than 9 years old, by 34% demonstrates the strength of our brand. This shows Pop! is its own established consumer category and showcases Funko as an entertainment platform. More importantly, it continues to act as our Trojan horse: a relatively easy sell-in to a new customer that then pulls in our other products around it when the customer sees the value in our broad pop culture products and offerings.

We've been saying for years that Funko's strength comes from being at the epicenter of pop culture, connecting licensors, retailers and fans. That's still true. But what's becoming more clear is that we've moved beyond just participating in pop culture and have become an integral leader in the entire ecosystem. We believe our brand, because of its unique design and look, is as strong, if not stronger, as some of the properties we base our products on. Having our products on shelves is a significant traffic driver for retailers. We are also an integral connecting point between licensors and fans. Our products are as recognizable as some of the most iconic properties in all of pop culture.

More and more, we are being approached by some of the biggest names in pop culture with proposals to collaborate, including film studios, apparel brands, digital game developers, location-based entertainment companies and so on. These potential partners recognize that: One, we can connect them to fans that are drawn in by our brand; two, we can help keep them relevant; three, we can help them tell their stories better; and four, we can help them monetize their brands while simultaneously building our own.

The world is viewing pop culture through the lens of Funko. This is leading to a growing array of business opportunities that are just beginning to play out, and we will continue to find new and increasingly profitable ways of leveraging our iconic brand.

While our iconic Pop! Vinyl figures continue to be one of our main growth drivers, the very fact that Pop! Vinyl has gotten so big and continues to grow so fast tends to overshadow the rest of our business. We would focus on diversifying our revenue base, and we have so many other offerings that are also growing and becoming increasingly important to our overall business. In fact, in the last 12 months ended June 30, our sales of products other than Pop! Vinyl grew 45% and almost exceeded our entire company sales for the year of 2015. Loungefly is just one part of our business outside of Pop! Vinyl, and its sales are on pace to triple the level they were just 2 years ago when we acquired the company.

Loungefly is outpacing our expectations in both sales to retailers and in direct-to-consumer sales at We continue to be impressed with the business and the plan to continue to invest to grow this business in a profitable way. While we are still encountering some hitches in integrating Loungefly with the rest of the business, which Russell will discuss, we think Loungefly alone could be one of our top-selling lines over the long term, delivering growth in categories, properties and geographical expansion.

At Comic Con a couple weeks ago, we formally launched Funkoverse, the first offering from Funko Games. Funkoverse was developed by the team at Forrest-Pruzan, which we acquired earlier this year. The game experience is amazing, and the fans and retailers alike are excited for it to hit retail shelves in a couple of months. This is just the beginning for us in the board games business. And we think in a few years, Funko Games will be a significant player in the games and puzzle category, a category that is larger and growing faster than the core category we're already in. We expect over time this will become a meaningful and profitable new line of business for Funko.

As we've said before, we are exploring the launch of several new toy lines based on our own IP that will live in the traditional toy space. We continue to see interest from our retail partners and expect to roll out one program this fall, followed by several more in 2020. We think this represents a strong growth opportunity to capture a new space and new age ranges outside of the traditional collectible pop culture area. Just as we disrupted the action figure category, we expect our fresh and innovative delivery and merchandising of these new toy lines will also be disruptive.

We are on track to open our Hollywood store in the fourth quarter, and we can't wait to show you how our vision will come to life. This store will be a physical manifestation of how we are at the epicenter of pop culture, bringing fans and licensed properties together. We have already begun to partner with major studios to provide a presence in this store. We believe fans will come to the store to experience and interact with those amazing licensed properties and because of the connection they feel to Funko.

Before I turn the call over to Andrew Perlmutter, our President, let me take this opportunity to thank all of our team members who contributed to our terrific growth as well as our retail and licensing partners. And most of all, thanks to our fans, whose passion for our entertainment content and for Funko is the number 1 reason we exist and why we succeed. Andrew?

