Turtle Beach Corporation
Q3 2018 Earnings Call Transcript

Published: 7 Nov 2018

[Operator:]

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Third Quarter 2018 Conference Call. 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] Before we get started, we’ll be referring to the press release filed today that details the company’s third quarter 2018 results, which can be downloaded from the Investor Relations page at corp.turtlebeach.com. On that website, you will also find an earnings presentation that supplements the information to be 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 the 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 the Turtle Beach Corporation’s results to differ materially from the 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 the 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 the date of this conference call. The company also noted 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 can find a reconciliation of the metrics to their reported GAAP results in the reconciliation tables reported in today’s earnings release and presentation. And now I will turn the call over to Juergen Stark, the company’s Chief Executive Officer. Juergen?

[Juergen Stark:]

Good afternoon, everyone, and thank you for joining us. As communicated in our pre-release, we delivered another quarter of phenomenal growth and record profits both compared to the last year and to our prior outlook. The growth in our market share is due to our great portfolio of innovative products for all levels of gamers and the strong overall console gaming headset market. In fact, all areas of our business continued to perform well during the third quarter. From a product perspective, Turtle Beach remained the leader in all price tiers $199 and below. Based on NPD’s sell-through data for the U.S. and Canada, in the sub-$50 price tier year-to-date through September, Turtle Beach led the market with the Recon 50X, our long running top seller. In the $50 to $99 range, we led the market with our wireless Stealth 600 series on both Xbox and PlayStation platforms. The Stealth 600 for Xbox has also been North America’s best-selling wireless gaming headset of 2018. In the $100 to $199 tier, Turtle Beach again led the market with our wireless 700 Xbox model. In the $200 and above tier, in September, we launched the Elite Pro 2 + SuperAmp bundle, which we believe will increase our share in this tier over time, more on this shortly. Operationally, our business also continues to perform very well. Inventory for the upcoming holiday season is now fully secured, including long lead time components to meet our forecast plus some potential upside. This was arguably one of the biggest risks and possible constrains for the year. Given the fact that our year-to-date sales are up 153% versus the same period in 2017, being in a position to deliver our 2018 forecast with no supply gaps is a huge operational achievement and shows our executional capabilities. I’m very proud of our team for this accomplishment. Many thanks also to our manufacturing partners and key component suppliers on this front. So, taking all together, strong products driving our leading market share even higher and solid operational execution allowed us to generate $19 million in free cash flow during the third quarter, enabling us to pay down another $5 million in subordinated notes on October 12, while allocating more resources to our long-term growth strategy. In fact, this repayment brings the balance on the remaining outstanding subordinated notes to $10.4 million, a cumulative $12.2 million or 54% reduction in the outstanding balance since March, significantly transforming our balance sheet and liquidity profile. I would also like to address some of the key new products we have launched for the upcoming holiday season. Given this year’s variety of games that have a battle royale mode, we wanted to be ready with products tailored to this new genre and new audience of gamers. So, in July, we announced retail availability for the Stealth 300 Amplified Gaming Headset for Xbox One and PlayStation 4. Whether you’re playing genre titles such as Fortnite or PUBG were this fall’s big AAA releases like Call of Duty

[John Hanson:]

