Turtle Beach Corporation
Q2 2016 Earnings Call Transcript

Published: 9 Aug 2016

[Operator:]

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Second Quarter 2016 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] As a reminder, this conference is being recorded. Before we get started, we will be referring to the press release filed today with details of results which can be downloaded from the Investor Relations page of our website at corp.turtlebeach.com. In addition, a recording of this call will be available on the Investor Relations of the Company's website later this evening. Please be aware that some of the comments made during our call may include forward-looking statements within the meaning of the federal securities laws. Statements about our 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 our operations and future results that could cause Turtle Beach Corporation's results to differ materially from management's current expectations. We encourage you to review the Safe Harbor statements and risk factors contained in today's press release and in our filings with the Securities and Exchange Commission, including without limitation our most recent Annual Report on Form 10-K, our most recent quarterly report on Form 10-Q and our other periodic reports, which identifies specific risk factors that also may cause actual results or events to differ materially from those described in forward-looking statements. We do not undertake to publicly update or revise any forward-looking statements after the date of this conference call. We also note that on this call we will be discussing non-GAAP financial information. We are providing that information as a supplement to information prepared in accordance with accounting principles generally accepted in the United States or GAAP. You may find a reconciliation of these metrics to our reported GAAP results in the reconciliation table provided in today's earnings release. And now, I'll turn the call over to Juergen Stark, the company's CEO. Juergen you may begin.

[Juergen Stark:]

Thank you and good morning everyone. First I will hear some highlights of another strong quarter before passing the call to our CFO John Hanson who will provide details on our Q2 financial performance. I will then expand upon our operations and speak more about our increased outlook for 2016. The strong performance of our headset business has continued through our second quarter. Not only was headset net revenue up 29% versus the year ago quarter, our Next-Gen sales grew by 80% versus the same period. Next-Gen headsets also comprised 91% of our net revenue in the second quarter and was a driver of 840 basis point expansion in our headset gross margin and 240 basis point expansion in our consolidated gross margin. Sell through of our Next-Gen portfolio continues to be very strong both domestically and in Europe, in fact in NPD data has confirmed that our market share grew even higher during first half of the year, not an easy feat given our already strong market share. So the first half of 2016, the overall console market is up a healthy 20% on a unit basis, total Beach is up 27% on a units basis during the same period and we own all of the top five selling third-party headsets year-to-date in 2016. Given this momentum in our Next-Gen headset business we expected to represent over 90% of sales in 2016, we are again raising our 2016 outlook and believe we remain well positioned as we approach our important holiday season. In our HyperSound business, we experienced lower-than-expected sales due to the continued slower ramp in the Audiology’s channel. We’ve also continued to find that it's taking significantly more effort than anticipated to get hearing healthcare offices to integrate HyperSound Clear 500P into their daily office workflow. However, we carefully managed our spent, continued to refine the sales approach and have begun to actively test and pursue alternate sales channels to sell this breakthrough living room audio product. In June, we also unveiled HyperSound Glass, the world's first transparent directional speaker. Our HyperSound Glass video demonstration on YouTube already has over 130,000 views. We believe the technology is extraordinary and we are already beginning commercial licensing discussions. In today's earnings release, we also announced the engagement of Piper Jaffray to explore strategic options for the HyperSound business. As we said in the earnings press release, we are testing and pursuing alternative more consumer and retail oriented channels for our HyperSound Clear product. We’re also developing and seeking FDA clearance for [indiscernible] [00

[John Hanson:]

