Turtle Beach Corporation (TBCH) Q3 2020 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Third Quarter 2020 Conference Call. Delivering today's prepared remarks are Chairman and Chief Executive Officer, Juergen Stark; and Chief Financial Officer, John Hanson. [Operator Instructions] Before we go further, I would like to turn the call over to Sean McGowan of Gateway Investor Relations, Turtle Beach's IR adviser, as he reads the company's safe harbor that implies important cautions regarding forward-looking statements. Sean, please go ahead.

Thank you, Joelle. On today's call, we will be referring to the press release filed this afternoon that details the company's third quarter 2020 results, which can be downloaded from the Investor Relations page at corp.turtlebeach.com. There, you will also find the latest earnings presentation that supplements the information discussed on today's call. Finally, a recording of the call will be available on the Investor section of the company's website later today. 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. While the company believes that its expectations are based on reasonable assumptions, numerous factors may affect actual results and may cause results to differ materially. So the company encourages you to review the safe harbor statements and risk factors contained in today's press release and in its filings with the Securities and Exchange Commission, including, without limitation, its annual report on Form 10-K, most recent quarterly report on Form 10-Q and other periodic reports, which identify specific risk factors that may also cause actual results or events to differ materially from those described in our forward-looking statements. The company does not undertake to publicly update or revise any forward-looking statements after this conference call. The company also notes that on this call, we'll 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, and you can find a reconciliation of these metrics to the company's 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 Chairman and Chief Executive Officer. Juergen?

Good afternoon, everyone, and thank you for joining us. We are extremely pleased to deliver another record quarter and again raise our guidance for the year. Our third quarter sales of $112.5 million, up 140% year-over-year, reflect the continued strength of our brand and product portfolio, including our expanding line of PC gaming accessories as well as another quarter of phenomenal execution in all areas of our business. In the past months, we've again exceeded, on all fronts, the goals we articulated to maintain or lead in console gaming headsets, drive growth in PC accessories, maintain a healthy balance sheet and execute well in this unusual and dynamic environment. This has us tremendously excited about our future. I couldn't be more proud of our team, who, in many cases, has accomplished this from their kitchen tables, make-shift home offices and amidst the many other constraints the COVID situation has put on all of us. The Q3 results speak for themselves. We've set records for revenues, margins and EBITDA, which John will cover in more detail. Here are the 3 key drivers of our strong top line results. One, the market for console gaming headsets continues to be very strong. Using NPD data for North America, sell-through was up 46% year-over-year in dollars for Q3. We believe the factors we laid out last quarter continue to drive strong demand. Higher gaming engagement, the continued influx of new and lapsed gamers, as well as consumers buying gaming headsets for working, schooling and socializing at home. Two, we didn't just ride the coattails of a strong market. Once again, we significantly outperformed the market, which was a major factor in our quarterly results. With the North American market up 46%, sell-through of our console gaming headsets was up 76% in dollars. Our revenue share was over 50%, and our share of the units of headsets shipped was over 60%. In fact, excluding the increase in units we supplied and sold through in Q3 from the North American market numbers, the rest of the market was only up 2% on a unit basis. Our ability to continue to execute on supply, logistics and retail operations played a key role in our exceptional market share performance. As one example, Q3 factory headset production in units was almost 90% of our total 2019 headset unit production. Of course, our market share continues to be a testament to the strength of our brand and product portfolio. As an example, we recently launched successors to our top-selling STEALTH 600 and 700 line of wireless headsets for Xbox and PlayStation. These are phenomenal headsets, the best we've ever produced at these compelling price points. Both new STEALTH 600 models, Xbox and PlayStation, are already in the top 4 revenue products in the U.S. per NPD for September. And one of the models achieved this with only a partial month of sales because the model launched partway into September. In September, all 8 of the top 8 selling console headsets in the U.S. were Turtle Beach. Three, we continue to make exciting progress with our PC gaming accessories. During Q3, we launched the first of our new line of PC headsets, 3 ROCCAT Elo models that have received rave reviews. One professional reviewer couldn't seem to get past the fact that our entry-level $49 model sounded better than his far more expensive headsets. These headsets all apply the same strengths and capabilities that have made our console gaming headsets bestsellers for years. The $99 Elo Air wireless model, for example, leverages all of the capabilities in our industry-leading STEALTH 600 I just mentioned. I'll cover our other PC gaming product launches later. Of course, everything I've said so far pertains almost entirely to the top line, but our excellent performance goes well beyond just record sales. And as John will review in a moment, our gross margin levels and our operating expense leverage were excellent, strong execution across the board. As a result of the strong third quarter and our view that many of the underlying positive trends over the past quarters will continue in the holidays and next year, we are increasing our sales outlook for the full year to $330 million, which would exceed our prior high revenue mark by over $40 million. With that, I will turn the call over to John to review our financial performance, after which I will come back with some additional comments about what we see for the balance of the year and into 2021. John?

