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Edited Transcript of HEAR earnings conference call or presentation 7-Nov-19 10:00pm GMT

Q3 2019 Turtle Beach Corp Earnings Call

Nov 17, 2019 (Thomson StreetEvents) -- Edited Transcript of Turtle Beach Corp earnings conference call or presentation Thursday, November 7, 2019 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John T. Hanson

Turtle Beach Corporation - CFO, Treasurer & Secretary

* Juergen Stark

Turtle Beach Corporation - CEO, President & Director

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Conference Call Participants

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* Mark Nicholas Argento

Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst, Founding Partner & Head of Institutional Equities

* Sean Henderson

D.A. Davidson & Co. - Research Associate

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Corporation Third Quarter 2019 Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions) Before we get started, we will be referring to the press release filed today that details the company's third quarter 2019 results, can be downloaded from their investor Relations page@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 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 releases 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 the 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 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 can find a reconciliation of these metrics to the reported GAAP results in the reconciliation tables provided in today's earnings release and presentation.

And now I'll turn the call over to Juergen Stark, the company's Chief Executive Officer. Juergen?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [2]

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Good afternoon, everyone, and thank you for joining us. We are pleased with our results for the third quarter, which came in just ahead of our expectations and the published consensus estimates. We posted the second highest level of Q3 revenue in the company's history, up 30% compared to Q3 2017 and down 37% compared to last year's extraordinarily strong Q3 sales. This is consistent with the results we previously reported for the first half of the year. In fact, as we look at the console headset market and our position in it as well as our emerging presence in the PC gaming accessories market through the first 9 months, things are tracking pretty closely to what we predicted when we laid out our initial outlook for 2019.

2019 is shaping up to be the second biggest year for console gaming headsets ever, second only to last year. We continue to lead this market as we have for 10 years with a powerful high-quality and innovative portfolio of headsets for all levels of gamers. And our continued growth in the PC gaming accessories market has gone well with our PC gaming headset market share increasing due to both the ROCCAT line of accessories as well as our own line of PC headsets. As a reminder, the 3 main components of our outlook at the beginning of the year were: One, that the industry-wide console headset sales would be significantly higher than the level seen in 2017, but would decline from 2018's record levels; two, that we would continue to have the clearly leading share of the console headset market, which had risen to 46% in 2018 compared to 42% in 2017, but our share would normalize somewhat this year; and three, that our sales of PC accessories would increase significantly, driven by the Turtle Beach line of Atlas PC headsets and the addition of ROCCAT's PC gaming mice, keyboards and headsets. All 3 of these are unfolding as expected.

I'll add a bit more color on these 3 points before turning it over to John for details on Q3 financials. Last year, millions of new gamers bought headsets to play games like Fortnite and PUBG. This generated a first-time buy effect that caused the console gaming headset market to increase by 70%. Note, I'm using U.S. NPD data for growth and share stats. We predicted those gamers would join the installed base of gaming headset users who upgrade and replace their headsets over time. The net effect would be a significantly larger console gaming headset market versus 2017 and going forward, but a drop from 2018. This is playing out as we predicted. We expect that our market in console headsets share to decline a bit because it got a boost last year from our relatively better in-stock position in the face of competitive inventory shortages, and the fact that we had over 50% share in the entry-level price segments. With that segment making up less of the overall market, there is a mix impact that reduces our share somewhat, plus we lose the in-stock advantage from last year. This is also playing out roughly as we expected with our year-to-date share higher than 2017, but lower than 2018. And most importantly, our share continues to be higher than the next 3 competitors combined.

Let me emphasize on the above 2 points that we are 3 quarters into the year, and both the console headset market overall and our console revenues are tracking quite well to our original forecast. While others may be surprised, we are seeing what we expected to see with no surprises. As you know, we launched our push into PC headsets about a year ago and amplified that effort by adding a great portfolio of PC gaming keyboards and mice with our acquisition of ROCCAT in June. The PC gaming headset market for -- PC gaming market for headsets, keyboards and mice has a TAM of roughly $2.7 billion versus the TAM of $1.4 billion for the console gaming headset market we lead by far. These are global market estimates from Newzoo. Our PC accessories sales, while still a small part of our overall business, nearly tripled year-over-year in Q3 due to the growth in sales of our Atlas line of PC headsets and the addition of ROCCAT product revenues. We've also made good progress leveraging ROCCAT's presence in Asia.

