Turtle Beach Corp – Undervalued Microcap?

Sometimes you come across delicious opportunities in the small/micro cap space you can’t help but investigate…. When I first found this it was hovering at $1/share, but it ran up to $1.3 while I was writing this. I think the upside can be pretty good if video-game headset sales remain strong – $2/share is definitely possible with even more upside. The equity isn’t riskless given the debt, but the industry seems robust, the company is a leader, and the execution seems very shareholder-oriented.

tb-headsets

Long Turtle Beach (NASDAQ: HEAR)

Price Target: $2.00+

Current Price: $1.00

Upside: 100%

Avg. Daily Vol: $360K (suitable for P/A or small funds)

Thesis: Long HEAR. Declining revenue from headset sales to older generation gaming consoles masking robust revenue and profitability growth in headset sales to new console cycle. HEAR is the undisputed market leader (40%+ dollar market share) in videogame audio headsets. 2016 marks the inflection point where revenue growth should recover. Additional accounting noise from Hyper-Sound business may soon dissipate as HEAR is exploring a potential sale. Sale of Hyper-Sound and removal of associated business expenses should reveal a much more robust core headset business. Rogue selling by former founder depressing stock but unrelated to fundamentals.

History: Turtle Beach, headquartered in San Diego, is a 41-year old producer of audio headsets. HEAR started producing video game headsets in 2005 and in 10 years became the market leader in this niche space, with top (40%+) market share in the US (its core market) and similarly strong market presence in Europe. Sales are about 72% US, 13% UK, 10% Europe, and 5% elsewhere (HEAR sells to over 40 countries in both offline and online channels).

In 2013, Turtle Beach merged with Parametric Sound, the original developer of what is now the Hyper-Sound segment of HEAR. Original Turtle Beach shareholders got 80% of the combined entity with 20% going to Parametric’s prior shareholders.[1] Thru the transaction, HEAR added Hyper-Sound has a new business segment. Hyper-Sound focuses on the development and commercialization of focused sound beams in home and outdoor settings, targeting people who have hearing issues (estimated 50M people in the USA alone – 1/7 of the population, have some degree of hearing loss[2]). Hyper-Sound is currently exploring opportunities to incorporate its sound-focus technologies in retail and commercial applications as well.

Turtle Beach has dominated the gaming headset market for the past decade. Sales are correlated with console cycles. Back in 2011-2012, Turtle Beach headsets had over 50% dollar market share of the US gaming headset market and did over $207 million in revenue in 2012. Competitors include Astro (owned by Skullcandy), Performance Design Products (PDP), Mad Catz (MCZ), and headsets produced by MSFT and SNY themselves. But Turtle Beach’s market share is far larger than the rest of the players in the market, due to design knowhow, excellent product quality, and strong marketing. Turtle Beach has around 40% market share in both US and UK. PDP (mid-teens market share), Sony (10% market share), and Microsoft (10% market share) are the next three largest competitors, so Turtle Beach is bigger than the next three competitors combined.

Sony and MSFT’s release of PS4 and Xbox One consoles in 2013 (the next generation) took analysts and HEAR by surprise. Sales of the prior generation products (PS3 and Xbox 360) rapidly declined as gamers upgraded. Unfortunately, sales of Turtle Beach headsets for PS3 and Xbox 360 declined as well starting in 2013. The company’s quickly designed and released products for the new generation consoles but the rapidly increasing sales of the new products could not completely offset the decline in headset sales for old generation consoles. Old headset revenue was a significant majority of revenue for HEAR in 2012 and 2013 but that proportion has come down to 20% in 2015 and an estimated 5% for 2016. HEAR stock traded as high at $21 back in 2013 but due to declining topline and margin contraction related to inventory clearances (lots of earnings misses) the stock fell all the way down to the $1 range where it sits now.

The continued investments in Hyper-Sound, an early-stage prototype concept with limited commercial application, added fuel to fire for HEAR. Hyper-Sound had zero revenue contribution in 2013 and in 2014 and 2015 revenue was a mere $1 million / year. Research and marketing expenses on Hyper-Sound was draining cash on HEAR’s headset business as the latter was concomitantly affected by unexpected announcement of the new PS and Xbox 4th generation.

Hyper-Sound hasn’t been fully commercialized yet but it is showing great promise as an innovative audio solution for focusing sound beams. Here is a short video that talks about the Hyper-Sound concept and the warm reception at E3 this year: https://www.youtube.com/watch?v=xbUahUG3Gwg.

The Opportunity:

For HEAR and investors, 2013-2015 was the “perfect storm” of sorts. The 4th generation console cycle came a little earlier than expected. Hyper-Sound continued to drain cash without commercialization breakthroughs. The company missed consensus expectations for several quarters in a row leading to its stock price falling like a rock.