Thank you Juergen and good morning to everyone. Jumping right into the numbers, net revenue in the second quarter of 2016 increased by 30% to $29.4 million compared to $22.6 million in the same year-ago quarter. The increase was attributable to a 29% increase in headset sales due to continued robust sell through of our Next-Gen headset portfolio. Gross profit in the second quarter increased 50% compared to the year ago quarter to $5.1 million. Gross margin was 17.4% compared to 15% in the second quarter of 2015, an 840 basis point improvement in headset gross margin to 24.5% was partially offset by amortization cost associated with the launch of HyperSound Clear 500P which resulted in negative HyperSound gross profit in the quarter. Keep in mind that gross margins historically have run lower in the non-holiday period based on fixed operating costs. Our higher margin Next-Gen headsets contributed 91% of revenue in the second quarter, up from 65% during the same period in 2015. As a reminder, we have recognized between $3 and $4 million in fixed costs relating to supply chain, logistics, depreciation, amortization and stock compensation expense in each of the past six quarters. The amortization portion is expected to modestly rise sequentially in the final two quarters of 2016 primarily due to amortization of the HyperSound healthcare product. As such, consolidated gross margins are expected to be lower in the non-holiday quarters due to fixed cost deleveraging as well as the seasonality of the headset business that are expected to expand for the full year driven by higher revenues during the holiday season. Operating expenses in the second quarter were $45.6 million compared to $16 million in the year ago quarter. In accordance with US GAAP accounting rules, the second quarter of 2016 included a $31.2 million non-cash goodwill impairment charge relating to the HyperSound acquisition. Excluding the impairment charge, operating expenses declined 9% to $14.4 million compared to the same period of 2015. The year-over-year decrease was driven by our continued cost management effort across the entire business. Net loss in the second quarter was $42.6 million or a negative $0.86 per diluted share compared to a net loss of $9.9 million or a loss of $0.23 per diluted share in the year ago quarter. Excluding the $0.63 per share non-cash goodwill impairment charge, net loss in the second quarter was $11.4 million or a negative $0.23 per diluted share. The year ago quarter included a $3.1 million income tax benefit, approximately $0.07 per diluted share versus $0.3 million benefit in the second quarter of 2016 due to the valuation allowance recorded in the third quarter of 2015. The second quarter of 2016 also included approximately 7 million incremental diluted shares compared to the year-ago quarter primarily due to the February 2016 follow-on public offering of common stock and concurrent private placement. Adjusted EBITDA on a consolidated basis improved to a loss of $6.3 million compared to adjusted EBITDA of a loss of $8.2 million in the year ago quarter, the 23% improvement was primarily driven by strong Next-Gen headset sales and cost reduction initiatives partially offset by a $0.7 million negative impact from foreign exchange. This was due to the sharp decline in the British pound following the Brexit vote. Had it not been for this unexpected impact, we would have exceeded every metrics of our Q2 guidance. Adjusted EBITDA for the headset business was a loss of $3 million in the second quarter compared to a loss of $5.2 million in the year ago quarter representing a 43% improvement. Looking at the first half results, let me provide just a couple of highlights from our headset business. Next-Gen headset sales accounted for 90% of total headset sales in the first half of the year, up from 64% last year. Consolidated gross margin in the first half were 15.9% of total revenues, up from 15.4% last year. But our headset gross margins in the first half were 22.5%, a 600 basis point higher than the first half of last year. The net loss per share in the first half of 2016 was $1.14 or $0.49 excluding the goodwill impairment charge compared to $0.49 in the first half of last year. Consolidated adjusted EBITDA in the first half of this year was negative $12.6 million compared to negative $18 million in the first half of last year. In the headset business, adjusted EBITDA in the first half was negative $6.2 million compared to a negative $11.8 million last year. In fact, trailing 12-month EBITDA for our headset business as of the end of Q2, is approximately $8 million higher than 12 months ago. Please recall, with revenues expected to increase in the remainder of the year as we enter our peak selling season for handsets in Q4 and assuming continued improvement in gross margins and OpEx, we would naturally expect to flow through more EBITDA in the headset business in the latter part of the year. Now turning to the balance sheet, we ended the quarter with cash and cash equivalents of $1.2 million compared to $7.1 million at December 31, 2015. As a result of the availability under our $60 million revolving credit line, we generally do not hold a large cash balance. Outstanding principal debt at June 30 was $41.5 million compared to $68.1 million in December 31, 2015. The decrease in debt was due to a 25.3 million reduction in our revolving credit facility which was driven primarily by receipts from strong holiday sales and our February 2016 follow-on public offering. The debt as of June 30 included $7.2 million of borrowing under our revolving credit facility. Historically, the outstanding balance fluctuates throughout the year being close to zero in the early year before it ramps up ahead of the holiday. At the end of the second quarter, the revolver balance is to getting the show the holiday increase, consistent with our expectation and goal. Subordinated debt total $18.3 million and term loans totaled $16 million. The addition of a term loan and subordinated debt in 2015 provide the company permanent capital reducing our dependency on the ABL revolver. Continued strong headset sales, solid consumer response to our Elite Pro headset along with our just announced holiday products are driving us to buy more inventory in advance of the upcoming holiday season. So in June, we amended our credit agreements with the term loan and ABL lenders. The amendments provide among other things a temporary reduction of the existing loan availability block for the period of June 17, 2016 through October 31 of 2016. This temporary reduction enhances our borrowing base by $3 million through September 30 and by $1.5 million through October 1 through October 31, 2016. Internally, we look at cash plus accounts receivables less accounts payable as one measure of our liquidity. At approximately a positive $300,000 this is approximately $3 million higher than the second quarter last year. Taking into consideration, the availability on our line of credit and our expectation to be EBITDA positive on a consolidated basis in 2016, we believe we have sufficient capital to fund our business plan. This is further supported by our continuing cost and expense management in the first half of the year, which we expect will continue throughout 2016. And now I will turn the call back over to Juergen for some additional comments on the business and our updated outlook. Juergen?