Andrew Perlmutter

Thank you, Brian. Our partnerships with retailers around the world are one of Funko's key strengths. As Brian mentioned, we continue to connect our fans with their favorite content through our retail partners. Funko's unique ability to drive traffic to our retailers is one of the elements that differentiates Funko from our competition.

As we've been saying for some time, 2019 is a very strong year for content. During the second quarter, newly launched properties like Stranger Things Season 3, Spider-Man: Far From Home and Toy Story 4 did very well, as did several giant properties launched prior to Q2, such as Avengers: Endgame, Fortnite and Game of Thrones. New content for Dragon Ball Z drove strong sales of that anime property.

Evergreen properties, such as Harry Potter and DC Comics, also performed very well in the quarter despite not having any fresh content to drive demand. Our evergreen properties continue to provide a solid mortar for the foundation of sales, typically representing 40% to 45% of our sales, as was the case in Q2 when they amounted to just over 45%. Pokémon almost made the top 10 despite still being limited distribution with limited SKUs. We expect Pokémon to do even better when we broaden the distribution product offering in 2020.

While we saw growth with most of our retail partners, the strongest growth continues to come from the specialty retail channel, which represents our largest channel. Although it is in some ways our most mature channel, it continues to be an important and reliable source of growth, and Funko continues to act as a major force driving consumers into these stores.

We also continue to see our sales shift to higher-priced products across all of our channels. The traditional 4-inch Pop! Vinyl figures are growing, but products like the 10-inch Pop! Vinyl figures, Movie Moments and Pop! Rides account for an increasing percentage of our overall sales. We continue to see good sell-through as well as sell-in in the U.S., where we get this data. Our sales in the U.S. rose 26% in Q2. Looking at the retailers that report sell-through to us, our sell-in was up 16% and our sell-through was up 21%.

The Funko brand continues to resonate and expand globally. In addition to the U.S. being up 26%, Q2 sales in the rest of the world rose 65%. Growth in international markets is being driven by onboarding new customers, increasing our shelf space for our core products and expanding the range of products that we sell. We officially began rolling out our proprietary Wetmore Forest program in late June and early July. It is still early, but we are seeing positive results so far. Plush and books are driving the business, which is why we chose Barnes & Noble to be the first to market.

Brian mentioned the launch of Funkoverse at San Diego Comic Con and Gen Con, but let me provide a little more color. Retailer adoption and selling is outpacing our expectations. The major retailers we work with have placed orders, including several that don't traditionally carry, boardgames, and those orders have exceeded our expectations. Just as pop culture fandom is a global phenomenon, we are launching Funkoverse globally with 3 fully translated versions, including French, German and Spanish.

Our game strategy is also multipronged. Brian mentioned that we've been talking to digital gaming companies interested in partnering with us, and we just announced our new partnership with Universal Games for a digital app featuring pop characters. This is in addition to Microsoft, which is launching Gears Pop! in Q3.

As we said last quarter, we are taking steps to improve our operating efficiencies in the U.K. by streamlining our operations and processes for the U.K. and the European markets. We are making good progress on that, and we are scaling up faster than planned but doing so in a controlled manner.

Finally, we are glad to report that we are seeing less in the way of vendor noncompliance charges than we saw over the past couple of quarters. Catching up operationally with these issues caused by our rapid growth is challenging, but we are clearly making progress. It is still higher than a year ago but significantly lower than we saw in Q4 of last year and Q1 of this year. We recognize that while we are focused on performance and execution, there are areas in which we can continue to improve, and we are making investments we need to accomplish that, not just for what it means now but also so we can continue to support the business and capitalize on longer-term opportunities that we see in front of us.

With that, I will turn the call over to Russell, who will review the details of our financial performance in the quarter.

Russell Nickel

Thanks, Andrew, and good afternoon, everyone. As Brian and Andrew have indicated, we have again delivered better-than-expected results for the second quarter driven by strong performance globally across multiple product lines, and we are able to bring more of the sales upside to our bottom line. We exceeded expectations on sales, adjusted net income and adjusted EBITDA. As I will discuss later, part of the bottom line upside was due to the timing of investments when compared to the prior year.

