Funco, Inc. History

Address:

10120 West 76th Street
Minneapolis, Minnesota, 55344
U.S.A.

Telephone: (612) 946-8883
Fax: (612) 946-7251

Public Company
Incorporated: 1988
Employees: 486
Sales: $120.6 million (1997)
Stock Exchanges: NASDAQ
SICs: 5945 Hobby, Toy, & Game Shops

Company History:

Funco, Inc. is a leading specialty retailer of new and used interactive entertainment products. At the end of March 1997 the company operated 188 FuncoLand stores in 12 major American markets. Funco, Inc. has weathered rapid growth, bust-and-boom cycles in the video game industry, the dynamics of consumer preference for particular games, game systems, and game categories (sports, adventure, action, role playing, and family games), as well as increased marketplace competition.

Learning the Hard Way, Early 80s

David R. Pomije had two failed business attempts to draw on as he began to build Funco, Inc. First was a travel-package company established in 1980, when he was 23 years old. According to Dick Youngblood, "It took him 18 months to put the business together--and less than a year to blow through the $100,000 he'd borrowed from friends and family before closing the doors in 1983." The next time the entrepreneurial bug bit was in 1985, when his employer rejected his idea to buy liquidated Commodore computers for resale through the mail-order business. He left his position as marketing director and purchased the equipment himself, with a loan cosigned by his father, a New Prague, Minnesota, high school teacher.

Protechtronics, Inc. sold $2 million in computers the first year and $10 million in year two. When his supply of computers deteriorated Pomije sold a hodge-podge of consumer goods ranging from Rambo knives to radar detectors. The company not only lacked focus but was burdened by heavy debt, an inadequate information management system, and Pomije's personal expenditures. Protechtronics moved into Chapter 11 reorganization in 1987 and then Chapter 7 liquidation in 1988. But out of the ruin Pomije salvaged the beginnings of a new business venture.

A New Start, 1988

Nintendo video games were just entering the U.S. market, and Pomije picked up two of the game systems. They sold quickly, and Pomije began purchasing more of the games. When Protechtronics was liquidated, he borrowed the money to buy back 1,100 game machines which he resold. But he had 1,100 game cartridges on his hands. Pomije approached video stores with the idea of renting the games, and with the help of his wife, uncle, and father, he was back in business.

Funco, Inc. grossed $24,000 in 1988, its first year of business. Pomije supplemented the original supply of video games with games purchased on sale from discount stores. Demand on games dwindled when kids tired of playing them, so Pomije began contacting used video game buyers/sellers listed in magazine ads. His experience with the mail-order businesses led him to believe he could do a better job, and he placed his first ad in September 1989. The home-based mail-order business took off. So many kids arrived on his doorstep wanting to buy or sell games neighbors suspected something illegal and called the police. Gross sales for the year were about $120,000.

Pomije moved the operation to a warehouse in 1990. Newspaper and video magazine ads drew mail orders from around the country and overseas. Funco's will-call window operation generated $15,000 in business in the first six months without any advertising. When Pomije tested his first retail ad in August 1990, it drew people from the five-state area. The first two FuncoLand retail stores opened in late 1990 and brought in $200,000 in sales by the end of the year. Funco, Inc. had grown from a family enterprise to a 40-employee operation in its first two years.

Funco managed its inventory by balancing the buy and sell prices of the used games. Dan Wascoe, Jr., wrote, "The company's nerve center in New Hope is a room whose grease-board walls are marked with the names of hundreds of games. Prices and supply symbols next to the names change frequently, making the place look a bit like the trading floor of a primitive commodity exchange." Popular out-of-production titles demanded higher prices, but paying too much for a less-in-demand game resulted in excess supply. With over 500 to choose from, Funcoland claimed to have the most titles of any company selling used games. In addition to buying used games from the public, Funco purchased discounted overstocked titles from manufacturer licensees.

At the time, 90 percent of sales came from used games--or as Funco referred to them, previously played games. The majority of titles, about 85 percent, were by Nintendo licensees: Nintendo controlled 80 percent of the $5.1 billion video game market.

Rapid Expansion

Funco continued to operate its mail-order and video game lease businesses, but the success of the FuncoLand stores fueled dreams of expanding the retail segment. But in order to manage the growth, Pomije needed a professional management team and an effective information management system. Pomije said in an August 8, 1994 Fortune magazine article, "This time I said, 'Time out! We need to have more than a cigar box and little bell for a cash register before we go forward."' Pomije began by bringing in the former head of B. Dalton Bookseller's MIS department, as well as, a former senior vice president of Haagen-Daz, who had opened the company's stores in Europe and Japan.

The company employed more than 100 people and operated 10 Minneapolis-area stores when it announced its initial public stock (IPO) offering in July 1992. Funco stock sold at $5 per share and generated $5 million for a national store expansion. The company began with multiple-store openings in the Chicago and Dallas areas. The strategy both pushed aside independent used-video game businesses and kept individual store opening costs down through economies of scale in leasing, distribution, and advertising.