[Juergen Stark:]

Thanks John, we are particularly pleased by the success of every model in our New-Gen headset line-up. Those of you who have been following us closely over the last couple of years will recall the surprisingly rapid adoption of New-Gen consoles which caught many industry analysts and observers by surprise resulted in faster than expected declines in Old-Gen headsets before the installed base of new consoles was large enough to offset the decline. This led to lower than expected overall sales in 2014 and 2015 and impacted us disproportionately to others headset makers given that we had by far the largest line-up of Old-Gen products and by far the largest Old-Gen headset revenues. The console transition drove us to end-of-life 16 Old-Gen models and design, develop and launch 17 Next-Gen models in under three years. Not only did we accomplish that, but those 17 models reflect a level of innovation that we believe rivals the rest of the industry combined. This includes being first to market with both Xbox One and PlayStation 4 headsets, first to market with wireless headset for Xbox One. We had the first gaming headsets with DTS Headphone

[Operator:]

[Operator Instructions] And our first question comes from Mark Argento with Lake Street Capital. Your line is open.

[Mark Argento:]

I had a bunch of questions, but I think they are all answered now. So a comprehensive job with the prepared remarks. I guess really what it boils down to is obviously seeing a lot of strength in the headset business, you got the balance sheet to be able to execute against that opportunity here. I know you’ve made some adjustments to some of the covenants recently, John, maybe you can walk us through how you feel about the balance sheet here and its ability to make sure you can get product into the market for the strong sell-through season.

[John Hanson:]

Sure, Mark. So the amendment where we freed up a portion of the block here, ahead of the holiday, peak holiday season, certainly allows us to now to deliver on the product and bring the product forward into inventory to hit the projections that we have a range of projections that we have for the headset business. So we feel real good about getting that done and having the ability to ensure that we’ll have appropriate product which will avoid any potential stock-outs or delays. So the actions that we took do in fact position us to be able to meet the current demand that we see from the retailers and distributors.

[Mark Argento:]

And when do you typically, when do you start to see orders coming in, what’s the lead time you have, typically in front of the holiday season?

[John Hanson:]

Yes. So. Go ahead, Juergen.

