Turtle Beach Corporation
Q4 2019 Earnings Call Transcript

Published: 11 Mar 2020

[Operator:]

Good afternoon, ladies and gentlemen and welcome to the Turtle Beach Fourth Quarter and Full Year 2019 Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that this conference call is being recorded.Before we get started, we will be referring to the press release filed today that details the company’s fourth quarter and full year 2019 results which can be downloaded from their Investor Relations page on corp.turtlebeach.com, where you will also find a latest earnings presentation that supplement the information discussed on today’s call. Finally, a recording of the call will be available on the Investor Relations section of the company’s website later this evening.Please be aware that some of the comments made during this call may include forward-looking statements within the meaning of the federal securities laws. Statements about the company’s beliefs and expectations containing words such as may, will, could, believe, expect, anticipate and similar expressions constitute forward-looking statements. These statements involve risks and uncertainties regarding the company’s operations and future results that could cause Turtle Beach Corporation’s results to differ materially from management’s current expectations.The company encourages you to review the Safe Harbor statements and risk factors contained in today’s press release and in their filings with the Securities and Exchange Commission. Including without limitation, their most recent quarterly report on Form 10-Q, Annual Report on Form 10-K and other periodic reports which identify specific risk factors that also may cause actual results or events to differ materially from those described in forward-looking statements.The company does not undertake to publicly update or revise any forward-looking statements after this conference call. The company also notes that on this call they will be discussing non-GAAP financial information. The company is providing that information as a supplement to information prepared in accordance with accounting principles generally accepted in the United States or GAAP. You could find a reconciliation of the metrics to their reported GAAP results in the reconciliation tables provided in today’s earnings release and presentation.And now, I will turn the call over to Juergen Stark, the company’s Chairman and Chief Executive Officer. Juergen?

[Juergen Stark:]

Good afternoon, everyone and thank you for joining us. We are coming off a year that was the second best in the company’s history. We continue to lead the console headset market and more broadly are among the leaders in the exciting gaming accessory market with a profitable cash flow positive business.Today, I will focus my remarks on how we see the headset market evolving this year, our success in that market and our progress in growing our overall portfolio and position in the global gaming accessories market. But first, some brief comments on 2019. Driven by the massive influx of new invigorated gamers drawn to Battle Royale games like Fortnite and PUBG, our revenues in 2018 nearly doubled to $287 million. Because we have years of experience modeling the consumer behavior of headset users, we anticipated that the total market for console headsets in 2019 would be down around 20% and that’s roughly what transpired. The market and our own sales performed remarkably close to the forecast we provided this time last year. While the North American console headset market was down in 2019 compared to 2018, it was still 34% higher than 2017 according to NPD, supporting our belief that the total user base is now considerably higher than it was 2 years ago. Our own console headset sales were down about 25% last year, but were still 38% higher than 2017.Also accounted for in our 2019 guidance was a slight loss of market share because of how much higher our share was in the entry level price categories and because we believe we get a better job than competitors at keeping our retailers in stock during the spike in demand. Our market share in 2019 exceeded 43% according to NPD which was more than the market share of the next three biggest players combined. This marks 10 straight years with market share over 40%, unprecedented accomplishment and one that speaks loudly to our reputation for innovation. A company doesn’t hold 40% market share for a decade unless consumers realize that the products are highly differentiated and the brand is something they seek out year after year. Our retail partners know this well and appreciate how our product strength is complemented by great execution across every aspect of our business with them. Of course, our more than 150 issued patents in gaming accessories with many more on the way also speak to our continued innovation and differentiation. Our market share strength is both wide and deep.According to NPD U.S data in 2019, we had all three of the top three best selling models in terms of revenue, 6 of the 10 best selling models and 13 of the top 20 models. In December, we were even more dominant with all 6 of the top 6 best selling models and 7 of the top 10. Looking at various price points, we had the number one position in virtually every price segment below 150. One of the most important accomplishments in 2019 was our successful expansion into the broader PC accessories market with the acquisition of ROCCAT. We now have a good baseline of keyboard, mice and headset products for PC gamers to be sold under the ROCCAT brand. This is the large and growing market and we are gaining share more on that later. With this growing position in PC accessories and our long established leadership in console headsets, we are now a leader top 4 by our estimates in the $4.1 billion global market for gaming headsets, keyboards and mice.I am now going to turn it over to John to review the fourth quarter financial results and I will come back with comments about how we see 2020 playing out as well as review of our strategy to accelerate our growth in the global gaming accessories market. John?

