Turtle Beach Corporation (TBCH) Q3 2015 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Third Quarter 2015 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. I would now like to turn the floor over to your host, Cody Slach. Please go ahead.

Thank you, Kameron. Good afternoon, everyone, and welcome to the Turtle Beach Corporation’s third quarter 2015 earnings call, apologies for the short delay. We had a technique glitch getting today’s earnings release uploaded. However, it is live now. 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 www.corp.turtlebeach.com. In addition, 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 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, 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 risks factors contained in today’s press release and in our filings with the Securities and Exchange Commission, including without limitation our most recent Form 10-Q and our other periodic reports, which identifies specific risk factors that also may our 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 can find a reconciliation of these metrics to our current 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 Chief Executive Officer. Juergen?

Thank you, Cody, and good afternoon, everyone. Thanks for joining us for a review of third quarter 2015 results. First, I’ll share some highlights of the business before passing the call to our CFO, John Hanson, who will provide details on our financial performance. I’ll then return to share some additional commentary as well as our outlook. In the third quarter, we continued to execute on the critical areas of our business that we expect will drive sustained growth and improve profitability. Revenues, gross margin, and EBITDA were all up versus third quarter of 2014. With the recent successful launches of additional new headset models, we are now largely complete with a multi-year transition of our product portfolio from old generation to new generation console headsets. Out of our 18 core old generation models, we’ve now wound down or end-of-life 13 of the 18 or roughly three quarter of our portfolio. This does not include winding down approximately a dozen licensed models over the past two years as well. As we’ve communicated in the past quarters, winding down products is messy and expensive from a margin standpoint. So to be largely through this process positions us well for the quarters to come. On the flip side, we’ve now launched 16 core new headset models for new generation consoles, many that were first to market indoor with industry-leading capabilities. This is more than five years worth of new product launches compressed into two years, and has resulted in us having the best and broadest line of headsets for Xbox One and PlayStation 4 platforms. Reaching this milestone was an incredible accomplishment, and I want to thank our team for their hard work over the past two plus years to get this done. From an execution standpoint, our headset products launched this plan and have received excellent reviews and strong retail placements consistent with our reputation for high-quality products and category leadership at retail. We believe this is a great indicator of what’s to come as we also expect the new generation console active user base to surpass the old generation user base in the current fourth quarter based on the latest industry estimates from DFC. We believe an even better measure of our brand and product strength is sell-through data we monitor from NPD. According to their latest U.S. retail sales data, Turtle Beach is the leading player in the market in terms of new gen headsets sell-through measured in units. In fact, through September of 2015 at 1.6 million units in the U.S., we have sold over half million more new gen headset units since launch of the platforms than our closest competitor. Four of the five top-selling third-party Xbox One headsets and three of the five top-selling third-party PlayStation 4 headsets are Turtle Beach. Year-to-date, Turtle Beach has the top-selling third-party headset for every console platform period. We believe our track record, brand loyalty, and strong market share position is based on launching high-quality products with industry-leading innovations that enable our customers to have a more immersive and competitive gaming experience. Speaking of innovation, on the HyperSound side of our business, things continue to go well during the third quarter in terms of preparing the channel for the launch of HyperSound Clear. We signed and announced new channel relationships with Beltone East and Battery Benelux, and established a partnership for White Glove Installation with CaptionCall. In October, we successfully launched our HyperSound Clear healthcare product with shipments beginning to the channel. This was a big milestone after almost two years of hard work and investment to commercialize this completely new type of audio technology for home entertainment. For those of you new to our company, HyperSound technology is a fundamentally new approach to sound delivery that generates a highly directional narrow beam of audio in the air. Similar to how a flashlight directs a beam of light, HyperSound clear directs a beam of audio to targeted listeners, which has been shown to improve sound clarity and speech intelligibility for individuals with hearing loss. We have an extensive and growing portfolio of patents on this technology. HyperSound Clear works in parallel with the audio from the TV or home theater system, so person with hearing loss will experience immersive 3-D audio when sitting in the HyperSound beam, while everyone else in the room hears the audio from the TV speakers or home theater system at normal volume level. This means that people with hearing loss along with family members and friends can once again all enjoy the latest home entertainment together. During Q3, we also began production of multiple headset models and HyperSound Clear with Foxconn, the world’s largest contract manufacturing company. That completed a nine-month transition out of one of our previous gen – previous manufacturing partners and into Foxconn, enabling a relative cost savings on headsets and the production of HyperSound Clear in Mexico. This partnership provides us with excellent capabilities and geographic flexibility on production in the future. One note on the recently announced recall, in cooperation with the U.S. Consumer Product Safety Commission on October 20, we voluntarily recalled approximately 60,000 XO4 Stealth headsets. Given our long-standing reputation for delivering high-quality products, we believe that recalling these units was in the best interest of our consumers. The number of units being recalled is a small percentage of the millions of units of headsets that we shipped in a year. While this is a rare event that has never occurred for us before, we are working with our manufacturing partners and believe we have taken all necessary steps to help prevent this in the future. We are also in the process of working with the responsible manufacturer to provide replacement units and address associated costs. I’ll provide more context on the – our headset in HyperSound businesses and outlook after John’s discussion of the third quarter financial results. John?

