Motley Fool Hidden Gems Investing - More Dealmaking On The Way?

Episode Date: May 23, 2022

It’s not quite Merger Monday, but it’s close! (0:25) Jason Moser discusses: - Starbucks becoming the latest U.S. business to exit Russia - VMWare shares popping 20% on reports it will be acquired by Broadcom - The chances more companies with deep pockets will start buying companies at lower valuations (13:55) Nick Sciple and Asit Sharma take a closer look at Funko and share some of the fundamental reasons they’re feeling bullish about a company that makes bobbleheads. Stocks discussed: SBUX, VMW, AVGO, FNKO, DIS, EBAY Host: Chris Hill Guests: Jason Moser, Nick Sciple, Asit Sharma Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill A week ago when McDonald's announced it's leaving Russia and we asked who's next, today we got the answer. Motley Fool Money starts now. I'm Chris Hill and I'm joined by Motley Fool Senior Analyst, Jason Moser. Happy Monday. Jason Moser Hey, happy Monday indeed. We have a Merger Monday-esque story we're going to get to, but let's start with Starbucks. The coffee chain announced this morning it is leaving Russia and will no longer have any kind of brand presence there. Starbucks committed to paying its Russian workers for six months and helping them transition to new jobs. But from a financial standpoint, Jason, this is not going to

have as big an impact as what we talked about last week with McDonald's, because for Starbucks, it's a smaller store count and a smaller percentage of their annual revenue. Yeah, you're right. I think Starbucks was the example that we used when we were talking about McDonald's recently and thinking, okay, well, is there another restaurant that will follow suit. Starbucks seemed like an obvious candidate, just giving them a chance to maybe weigh exactly what the reaction to McDonald's actions ultimately was. To me, this makes a lot of sense. Following McDonald's lead, generally speaking, they just look at this, they figure, like you said, the juice ain't worth the squeeze. When you look at Starbucks'

presence in Russia. This is going to have a negligible impact on the business. I think it's something less than 1% of the company's overall revenue. Remember when we were talking about McDonald's before, McDonald's in Russia, where franchisees operate only 15% of the Russian locations, the company owned the rest. When you look at Starbucks' presence there, all licensed locations. This is not one of those situations where the company actually owns these stores. But again, less than 1% of revenue, it seems like a very easy decision to make when you look at the big picture. Generally speaking, I think most of the free world is quite opposed to what Russia is doing and rightly so. This is, I think, an opportunity for companies to

take a little bit of a step back, assess not only where they're doing business and what makes the most sense from an economic perspective, but also what makes the most sense from just their core values perspective. I think with McDonald's, we talked about one of the core values there being integrity and just doing the right thing, and Starbucks clearly a business that's been built on that type of framework as well. To me, this is a decision that feels like a no-brainer. They had suspended operations, I think, since March there, and this is really just putting a stamp on the envelope, so to speak. Where do you suppose the bar is now for businesses like McDonald's and Starbucks when thinking about entering new markets? I'm

just thinking, five years down the line or something, when hopefully what's happening in Ukraine is long past the rearview mirror, maybe someone else is in charge instead of Vladimir Putin, and they're trying to woo the McDonald's and the Starbucks of the world back, like, no, it's going to be better this time around. Does it put these businesses a little bit more in the driver's seat in terms of terms that they can dictate or is that just negligible? I feel like it definitely puts the businesses in the driver's seat. They've shown that they don't need to do business there if they don't want to. It certainly depends on the location and perhaps the business and where they source whatever they're sourcing.