[John Hanson:]

Thanks, Juergen and good afternoon everyone. Most of my comments today will focus on our results for the fourth quarter. Net revenue was $101.8 million or $102.1 million on a constant currency basis compared to $111.3 million in the year ago quarter. While customer demand remains above historic levels, this decrease was the results of the expected decline from the record levels of demand in the prior year driven by new headset users buying their first headset for Battle Royale games.Gross margin in the fourth quarter was 35.1% compared to 38.5% in the fourth quarter of 2018. This expected decrease was primarily due to a more normal level of promotional activity compared to 2018 when less promotional effort was necessary in the record-setting Battle Royale boom as well as increased tariff costs and product mix which was partially offset by lower standard freight costs. Operating expenses in the fourth quarter of 2019 were $22.3 million compared to $17.4 million in the same quarter of 2018. This was primarily due to the addition of the ROCCAT operating costs.Net income in the fourth quarter of 2019 was $20.4 million compared to $24.6 million in the year ago quarter, reflecting the commentary I just covered. Net income in the fourth quarter of 2019 included a $7.4 million benefit from the release of the valuation allowances on deferred tax assets. Net income per share in the fourth quarter of 2019 was $1.29 on 15.7 million weighted average diluted shares outstanding compared to $1.33 on 16.2 million weighted average diluted shares outstanding in the year ago quarter.Adjusted net income for the fourth quarter of 2019, which excludes transaction and integration costs incurred related to the acquisition of ROCCAT as well as the release of the valuation allowance, was $13 million or $0.83 per diluted share compared to $21.5 million or $1.33 per diluted share in the 2018 period. Adjusted EBITDA in the fourth quarter of 2019 was $16.6 million compared to $25 million in the year ago quarter. Cash provided from operations during the full year 2019 was $39.4 million down modestly from $42.2 million in 2018. This continued strong cash flow allowed borrowings against our revolver to remain historically low throughout the year in spite of the cash outlay for the ROCCAT acquisition reducing our cash interest expense.Now, turning to the balance sheet, at December 31, 2019, we had $8.2 million of cash and cash equivalents with $15.7 million of outstanding debt under our revolving credit line. This compares to $7.1 million of cash and cash equivalents and $37.4 million of outstanding debt under our revolving credit facility at December 31, 2018. Inventories at December 31, 2019 declined to $45.7 million compared to $49.5 million at December 31 last year. The decrease was driven by the lower level of revenue offset by the addition of inventory from the ROCCAT acquisition. We did bring in a bit more inventory to mitigate the impact of tariffs and we believe both our inventories and channel inventory of our products are on balance at appropriate levels. During the quarter, we continued our share repurchases acquiring 65,500 shares at an average price of $8.91. Since our share repurchase program was announced on April 10, 2019, we have repurchased 271,300 shares for $2.5 million or an average of $9.30 per share. The timing of our buyback activity will of course be subject to regulatory parameters, market conditions and our cash flow and we will continue to prioritize investing in growth and business development.Now, I will turn the call back over to Juergen for some additional comments. Juergen?

[Juergen Stark:]