[Juergen Stark:]

John, I can maybe start and you can add on. So we have holiday plans, Mark, that get discussed in pretty good level of detail with all the top retailers, both in the US and Europe. So we kind of, we put together plans, including their expectations, our expectations at a model level and that helps guide us alongside what is now I think three years of highly detailed market sell-through data tracking. So we've got the sales team that knows by week, by model what the expected seasonality curve looks like, and then obviously for new products, the sales rate and we compare that to the retail expectations and that is really what provides us with the forecast, we used to plan inventory and receipts and all that and that’s done on highly collaborative way with the top retailers. And then as we go into the holiday season, we track weekly sell-through for the top retailers in the US. They track it and we kind of adjust as we go along. In holiday, really, there are no far advanced orders, it's really run based on, I would say half monthly sell-through rates where they may adjust some of their purchases and we adjust our inventory levels, our buffer stock, all of that. That's kind of how the process works. So there is a lot of adjusting that happens in Q4, and keep in mind, we've got, we had very good first half of the year obviously. That's about 30% of our year, if you take into consideration what's left here from a revenue standpoint and we’re excited with -- obviously that bodes well for the holiday, but that gets managed, the actual outcome that will then get managed week-to-week as we go through the holiday period.

[Mark Argento:]

Great, that's helpful. And then just maybe give us an update in terms of the adapters for Xbox, is that continuing in the vein, how does that kind of fit into the expectations for the year.

[Juergen Stark:]

Yes, they continue to sell. I think the last number I saw was 20,000 in June or something like that, they are fully baked into our numbers, they are just part of the competitive dynamic. There is one positive there, which is our two bestselling headsets, two of our best-selling headsets, XO4 and XO1, both have the adapter, our own version with some enhanced features obviously, but one of the things that we like frankly is that it’s clear that gamers like to have the ability to control the audio, right there at the controller versus just using the 3.5 millimeter jack where you can get audio but you have no ability really to control. So it’s not a huge volume any more with the adapters, but they still out there, they’re still selling.

[Mark Argento:]

Thanks, guys. Appreciate it.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from James Medvedeff with Cowen & Company. Your line is open.

[James Medvedeff:]

Sorry, I did have it on mute. Good morning. I agree that that was a very thorough presentation of all those stuff. So, can you break down the HyperSound EBITDA investments into the various categories like variable production costs, or COGS, R&D, SG&A and so forth?

[Juergen Stark:]

John, do you want to provide the rough breakout? Most of it’s OpEx obviously.

[James Medvedeff:]

So I think it was the last time you told us that the HyperSound had a specific amount of fixed COGS, which was 1.2 million I believe?

[John Hanson:]

I think we were talking about the amortization for HyperSound.

[James Medvedeff:]

Yes, correct.

[John Hanson:]

Excuse me, I apologize for that. So the amortization for HyperSound, you should think about it on a quarterly basis is about $1 million.

[James Medvedeff:]

1 million, okay. And then just kind of directionally, is the rest of the $12 million invested more in R&D or more in sort of building up and addressing the sales opportunity in the channel?

[Juergen Stark:]

It's a mix of sales and marketing, we do have a small sales team that calls on the audiology offices. They’re now being repurposed without adding to the staffing to also cover some of these retail tests with a Chicago large retailer that I mentioned. So we're kind of using the resources we have to kind of double team and cover some of the new channels as well. Some marketing spend, not at a ton, we’re not doing any large expenses in terms of marketing campaigns. They are more focused marketing efforts including, there will be some effort to help support the Chicago retail trial and then we've got, about half a team is R&D and including the guys who are working on the HyperSound glass, working on product enhancements, working on Tinnitus, working on software. So rough staffing would be half R&D, half sales and marketing and obviously G&A is largely an expense that’s an allocation from essentially corporate.

[James Medvedeff:]

Understood, okay. That's good color. Switching gears, can you talk about, I know it's not the best time of the year, because this is not going to be that indicative, but channel inventory, you say it's about a five monthly kind of sell-through that the customers, that the retailers provide and then reorder. I'm just wondering what kind of visibility you have on inventory that is out in the channel right now?

[Juergen Stark:]

Yes, James. I'm actually glad you asked. It's something that we track for our large retailers, we have good visibility, every week, we look at sell-through, we calculate a weeks of supply, weeks on hand that again, this is for the top retailers and so we have very good visibility to it. We have an expectation of where each of the retailers, where we would want them to be and we know where they want to be. In some cases, they will be going a little heavy, but we know when that is, for example, when we put in new displays or something like that, so it gets tracked very actively and our view is that the channel inventory level in aggregate is roughly where we would expect it to be and we -- actually, we try hard to keep it in balance and not have our revenue levels. The artificially high or low based on higher low channel inventory. Obviously, we have had as we talked about in the last earnings call, very high revenue flow through and retail inventory levels that were too low in earlier Q2, we had some stock-outs, we used air freight ticket products to shelf to try to minimize that, but kind of everything at this point is running the way we would expect it to with levels where we would expect, including our own inventory levels.