But for the most part, I think this really is just a testament to the businesses holding more leverage in this case. They can say, hey, listen, we just prefer to do business in a place that's going to stand for the things that we stand for. and it ultimately boils down to determining that line. This is a very easy line, I think, for the most part. This isn't a very debatable issue. I think that when you get into the more debatable issues, that's when it becomes a trickier decision, and that remains to be seen. But for the most part, I think ultimately, this puts countries, this puts the leadership of these countries on notice to ultimately say, the companies are going to say, listen, we're going

to do business in countries that stand for this, that do this, that take these types of actions. And they ultimately, I think, have the power, whereas as opposed to the countries, particularly with leadership such as Russia and Putin today, it's just a very easy decision for most companies to say, no, we don't really want to deal with you. You're way more trouble than you're worth. And until things change materially and sustainably, I think that's really one of the bigger points is that you need to be able to see a sustainable change, not something that's just superficial, but something that's really more in-depth and meaningful and longer-lasting. Cloud computing business VMware is reportedly in talks to be acquired by Chipmaker Broadcom.

The talks are ongoing, so we don't know what kind of terms may be involved here, whether it's all cash, all stock, or a mix. That information not being available, however, is not stopping some investors because shares of VMware are up 20% on these reports. I guess we'll see hopefully in the coming days, if not weeks, whether or not this actually goes through. You and I were talking right before we started recording. Broadcom has grown in part through acquisition, so it is very much in the company's DNA. In that sense, maybe not that surprising that they would go after VMware. No, this does feel like it would be a complimentary deal if they're able to pull

it off, Broadcom being more of a semiconductor-oriented business. To your point there on growth via acquisitions, I mean, Broadcom certainly has grown via acquisitions over the last several years. You look at the business today, they have $43.5 billion in goodwill on the balance sheet, and that's basically doubled over the last five years. Ultimately, goodwill, if remember, goodwill is essentially overpaying for acquisitions. You're making acquisitions, it represents what you pay beyond the fair deal, so to speak, of that acquisition. Oftentimes, we'll see companies over time, they'll write down a lot of that goodwill. We can discuss that, debate that for another time. But ultimately, as you see that goodwill number

continue to creep up, you have to at least keep an eye on that. Because you start asking the question, is the company making good acquisitions? Is the company paying fair prices for these acquisitions? With $43.5 billion of goodwill on the balance sheet, it's at least worth considering that, hey, maybe at some point, Broadcom is going to write down some of that goodwill. Who knows? Maybe they're making great acquisitions. We'll have to wait and see. This to me seems like it could be actually a pretty good acquisition if it's able to happen. VMware, being a company that's more focused on becoming a multi-cloud leader, they're focused more on the cloud computing market opportunity, and that's something where Broadcom could really benefit. Multi-cloud

is ultimately just that cloud computing where an organization just utilizes a combination of clouds, whether it's two or more public clouds or private clouds, a combination of public and private or edge clouds. It's ultimately bringing all of those cloud resources together for their customers. You look at how this has worked out for VMware and it's so far so good. The company is moving more and more towards a SaaS model, which is something we've seen that's been obviously a big trend over the past several years. If you look at the breakdown of the fiscal year 2022 revenue, revenue. You had about 25% of the business's revenue, which was from licensing, 50% from services servicing, and then 25% from SaaS, that software as a service. It continues to

become more and more of a subscription and servicing that subscription model. I think that's ultimately a good thing. Given the direction the world is headed, given the tailwinds in the cloud computing space. I absolutely understand Broadcom's interest here. It probably is not a bad time to consider doing a deal like this given where valuations are right now because if you hadn't heard, Chris, we're in the middle of a bear market. It's having a bit of an impact on some stock prices, not all, but most. Oh, I've noticed. It's distinctly possible they could end up getting VMware for a very respectable price, along with the fact that now that VMware,

there was this big Dell relationship where Dell recently spun off its VMware stake last November, so there's a little bit of uncertainty that's been resolved there. Maybe that's why this interest really is developing now. It remains to be seen whether this deal actually happens or not, but it does feel like it would be a complimentary one for Broadcom, and I guess really then it just depends on what price they're willing to pay. Before I let you go, let's broaden this out a little bit. There are a lot of companies that, from a market cap standpoint, are less expensive than they were six months ago. There are also a lot of companies out there with cash on the balance sheet, do you think we could be entering a period over the next three to six

months where we see more dealmaking going on, more acquisitions? It is not lost on me that there are no names attached to these reports. There are no analysts, there are no executives. I trust the reporting. If Reuters and CNBC are reporting this, I take them at their word. But it just makes me wonder if we're going to see this scenario play out multiple times over the next three to six months. It feels like it should. It feels like logic dictates that it should. I don't think it's going to be something where the obvious suspects are the acquirers. I don't think it's something where your Alphabets and your Amazons and your Microsoft. Granted, Microsoft is in the middle of trying to wrap up this Activision-Blizzard deal.