Thanks, John. As I said earlier, the integration of ROCCAT into our existing business transforms our company from a leader in console headsets into a leader in gaming accessories more broadly. This has been a goal of ours for many years and it’s very gratifying to be able to parlay our success in the console market into a strong foothold in the large PC accessories market. While we knew at the outset of 2019 that console headset sales were likely to decline from the Battle Royale driven boom of 2018, one of the unique dynamics this past holiday was that both Sony and Microsoft had already announced their next-gen consoles expected to launch later this year. In the past, the hardware leaders would wait until well into the year of the launch and importantly after the holiday season to formally announce the upcoming launches. The market data shows that these earlier-than-normal announcements of incoming new Xbox and PlayStation consoles has disrupted the console market overall as well as the market for console accessories, particularly after the holidays.According to NPD, total U.S. videogame sales in January 2020 were down 26% compared to 2019. U.S. videogame hardware sales were down 35% and videogame accessories and game cards were down 11%. These figures are up against some pretty results from January 2019, but still they show that some consumers are holding back. Because of the console headset market is largely driven by upgrades and replacements rather than new console buyers, the impact of the preannouncement of the consoles affected sales of Xbox and PlayStation consoles more than it did for accessories for those consoles, but it’s still significant. You can see this impact in the NPD data which shows new Xbox and PlayStation console sales in the U.S. are down nearly 50% in January. It does help that the current console headsets are expected to work on the next generation consoles, but some consumers may still wait on purchasing or upgrading console accessories to try to match their new Xbox or PlayStation with a new headset and/or to save some of their gaming budget to be able to get that new console when they launch.According to a survey by Newzoo, the gamers that are most likely to upgrade their consoles also intend to upgrade their gaming headsets. This is what tends us to drive an uptake in sales once new consoles are launched. As a result of all these dynamics, we expect the console headset market to decline about 11% for the full year, reflecting a deeper decline until the new consoles launched partially offset by a year-over-year growth in Q4 once the new consoles have launched. History tells us that the launch of new consoles triggers a sustained increase in spending on accessories for several years. So, the anticipated launches this year should kick off a new growth cycle in console accessories. As a result, we expect mid to high single-digit growth in console gaming accessories market for 2021 and 2022.Even with the disruption of the pending hardware launches, console video gaming remains a thriving and exciting category. In a way the disruption caused by consumers holding back is itself a sign of strong future demand. And game publishers continue to evolve to produce games that invigorate the market. For example, just today, Activision released Call of Duty

[Operator:]

Thank you, sir. [Operator Instructions] Our first question comes from Thomas Forte of D.A. Davidson. Your line is open.

[Thomas Forte:]

Great. Two questions on coronavirus. So the first question I had was between the tariffs and the coronavirus how should we think about the role of China in the long-term as it pertains to your supply chain? And then I think you commented on the supply chain elements as far as near-term disruptions? Should we also assume that there has not been any near-term disruption from a sales or demand standpoint? Thank you.

[Juergen Stark:]

Sure. So on China, long-term role for us. So we, as I mentioned, were fully up and running now on non-China production and we will actually this year already have a substantial portion of our supply coming from non-China countries. That’s an initiative we have started in 2018 and now of course that’s helpful with the coronavirus even though the Chinese factories are fully committing to our supply needs for the rest of the year. And of course, having non-China production also enables us going forward to have the ability to flex production between China factories and non-China factories and gives us just simply a more diversified supply chain which is something we have been working on since 2018. On the demand side, we have not seen any meaningful impact on demand. It’s something we are watching closely especially in countries that are hotspots. I will just say that it’s not clear that while retail sales might suffer, online sales might counteract that. And remember that gaming is something that people do at home for entertainment so just by its nature, it’s hard to judge whether that’s going to have an impact on us or not, but it’s something we are watching very closely.

[Thomas Forte:]

Thanks for taking my question, Juergen.

[Juergen Stark:]

Thanks, Tom.

[Operator:]

Thank you. Our next question comes from Mark Argento from Lake Street. Your line is open.

[John Godin:]

Hey, guys. This is John on for Mark. Thank you for taking my questions. Two kind on the PC business overall, first, how do you see gross margin trending both overall and on a seasonality basis as PC becomes the larger portion of the mix? And number two now that it sounds like you have ROCCAT fully integrated and you are positioning yourself to make investments in growth, what are some early signs that give you confidence that you will not only be able to kind of grow with the market, but also be able to take share from your competitors in the PC accessories market? Thank you.