Thanks, Juergen, and good afternoon, everyone. We are pleased to report another very strong quarter of better-than-expected results across all of our financial metrics. As Juergen said, this was a record-breaking quarter, record sales, record gross margin, record adjusted EBITDA, record third quarter operating income, record third quarter EPS, record market share. It is truly gratifying to be able to talk about these results. And as we said last quarter, this is not a fluke. We have built a track record of delivering positive adjusted EBITDA on a 12-month basis going back to 2012. Our gross margins have been strong and have shown consistent operating leverage. And in a year like 2020 when lockdowns presented significant challenges earlier in the year and then drove rapidly increasing consumer demand, we had to overcome significant obstacles in March and April in order to produce excellent results these past 6 months. Net revenue for the third quarter of 2020 was $112.5 million or $111.5 million on a constant currency basis, compared to $46.7 million in the year ago quarter. We had not given specific revenue guidance for the third quarter, but the 140% increase in sales we saw in Q3 put our sales for the quarter at just over 60% of the $185 million in sales we had forecast for the second half of the year. As we've discussed in the past, it's important to look at the consolidated second half rather than just Q3 or Q4, because small changes in timing can result in significant amounts of revenue, and in some cases, expenses being recognized in one quarter versus the other, but results in the same second half outcome. And given what we estimate to be roughly $20 million of early holiday purchasing this year, that is certainly the case this year, even more so than we had expected. Gross margin in the third quarter was 41%, 880 basis points higher than 32.2% we reported in the third quarter of 2019. This increase was driven by several factors: volume-driven fixed cost leverage, lower-than-normal and lower-than-expected promotional spending as a result of the supply and demand dynamics, and favorable business mix, partially offset by roughly $2 million in incremental airfreight cost to facilitate the increase in sales. Operating expenses in the third quarter of 2020 were $21.9 million compared to $17.6 million in the same quarter of 2019. The increase was driven by volume-related selling costs, as well as additional investments to expand our PC accessories business and drive future growth. Accordingly, adjusted EBITDA in the third quarter of 2020 was $27.6 million, compared to $0.3 million in the year ago quarter. This is the highest level of adjusted EBITDA we've ever had in a single quarter. The year-over-year improvement was driven by higher revenue, increasing gross margins and operating expense leverage and includes over $2.3 million of airfreight expense as well as a portion of our investments in growth. Obviously, the bulk of the EBITDA performance above our expectations was driven by higher revenues at higher gross margins, but there were also some expenses like airfreight and marketing, which we had planned for Q3, but will now be in Q4, which is, again, why we look at the second half consolidated, as I mentioned. Year-to-date, adjusted EBITDA is $37.8 million compared to $6.2 million in the 9 months ended September 2019. Net income in the third quarter of 2020 was $17.8 million compared to a net loss of $3.1 million in the year ago quarter, reflecting the trends I just discussed. This was the highest level of third quarter net income in our history. Net income per share in the third quarter of 2020 was $1.04 on 17.2 million weighted average diluted shares outstanding compared to a net loss per share of $0.22 on 14.5 million weighted average diluted shares outstanding in the year ago quarter. Note that the higher share count is primarily a result of shifting from a loss to a profit from the comparable quarter as the diluted share count is higher in profitable quarters than in quarters with a net loss. Adjusted net income for the third quarter of 2020, which excludes changes in the fair value of contingent consideration and modest acquisition integration costs, was $17.9 million or $1.05 per diluted share compared to an adjusted net loss of $2.6 million or $0.18 per diluted share in the 2019 period. Free cash flow, defined as net cash provided by operating activities less CapEx, totaled $28.7 million year-to-date and has increased year-over-year from $25.7 million in 2019. We have delivered positive free cash flow for 3 consecutive years, strengthening our balance sheet and positioning us for growth. As I mentioned in March, our effective tax rate could be higher if we exceeded the full year guidance that we had provided on that call. Since we are significantly increasing our financial outlook for the full year, the full year tax rate for 2020 is now expected to be approximately to 27%. Now turning to the balance sheet. At September 30, 2020, we had $27.3 million of cash and cash equivalents with 0 debt, including no borrowings on our revolving credit line. That's a $46 million net change from last year. Inventories at September 30, 2020, were $79.5 million compared to $67 million at September 30 last year. The increase in inventory was driven by expected earlier retail holiday purchasing and higher revenue run rate for the business. Now I'll turn the call back over to Juergen for some additional comments. Juergen?