But for the most part, I feel like those are the companies that are really under the microscope of regulators right now. Maybe there is this lower-level echelon, just that next step below, like your Broadcoms of the world, where they could get away with something like this without necessarily getting right there on regulators' radars there. It does feel like it's something that should happen because you're right. Valuations have come down considerably. Granted, we live in a world right now where it feels like every single headline is bad. It really does feel that way. It just feels like there's so much bad news out there right now that any spate of good news could really turn things around. It does feel like there should be more interest in

making some deals happen right now, particularly for those mid-large cap companies that aren't necessarily on the radar of regulators. They have the financial resources, they have the wherewithal to get these deals done, and they don't necessarily have to worry about being on regulators' radars. It'll definitely be interesting to see how the remainder of this year shakes out, because if these market conditions persist, and it feels like they will, at least for a little while, it definitely feels like we could hear more news like this. Jason Moser, thanks so much for being here. Thank you. All right. Enough talk about companies involved in cloud computing and semiconductor

chips. Can I interest you in a publicly traded business based on selling vinyl figurines? No, really. Nick Sciple and Asit Sharma are taking a closer look at Funko, some fundamental reasons they're feeling bullish about bobbleheads, and what a new investor group could mean for the company. Welcome in, everybody. I'm Motley Fool Canada analyst Nick Sciple, and I'm here today to talk about why Funko could be a fun company for your portfolio. Joining me to help me do that is Motley Fool analyst Asit Sharma. Asit, how's it going? Asit Sharma. Great, Nick. Good to see you and chat with you after a long time.

Yeah, it's been a long time since we've been together in podcast land. It's great to be back here with you. We've got a fun company to talk about today. Funko, if folks aren't familiar with the company, you've probably seen their Funko Pop dolls, action figures, figurines in stores, whether it's a bookstore or Target or a place like GameStop. They're all over the place. They're one of the biggest pop culture merchandise providers really in the world. Asit, for folks who aren't familiar with Funko, what do they do? I like to think of Funko as a company that bridges the physical and digital divide. Stuff that we experience first digitally, so movies, music, and video games, bringing that into

collectible format with their vinyl pop figures, their bobblehead figurines, and an array of other merchandise, which includes backpacks, keychains, you name it. This is a company that has very deep partnerships with big intellectual property giants like Disney, Netflix, Warner Brothers, Activision, Blizzard. They basically license the right to intellectual property and turn out these figurines, which they then distribute through big box retailers, through their own direct commerce channel, and for their products like backpacks through stores. You can even buy them at Disney, which is a big, big part of this business. Loungefly has been a growing part

of Funko's business. It's actually up to 16% of the business, up over 100% year-over-year in the most recent quarter, which is helping diversify the company's revenue. Traditionally, Funko Pop vinyl figures that you mentioned really drove the vast majority of the business and they still drive over half of the business today. Historically, there's been some concern just given that dependence on those Funko Pop products and that being a single product company that perhaps there's a little bit of a risk of Funko being a fad. However, they put up some really impressive growth numbers, Asit. What do you make of that potential fad risk, the dependence on the the Pop products, and maybe prospects for diversification moving into the future.