Over the past 4 months, we've worked to integrate the ROCCAT team, align many of the internal processes, reviewed and modified the plans for the combined PC product portfolio, developed our approach to branding and solidified our overall multiyear PC market attack plan. I'm proud of the cross-company teamwork to accomplish those items and excited about the plan for the coming years.

I'll have more to say about the console headset environment, our PC plans and our outlook after John walks through our third quarter financial results. John?

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John T. Hanson, Turtle Beach Corporation - CFO, Treasurer & Secretary [3]

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Thanks, Juergen, and good afternoon to everyone. Moving right into our third quarter results. Net revenue in the third quarter of 2019 was $46.7 million or $47.1 million on a constant currency basis, reflecting the increased installed base of gaming headset users who are now part of the core market. Q3 '18 net revenue was $74.4 million. While customer demand remains above historic levels, this delta was the result of the expected decline in demand, given the tough comps from last year, as Juergen just covered.

Note that the somewhat higher-than-expected revenues in Q3 are largely the result of revenue timing between Q3 and Q4, which, as we've mentioned each year, can vary significantly as retailers prepare for holidays. Gross margin in the third quarter was 32.2% compared to 41% in the third quarter of 2018. This expected decrease was primarily due to a more normal level of promotional activity compared to 2018 when promotional activity was very light, given the record-setting period as well the impacts of product mix, revenue driven fixed cost leverage and the impact of purchase accounting inventory cost step up from the ROCCAT acquisition. Operating expenses in the third quarter of 2019 increased as expected and planned to $17.6 million from $14 million in the same quarter of 2018. This was primarily due to incremental ROCCAT operating costs, ROCCAT acquisition and integration costs and digital marketing and sponsorship initiatives, partially offset by decreases in revenue based compensation as compared to the 2018 period.

Net loss in the third quarter of 2019 was $3.1 million compared to net income of $14.9 million in the year-ago quarter, reflecting the commentary I just covered. Net loss per share in the third quarter of 2019 was $0.22 on 14.5 million weighted average diluted shares outstanding compared to net income per share of $0.91 on 16.2 million weighted average diluted shares outstanding in the year-ago quarter. Adjusted net loss, which excludes transaction and integration cost incurred related to the acquisition of ROCCAT, was $2.6 million or $0.18 per diluted share compared to net income of $14.7 million or $0.91 per diluted share in the 2018 period. Adjusted EBITDA was $0.3 million compared to $17.6 million in the year-ago quarter.

Now turning to the balance sheet. At September 30, 2019, we had $7 million of cash and cash equivalents with $26.6 million of outstanding debt under our revolving credit line. This compares to $6.2 million of cash and cash equivalents and $31.4 million of outstanding debt at September 30, 2018, which consisted of $15.4 million in subordinated notes, $12.5 million in term loans and $3.5 million in revolving debt.

During the quarter, we continued our share repurchases. Since our share repurchase program was announced on April 10, 2019, we have repurchased approximately 206,000 shares for $1.9 million or an average of $9.43 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.

Inventories at September 30, 2019, were $67 million compared to $73.3 million at September 30 last year and is tracking in line with our expectations. This includes new inventory from the ROCCAT acquisition as well as some early buying to help mitigate the impact of tariffs. The effective tax rate for the full year is expected to be approximately 19%.

Now I'll turn the call back over to Juergen for some additional comments. Juergen?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [4]

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Thanks, John. I would now like to turn to some comments on how we see the console market evolving over the next few years, our PC plans and our outlook. We continue to be very excited about the upcoming launches of PlayStation 5 and Microsoft's next Xbox system, both of which are expected to be in market for the 2020 holiday season.

PlayStation 5 is expected to have custom 3D audio designed to excel with headsets. Xbox is working on integrated cloud gaming to lower the barrier to entry for playing new games. Both are exciting developments on the new consoles that will, of course, also set a new bar for graphics and processing power. Meanwhile, the older consoles will continue to constitute a strong installed base of headset buyers.