By February 1993, Funco owned more than 50 retail stores and its stock had climbed to nearly $18 per share. Pomije still held 71 percent of the company. The interactive video game industry had skyrocketed in 1992: game software sales climbed 60 to 80 percent and hardware sales climbed 20 percent. Sophisticated new games were drawing adults into the market. Funco stock was hot, but not for long.

The shares, which had been selling well above corporate earnings, had already begun to come down. But when Sega of America announced in April that it would offer subscribers the opportunity to download and sample its new video games on an interactive cable channel, Funco stock dropped to $8 per share. As Tony Carideo wrote, "Some investors interpreted the news as the distant death knell of the retail outlet concept." Revenues for Funco's 1993 fiscal year--which ended in April--were $20.5 million, but the company lost $520,000 due to the addition of management and control systems.

A secondary stock offering, in June 1993, yielded $13 million at $11 per share. Funco, already the largest national seller of used videos, planned to move into the suburban New York metropolitan market with 30 stores.

Funcoland stores drew customers with video games selling for about half the original retail price, opportunities to try before buying both used and new games, and three times the number of titles as most specialty retailers. Funco was buying about 3000 games per day and offering store credit or cash for the used games. The top 10 bestselling games were more than five years old. New merchandise accounted for just 25 percent of total sales.

The rapid growth of the past two years boosted the number of Funcoland stores past the 100 mark and landed Funco the number 11 spot on Fortune magazine's fastest growing company list in 1994. The stores averaged about 1,600 square feet and were generally located in strip malls near busy retail areas. The company chose sites with little used game competition but showing high potential according to mail-order sales. New stores typically became profitable after six months. Funco published 250,000 mail-order catalogs on a quarterly basis, and its bimonthly video magazine, Game Informer, established in fiscal 1992, exceeded 100,000 subscriptions in 1994.

Funco Falters, 1994

Competition heated up for FuncoLand stores in 1994 when superstores and discounters entered into a price war. Funco had been building its new game sales, but could not compete when the big retailers slashed prices to or below cost. The company was also forced to cut prices on used video games. When Funco announced third quarter earnings would fall below the expectations of financial analysts, the stock fell by 46.5 percent, back to about its IPO level.

The delay in release of the next generation of video games made matters worse. Sales slowed during the important Christmas season as customers waited for the new video game technology. Game manufacturers dumped inventories of their existing games to mass merchandisers compounding the pricing problem.

Funco lost $1.3 million or 22 cents per share on $80.4 million in sales in fiscal 1995. The company turned its attention to improving sales in its 182 existing stores and improving expense controls and margins. Stanley A. Bodine, the Haagen-Daz executive who came aboard with the new management team, was promoted to president and COO; Pomije continued on in his positions as chairman and CEO.

Funco lost an additional $2 million or 35 cents per share in the first half of fiscal 1996. The company responded with salary cuts for the two top officials; freezes on other senior staff salaries; a 20 percent reduction in headquarters staff; tightening of store staffing; and cancellation of most of the 50 store openings scheduled for fiscal 1996-72 stores had been added in fiscal 1995.

The market outlook brightened with the release of new video game technology by Sony and Sega, but the industry slump had driven some used video game sellers out of business and hurt others. Video Game Exchange Inc., based in Cleveland, filed for bankruptcy protection in February 1995. When the company reorganized it reduced the number of its stores by half.

Funco cut its capital expenditure budget to $1 million for fiscal 1996, down from $8 million in 1995. The company also began to experiment with some new concepts. A FuncoLand outlet was opened in a super Kmart store, and Funco joined with Supercenter Entertainment Corp. in Dallas to test the used movie market. In a Corporate Report by Kelly O'Hara, Pomije predicted a video game industry comeback saying the cyclical industry was moving out of the transition period from the old to new technology.

The industry had changed somewhat since Funco first began selling used video games. More manufacturers were producing video games machines making it more difficult to read the used game market--the majority of Funco revenue continued to come from used games and equipment. And in February 1996, the $9 billion, 653-store Toys R Us began purchasing used video games from their customers.

The Game Continues

Seven new stores were opened but 16 were closed during the 1996 fiscal year, leaving 173 stores in operation in 11 major metro areas on the East Coast and central regions of the United States. The new Sony PlayStation and Sega Saturn systems had slowly begun to help lagging sales. Funco returned to profitability for fiscal 1996, but sales for the year were flat.

With the addition of Nintendo 64 to the market, Funco revenues recovered. In fiscal 1997, net sales were $120.6 million up 48 percent, and earnings were $5.34 million, the highest level ever posted by the company. New game sales were 47 percent of sales, also at their highest level. With business booming again, Funco elevated planned store openings to 40 for the remainder of calendar year 1997--the expansion included stores on the West Coast.

Funco's future held some of the same obstacles it had faced in the past: changing technology, a cyclical industry, and dynamic consumer preferences. Pomije had negotiated the company through the danger before and reached a higher level. It will be interesting to see if he continues to win the game.

Funco, Inc. History

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