[James Medvedeff:]

Are you still producing any of the old generation headsets or has production been shut down?

[Juergen Stark:]

Mostly, no. There are maybe some final production runs where we know we've got some, maybe Black Friday specials, that type of thing on old-gen, but if that is still going on, it would be ending quite soon and it may have already ended frankly. The rest of the -- and it would be limited to a couple of models. Again, something that we very, very carefully track to make sure that while we would expect ourselves to be kind of the last supplier of old-gen, the retailers are most likely to keep our stuff on shelf. We know who is going to keep some old-gen on shelf for holiday, what promotions they are planning to run and mostly collaboratively plan with us and so any inventory or supply would be aligned with those plans.

[James Medvedeff:]

Okay, kind of following up on that and this will be my final question, I understand new-gen is 90% plus of sales for the full year and that sort of was in the first half and even higher in Q2, but going forward when old-gen kind of leaves the model, what's left is then the accessories and other stuff, so in Q2, can you say how much was old-gen?

[Juergen Stark:]

Inventory level, John, do you have that?

[James Medvedeff:]

Sorry, revenue.

[Juergen Stark:]

Yes, we’ve actually said old-gen revenues were around 5%, new-gen was like 90%, John, correct me if I get this wrong, old-gen was like 5% and then other accessories, et cetera were about 5%.

[James Medvedeff:]

Great, perfect. Thank you very much.

[Operator:]

Thank you. And our next question comes from Alex Silverman with Special Situations Fund. Your line is open.

[Alex Silverman:]

Good morning. Really fantastic numbers out of headset. Just to kind of continue old-gen, new gen, I went back, looked at my notes, it looked like old-gen was about 10% or 11% in Q4 of last year, assuming that shrinks down to somewhere about where it is, that would be a 5 point drag. Given the revenue growth you're seeing and backing out Q3, your guidance, middle of the guidance this quarter up just slightly in Q4 or even flat. Are you being conservative here because who knows what the holiday looks like or are you being conservative just to, is there something else going on?

[Juergen Stark:]

Yes. There are three factors, Alex. The first is that the year-over-year comps are somewhat, for Q3, and especially Q4, are now going to compare to a very successful Q4 last year where we had launched kind of the final suite of new-gen products, the Recon series and the PX24. So we're not projecting forward 30% or 20% year-over-year growth because we’re now normalizing a comp to reflect a portfolio change that started hitting in later Q3 and then was obviously fully baked into Q4 last year. That's number one. Number two, we are being a little bit cautious, because of the Brexit. And we're still -- while the impact we believe will be limited to the UK, we still are trying to get a read of where is the pound going to settle, I think it dropped more again in the last week. What's they going to do to pricing and just, we’re just being conservative, we’re not seeing a market impact right now yet, by the way, on sell-through, we watch it every week, sell-through, so it doesn't look like the market or the consumers there are kind of having a reaction, but pricing may be forced to change, given the exchange rate and as you know, the 4x component is really the small part of the impact, it's really the impact on pricing and price elasticity in the market that we’re trying to get a handle on. And then number three, just the macroeconomic environment, including with the elections and all of that, Q4 is 50% of our quarter and that can move a lot of revenue around. And so we’re just taking a cautious view as we head into that, based on some of the uncertainty in the US and in Europe with the kind of the macroeconomics.

[Alex Silverman:]

Very reasonable. Great, thank you guys.

[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:]

Okay, just want to thank everybody again for joining us, very pleased with the outcome for the quarter and again thank the fantastic team of people at Turtle Beach for their continued support and dedication. Thanks, everybody. Have a good day.

[John Hanson:]

Thank you.

[Operator:]

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your line at this time. Thank you for your participation. Everyone, have a great day.