Behind these unfortunate factors, Turtle Beach is actually enjoying strong growth and likewise leading market share in sales of gaming headsets to the new generation console customers. Management is confident Turtle Beach can maintain 40% market share over the next cycle. 2016 will be the last year of the “transition period” where sales of headsets designed for the 3rd generation should disappear, leaving 2017 and beyond figures to properly reflect the strong business momentum in headset sales for the 4th generation consoles.

Despite their mundane appearance, the gaming audio market (and audio in general) requires some tech knowhow. Traditionally strong players, including Turtle Beach, PDP, Skullcandy, Astro, and Mad Catz Interactive are getting only stronger. In 2011, Skullcandy acquired the gaming headset assets of Astro, further fueling market consolidation. The console makers like Sony or Microsoft sell their own headsets, but this is not a technological advantage or focus for them.

HEAR’s management believes that the 4th generation console cycle will not cause as much “disruption” to headset manufacturers as the sudden decline in the 3rd generation consoles did. Audio connectivity for headsets for the 4th generation are much more standardized and it appears that even if a 5th generation could come earlier than expected, 4th generation products will still be usable on 5th generation products.

Moreover, HEAR also believes that it will be able to take advantage of the virtual reality market. It already has introduced the Stealth 350VR headset for virtual reality games that enhances and amplifies the standard VR headset audio. The company believes that VR helmet manufacturers are mainly focused on the “visuals” and will work with audio companies like itself and Skullcandy on the audio side. It views VR as an opportunity (rather than a threat) to assert its expertise and dominance in video game audio solutions.

Moreover, despite the potential of Hyper-Sound, Turtle Beach announced on its 2Q16 earnings call back in Aug 2016 that it hired Piper Jaffray to explore “strategic options” for this segment, which includes a sale to someone else who can better monetize Hyper-Sound. HEAR hasn’t guided to any timeline for this but any sale of the technology would be a huge catalyst: (1) a sale would eliminate an expense drag on HEAR’s consolidated numbers to allow investors to appreciate the increasing profitability and cash flows of the core headset business, and (2) a sale would likely net a substantial amount of cash that HEAR can use to de-lever its balance sheet.

Why does this opportunity exist? For one, HEAR has a market-cap of only $48M which makes it off the radar for larger funds. Second, the tepid topline growth (which is caused by a declining sales to 3G consoles that will end in 2016) and lack of GAAP profitability means it is unlikely to show up on screeners. Third, Carmine Bonanno, one of the co-founders of Turtle Beach before the current CEO Juergen Stark was brought in by HEAR’s VC investor Stripes Capital in 2012 to run the company[3], once owned 10% of the company and has been selling without regard to valuation. Bonanno’s sales are probably: (1) to reduce his rather concentrated net worth exposure to HEAR, and (2) he does not like Stark’s combination of HEAR’s core headset business with Hyper-Sound, which he calls a “science experiment.”[4]

Carmine sells at regular intervals but has sold most of his original 5 million shares (10% stake). As of the latest Form 4 (filed September 21, 2016), he is down to 407.6K shares, so his selling is almost complete. Since I started writing this idea, the stock is already up 30% from $1.00 to $1.30 – part of this could be that Carmine is out of “powder” and can no longer depress the share price. Alternatively, if HEAR sells the Hyper-Sound business, Carmine might be appeased and stop selling when that happens. Whatever the reason, his selling is regular and appears more in protest rather than reflective of fundamentals. Given the $300-400K daily trading volume I would speculate that Carmine’s sales has been what’s preventing HEAR stock from going higher, despite strong 1Q16 and 2Q16 numbers. But that’s why the opportunity exists.

Valuation:

The best way to value HEAR is to consider its core headset business as a standalone business and guess as to how much Hyper-Sound could fetch in a sale as icing on the cake. It appears to me that HEAR is quite adamant about selling Hyper-Sound so this “sum-of-parts” valuation makes sense.

Going forward, Turtle Beach stock price will be driven by (1) the console cycle, (2) increase sales / market share of Turtle Bay products, and (3) profit margins and cash flow. The new console cycle appears to be at still early stages with strong sales in both consoles and game-related headsets. We are only a few years in the total life cycle of the PS4 and Xbox One and analysts predict that still 2/3 sales in this cycle are yet to come. 2015 marked the first time that the installed base of the fourth generation consoles exceed that of the third (see charts below taken from HEAR’s investor presentation).

hear-chart

Source: Turtle Bay May 2015 Investor Presentation

Industry participants expect the next few years to remain extremely strong for video game headsets – the market dominated by Turtle Beach with 40% market share. Below are several statements taken from public earnings calls of competitor Skullcandy (which sells gaming headsets under Astro brand) and Mad Catz Interactive. Newer version of the Xbox One and Play-Station 4, such as the Neo, will probably help the market grow as well.