Thanks, Juergen, and good afternoon, everyone. Our third quarter had several important financial accomplishments. All of our key performance indicators were up compared to the same period last year, as we delivered 8% revenue growth and 340 basis points of improvement in gross margin. Sales of our new generation headsets several of which feature first and only innovations also increased by 69% from the third quarter last year. Year-to-date, these headsets have generated gross margin roughly 1,000 basis points higher than our previous generation models. With our Foxconn transition and logistics consolidation complete as well as the launch of HyperSound Clear, we believe we are well positioned to deliver strong results going forward. Now jumping into the numbers. Sales from the third of 2015 increased 8% to $35.9 million compared to $33.3 million in the same year ago quarter. The increase was attributable to a gain in domestic sales with new gen sales up over 50% from the third quarter 2014, which outpaced an overall decline in sales of old generation headsets. The increase was partially offset by lower international distributor sales and the negative impact of foreign currency, primarily the euro, which lowered our sales by approximately $600,000. So on a constant currency basis, our third quarter sales were up 10%. Gross profit for the third quarter increased 23% to $9.6 million compared to $7.7 million in the year ago quarter. Gross margin increased 340 basis points to 26.7% compared to 23.3% in the year ago quarter. The increase was primarily due to a product mix shift to the higher margin new gen headsets, including the release of certain new models for the holiday season and the continued channel mix shift to higher margin domestic revenues. These benefits were partially offset by higher royalty costs and the negative impact of promotional credits in order to continue clearing old generation inventory. As we’ve stated on previous earnings calls the transition from old gen to new gen consoles has put pressure on our operating results and the decline in old gen consoles and associated accessories has been faster than we or industry analyst expected. When analyzing our business, we think it’s important to understand the performance of the declining old gen headset segment separately from the rapidly growing new gen segment, particularly given the fact that we were and are one of the largest providers of hardware accessories for consoles and had a far larger business in Xbox 360 and PlayStation 3 headsets than any other company. As the old gen segment has declined faster than expected, we’ve had to respond with promotions in credits to help our retail partners move their inventory, which impacted gross margin by approximately 100 basis points in Q3. So good news is that old gen continues to be a smaller part of our business, in fact, it stands at under 30% of our revenues for the year, in contrast to 100% of our business two years ago. Obviously, the old gen will continue to decline as the share of our business as that console generation winds down. Third quarter operating expenses were $15.3 million compared to $15.1 million in the same year ago quarter. The slight increase was primarily attributable to higher costs associated with additional head count to support the HyperSound Clear commercialization, increased legal and financial costs, and incremental stock compensation expense. These costs were partially offset by operating expense reductions in other functional areas. Adjusted EBITDA for the headset business improved to $0.3 million in the third quarter from a loss of $2 million in the year ago quarter. Adjusted EBITDA on a consolidated basis improved to a loss of $3.3 million, reflecting investments of approximately $3.6 million in the HyperSound business, compared to an adjusted EBITDA loss of $4.5 million in the year ago quarter. We reported a net loss for the third quarter of $15.9 million, or $0.38 per diluted share, compared to a net loss of $5.6 million, or $0.13 per diluted share in the same year ago quarter. The decline was due to a $10.5 million non-cash expense recorded in connection with a valuation allowance on our deferred tax assets. Given that the majority of our annual headset business revenues were generated through the holiday season of September through December, we reassessed our valuation allowance requirements, taking into consideration the latest forecasted net taxable loss for the current year. This does not mean in any way that we will lose our ability to utilize our net operating losses. But as a result of cumulative losses in recent years, primarily due to incremental costs associated with the console transition, Parametric acquisition costs, financings, and initial investments in the HyperSound business, we concluded that a full valuation allowance was required. If you were to exclude this non-cash charge, net loss in the third quarter would have been $5.4 million, or $0.13 per diluted share flat to the third quarter of 2014. Now turning to the balance sheet. At September 30, we had cash and cash equivalents of $3.1 million compared to $7.9 million at December 31, 2014. The decrease in cash from year end is due to our HyperSound investments in higher purchases to support our Foxconn contract manufacturer transition. Total inventory as of September 30 was $49.7 million, a 7% increase from $46.6 million a year ago. We were carrying a higher level of inventory to support the contract manufacturer change, and we now expect inventory levels to decline to historical levels. Outstanding debt principal at September 30 was $56.3 million compared to $44.6 million at December 31, 2014. The debt consisted of $20.6 million of borrowings under the company’s revolving credit facility, $14.3 million of subordinated debt, and term loans that totaled $21.4 million. The increase in debt was due to the establishment of the new $15 million term loan in the third quarter, which improved the capital structure and enhanced liquidity. Please also recall that the September through November timeframe typically reflects the maximum borrowing on our asset-based loan, as we ramp inventory ahead of the holiday season. And now I’ll turn the call back over to Juergen for some additional comments on the business and our updated outlook. Juergen?