Hey. Thanks Juergen, and good afternoon, everyone. Net revenue in the third quarter of 2018 increased 107% to a company record $74.4 million compared to $36 million in the third quarter of 2017. The significant year-over-year increase was the result of strong market demand for console gaming headsets driven by continuing increased usage of gaming headsets, particularly among battle royale players, along with the company’s increase in market share over 2017. Gross margin in the third quarter increased 610 basis points to 41% compared to 34.9% in the third quarter of 2017. This is the highest third quarter gross margin in Turtle Beach’s history as a public company. The increase was primarily due to a favorable product and customer mix, continued higher volumes driving fixed costs leverage, a reduction in freight costs and a less promotional environment. A quick comment on tariffs, at this point, Turtle Beach is not impacted by the recent China tariffs. We are closely monitoring this dynamic situation and are contemplating changes to our supply chain strategy should additional tariffs be put in place that would impact products in our category. Operating expenses in the third quarter of 2018 increased to $14 million from $10.7 million in the same period in 2017. This was primarily due to an increase in marketing spend related to new product launches including our new PC products, as well as revenue driven commissions and expenses and other performance-based compensation. As a percent of net revenue, operating expenses fell sharply to 19% compared to 30% a year ago, reflecting favorable operating leverage and continued tight management of OpEx. Net income in the third quarter increased significantly to a record $14.7 million or $0.91 per diluted share based on 16.2 million diluted shares outstanding compared to a net loss of $0.05 -- $0.5 million or $0.04 per diluted share based on 12.3 million diluted shares outstanding in the year ago quarter. The improvement was mainly driven by the significant revenue growth and the corresponding increase in gross margin. Note that we’ve included a share account bridge in our Q3 earnings presentation. Adjusted EBITDA in the third quarter of 2018 increased $14.3 million to a record $17.6 million compared to $3.3 million in the year ago quarter. Cash provided by operating activities in the first nine months of 2018 increased by $34.1 million from the corresponding 2017 period, mostly as a result of higher gross receipts from the significant increase in revenue, partially offset by a resulting increase in inventory levels. And now turning to the balance sheet, we ended the quarter with cash and cash equivalents of $6.2 million with $3.5 million outstanding under our $60 million revolving credit facility compared to $0.5 million in cash and cash equivalents and $24.8 million outstanding under the revolving credit facility one year ago. This represents a $27 million improvement in our net cash position versus last year. Inventories at September 30, 2018 were $73.3 million compared to $45.9 million at September 30, 2017 and $28 million at June 30, 2018, reflecting the higher level of expected sales going into the 2018 holiday season. Recall that we spent much of the first half of the year chasing inventory and airfreighting product because supplies were so tight. We have bolstered and solidified our inventory levels as a result of excellent execution by our factories and operations teams. Total outstanding debt principal as of September 30, 2018 decreased to $31.4 million compared to $59 million at September 30, 2017. The debt at September 30, 2018 consisted of $15.4 million in subordinated notes, $12.5 million in term loans and $3.5 million of revolving debt. Our senior debt leverage ratio, which we define as total term loans and average trailing 12 month revolving debt divided by trailing 12 months adjusted EBITDA improved significantly to 0.4 times at September 30, 2018 compared to 2.1 times at the end of 2017 and 2.2 times just one year ago. Cash used in financing operations in the first nine months of 2018 increased by $27.7 million from the corresponding 2017 period, primarily as a result of an increase in repayments of the company’s revolving credit facility and repayments of outstanding subordinated notes with operating cash flows and proceeds received upon the exercise of stock options and warrants. Subsequent to the quarter, as Juergen mentioned, we repaid an additional $5 million of our subordinated notes, bringing the outstanding balance to $10.4 million. Since March 31, 2018, the company has been able to reduce its aggregate term loans, subordinated notes and preferred Series B stock obligations by $28.2 million or 55% from $51.1 million to $22.9 million payments from operating cash flows and the issuance of common stock and fully funded warrants in exchange for the outstanding Series B preferred stock at a discount in excess of 50% of the carrying value at the time of the exchange. This is supportive of our commitment to further reduce debt and maximize value for our equityholders. In fact, we anticipate using operating cash flows to repay the remaining $10.4 million of our subordinated notes by the end of March 2019. In our earnings presentation we have highlighted the evolution of our enterprise value, which shows the significant increase in equity values these actions have had on our company since the start of the year. Before I turn it back over to Juergen, let me say a few words about taxes. In our financial outlook we have assumed an effective tax rate of approximately 9% for the fourth quarter of 2018 and 6% for the full year. Due to the record year we are having, we expect to realize a significant portion or most of the deferred benefit associated with our cumulative NOLs in 2018. As such, going forward we expect that our effective tax rate will increase and could potentially reach below tax levels in 2019. Now I’ll turn the call back over to Juergen for some additional details on the business and our updated outlook. Juergen?

[Juergen Stark:]