Before I go into the details of the quarter and our improved outlook for the year, I want to discuss a matter concerning duties paid by Loungefly. During the quarter, we identified that Loungefly had historically underpaid certain duties owed to U.S. Customs. Once we discovered this issue, we acted quickly. And in July, we paid $7.8 million to U.S. Customs. This $7.8 million covers a 5-year statutory limitation period through June of 2019. Of that amount, $6.3 million relates to periods prior to Q2, and the remaining $1.5 million relates to Q2 and is split nearly equally between inventory on hand and cost of goods sold. While we have concluded that these errors identified were immaterial individually and in the aggregate to our previously issued quarterly and annual consolidated financial statements, we have also concluded that correcting these errors cumulatively would have been material to our second quarter of 2019. Accordingly, prior periods' amounts have been revised to reflect the correction of these errors. Additional detail and the impact of this -- of the revision by quarter can be found in our second quarter Form 10-Q.

Looking at tariffs more broadly, we are reviewing the potential impacts of the tariffs recently ordered by the administration that go into effect on September 1. While we have moved much of our production out of China, we believe our gross margins in the fourth quarter could be adversely affected. We are looking at a number of ways we can mitigate the impact of tariffs over time. But if these tariffs do go into effect and we are unable to offset them in the near term, it could reduce our Q4 gross margin by as much as 50 basis points. Despite these headwinds, we still expect our reported gross margins in 2019 to be in line with the level we reported in 2018 or approximately 37.5%.

Longer term, we believe we are in a very good position to offset the impact of tariffs. We continue to shift production outside of China, and sales to regions outside of the U.S. are growing faster than our sales in the U.S. In addition, given the generally low retail prices of most of our products, we believe that the negative impacts of higher tariffs can be offset with relatively modest price increases that we don't believe would adversely affect demand for our products.

Now let's talk about our second quarter results. Net sales in the quarter increased 38% to $191.2 million and were driven primarily by the continued expansion in products and properties in our portfolio, broader distribution into new territories and customers and greater sales per property. In the quarter, the number of active properties increased 16% to 592. And net sales per active property were $323,000, which was up 19% year-over-year. In the first 6 months of the year, we sold again 663 properties, 23% more than a year ago. And our sales per active property were $540,000, up 5% over last year. As a reminder, we expect net sales per active property to fluctuate from time to time. We believe it is a good sign to see leverage from each property and our sales spread over a wider range of properties.

The top-performing property in the quarter was Avengers: Endgame, which accounted for approximately 6% of our total sales, slightly edging out Fortnite. In the second quarter, no customer accounted for more than 8% of our total sales, which highlights our diversification. We are not reliant on any one retailer, and we believe our products are channel-agnostic.

On a geographical basis, in the second quarter, net sales in the United States increased 26% to $122.7 million from Q2 of 2018. And net sales internationally increased 65% to $68.5 million. Europe, Australia and Asia were each up more than 64% year-over-year.

As a reminder, a year ago, as we were implementing the new ERP system in the U.K., we intentionally pulled forward about $5 million of sales that would have otherwise shipped in Q2 of 2018. If this $5 million pull-forward had not occurred, our international sales growth year-over-year would have been 47% and our consolidated sales growth would have been 33%.

On a product category basis, Q2 net sales of figures increased 39% to $159.7 million. And net sales of other products such as bags, accessories, apparel and homewares increased 30% to $31.5 million. As Brian said, sales of Pop! Vinyl figures increased 34% on a global basis over the prior year period. This is in year 9 of this product line and this platform. This growth is driven by the breadth of our licenses and by the continued expansion of shelf space, retail doors and geographic markets.

Additionally, the broader Pop! brand, which includes other product lines, was up 49% over the prior year. Some of this growth is the result of the pull-forward of revenue from Q2 into Q1 of last year. But even excluding that, the brand continues to demonstrate strength in all markets.