Great. Thanks, John. I’ll provide some further context in our headset and HyperSound businesses and our expected outlook. As mentioned earlier, we successfully transitioned manufacturing partners for Foxconn, along with our recently announced global logistics partnership with Keuhne + Nagel, we believe we have executed on several key parts of our supply chain strategy. This strategy is designed to support market expansion as we manage costs, optimize inventory, maintain superior product quality, and enable flexibility for regional manufacturing over time. Our strong portfolio new product launches and supply chain improvements have produced improved headset sales and product margins. However, as we have previously disclosed, the strong dollar can have a significant impact on our international business that goes well beyond simple constant currency calculations. In most European countries and in Australia, we sell through distributors and those partners buy in dollars. The strong dollar increases their product costs in local currency reducing their margins or forcing them to raise prices, which lowers our sales. We’ve also seen some weakness in our UK business, where we sell direct to retailers. So far we’ve been offsetting some of this pressure with strong domestic performance, which we expect to continue. But following the third quarter, it has become clear that Europe and Australia will create $10 to $15 million of pressure on our roughly flat revenue guidance for the year. We’ve not been sitting still for this. In addition to actively working with our distributors, we have now moved two large pan-European retail accounts to a direct sales model. That transition has created some short-term revenue gaps, but we have already started to realize increased margins and market share benefits. And this move should help offset some of the issues created by today’s strong dollar in the future. In addition, we’ve made a decision to delay certain investments in China, given that the console market has not yet begun a meaningful ramp, due to lack of compelling multiplayer games, and we are intentionally restructuring our distribution in Latin America. These are both currently small markets in terms of revenue for us. But together our actions in China and Latin America are expected to reduce revenue in 2015 by roughly $2 million relative to 2014, and about $5 million relative to our prior revenue guidance for the year. Despite these near-term headwinds, we remain confident that our international markets provide compelling long-term growth opportunities for our gaming headset business. Like the U.S. we are the market share and brand leader in the UK by far, and recent sell-through data shows excellent progress in other regions with a growing share in Germany and France. A key part of our plans for 2016 will be continuing to look at how to better accommodate the strong dollar and driving growth in China. During the all important holiday season, we expect our robust North American market to benefit from the broadest most advanced product offering in the industry during a period, where the number of new generation counsel users is expected to surpass those of old generation consoles. October also marked the official launch of HyperSound Clear. This was more challenging and took longer than we had planned. In addition to the innovations on the product itself, we’ve developed significant new capabilities on how to reliably mass produce the unique new type of ultrasound speaker used for HyperSound. As I previously stated we would only launch this product when we were confident we could support production with high-quality and high customer satisfaction. We are very pleased to have achieved this major milestone. Our priority now is to execute a well controlled successful ramp of this new business versus trying to maximize revenues in the first months. We will be rolling out the product into groups of hearing health care provider offices, starting small to ensure proper training, good workflow, high customer satisfaction, and then tweaking any required aspects as we scale from there. So far, we’ve experienced strong initial preorders and have begun our stage rollout to our partners, some of which represent the largest corporations in hearing healthcare. In fact, we’ve secured partnerships with industry-leading channel partners that collectively represent about 4,000 hearing healthcare offices and retail locations in the U.S., or roughly 30%, or