  • “The gaming industry is an exciting industry, right, like everywhere you read, I think people are more excited about the growth opportunities in the industry. It’s – more people play games – and I was reading that the other day, more people play games now than they watch movies or listen to music” ~ Karen McGinnis, CEO of Mad Catz, 4Q16 earnings call
  • “Now to Astro, which is also killing it at retail… domestic sell-through increased 24% over last year ahead of strong teens industry growth… This occurred despite the fact that demand exceeded our supply during this past holiday season and retail shelves were literally bare of certain Astro’s SKUs at various times… We believe Astro can be a much bigger business… the gaming headphone market seems to be accelerating faster…Astro brand sales were exceptionally strong.” ~ Seth Darling, CEO of Skullcandy, 1Q16 earnings call
  • “I believe that Astro has the potential to grow into a dominant gaming company. Gaming is such a strong trend and Astro is at the top of the most desired performance products in gaming audio… This is a dynamic period for the gaming industry. Participating rates are growing rapidly as the new consoles continue to sell well.” ~ Seth Darling, CEO of Skullcandy, 1Q16 earnings call
  • “Gaming had such a strong end to year in Q4” ~ Jason Hodell, CFO and COO of Skullcandy, 4Q15 earnings call

HEAR ended 2015 with $163 million of revenue, 80% from headsets to new consoles and 20% from old-console headsets. Revenue has declined every year from the 2012 “peak” of $207 million, but that’s because of the rapid drop in old-console headsets. In the first half of 2016, revenue from new-console headsets increased 76%, but the continued decline of 65% in old-console revenue offset much of the consolidated growth, which beat expectations at 26% y-o-y. The real growth should come in 2017 and beyond as the drag from old-console headset sales disappears. I model 15% growth in each of the next three years as Turtle Bay continues to assert its dominant position in a mid-teens growth industry. HEAR has been able to take market share despite 40% market share already but I just assume industry level growth going forward. I expect HEAR to generate over $200 million in revenue by 2018 and possibly $230 million or higher in 2019, beating the previous “peak” back in 2012.

HEAR is guiding $12 million in adjusted EBITDA for 2016 from headset sales. That translates to about 7% EBITDA margins. EBITDA margin was 1.5% in 2015 due to the promotions related to clearing out old-console headset inventory. Back in the previous cycle peak, the company generated a 22% EBITDA margin on $207 million of revenue, so 7% margins for 2016 appears quite achievable. The company has mentioned that 10% EBITDA margins are probably more realistic going forward but I feel the experience of last few years had made them very conservative. Management believes 20% EBITDA margins (from 2011-2012) is not realistic – very few electronic hardware companies have 20% EBITDA margins. The company grew “too fast” back in 2011-2012 and didn’t invest enough, so they are targeting 10% margins going forward, and probably will move that a bit higher when it is reached. . At a 10% EBITDA margin, that’s $20 million of EBITDA, which compared to current TEV of $94 million, is a 4.7x EV/EBITDA.

The nearest comp is Skullcandy which has traded anywhere from 5-13x EBITDA over the past 5 years. However, SKUL includes a slower growing regular headset market in addition to their Astro gaming product line, which makes the comparison to HEAR’s pure, faster-growth gaming headset business imperfect. If anything, HEAR should be valued at the higher end of the 5-13x range given its dominance and growth.

As a crude reference, SKUL bought Astro in 2Q 2011 for $10.8M, or 1x sales. At 1x expected sales of ~$167M for 2016 (likely conservative), that translates into $167M of TEV, which translates into a $2.00-$2.30 stock price after netting out debt.[5] Takeout multiples are less precise but indicative that HEAR shares appear undervalued. A takeout could make sense at these valuations given that HEAR could be a strategic asset to a larger company like MSFT or Sony. Moreover, this assigns zero value for Hyper-Sound.

Two years ago, Wedbush published a report valuing Hyper-Sound at a $100 million valuation in itself.[6] The company also used a 12x EBITDA for Turtle Beach’s core headset business, but the numbers were caught off guard by rapid drop in revenue related to 3rd generation consoles. Hyper-Sound’s value today is anyone’s guess, but the technology seems to have improved in the past two years (management says that far more IPs have been filed since), despite uncertainties with commercialization.

The company wants to focus on the core headset business and has hired Piper Jaffrey to pursue strategic options with Hyper-Sound. The company is planning to either 1) pursue a sale altogether, 2) spin out Hyper-Sound as a separate publicly-traded vehicle, or 3) find a way to license Hyper-Sound to someone else for a royalty. Regardless of the result, management seems determined to monetize the inherent value of Hyper-Sound and focus on growing core headsets. My guess is they eventually find a buyer.