Thanks, John. I'll finish with some comments on what we see for the rest of the year and beyond. We believe that gaming has been and continues to be one of the best, if not the best consumer category in which to be a leader. Some call it e-sports, which is really only one aspect of the category. It's entertainment that continues to grow in share of people's leisure time. It's socializing that has become a popular way to get together with your friends. It's competition, including at a professional level that is on track to exceed viewership of many other sports. But at the end, it's all gaming, and we are one of the top few hardware companies in the $5 billion market for gaming headsets, keyboards and mice. We continue to believe that the future for gaming looks very bright. Gaming in general was a strong market segment already coming into 2020, often tracking as the highest growth segment measured by NPD for all consumer retail segments over the past years. The stay-at-home orders have accelerated these positive trends, and we share the view that even when things return to normal, some of the positive dynamics on gaming engagement and ever-expanding popularity of gaming will persist. According to the consulting firm, Activate, time spent by consumers on console gaming with the stay-at-home orders has increased 27%, and more than half of this increase is expected to remain even after things return to normal. Activate estimates that time spent by consumers on PC gaming is up 30% compared to before stay-at-home orders, and that, that increase will be over 10% when things return to normal. In console gaming specifically, we're days away from the launch of new Xbox and PlayStation consoles. According to a recent statement from CEO of Sony Interactive Entertainment, the company presold as many units of the PlayStation 5 in the U.S. in the first 12 hours they were available as it did in the first 12 weeks of PlayStation 4. And Microsoft has said that it's seeing record-breaking demand for Xbox Series X and S. The market research firm, DFC, forecasts a 55% increase in console unit sales globally in 2021 versus 2020, and also forecasts that this higher sales rate will carry through to 2022, which would make both 2021 and 2022 roughly 20% higher than the previous highest year in console unit sales. Given the step function change in realism, with this generation of consoles, I expect these new consoles will do very well, which is a good long-term trend for our console accessories business. Robust growth in the PC gaming category is also very positive for us specifically as we remain on track to more than double our rocket sales versus last year and to increase our market share in PC accessories. I mentioned our new Elo PC gaming headsets earlier. In addition to the PC headsets, we launched 3 new models of our Vulcan PC gaming keyboards. These are line extensions to the Vulcan 121 and 122 keyboards which are top-selling keyboards in Germany year-to-date. Two of the new models are what's called tenkeyless, a smaller keyboard format that's becoming very popular with gamers. And 2 of the models use our new proprietary Titan Optical Switches, which provide response rates up to 100x faster than mechanical keys, ridiculously fast. And yes, that matters to serious high-end gamers. We also launched 2 new PC gaming mouse -- mice, the Burst Core and the Burst Pro. Both of these also use our new Titan Optical Switches, and the Burst Pro features a new extremely lightweight transparent honeycomb shell with really cool organic lighting coming through the shell. This expansion of our PC accessories portfolio is part of where our roughly $12 million growth investment is going this year, along with building the ROCCAT brand. Of course, the ROCCAT brand and products are very strong in the original core market, Germany, and we are making good in the market by gaining market