Thanks, John. Clearly another set of fantastic results from top to bottom. I’d like to discuss some of the dynamics driving the strong industry market and introduce our increased fourth quarter and full year outlooks. Our record sales growth in the third quarter was fueled by continued strong industry growth, particularly in the console gaming headset market and by our continued market share gains over last year. According to NPD’s latest U.S. and Canada console headset update, year-to-date through September 2018 our revenue share increased 490 basis points to 45.2% from 40.3% in the same period 2017. In addition, while the gaming headset market was up 84% on a sell-through basis, Turtle Beach was up a 106%, once again significantly outpacing the rest of the market. And again, we grew more revenue in Q3 year-over-year than the next closest competitor’s entire Q3 console gaming headset business. Our share gains and outperformance versus the rest of the market span our major European markets as well. In the UK for example, based on GFK data, console gaming headset market revenue is up 70% year-to-date, while Turtle Beach is up 90% with a 51% market share. Even if you fold in data from the PC gaming headset market into which we just launched three new products with our Atlas line, using NPD’s latest U.S. data, we have 34.2% revenue share year-to-date September 2018 versus 30.4% during the same period of 2017. The 34% U.S. revenue share in the combined PC and console gaming headset market is larger than the next three competitors put together. Market share is driven by great products and a strong brand. I’ll highlight -- a few highlights on our product sales in the first nine months of the year. According to NPD’s tally of retail revenues in the U.S. and Canada year-to-date through September 2018, Turtle Beach had six of the top 10 selling console headsets. The number one selling console headset on both Xbox One and PlayStation 4, the number one and number two selling Xbox One wireless headset, the number one selling PlayStation 4 wireless headset and the number one selling console chat headset for both Xbox One and PlayStation 4. This is a great testament to a line of winning headsets at price points for every level of gamer. As we covered on our last call, we believe battle royale games like Fortnite have set off a higher growth trajectory in the video game industry. More consoles, more gamers and a significantly higher proportion of gamers using headsets. Beyond any specific titles like Fortnite or PUBG, we believe that this big jump in highly social, collaborative and competitive game is here to stay. We believe games won’t be competitive if they don’t bring the same level of fun and social interaction as well as a comparable level of immersive sound, all of which drive the desire to game with a headset. As expected, other large game publishers are introducing new games incorporating the battle royale format. Activision released Call of Duty

[Operator:]

Thank you, sir. [Operator Instructions] And our first question will come from Mark Argento of Lake Street Capital. Please proceed.

[Mark Argento:]

Congrats on a solid quarter. I have a couple questions around. So, if you look at the sales trends through the first nine months of the year, Q1 you guys were up a 184% I believe, Q2 up 219%, Q3 107%. If we look at the Q4 guide and you’re up 18%, could you just talk a little bit about how you’re thinking about the holidays? I know it’s a little bit of a wild card, but what you’re hearing from retailers to think that the growth rate would decelerate to 18% when it’s been such a high clip going in?

[Juergen Stark:]

Yeah. Sure Mark. Glad you asked actually. I’ve mentioned this in the past; there is a dynamic to this year where we’ve got new gamers entering the market based on these new games like Fortnite and PUBG. That and you can look at that as like a number of millions of gamers or a set amount of rough revenue for us. The key thing with Q4 is that the core underlying market is much, much larger in Q4 than other quarters during the year. It’s larger in Q3 than Q2 and Q1. So, that kind of that new installed base as a percent of the total market is much smaller in Q4. So, that’s what drives the numbers. Remember that in typical Q4, the market does about 50% of all the revenues for the year in that market. So, it’s basically your denominator is much, much higher in Q4 than it is even in Q3 and particularly than in Q1 or Q2. That’s the driver. But you asked me also by the way about retail expectations, everybody is super excited. The new games are getting good reviews. There is a lot of excitement from retail. And we see upgrade trends from consumers already who have entered the market earlier this year that all are contributing to what we view as a very strong Q4. The other thing I’ll mention and just reinforce from the comments is that we’ve secured -- now fully secured inventory including long lead components for our forecast plus as we’ve comment in the past prior quarters an upside scenario in case the market is stronger than our guidance would forecast that we would be able to provide inventory to hit an upside revenue scenario.

[Mark Argento:]

That’s helpful. I know historically -- I think in years past retail has been almost the counter indicator in terms of over ordering or under ordering, I know in the past couple of years it seems like they were over ordered. How do you guys manage going into what’s a pretty robust environment right now with retail? Do you guys have to put retailers on allocation or how you’re managing through like you said in an environment even though from a percentage basis the growth decelerated, but on an absolute unit basis and dollar basis still pretty strong?

[Juergen Stark:]

Sure. So, we -- number one, you asked about retail sentiment and I will tell you the first part the answer is we don’t pay attention to retail sentiment. The sentiment is what drives the retailers to order more or less on either on the positive or negative side. What we pay attention to is detailed analysis and modeling of what we expect sell-through to be that gets updated on a weekly basis by retailer by model by price tier across all of our core markets. And that’s what we use to estimate what the retailers need in terms of their inventory levels. And we interact with the retailers to give them guidance, to let them know they’re over ordering they’re under ordering. And given that, over the past two years, we have tended to be right based on our analysis. We’re hopeful that they will listen to us and we will try to modulate their ordering in the right place. By the way, you’ll never get it perfect. This is one of their 5% in Q4, can be a big portion of Q3 and a 5% accuracy level ending inventory would be pretty damn good for Q4 in a dynamic market. So, you never get it perfect which is another reason why we don’t give guidance for 2019 until we’ve seen where everything comes out for Q4.