Last quarter, PlayStation 4 hit the $100 million mark for cumulative units sold, and Xbox One should hit about $50 million according to BSC. I believe this is the first time that new consoles have been announced ahead of the prior holiday season, so it will be interesting to see how this impacts the market. Many in the industry are on the lookout for potential price reductions from Sony and Microsoft to make a last push on the existing console, which could boost sales of games and accessories for these legacy systems.

We believe the market for video game consoles and accessories will get a big boost with the new console launches. And as we've mentioned before, the launch year 2020, in this case, is a transition year, and we already see retail channel inventories at relatively low levels, we believe, in anticipation of next year's console transitions. In fact, given the console gaming market continues to track to our forecast, we've responded to some low retail stock levels, which also contributed to Q3 revenues coming in a bit above our expectations. If this new console cycle follows the pattern we'd expect, the first year or 2 after launch will show higher-than-average growth rates for consoles and for console accessories.

In fact, DFC has said that with the launch of the new systems and continued sales of the current consoles, it forecasts that the combined hardware sales will set records in 2021 and 2022. Our console product portfolio plans also reflect 2020 as an important transition year with a focus to have key new Xbox and PlayStation products launched next year ahead of the expected uptick in 2021. Very exciting.

Nintendo continues to do very well. According to DFC, Switch is at 42 million units and growing. Switch is the best-selling platform and the only platform showing growth this year, and it got a boost in September from the launch of Switch Lite. While it's a small driver of headset sales relative to Xbox and PlayStation, it is indeed becoming a third platform for gaming headset use. And of course, we have a great portfolio of headsets for those Switch gamers.

Turning now to our PC plans. As I said earlier, we continue to be very enthusiastic about the addition of ROCCAT and the opportunities for the combined portfolio in the years to come. PC gaming headsets, keyboards and mice represent a market size that is 2x the size of the console gaming headset market, and Newzoo predicts double-digit market growth for the PC accessory market. So we believe the PC gaming accessory market can be a great source of growth for us in the coming years. We know full well that it's a competitive market, which, of course, we're used to in our console headset market. And we know that it will take some time to do this right. So we've developed a product portfolio plan that will span the next few years with the goal to have the best ecosystem of PC gaming headsets, mice and keyboards for gamers who want to play better and enjoy their gaming experience. We've also done extensive work examining the strength of the ROCCAT brand and determined that ROCCAT's reputation for high-quality German-engineered products fits well with the vision for our PC gaming portfolio and that it's a great complement to the recognized leadership of the Turtle Beach brand in the console market. So we'll be transitioning to the ROCCAT brand for our PC products.

Our first target, as we've stated on prior calls, is to reach $100 million in PC accessory revenues in the coming years. We've plotted our plans to get there, and we're off to a good start. As I mentioned earlier, both our Turtle Beach PC headsets and the ROCCAT PC products have shown strong growth in Q3 and year-to-date, with our PC accessory revenues nearly tripled versus the first 3 quarters of last year, based on the growth that Turtle Beach PC headsets plus the ROCCAT revenues.

Before I get to our outlook, let me comment briefly on tariffs since we get asked about it frequently. Like other consumer electronics companies, our China-manufactured products are either currently subject to the new tariffs or are expected to be tariffed later this year if current tariff plans stay in place. We have been taking a number of steps to mitigate the impact of tariffs this year, including bringing in some products early with the goal of not disrupting holiday sales with price increases. Those efforts have mitigated about half of the impact this year, including the increase in the tariff rates that happened in September. Going into 2020, we expect to have non-China production for some of our products with a Q2 timing target and plan to increase our diversification outside of China during the course of 2020.

Of course, there is a chance that the leadership of both the U.S. and China will come to an agreement that eliminates tariffs as was hinted earlier today, but we're preparing as though that won't happen.

Now turning to our outlook for 2019. We expect our full year revenue to be in a range of $236 million to $242 million. Our narrowed and slightly reduced revenue guidance range reflects console revenues tracking roughly to plan, and our expectation that ROCCAT revenues will come in toward the lower end of the $16 million to $20 million range we gave last quarter based on the later timing of the transaction close and our intentional reduction of ROCCAT product channel inventory as we align the sales process to the analytical sell-through base model we use at Turtle Beach. We expect the remaining impact of tariffs to be approximately $1 million to $1.5 million, which will be reflected in the fourth quarter. While we expect to be in our prior gross margin range of 33% to 34%, we expect the tariff impact to move us down in that range a bit. We've also made the decision to increase the investments in marketing and promoting our brand and products in Q4, both in support of our console, product and PC business.