Gross margin, which excludes depreciation and amortization, decreased 90 basis points from Q2 of last year to 37.2%. The decrease in gross margin this quarter compared to Q2 of last year was driven primarily by higher reserves taken for slower-moving inventory of some old lines as well as the higher Loungefly tariffs I discussed earlier, which was partially offset by lower product costs and royalty costs as a percentage of net sales. These favorable trends in product and royalty costs should help offset the impact of higher tariffs.

Through the first six months of 2019, our gross margin was 37.6%, in line with the level we reported last year for the full year. Like last quarter, we experienced higher chargebacks in Q2 of 2019 than in last year's second quarter, which was a headwind on our gross margin in Q2. But these chargebacks were lower as a percentage -- percent of net sales than what we saw in the last couple quarters.

Selling, general and administrative expenses in Q2 increased 26% to $43.6 million from the prior year. This amounted to 22.8% of this year's Q2 sales and represented a 210 basis point improvement in SG&A expense leverage compared to last year. Some of this leverage is driven by the fact that last year, some of our major investments were timed for the first half of the year, whereas this year, the investments come more in the second half. Also, please note that part of the increase in leverage in Q2 is the result of timing of some marketing expenses, which will be shifted from the first half to the second half of this year.

Depreciation and amortization expense in Q2 increased 8% from the prior year to $10.4 million. This represented 5.5% of Q2 sales and an 150-basis-point improvement as a percentage of sales over the prior year. The combination of higher revenues and lower operating costs and D&A as a percent of sales offset by the slightly lower gross margins resulted in a 98% improvement in our operating income in the quarter to $17.1 million or 9% of net sales. This is compared to the Q2 2018 operating margin of 6.2%.

Net interest expense decreased 33% to $3.8 million from $5.6 million in Q2 of 2018 due to reduced debt levels and lowered rates following our debt refinancing in Q4 of last year. As a result of all these factors, adjusted net income increased by $9.7 million or 305% to $12.9 million compared to $3.2 million in Q2 of 2018. Adjusted earnings per diluted share was up approximately fourfold to $0.25 compared to $0.06, and adjusted EBITDA increased 61% to $31.4 million. This represented a 16.4% adjusted EBITDA margin, which improved 240 basis points over Q2 of 2018.

Looking at the balance sheet. We ended Q2 with net debt of $221.8 million compared to $233.8 million at the end of 2018 and $237.6 million at the end of Q2 of 2018.

Inventory was up to $75.3 million versus $64.2 million at the end of Q2 2018, an increase of about 17% despite sales growth of 38% over Q2 of last year and was down 13% compared to year-end 2018.

Turning to our outlook. Considering that both Q1 and Q2 results exceeded our expectations, we are raising our full year guidance at this time. We now expect net sales of $840 million to $850 million, representing year-over-year growth of 22% to 24% compared to our prior guidance of $810 million to $825 million or 18% to 20% growth.

Adjusted EBITDA of $140 million to $145 million compared to our prior guidance of $133 million to $143 million. We are taking advantage of the strong upside we saw in the sales and adjusted EBITDA in Q1 and Q2 to increase investments in the business, including our U.K. operations, the Hollywood store, Loungefly, Funko Games and other areas.

Adjusted earnings per diluted share of $1.15 to $1.22, which assumes a blended corporate tax rate of 25% and a weighted average diluted share count of 53.5 million shares. This compares to our prior guidance of $1.05 to $1.15.

Before I turn the call over to the operator to start the Q&A session, just let me say what a great honor and privilege it has been for me to be part of this team and part of this company for nearly the past 6 years. This is my last quarterly conference call as CFO, but I will be still working with Funko through the end of the year and I will carry a part of Funko with me forever, especially my Batman collection. It has been a pleasure working with all the analysts and investors we have talked to over the years, and I am confident you will continue to be rewarded for your interest in and support of Funko.

With that, I will now turn the call over to the operator.

Question-and-Answer Session


[Operator Instructions] The first question is from Alex Perry of Bank of America Merrill Lynch.