[Mark Argento:]

Great. Thanks guys. I’ll hop back in the queue.

[Juergen Stark:]

Thanks Mark.

[John Hanson:]

Thank you, Mark.

[Operator:]

Thank you. Our next question comes from Scott McConnell of D.A. Davidson. Your line is open.

[Scott McConnell:]

Great. Thanks so much for taking my question guys. So, it’s still real early on, on the sale of the PC headsets in retail, but can you talk about how the competitive landscape has been in the PC headset market and how that’s differed from console headset market? And then if you have any updates on how much of that addressable market you hope to capture? Thanks.

[Juergen Stark:]

Sure. Thanks Scott. PC market is just like console market, it’s very competitive. It doesn’t have any players that have the level of share that we do. It tends to be a little bit more evenly distributed among a number of the stronger players in the market. So, in that regard, we view that as a positive because the market is growing overall. So, we can grow revenues without taking share, but over time obviously, we hope to take share from the other players. And it’s -- for us it’s -- we’d much rather be competing against them than they probably would be competing against us given how strong our share is in console. In terms of our expectations over time, keep in mind that the console gaming headset market is larger in our core geographies than the PC gaming headset market, roughly double the size. So PC, as we gain share will become a more meaningful part of our numbers, but it will take a while. And we’ll start -- once it becomes real meaningful, we’ll start to indicate how we’re doing. But for now, small changes in console will outweigh anything that happens in PC for our overall business just based on the size of the relative market. Lastly, over time I would hope that we would be able to get 10% to 20% market share in the PC gaming headset. That would be put us in the top couple and that is over time it would be great to lead the category like we do in console, but for us more realistically in the next couple of years we hope to get in that kind of share range.

[Scott McConnell:]

Great. Thanks for taking my question.

[John Hanson:]

Thanks Scott.

[Juergen Stark:]

Thank you.

[Operator:]

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

[Nehal Chokshi:]

Thanks. And nice guidance here, I do have a question on that. But before I get to that, I’d like to get your perspective on how fast has the Turtle Beach headset installed base been growing prior to the Fortnite phenomenon?

[Juergen Stark:]

You know I don’t have that number off the top of my head, but I would estimate that the Turtle Beach installed base over the last couple of years has grown probably at mid-to-higher single digit percentage rate would be a fair estimate. And then obviously this year’s market share gains would have made that growth rate much faster obviously. Gaining almost 5 points a share given our strong position is I think quite impressive and speaks to our product portfolio.

[Nehal Chokshi:]

Definitely. And then from analysis of the overall console headset market, do you -- clearly it’s grown much faster than the high single digits historically. What’s your best guess as far as what has been that installed base growth rate during the Fortnite phenomenon?

[Juergen Stark:]

Sure. So, I mentioned a couple of numbers which would be useful to the analysis here on purpose to give everyone kind of an idea of the rough magnitude. So, I’ll just reiterate here. 2017 8.5 million console gaming headsets were sold and this is U.S. and Canada NPD sell-through data in units, 8.5. This year through September 2018, 4.1 million incremental gaming headsets were sold versus the same period in 2017. So, those two -- 4.1 million is almost 50% of the 8.5 in a full year of sales. Now some of the 4.1 million is not brand new headset users, it’s existing users or brand new games, it’s a mix of two things. It’s new gamers coming in and buying headsets and it’s existing gamers who start to use headsets that weren’t using headsets before. And so, that set of numbers should you a decent idea of how the incremental units have progressed even through September.

[Nehal Chokshi:]

Okay, all right. And then the revenue guidance of 18% year-over-year, you mentioned that the assumption there is that you will have the same percent or same number of incremental new headset users in the December quarter, which one was it?

[Juergen Stark:]

Restate that Nehal if you would?

[Nehal Chokshi:]

Sorry. So, usually I guess in the December quarter you might have like 20% of your revenue attributable to incremental users or is it a dollar amount that’s typical? That’s the question.

[Juergen Stark:]

That is -- that’s a tough number to nail down. In the past we’ve said, our rough modeling would indicate $20 million to $30 million worth of new gamers, new headset users that came into Q1 and Q2 for example. And that math roughly works with kind of our performance for those two quarters. But that’s a hard number to try to figure out and peal back from existing users who are upgrading headsets and all of that.