The above items give us an expected adjusted EBITDA range of $23 million to $25 million, GAAP EPS of $0.50 to $0.60 and adjusted EPS of $0.65 to $0.75. These EPS figures are based on 15.7 million shares, and per John's comment, the EPS numbers also reflect the higher estimated tax rate for the year. We have a terrific position in a great market.

Gaming, including eSports, streaming and influencers continues to be an exciting market that we believe is the best global consumer segment to be participating in today. We have a strong brand and leadership position in console gaming headsets, which are additionally benefited from the continued increase in multiplayer and social gaming. And the new Xbox and PlayStation consoles could drive incremental growth after they launch next year.

I'm also very pleased with the opportunity we see in the large PC accessory market, as I discussed. We positioned ourselves well to drive future growth with a long-term target of 10% to 20% per year in revenue and 15% to 30% per year in EBITDA.

A few closing notes that are people related. Yesterday, we announced that after more than 9 years as our Chairman, Ron Doornink has decided to retire and will be leaving the board at the end of the year. It has been my personal privilege to work with Ron over these years, and I can't thank him enough for his contributions and partnership. The board and I will miss him, and we wish him well in his retirement. As we also reported yesterday, the board has appointed me to the Chairman role, while also continuing as CEO. We have a great board, including the addition of Kelly Thompson in August, with her strong retail background. And I'm delighted to take on the additional responsibilities of Chairman. As is often the norm when the Chairman and CEO roles are combined, the board appointed Bill Keitel as the Lead Independent Director. Bill is the retired CFO of Qualcomm and has been a board director with us since 2014. I look forward to continuing to work closely with Bill and the rest of our excellent board to execute on our plans and drive shareholder value.

And finally, a big thank you to the fantastic team of colleagues across the company for the great work they do and their dedication to delivering the best gaming products for our customers. I'm really grateful to be working with all of you and appreciate all you do.

Operator, we're now ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question will come from the line of Mark Argento from Lake Street Capital.

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Mark Nicholas Argento, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst, Founding Partner & Head of Institutional Equities [2]

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Just wanted to dig in a little bit on the guidance. I know it looks like the revenue level for the full year coming in a little bit and then the EBITDA guidance as well coming down. Could you talk a little bit -- I know you broke out the tariff impact, $1 million, $1.5 million, but the, kind of, the magnitude of the incremental marketing spend, where you're going to spend those dollars? And then maybe some puts and takes into kind of the roll-up in your top line forecast on the guidance on the revenue side, please?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [3]

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Sure, Mark. So on the revenue line, yes, we reduced the range somewhat and narrowed it. It's in the midpoint of the range. It's down about 2% and is actually, by coincidence, centered right around the analyst consensus of 2.39%. The key drivers are -- you'll recall, we took the ROCCAT revenues down to $16 million to $20 million last time based on the delayed -- the later close than we had expected, that factors in. And that also has an impact on EBITDA. We have taken some intentional actions to align the way we sell ROCCAT products into retail by using the Turtle Beach process, which looks extensively at sell-through and basis sell-in on sell-through. So that took us a couple of -- a little bit of time to get that going, but we like channel inventory to be right where we want it to be at so that revenues don't move around unexpectedly over time. So that's been now implemented on the ROCCAT side with lower channel inventory, but that does take a little bit out of the sell-in in a transitory few month period.

Those are the 2 biggest drivers on the revenue line. Console, now we've narrowed our range of expected outcomes, and it's tracking roughly where we have expected. But the net-net of all those is, as you can see, a very small adjustment to the full year revenues.

Okay, on the EBITDA line, it's pretty simple. So the revenue reduction results in the impact to EBITDA to the tune of a few million dollars. We've got tariffs in there for just over $1 million. And then we're spending about $2 million more on marketing and promoting our products, both in our brand -- both for Q4, frankly, and to help us in terms of momentum into 2020. That's a decision we feel good about, and we believe will pay long-term dividends. And so we've executed on those moves.