Congrats on the strong quarter. Just first, can you talk specifically on what drove the exceptional growth in the specialty channel, which was up 83% this quarter? Just some more color there would be really helpful.

Brian Mariotti

Yes, I can start. I'm sure Andy will chime in. Like anything else, it's our longest, most established, most mature channel. It continues to grow year-over-year. I think we're seeing continued shelf expansion, one. We're doing a better job of product segmentation, earmarking products for vast retailers and trying to separate ones that are unique for a specialty retailer. That seems to be -- that strategy seems to be helping as well. A lot of that -- those channels are still growing also in EMEA and Latin America as well. I think just all 3 of those strategies are really, really paying off and the business just continues to mature. And with that, we continue to be able to annex other adjacent categories, and I think all of it seems to be working.

Andrew Perlmutter

Yes, I would just -- the only thing I would add, I would echo everything that Brian just said. And I would say that we are seeing some strength from the Loungefly brand or the Funko brand, bringing programs to these retail partners together, which is helping to accelerate the expanded shelf space, and continue proving that Funko is a valued resource for these specialty customers.


Perfect. That's really helpful. And then maybe, Russell, just for you. Can you help us think through the tariff's impact a bit more? Remind us sort of the percent of U.S.-bound imports that are coming from China. And then are you guys considering any other offsets other than the price increases?

Russell Nickel

Yes, absolutely. So as we've talked about for a number of quarters, we are now -- 70% of the core production is outside of China and located in Vietnam. That remaining 30% is then distributed worldwide, including coming to the U.S. So when you look at it, that mix starts to shift down. And then even that mix that is U.S.-bound is split pretty much between 80% to 20% FOB to non-FOB. So when you layer in that mix, the fact that we're ahead of the game in terms of moving production outside of China, we looked at -- it would take a modest price increase to offset. It is looking like if we did nothing or were unable to do anything, which is not the case, it would have a 50-basis-point impact. But as we said, there are opportunities to raise prices with our retailers that wouldn't affect demand. We are also working with our supply chains as well as our licensors to look at other avenues across the board. That said, I would highlight again that we're seeing favorable trends from a pure product margin perspective that we believe will offset some of those incremental tariffs on -- of the 10% should they go through later in Q3.


The next question is from Drew Crum of Stifel.

Drew Crum

So the midpoint of your revenue guidance increase was a little less than $30 million. I know you referenced the first half being above expectations, but are you seeing anything in the second half that's also being factored into that increase?

Brian Mariotti

I would continue to say the content year as a whole, it's extremely strong. And we have 2 big bullets left to fire with Frozen 2 and Star Wars: Episode IX. The demand -- if you look at just kind of the interesting mix of our top 10 licenses quarter-after-quarter and how varied they are, you see something like Dragon Ball Z that sometimes sits in the 8, 9, 10 spot or the 15th spot move up to like 3, I think it was, this quarter. We still have a ways to -- we have so many different ways to monetize different properties for the second half of this year. We're excited. We think the content is extremely strong.

And I think the other thing is, too, is we've really dived in and spent a lot of time over the last 4, 5 months on what 2020 is. 2020 looks a lot stronger than I originally thought and possibly even stronger than '17 and '18 as far as content is concerned. So I think that we're in really good shape for the second half of the year.

Drew Crum

Okay. Okay. And then, Russell, just setting aside the tariffs, the 37.5% gross margin guidance for the year, can you talk about some of the other puts and takes to getting to that number? In the press release and the preamble, you mentioned lower license and royalty costs. Any detail behind what drove that?

Russell Nickel

Yes. Yes, broadly speaking, I mean, obviously, there are a lot of puts and takes to gross margin as a whole. The -- we are seeing favorable trends or progress that we've been making. We talked about this the last couple quarters in terms of customer chargebacks that have a headwind from a gross margin perspective. We are seeing favorable trends in our product costs, which I think speaks to our strong pricing -- ability to hold pricing as well as our strong demand.