roughly 30% of the total points of distribution. And consumer feedback on the product continues to be very positive. We are encouraged by the initial channel reception and expect the moment to continue, as we further rollout this incredible new product. With all this in mind, I’d like to now address our financial outlook for the fourth quarter and full year. Starting with Q4, we’ve revised our outlook and now expect net revenue for our headset business to range between $82 million and $92 million, compared to $91.8 million in the quarter – year ago quarter. This revision is due to my aforementioned comments regarding the international markets. Headset gross margin was expected to improve and be in the range of 31% or better, compared with 28.2% in the year ago quarter. Despite the delay in HyperSound’s launch, revenue is expected to be approximately $2 million in the fourth quarter with net investment on an adjusted EBITDA level expected to range between $3.3 million and $4.3 million. This also reflects a gradual conservative pace of ramping offices as I’ve discussed. Our gross margin target for HyperSound remains 50% long-term, but gross margins are expected to be lower for the first three to four quarters, while we improve yields, optimize product costs, and drive fixed cost leverage with increasing revenues. Headset adjusted EBITDA is now expected to show improvement over the $13.7 million reported in the fourth quarter of 2014. Consolidated adjusted EBITDA is expected to range between $9.5 million and $13 million, compared to $10.4 million in the year ago quarter. Net income on a consolidated basis for the fourth quarter is expected to improve to a range of between $3.5 and $7 million, or $0.08 and $0.16 per diluted share, compared to $2.4 million, or $0.06 per diluted share in the year ago quarter. For the full-year of 2015, we’ve also revised our outlook and now expect headset revenue to range between $160 and $170 million, compared to $185.5 million in 2014, with the vast majority of the reduction being a result of the international sales issues I’ve discussed. Please also keep in mind that 2014 included over $15 million in additional revenues during Q1 of 2014 from the delayed 2013 Xbox 1 headset launch, making the annual comparison a bit challenging. Headset gross margin is expected to be at least 26% reflecting good progress on margin improvements, as shown by third quarter results and expected fourth quarter results, but reduced operating leverage due to lower revenues annually in the annual impact of the credits and write-offs taken during the first and second quarters. Revenue from HyperSound is expected to range between $2 and $3 million in 2015 with net investment on an adjusted EBITDA level, ranging between $13 and $14 million. This investment is higher than expected due to the later launch and more conservative ramp plans, as I’ve discussed. Headset adjusted EBITDA in 2015 is expected to be between $2 and $5 million with consolidated adjusted EBITDA loss expected to range between $12 and $8 million. Net loss on a consolidated basis in 2015 is expected to range between $33 million and $29.5 million, or $0.78 and $0.70 per diluted share. A reconciliation of the non-GAAP financial figures is available in the press release we issued prior to the conference call, which is available on our website. As a result of some of the same issues as we disclosed last week, we’ve amended the covenant terms with both our lenders to provide additional flexibility for the September, October, and November periods. And we will be working to make longer-term adjustments to accommodate our plans and needs for 2016 and beyond. Before we turn it over for questions, I’d like to add some perspective to my commentary on our outlook. Over the past two plus years, we’ve managed through an industry transition that took out more than 70% of our core business, headsets for Xbox 360 and PlayStation 3. It required the launch of a whole new product portfolio for Xbox 1 and PlayStation 4, which we have by far led the industry in executing. And we believe we are now largely passed this transition. Keep in mind that we were about four times larger than the next largest player in the console gaming headset market. So this transition was considerably more challenging for us to manage through than anyone else in the headset category. Despite this, we were first to market with headsets for both new consoles. We delivered fully wireless headsets