[Nehal Chokshi:]

I guess at the end of the day what I’m trying to drive is that the December quarter guidance more or less embed slowdown in that installed base growth rate because you don’t know exactly how that Fortnite phenomenon will continue to play through in the December quarter?

[Juergen Stark:]

Yeah. Look at it this way, and I’m just going to use some example math. These are not the right numbers, but just to create a clear picture. So, if it’s $20 million or -- yeah $20 million of increased net revenues based on these new incoming gamers and people using headsets for the first time, $20 million versus the normal Q1 like if you look at 2017-2016, you got to look back a couple of years for us because every year there are some kind of tail adjustments in Q1. But $20 million of incremental is 80% of $25 million for Q1. A normal Q4 in the past might be around $90 million and $20 million is 22% of $90 million. So, because the underlying core is a much larger number, just using some sample net revenues for us, by definition you get a lower percentage in Q4. Does that make sense?

[Nehal Chokshi:]

Yeah, it does. My last question is that the -- so you’ve lost PC headsets here presumably during the channel fill, you mentioned you hit your shelf space targets. Can you give us a concrete number as far as what’s the expectation for the contribution for the PC related products?

[Juergen Stark:]

Sure. So, we’ll talk more about that in the future. We just launched, literally 30 days ago. So, it’s too early even for us to get a good read on the headsets. The most important thing is that there are two key steps at the start and I’ve talked investors through this in the past. Number one, you’ve got to get shelf space. And we hit our target in terms of getting the shelf space that we had intended to get or wanted to get in our launch plan. That’s very good, and that’s not a given by the way. And then number two, like we do on every product we launch, we want to nail it with the products. And given the reviews if you search Elite Atlas for example, you will see rave reviews and that is exactly the way we want to start as we put focus into this new market.

[Nehal Chokshi:]

Okay. That was it for me for now. Thank you.

[Juergen Stark:]

Thanks Nehal.

[Operator:]

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

[Mark Argento:]

Hey. Just wanted to follow up quickly just on the balance sheet. And John, maybe you could just touch base or just walk us through, are there any prepayment penalties on any of the debt here in terms of our expectations if you pay that down over the next couple of quarters? And then dovetailing on that, in terms of the free cash flow generation here, it’s like you’re going to start throwing off a decent amount of cash, any thoughts on a buyback or any other type of constructive use for excess capital going forward?

[John Hanson:]

Sure. So, let me cover your first question here which is around prepayment penalties. The only early payment penalty or premium that we have in any of our -- any of the debt facilities is with the $12.5 million term loans that are with Crystal Financial. All the other -- and it’s several hundred thousand dollars…

[Juergen Stark:]

Those reduced I think after January next year.

[John Hanson:]

And they’re sliding over the life of the loan.

[Juergen Stark:]

Yeah. And they wouldn’t -- they wouldn’t meaningfully impact our decisions on what we do in terms of that loan.

[John Hanson:]

That’s correct.

[Juergen Stark:]

So, second you asked -- yeah, you said starting to generate good cash flow. We’ve been generating really good cash flow. And as I mentioned, we anticipate about $47 million of free cash flow this year. So, yeah, we’re going to be in a position to pay down the sub-debt and even all of the debt as we mentioned if we decide to do so in Q1 of 2019. And then what we -- the next priority for the cash flow would be investing in the business and driving long-term growth, which is fully on our radar and very actively underway like any category leader would in our position. What we do beyond that would be a better topic for probably Q1 or Q2 next year once the cash is in the bank and we’ve done what we want to do on the loans and funded the growth efforts.

[Mark Argento:]

And just one last one for me. Any changes in terms of full time equivalent or headcount?

[Juergen Stark:]

Yeah. So, we’ve mentioned in the past we have about a 150 people. We have increased that a bit, but not meaningfully. And I’m frankly given the level of volume we’re doing, I can’t tell you how pleased I am to only have small increases in headcount dealing with a 150% higher volumes in a lot of cases. And again, I’m really thankful to the team who’ve been working really hard all year to make that happen without significantly increasing our permanent OpEx.

[Operator:]

Thank you.

[Juergen Stark:]

Thanks Mark.

[John Hanson:]

Thanks Mark.

[Operator:]

Thank you. At this time, this concludes our question-and-answer session. I would now like to turn the call back over to Mr. Stark for closing remarks.

[Juergen Stark:]

Great. Thank you very much for joining our call. We look forward to speaking with our investors and analysts when we report our fourth quarter results in March. Thank you.

[Operator:]

Ladies and gentlemen, this does conclude today’s conference. Thank you for your participation and have a wonderful day. You may all disconnect.