On the royalty front, naturally, with the licensor mix, we're actually -- there is a -- the shift would suggest a higher royalty rate. But what we're seeing is in the last couple of years, we've had some higher minimum guarantees that we've had to write off in 2017 and 2018 that we're not seeing this year. Those adjustments or write-offs really related to our exit of the subscription box business as well as the acquisition and the timing of the ramp-up of sales in Europe. So largely, just we continue to do a better job and be disciplined from a minimum guarantee perspective on the royalty front.


The next question is from Christopher Horvers with JPMorgan.

Christopher Horvers

Great quarter. So a couple of questions. Just on the -- a follow-up on the tariff situation. So you've talked to the -- your major retailers and they basically said that they would -- they're willing to sort of take this price increase and are comfortable moving off like the $4.99 or $7.99 price point and, just psychologically, for the consumer?

Andrew Perlmutter

Yes. I'll take that one. It's Andrew. So we have been in conversations with most of our retailers. Where we sit with our retail price points, we believe that the type of price increase we're talking about could be absorbed easily without having to change the retail. There is more margin built in for the retailers on some of our products than other traditional action figure-type products. So we don't believe we're talking about anything that would shift the retail price point and we do believe that it would be absorbed.

Christopher Horvers

Understood. And then just understanding the -- Russell, you mentioned the Customs charges. So that ran through cost of goods sold and that impacted the second quarter?

Russell Nickel

So there was a mix. So it was immaterial. The ultimate findings related to a 5-year period on each individual quarter, the adjustments or the error, were deemed to be immaterial. If we had run the entire adjustment through in the first quarter, it was deemed to be material. So what we've done is revise our prior period numbers with the adjustment and the impact. So what's running through cost of goods sold this year is -- or this quarter is simply the incremental duties owed on Loungefly products appropriately reported and appropriately paid that were sold in the quarter. So comparatively, when you look at the revised numbers quarter-over-quarter or the prior years that I would point to that are disclosed not only in our 10-Q but also in the earnings presentation on our website, it would show kind of the true impact as we've revised those prior period numbers to reflect the correct duties owed.

Christopher Horvers

Got it. So my more -- bigger question is that the 37.5% for -- that you're seeing on gross margin for the year, the gross margin from the first quarter, which was 38.1%, that's intact? I'm just trying to figure out like...

Russell Nickel

Yes, that's intact. And so we're -- for the year-to-date, we're at 37.6%, and we are seeing the favorable trends from a product margin perspective that we believe will offset this higher-than-expected duty rate on our Loungefly products as well as the proposed or requested incremental tariffs on the core Funko products at 10% on the -- which, again, only relates to the U.S.-bound portion that's coming out of China. So all factoring that in, we still believe for the year we will be at that 37.5% rate.

Christopher Horvers

Got it. And then on the back half, are there things that pay attention to around the phasing of the third quarter versus the fourth quarter? I know you mentioned up to 50 basis points for the tariff in the fourth quarter. But for example, on the top line, do you expect retailers to adjust their -- when they're taking receipt of goods relative to last year because of the tariff and any other factors? And also, on the grosses, do you expect to get some of these chargebacks as you lap them in the fourth quarter?

Russell Nickel

So on the timing of revenue, I would say we're not specifically seeing a change in buying pattern or timing at this point given the proposed or requested tariffs. What we are seeing, and I would point back to this -- the consistent guidance, we would expect the Q3 to be stronger than the Q4 growth rate, in part because of the high growth rate and the high numbers that we saw in Q4 of last year with the Fortnite sales and other FOB. So broadly speaking, I think the cadence is similar to what we expected coming into the year, and we're not really seeing a shift on that.

Christopher Horvers

And then on the grosses?

Russell Nickel

Oh, on the chargebacks, I think it's just an incremental improvement quarter-over-quarter. So when you compare against Q4 of 2019 versus Q4 of 2018, we will -- we would expect that we will have made substantial improvement. That's also part of the reason why we still feel confident and comfortable with that gross margin number for the year even with the incremental tariffs in the fourth quarter.