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Mark Nicholas Argento, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst, Founding Partner & Head of Institutional Equities [4]

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And what kind of marketing spend? Is it promotional activity? What kind of marketing dollars are you guys spending?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [5]

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It's across the board. So it's promotions, getting some additional placements at retail and some additional media and straight-up marketing spend in Q4. Again, both on the console side and the PC side.

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Mark Nicholas Argento, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst, Founding Partner & Head of Institutional Equities [6]

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And one quick follow up in terms of what do you guys anticipate kind of peak borrowings looking like as you work through the holiday season?

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John T. Hanson, Turtle Beach Corporation - CFO, Treasurer & Secretary [7]

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Yes. So probably just under $40 million for the year would be the peak. That's about where our models show us today, Mark, which would be below last year.

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [8]

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Maybe one follow-on comment to that. Keep in mind that, that's a very normal level for the revolver. It typically goes to 0 in the early part of the following year. And the revolver also reflects buying ROCCAT for cash a few months ago. And remember, when you look relative to last year, in the meantime from the last year comp, we paid off all of our long-term debt.

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Operator [9]

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(Operator Instructions) Our next question will come from the line of Sean Henderson from D.A. Davidson.

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Sean Henderson, D.A. Davidson & Co. - Research Associate [10]

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So just on -- first on ROCCAT. When we think about the distribution of ROCCAT, both in the U.S. and internationally, when should we expect all the ROCCAT products to be fully rolled out on a retail basis? So is that now? Soon? Prior to the holidays? Or just on the timing front of that?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [11]

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That's a great question, Sean. Thanks for that. So the ROCCAT portfolio, and how it moves into distribution is something that we'll -- that we've now laid out over, frankly, the next couple of years. You don't want to be in retail too early and try to like grab too much shelf space if the portfolio is not complete. So kind of -- it comes in, I would say, 3 phases: Phase one, we've already implemented, which is to make some easy moves to increase the points of distribution with the current product portfolio. By the way, you can't get in everywhere this late in the year. So there are just some natural barriers to what you can do shelf space wise that when you haven't started the process kind of early in the year. So kind of like -- but phase 1 is going well. We've got some additional points of distribution. We're leveraging also the ROCCAT presence in Asia on the Turtle Beach side of the business, the Turtle Beach headset side. That's all going to plan. Kind of Phase two, I would characterize as the -- an expansion of the portfolio and driving some additional placements, and we expect that to happen in 2020. And then stage three is, I would call it, the complete version 1 of the PC portfolio with the headsets, keyboards and mice that we want. And again, done carefully to be -- to enable us to have what we feel will be the best ecosystem of those 3 types of products. And the goal is to have that in place for 2021. And then over time, you continue to drive -- as those products succeed, distribution, points of distribution, if you're successful, will continue to expand. You obviously then start adding and updating various products. But that's kind of how we see it rolling out, and back to my comments about now having a multiyear plan that I'm really excited about.

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Sean Henderson, D.A. Davidson & Co. - Research Associate [12]

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Great. And then just one quick follow up. I noticed a good amount of activity in the Athlete brand ambassador program since the last earnings call. I just want to know kind of what your long-term outlook is on that program? And how you guys will be ramping investments into it and what not?

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [13]

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Yes, I love that. Thanks, Sean. So yes, we signed a number of athletes, pro athletes who are big gamers. And that's been super exciting because they're using the Turtle Beach products. They like the Turtle Beach products. And they -- it's not an expensive kind of proposition, by the way. But it's been very productive as a way to expand the brand in the new consumer segments because these pro athletes have a lot of followers, as an influencer. And so we're -- I'm personally really excited about it. I think it's a really good move. And we're really -- the team is really having a great time working with these athletes and providing them with gaming products.

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Operator [14]

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

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Juergen Stark, Turtle Beach Corporation - CEO, President & Director [15]

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Okay. Well, again, thank you very much for joining us. We look forward to speaking with our investors and analysts when we report our fourth quarter and full year results in March of next year. Thank you very much.

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Operator [16]

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