Yeah, I think this is fair criticism of the company. Even today, if you look at their most recent quarter, their core collectible items make up about two-thirds of revenue. But as you mentioned, Nick, they've got now a good part of their business, which comes from an acquisition they made of a company based in the U.K., which is Loungefly, the one we've been mentioning. They've got some other revenue streams that branch all the way into NFT sales, although no one should hang their hat on that as an investment thesis. Call it gravy if they make that a more significant part of the business. These are some risks behind Funko. I'll say, this company has some other risks behind it that traditionally have

made it a hard investment to really entertain, but those are falling away one by one. First, it had a very large debt load about five years ago. If you look at the net income on their books going all the way back to, say, 2017, just the interest expense on their debt took out a big chunk of their earnings. They've gradually paid down the debt to a more reasonable level, so it's not affecting their income statement as much and it's not quite the existential threat on their solvency or liquidity that it was in the past. Also, they had a big private equity investor, Akon Investments, that at one point owned about 69% of this company. Over time, that private equity group, which has actually been pretty helpful in helping

this company grow its business and diversify, they've sold off their shares bit by bit by bit. We're going to talk about this last buyer that's come to buy shares from Akon in just a moment here. But I also want to mention, they didn't have a wide enough distribution footprint. Management made the push to get into stores like Walmart and Target and to push their products globally. Another thing is, they just really didn't have a great cost structure on the bottom line. But here, you look today, they've just moved into a million-square-foot distribution center. Not their headquarters, but their distribution operation. So, on all fronts, this company is looking a lot more investable, and I think it is an interesting play.

But Nick, what about this most recent investment? So, Akon is now selling most of its shares to another group, which is made up of some pretty interesting players. Yeah, Asit. If you look at the company today, some really promising growth numbers, 58% revenue growth year-over-year in 2021, a free cash flow, positive business, a business that's put some of those debt concerns behind it. Then again, you had this significant private equity investor, this overhang that we talk about sometimes when you have these large investors. Well, on the same day that Funko reported its first quarter earnings, it reported that Akon was going to sell about 80% of its stake, a stake equivalent to 25% of Funko's business

to an investment consortium led by, among others, the Ternan Group, which is led by Peter Ternan, a private equity investor that's invested in companies in the past like Barstool Sports. Another member of that investment consortium is former Disney CEO Bob Iger, someone who probably knows a thing or two about the IP licensing business. And then lastly, Rich Paul, who is LeBron James' sports agent as well, a significant super agent in the sports business. And so you had those investors buying a quarter of the company at $21 a share. If you look at where the company is trading today, it's about $19 a share. So we saw a little bit of value out there. It looks like these private equity folks did too. And then not only that, these are

folks you could argue can create potential additional value on top of just the value they recognized in the market at 21. Yeah, I agree, Nick. This isn't your group of financial buyers who are just in there to see if they can squeeze some more out of the bottom line. These are pretty forceful personalities in the business world. They want to bring their talent and their bona fides to bear here with Funko, and they are also extremely well-connected people who are used to the power of picking up the phone and getting deals done. I want to point another investor who's actually not an individual, but a company that's part of this consortium, which is eBay. eBay is now an investor in Funko. The two companies have a new partnership where

there'll be a nice secondary market for Funko's products on eBay, and the two companies will collaborate to create new products. Now, we didn't mention that the fun part of Funko, or one of the really fun parts of Funko, is the fact that these collectibles can often rise in value. Having a secondary market on eBay only makes the whole proposition more valuable, although I should mention in the same breath, Funko's aim is to have products that are affordable to everyone. But what do you think about all these big hitters coming in, Nick? Do you think they'll be able to add some juice to this revenue picture and help with some really great creation of IP? Or might this be just a little hype here?

Well, whether it's hype or not, it's something we'll have to find out, what kind of results they produce. I will say, I tend to follow the stuff that the Ternan Group does in the past. Again, the Barstool Sports investment, they were really transformational in getting that company up to scale. They also have some other investments in the kind of IP space, Crunchyroll, Golden Auctions, which is another kind of collectibles business. Obviously, Bob Iger, Disney, a huge, huge driver of that side of the business. I think there's lots of value to be created here as well. Then there's some pie in the sky stuff I'll mention. It's not something that I would build into the thesis or anything like that.