Just a few years ago, as a publicly listed company under Parametric Sound, Hyper-Sound had a market cap of over $130 million. Even if they sell for 1/3 of this value, that would yield $40+ million of cash that can be used to pay off the $54 million of debt and preferred liabilities – significantly deleveraging the company. As a quick exercise, if they sold Hyper-Sound for $40M of cash, net debt would come down to $14 million, TEV would be around $60 million, making the stock trade at 3x EV/EBITDA (assuming $20M EBITDA) for the core headset business – far too low.

HEAR also has $44 million of federal NOLs and $20 million of state NOLs that don’t expire until 2029. The significant NOLs could shield HEAR from tax expenses when pre-tax earnings turns positive. While this is more icing on the cake, note that the $64 million of NOLs > current market cap of $50 million, suggesting just how much HEAR equity may be undervalued if headset sales continue to do well for the foreseeable future. Management has said that the core headset business generates positive pre-tax profit and levered free cash flow – which means it will likely be able to realize the value of the NOLs once the Hyper-Sound related investments are removed from the financial statements to reveal “clean” headset segment figures.

While the company had $38 million of interest-bearing debt as June 30, 2016, none are due before 2018, and the company should generate enough EBITDA and cash flow to pay interest and principal upon due or to refinance the notes. In addition, while share issuances to fund debt repayments are also possible, we don’t think it is likely at current stock price level.

Insiders may be prohibited for purchasing more shares given HEAR is currently in strategic talks with Piper Jaffray about Hyper-Sound. Back in Feb 2016, the company did a private placement of $1.7M for $1.00 per share, and current CEO Juergen Stark purchased $150K at $1.00/share. He has not sold to date.

Stripes Capital LLC holds about 36% of the company via VTB Holdings. Moreover, the Chairman of HEAR’s board, Ronald Doornick (a partner at Stripes), holds another 3% stake. Juergen Stark, the current CEO, only holds 0.48% of the shares – we are a bit disappointed that his ownership level isn’t higher but we feel this doesn’t materially affect the thesis.

In July 2015, HEAR also issued to VTB and Ronald Doornick warrants to purchase 1.7 million shares of the HEAR common stock at $2.54 / share – which is over 100% higher than the current price. The warrants have a period of 5 years (expires July 22, 2020). Along with this, a variety of other small-sized warrant deals all have exercise prices far higher than the current stock price, so we believe management is correctly incentivized to get the stock price higher.   

tb chart 2.pngSource: Bloomberg

The chart below shows all insider buys (green) and sales (red) of HEAR stock in the past 3 years – pretty much all of the sales on the screen are price-indiscriminate sales by the original founders Fred (a little) and Carmine (a lot). Neither are involved in the current management of the company and both are retired. Carmine is actually almost done with selling his stake (as of Sept 22, 2016) but Fred could possibly start selling in the future which may temporarily depress stock price yet again.

tb chart 3.png

Source: Bloomberg 

Conclusion:

Investing in microcaps is not without risks and HEAR is no exception. But I think the strong fundamental growth, HEAR’s dominance in video game headsets, the potential imminent sale of Hyper-Sound, and the termination of rogue, indiscriminant selling by Carmine, are all catalysts that could propel the stock much higher when the smoke clears. A takeout is also possible.

Risks:

Nevertheless, possible concerns (non-exhaustive):

  • Competition or price wars in video-game headsets (HEAR’s core biz)
  • Reliance on retail channels
  • Obsolescence of technology
  • Surprises in the duration of the 4th generation console cycle
  • Hyper-Sound unable to fetch a buyer
  • F/X volatility and impact on overseas sales (core market is still US)
  • Mold or other product recall issues that harm sales/brand image
  • Inability to service $54 million of net debt (including preferred stock)
  • Manufacturing delays (Skullcandy alluded to this as a problem)
  • Active management (CEO, CFO) owning too little of stock
  • Additional equity issuance (mitigated if Hypersound is sold and cash used to de-risk the balance sheet)

[1] http://finance.yahoo.com/news/parametric-sound-corporation-merge-turtle-211000256.html

[2] HEAR 2015 10K, pg. 4

[3] See Stripes Capital’s page on Turtle Beach here: http://www.stripesgroup.com/investments/turtle-beach

[4] Call with HEAR Investor Relations

[5] [$167M TEV – 54M (net debt + preferred)] / 49M TSO = $2.30/share

[6] http://seekingalpha.com/news/1726323-wedbush-starts-parametric-at-outperform

 

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