for Xbox 1 customers nine months ahead of anyone else and continue to lead with three fully wireless models. We still have the only console gaming headset with DTS Headphone X surround sound, noise canceling, or our amazing superhuman hearing capability. As a result of all this, we are the clear category leader with every major gaming retailer. We’ve increased our technology in innovation lead and positioned ourselves to continue to lead from a brand, consumer, product, and operational standpoint. That is a good place to be, particularly with the majority of new generation console sales still expected to come for the latest DFC industry estimates. Indeed while new generation console sales are expected to hit over 50 million units sold life to-date by the end of 2015, DFC estimates more than a 100 million more units are yet to be sold in 2016 through 2019 period. On the headsets, our focus going forward will be to grow top line and profitability. While our full-year comparable results are impacted by write-offs and margin reductions in the first-half of the year associated with old gen transitions and then annual comparison incorporating first quarter of 2014, which included over $15 million of sell-in from the delayed 2013 Xbox One headset launch, both third quarter actuals and fourth quarter guidance show improvement in margins and profitability compared to the same period last year. We believe we’re on the right track. We have an industry leading portfolio for new generation consoles. We are still only at the beginning of what is expected to be a thriving growing console gaming market for the coming years. And while we are largely done with our portfolio transition, we do have a few more technology innovations that we’ve been working on for almost two years that we expect to come to market in 2016. We believe we have an additional growth opportunities from a recovery in Europe, as well as continuing to grow market share in this important region for Turtle Beach. China for us remains largely untapped. In addition to the potential console market growth in China, we believe we have opportunities to grow our PC gaming headset business there and in other parts of the world. We have opportunities to continue to improve margins as old gen winds down, and from the operational strengths we put in place, and we will continue to closely manage our operating expenses in the headset business. On HyperSound, our focus going forward will be to successfully ramp the healthcare product and get that business to cash flow break-even. We are shipping the product, it works. It’s highly patented and has proven benefits for global population of 350 million people with hearing loss. The product is currently purchased by this population today hearing aids generate a nearly $6 billion market, and hearing aid penetration is typically below 25%. While we are going to execute a careful control ramp of this business, we believe it is a significant market opportunity. And that leaves out the potential other new applications for directed audio in other markets. For example, we’ve demonstrated success with commercial retail displays using HyperSound, including the release of market data that shows the sales benefits of adding HyperSound to retail environments. While we’ve intentionally put very few resources into this segment of the market in 2015, in order to focus on the hearing product, it is starting to show good steady growth. And as I’ve indicated in the past, we are making good progress demonstrating the possibility of transparent HyperSound in admitters [ph]. Over time, we plan to look at additional opportunities in consumer audio, healthcare, and commercial markets with HyperSound. Given all the complex dynamics that affected our headset business over the past two plus years, as well as our simultaneous commercialization of HyperSound to a revenue-producing enterprise, we believe we’ve executed very well on all of the product and operational aspects of our business. We believe this will lay the groundwork for years to come. I’m very proud of our team for that and thank them for all of their continued dedication and good work. Going into 2016 with a product portfolio transition largely behind us, proportionally lower old gen headset sales, growing new gen headset sales, and HyperSound Clear now launched, we believe we are well positioned to drive top line growth and increasing profitability. Operator, we are now ready to take your questions.