share in PC gaming headsets, keyboards and mice in Q3, all 3 of our targeted product categories. As I mentioned, our first goal is to create an incremental $100 million business in PC accessories, and longer term, our goal is to lead the PC gaming accessories categories for headsets, keyboards and mice. As a result of these positive trends across our entire business, we are further increasing our sales outlook for the year to $330 million from the prior estimate of $300 million. $330 million would put us at over 40% year-over-year top line growth and a 5-year CAGR from 2015 of over 15%, consistent with our long-term objective to drive 10% to 20% top line growth. Let's revisit what John mentioned earlier about the impact of timing on results for the third quarter and fourth quarter. As we said after our second quarter report, we thought that this year could see significant shifts in timing of shipments into retail. Given strong second quarter sell-through and market share, we started the third quarter with low retail inventories, so we factored the necessary retail restocking into our second half guidance. We anticipated that some retailers will purchase earlier this year, which occurred as expected. Market sell-through, and in particular our market share, exceeded our guidance forecast, resulting in the trends on both ends of the quarter, so to speak, being higher than expected. As a result, our increased guidance reflects a 16% increase in total second half revenues with what we estimate to be roughly $20 million of revenues shifted into Q3 from Q4 based on earlier retail holiday purchasing, as John mentioned. And there are a few shifts in timing of expenses as well. Roughly $2 million of airfreight anticipated in Q3 will now be in Q4 to continue to keep up with strong demand, and we are anticipating a shift of a few million of marketing spend into Q4 as well. This is why looking at consolidated second half numbers, particularly this year, is important. We do expect promotional levels to return to normal for the holidays. So for the full year, we expect gross margins to be approximately 35%, reflecting gains due to operational leverage but also significantly higher-than-normal airfreight cost to enable revenues and some impacts from the portfolio expansions we are investing in. Note that given the supply chain initiatives we started 2 years ago, we now get more than half of our product supply from outside China. As a result of the above increased revenue estimates and updates on margins and investments, we expect adjusted EBITDA to be roughly $50 million for the full year, more than 66% higher than our prior guidance of $30 million. The change in EBITDA guidance increases our second half EBITDA guidance by 100%. The EBITDA includes the roughly $12 million of growth investments we've discussed. We expect net income per diluted share for the full year to be approximately $1.80, and adjusted net income per diluted share to be roughly $1.75 per share, both significantly increased from our prior guidance. We're very excited to be one of the few leaders in gaming accessories given all of the continued positive dynamics that make gaming such a great consumer segment. We have the best, broadest line of headsets, a brand consumers seek out, a tremendous retail position and growth opportunities in PC accessories we are already progressing on, and over time, in other gaming hardware categories. Combined with continued strong execution and the best balance sheet we've ever had, we believe we are very well positioned for the future. And finally, but importantly, I would like to once again thank the global Turtle Beach team members who have done an incredible job under extremely challenging conditions. You are all truly what makes this company succeed, and I'm very proud to be a part of this great team with you. Operator, we are now ready to take questions.