But if you look back, I think it's 2019, there were some rumors that WarnerMedia was going to produce a Funko movie using the Funko IP in the vein of what you've seen with the Transformers movie or the Lego movie or the Trolls movie, that sort of thing. I could see with folks like Bob Iger, and The Turning Group has actually been involved in the movie production business as well. Those folks get involved, maybe that makes that type of optionality more likely. But in any event, you have really smart, savvy investors that know a thing or two about the IP licensing business that have recognized Funko as a smart place to put their money. And listen, the Turing Group is a private equity company. They're in the business of making money. They're

not buying it just to be flashy. To the extent it's hype, they put real dollars behind this trying to make real money. I think these folks are smart. And listen, I thought the stock was attractive even before that kind of an investment took place. So, it's always nice to get a little bit of confirmation bias, too. Yeah, this is a company that looked like a value stock before and still does in some ways, even though it's had a nice pop. There's a pun for you who are fans of the company, a nice pop after the announcement with the first quarter earnings that you mentioned. I'll also say, too, that this is a fun type of private equity investment, because while you do have that PE angle, which is all about

making the money. There's a lot of creative energy here. For Funko, that's like oxygen for this company. They spent the last several years figuring out their distribution, getting their costs under control, getting that distribution that I talked about. Now, it's time to capitalize on creative ideas and partnerships they can build. I think all this is good. Any risks to the investment thesis that you see, Nick? One of the big ones is, they don't own the IP. To a certain extent, whether it's Loungefly or Funko Pops, they own the design for the bag, they don't own the IP that's going into creating those products. The relationships they have with those other parties are foundational to the business. Maintaining those relationships

is always going to be a key. That's one risk that pops to mind for me. What about you, Asit? I see a lot of the risk that I worried over in the past has slowly melted away. I talked about the balance sheet risk and the fact that they were controlled by this other group, and that gradually diminished. Now, the replacement group looks pretty capable, will help revenue and earnings as well. But in the near term, you could see a little bit of deceleration from this very nice pace of revenue growth they've been enjoying. If we go into a recession that obviously hits the consumer discretionary spend, some would argue

that because Funko's products are very accessible, maybe they don't lose that much. Maybe people choose to buy some Funko collectibles after they've been forced to stay home and not take that vacation because of inflation. That's yet to be seen, but that's a near-term risk. Longer-term is the ever-present risk that people will just change the way they consume their pop culture. For the longest time, Funko has benefited from what they call evergreen properties, so properties like Star Wars, Harry Potter, the NFL, these deals that enable them to keep churning out products that never go out of style. It could be that in the future, younger generation moves to more digital products for collectibles. But here again, we mentioned

they are getting a toehold in the NFT market, so at least they'll be able to maybe compensate if that risk of the physical product does become more prominent in the coming years. Yeah, I will say one thing. If you look at the consumer and potential slowdowns as a result of the consumer weakening, one of the areas that I think about that's probably a place that's a big demand driver for this type of fandom-based pop culture content is Comic-Cons and those types of conventions. If you think about it, San Diego Comic-Con is the biggest one, that's been canceled the past two years. While there are some headwinds when it comes to inflation, potentially weakening consumer, there are some tailwinds when it comes to reopening and

some of these traditional demand drivers for these types of collectible products opening back up. Before we leave, Nick, I've hinted at this, but I'll ask it as if I didn't know, do you or anyone in your family own any Funko products? Yes. We don't own any of the Funko Pop figurines, but we own three or four of the Funko Loungefly bags. We've got a Marie one from the Aristocats, and we've also got ones with the little mice from Cinderella. Whenever we go on our hikes in the park, or actually went to Disneyland Paris a month or two ago, those bags come with us. So, yeah, we represent a little bit. Awesome. Yeah, I have some in my house as well. Now, I personally don't own any products,

but my three sons love their Bobblehead Star Wars products, especially my oldest. He collected a few. After he went to college, my two younger sons took his passport photo and taped it on the front of the Bobblehead doll. You can't see it now because we're taping, and this is a radio-type show, but I'm showing it to Nick. When we walk by, we tap the top of the bobblehead now, almost like, hey, call home. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for

listening. We'll see you tomorrow.