Thank you. [Operator Instructions] And our first question comes from the line of James Medvitz with Cowen and Company. Your line is now open.

Hi. Good afternoon, folks.

Good afternoon.

Hi, James.

Good. For a second, I apologies, you could hear me, you need some special headphones.

We’re always ready with special headphones if you need them.

Yes, we’ll come back. So I don’t really have a lot of questions. I guess, I could ask,when you think about the fourth quarter or – I’m just kind of looking at the expense run rate here, they were a little bit lower than we had expected and good job controlling them year-over-year especially sales and marketing. But is there anything that would stop those from rising with the big increase in sales in Q4, or do we have kind of a big ramp in these expenses?

No, we’ve been very diligent the whole year actually to control our expense on the headset side, which we’ve done, in order to enable us to continue to kind of investing fund in the HyperSound part of the business. So overall, we don’t expect any meaningful surprise in OpEx on Q4. Our marketing typically does go up in Q4, and that’s all baked into our guidance for Q4.

Okay. I guess, I was a little unclear. I probably didn’t ask the question well. So expenses have been running excellent on, since sales and marketing have been running lower year-over-year. Should we expect the same sort of pattern to be there in the fourth quarter?

No, they’ll be slightly higher in Q4, based on additional sales commissions and marketing spend. We tend to focus on media investments, which are well over $1 million in Q4, along with the holiday selling cycle.

Okay. So I was speaking about year-over-year and I referred [ph] to last year?

Yes. The HyperSound spend will increase by a little bit, but the headset business OpEX will be comparable to last year, if not slightly better, yes.

Okay, great. Could you just give a little more detail on the recall? What was the issue?

So the issue was we had small number of headset that indicated the possible presence of more, very unusual, it has not happened to us on the headset business. And we’ve now taken all the actions in cooperation with them U.S. Consumer Product Safety Commission to handle that. And it’s 60,000 units as I mentioned which is a small fraction of the millions of headsets that we sold per year.

Okay. The transition – the manufacturing transition to Foxconn, is that now absolutely complete?

Yes. So we have – what’s really – what’s complete is we are now done with one of our three manufacturing partners. And have now ramped up both headset – some headset models and HyperSound with Foxconn. So we continue to use three manufacturing partners with Foxconn being new and that relationship we would expect to expand over time on the headset front. But we’re now complete in terms of their up and running on HyperSound production, and they are up and running on multiple headset models.

And when I say the transition is complete, so inventory is realigned, costs are running at full capacity type levels?

Yes, we – coming out Q3, we still have a little bit of additional inventory that were essentially advanced purchases from the old manufacturing partner that we’ve wound downwards. But by the end of the year, we expect inventory to be very well aligned, in fact, expect to generate cash from an additional improvement in our overall inventory levels.

How much of the – roughly $50 million of inventory is old generation headset?

I think that would be a good question after the holiday period, we’d have to get that things, and I don’t think we’ve broken out in the past. But overall, we carry a level of old gen inventory to support holiday sales. There are still some products in there that are in the wind down category, right? So those are still in process, but a lot of it is behind us and coming out of Q4 when – on our next earnings call would be a good time to kind of let everybody know when – how we look in terms of the old versus new inventory.

All right. Great. Thanks. Yes, look forward to talking to you soon.

Thanks, James.

Great. Thank you.

Thank you. [Operator Instructions] And I’m showing no further questions at this time. I would like to turn the conference back over to management for any closing remarks.

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

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program. You may all disconnect. Everyone have a good day.