[Juergen Stark:]

Sure. So a question on margins, our target for the company remains mid-30s gross margins. This year, our guidance is a few points lower than that and that’s reflective of some impact of tariffs and additional air freight is the biggest impact. That takes a few points off of our kind of our normal target run-rate. PC we said before we are targeting lower 30s gross margins and that’s mainly because we are attacking the segment, not but because we believe the segment long-term can have a margin profile that’s in the mid 30s. So that may have a small impact on our average gross margins as PC becomes a bigger and bigger part of our business, but we are still targeting in the long-term margins in the mid 30s range. So, that’s on the margins and then give me the second one is I think you asked for signs of success. And I mentioned two things so – and these are I think important leading indicators, Germany where ROCCAT really had its core focus before the acquisition. ROCCAT is one of the key players in the market. They are one of only three players in the largest retailers to have a dedicated area of the stores, for example. And in 2019, we outpaced the market growth in Germany in PC accessories by 3x. So that means that we obviously grew enough share in Germany to outpace the market growth and we achieved double-digit growth in our PC accessories there. And then I mentioned the U.S. market, we outpaced the market there by 2x, which means we gained share in the overall PC accessories category in the U.S. as well and there obviously the base is small, but it’s a good sign of progress in a market where we are really just getting started.

[John Godin:]

Thank you, guys.

[Juergen Stark:]

Thanks, John.

[John Hanson:]

Thank you.

[Operator:]

[Operator Instructions] Our next question comes from Nehal Chokshi of Maxim Group. Your line is open.

[Nehal Chokshi:]

Yes, thanks. So you guys beat your calendar year of ‘19 free cash flow by a massive $16 million almost 2x, it looks like that’s largely a result in the contraction of that cash conversion cycle. Should we be looking at that as a sustainable compression, any thoughts on there?

[John Hanson:]

Well, I think coming out of – hi, Nehal, it’s John. I think coming out of 2018 obviously, we did expect to see some benefit from working capital management in 2019 which you are seeing, but we would expect that to moderate a little bit.

[Juergen Stark:]

Yes, it’s largely the result of just normal working capital shift back as that happens with a lower market size and lower revenues.

[Nehal Chokshi:]

Right, right. And so the reason why I am trying to detail this is because does this impact the calendar year ‘20 free cash flow relative to the EBITDA?

[Juergen Stark:]

Free cash flow – now the cash flow so you were talking about operating cash flow before, free cash flow will follow the rough same formula we have had in the past. So it’s EBITDA minus 4ish so of CapEx. This year CapEx will be higher because we are spending on tooling and some other items associated with new product launches and then minus cash taxes.

[Nehal Chokshi:]

Okay, cool. And then – okay, and then so the $9 million incremental investment in PCs for calendar ‘20, was it a gestation time for return on investments?

[Juergen Stark:]

So that’s part of a 2-year effort as I mentioned, Nehal to drive growth in both the portfolio and make investments in brand, so that when those products launch over the next 2 years, some this year, more next year, the brand will be there to support it and then we will continue the brand investments in next years. Well, we may have some additional portfolio in the growth investments, but really, it’s part of our 2-year plan that kind of aggressively grow our position in PC. The gestation period, what I would expect from that, is that starting number one it enables continued double-digit growth in PC revenues over time and that it helps enable the company to grow at our target of 10% to 20% revenue growth.

[Nehal Chokshi:]

And as we didn’t make that investment, what kind of growth in PC would you have – would you expect on a long-term basis then?

[Juergen Stark:]

I don’t know that there is an easy way to judge that. We have a good position in PC with the portfolio that we have and we do well with the products that we have in the price tiers, particularly keyboards and mice in the price tiers that we have products in. And so our view is expanding that product portfolio in the different price tiers with more varieties of the products is going to be a very worthwhile investment. And then – and brand is obviously something that needs to be built particularly outside of Germany. The ROCCAT brand is very strong in Germany. It’s known in Europe. It’s less known here, but our consumer testing showed that that it’s known actually among PC gamers and has very positive attributes. And so it’s kind of like other investments of that type, it’s kind of hard to separate out if we didn’t promote and market the brand what would happen to the business. Our conclusion very simply is that, that is a very worthwhile investment to support the revenue growth over time.

[Nehal Chokshi:]

Alright, thank you. I will get back in the queue.

[Juergen Stark:]

Thanks, Nehal.

[Operator:]

Thank you. This concludes our question-and-answer session. I would now like to turn the conference back over to Mr. Stark for closing remarks.

[Juergen Stark:]

Thank you. We look forward to speaking with our investors and analysts when we report our first quarter results in May. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, this does conclude today’s conference. You may disconnect your lines at this time. Thank you for your participation.