The question is from Erinn Murphy of Piper Jaffray.

Eric Johnson

This is Eric Johnson on for Erinn this afternoon. First, congrats, Russell, and best wishes going forward on behalf of our team. And then I just wanted to ask one quick question on Pokémon development. What does the road map look like from here? Should we think about SKU expansion or distribution being the bigger driver moving into 2020?

Brian Mariotti

Yes, a great question. I think it's going to SKU expansion. First and foremost, we are still talking about how to expand international territories. So there is ongoing dialogue right now. But I would tell you, you'll see a significant bump in overall SKUs for us in '20 as compared to '19. So to see this wonderful license that took us for a long time to get into our portfolio, hover at number 11 with almost so little on a development against it and limited distribution is super exciting, because it really talks to what the strength of that brand is going to be for years and years and years to come, and the relationship just gets better on both sides with Pokémon. So we love that they're in our backyard. There's a lot of time spent between the 2 companies, so we're really excited.

Eric Johnson

Is it fair to say that density in terms of revenue per point of distribution or SKU is as high as you've ever seen in your portfolio?

Russell Nickel

On Pokémon specifically.

Brian Mariotti

Yes. It's strong. It is definitely a -- it would definitely be in that, we'll call it, the A category. We like to go A, B, C and D, as someone as basic as me likes to simplify things. It's an A level property. I'll leave it at that.

Eric Johnson

Got it. That's helpful. And then just on European operations after you've made a few key hires, what are the top priorities from here to refine across the region?

Brian Mariotti

Well, I mean, first and foremost, the new hires have been transformational as far as what we've been able to accomplish in a very short period of time, starting with the ability that -- we hadn't really onboarded any new customers in about a 6-month period as we try to get our ducks in a row over there. That faucet's been turned back on. Now we're being able to onboard new customers and know that we can do it with a sense of professionalism and an ability not to have a hangover later on with chargebacks and vendor compliance issues. So first and foremost, that's number one.

Two, on-time deliveries are through the roof with our key partners, accuracy with our key partners. All these things are really starting to turn the corner as far as making us more of a world-class organization over there. We always say that we believe that we're just starting to make inroads into what Europe is going to be for us overall. And to get these transformational, high-level people onboard is really, really making a difference over there. So I think as that team continues to grow and we continue to broaden our base as far as our brand awareness and diversity of product categories, I think it's just going to be nothing but amazing results over there.

Eric Johnson

Great. And then one final one, maybe for Russell. How do you feel about the incremental investments that have been pulled forward? What are the biggest pieces? And are those playing about -- playing out about as you had expected 90 days ago?

Russell Nickel

Yes. Great question, Eric. I mean, I will say that in terms of the investments that we're pulling forward, I would say those are playing out as expected and are on track as we talked about on the last quarter. That being said, I think what we're seeing with the stronger demand and the stronger opportunities, really, the great opportunities that Brian alluded to earlier in terms of revenue opportunities for the future that we haven't seen in the past or didn't even see 6 months ago, it's leading us to really kind of lean forward and also invest -- continue our investment in the second half of the year, as I alluded to on the phone call. So not only are the ones we thought about 30 days -- or, 90 days ago on track and running smoothly, we're seeing also opportunities to invest further in the future and the opportunities in front of the company.


[Operator Instructions] The next question is from Steph Wissink of Jefferies.

Steph Wissink

Most of our questions have been asked. But one for you, Russell, just on Chris' earlier question on the chargebacks. Wondering if you're willing to quantify how meaningful the handicap that is to your gross margin? And then maybe walk us through what needs to happen either to the infrastructure or to your processes to fully close those chargeback issues within the margin structure.

Russell Nickel

Yes. I think it's -- from a gross-to-net spread, it's been 100-or-so basis points' impact improvement that we've been seeing. In terms of what needs to be closed or needs to be ramped down, I mean, a lot of it was what Brian alluded to. It's not only the investments that we've already made and continue to make in the U.K. that allows us to ship on time, ship in full, onboard customers, make sure we really fully understand the requirements by each of our customers in terms of fulfilling for them, making those same investments in the U.S. as well. And so it's just a continued evolution and a continued process of review and enhancement that we continue to make. And each time we are doing that, it's leading to incremental improvements.

Steph Wissink

All right. That's great. And then our next question is just on inventory in the channel. I think you mentioned -- I think it was a U.S. comment, the sell-in up about 16% but sell-through up about 21% that's spread between in and through. Are you finding that your retailers are calling on you for more inventory, chasing a bit more inventory? Or how does the inventory position look in the channel?

Andrew Perlmutter

Yes. So it's Andrew. I'll take that one. So we saw certain retailers build inventory positions at the end of last year because of the fact that they found themselves in a chase position all too often. And so they were anemic on inventory during peak times and would come back to us and we would have it already allocated to other customers. So what we saw was -- the reason why you're seeing the 16% sell-through -- or sell-in on a 21%...

Russell Nickel


Andrew Perlmutter

Sell-through, is because there was a little bit of inventory in the channel with certain retailers, and they've actually been selling down and are continuing to build up on certain items. But the truth is they're still seeing that sell-through. They're still seeing that pull-through and the chase that they had before. So there are some bigger retailers who will have to understand the cadence that goes along with it. But yes, we're very happy with where we are, and we think that the inventory and sell-through is in a very healthy place.

Steph Wissink

Okay. Last one for us is just on the games business. I mean, your enthusiasm is palatable about how big and how far you could go with it, but can you give us a sense of how the margin structure of that business is relative to your core business? And then some of the products we saw at Comic Con had this really unique mash-up or ability to mash up characters from different licenses. Is that something that you feel like it's hyper unique to the gaming space and then an area or an attribute that you can lean into going forward?

Andrew Perlmutter

Yes. It's Andrew. I'll take that one as well. We just actually came off of Gen Con, which is a -- it's the Comic Con for the gaming industry. And we did launch at Comic Con. We thought that, that was the right thing to do to let our fans know about this, our hardcore collector fans that attend that show. The reception that we got at Gen Con blew us away. We are very enthusiastic about the retailers' reception of us getting into this gaming category. I think we have mentioned before that it is a margin-positive business for Funko. And that said, we are starting with very intricate games that do have figures in them. So those are probably the lowest-margin games that we could get into and it's still margin-positive. So we are very bullish on that aspect of the business.

But when you're talking about the overall game system that we've created, customers can -- will do a number of things with these in the aftermarket. If you're a Harry Potter fan and you want to buy the Harry Potter game, that's fantastic. I'm a DC Comics fan. I'm going to buy that DC Comics game. What we decided to do with it in the aftermarket is really on us, but I can tell you that the options are limitless. And I think people are starting to catch on to that. And we are as enthusiastic, if not more, than we've ever been about this opportunity, not just for Funkoverse but for the games category in general. There's a lot of opportunities that are coming our way outside of this initial launch.


This concludes our question-and-answer session. I would like to turn the conference back over to Brian Mariotti for closing remarks.

Brian Mariotti

In closing, we recently announced that Jennifer Fall Jung will be joining us as our new Chief Financial Officer. Jennifer has been working with us over the past several weeks and will take over formally as CFO on August 13.

We are pleased that Russell's last quarterly earnings report as CFO was a blockbuster quarter for us. Russell has been an absolute pleasure to work with over the last 6 years, an amazing valuable member of the team, navigated us through our sale with ACON in 2015. He basically led 4 acquisitions, our IPO and our incredible growth throughout his term. So we're going to miss Russell. We have him through the rest of the year. He's going to be working hand-in-hand with Jennifer throughout a transition period, but we are super excited about his future and our future with Jennifer as our new CFO.

So finally, just say thanks for your interest and support of Funko. We look forward to seeing some of you guys at our upcoming conferences that we'll be attending in the upcoming months, and we'll be speaking to you guys again on the third quarter earnings call, if not sooner. Thank you very much.


The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.