[Operator Instructions] And our first question will come from John Godin with Lake Street Capital.

Congrats on the nice quarter. First, as it relates to the new console launches, can you kind of refresh us on the demand cadence over the coming years of that increase in demand for headsets and maybe some historical headset attach rates? And then in the dominant ones, is there any reason to think that those historical trends would be different for these new console launches this year?

Sure. So normally, the trend with new console launches for accessories is that accessories are down the year of the launch as consumers start to wait for the new consoles. And then as the consoles launch in Q4, demand picks up for accessories again. You get some -- again, normally, you get some benefit in Q4, the holiday that they launch. And then typically, you get higher-than-normal sales over the next 2 years for accessories as people re-accessorize their new consoles. This year, those normal trends are clearly out the window because of the stay-at-home orders driving 1 quarter that's nearly double and 1 quarter that's up 50% for the whole market, with us up even more than that. So we expect the new consoles, which are launching in the next few weeks here, to do very well over time, and that should kick off a nice trend for us over the next few years in the console gaming headset category.

All right. And second, with companies pulling in some of their holiday orders to try to ease up on supply chains, is there any reason to expect any potential capacity constraints with your logistics partners kind of going through the rest of the quarter?

That's a great question. Logistics, frankly, have been a challenge, part of the operations and supply chain challenge since Q2, everything from securing airfreight to ocean containers. And we continue to see that in Q3. We factored in some conservatism in the Q4 numbers and the full year guidance based on the fact that we could continue to see some issues with logistics. Airfreight, shipping and even long-haul trucking and last-mile delivery have all been tough, and we have kind of factored that into our view for the rest of the year here.

Okay. And then last one from me. As far as new investments go and capital allocation. I guess as you look out maybe for the next 6 to 12 months, where do you guys think you're going to be able to earn a higher return on net capital going forward now that you've been generating significant amount of free cash flow?

Sure. I think our priority has been and continues to invest in the business, and specifically, to drive long-term growth. We originally came into this year with a $9 million investment plan. We've raised that to $12 million as the business has done, obviously, extremely well this year. And you're already seeing some of the results and the positive dividends that those investments are paying even in our results this year so far, as I mentioned, with the progress that we're making in the PC accessories. So going forward, driving growth, investing in the business will be the priority for use of our capital.

[Operator Instructions] Our next question comes from Elliot Alper with D.A. Davidson.

So I wanted to think about gross margins for the December quarter. You talked about 35% for the year. If I'm looking at it correctly, is it correct to assume about 28% gross margin for the December quarter? I guess what's going into that, if I'm thinking about that correctly. And if you could quantify any kind of uptick in the promotional spending or the increased airfreight, it would be helpful.

Sure. So the gross margin for the year, we expect the fourth quarter to have promotional levels return to normal. We had expected that for most of Q3, by the way. But given blistering, continued sell-through and supply dynamics, that was a big -- it didn't equate in Q3. It didn't come through the way we thought it would, and that was a major driver of the higher gross margins. Q4, we expect things to go back to normal. 28% sounds too low, I'm not sure where you're getting that average. We would expect Q4 margins to be slightly below last year, for example. And the whole difference, call it, roughly 2 points, is airfreight, which we expect to have several million of again in Q4 just to keep up with demand. But otherwise, we're -- our guidance reflects and the full year gross margin referenced reflects kind of a normal Q4 with a bit of additional cost for airfreight.

Okay, helpful. And then continued traction with non-gamers. Last quarter, you talked about the 3 equal parts. Wondering if we should be thinking about that the same way as it was for the September quarter. And then specifically for that non-gamer category, kind of what is that demand looking like? Kind of are there ASPs below the core gamer? And how's the refresh cycle different than kind of your core consumer?

Good question, Elliot. So the data we referenced last quarter of roughly 1/3 of the incremental demand for Q2 -- and remember, Q2 sell-through for the market was nearly doubled, so about half of the sales for Q2 you could call incremental. And we stated that from surveys and analysis we conducted, roughly 1/3 was higher engagement by existing gamers, 1/3 was new gamers coming into the market and 1/3 was non-gaming uses of headsets given that Q2 obviously had an initial very large bump from the start of the stay-at-home orders. Q3 is, as I mentioned before, and I'm just going to use the market numbers, which we've exceeded per my comments, the market was up 46%. And so the market has slowed down, but continues to way outpass last year. So we believe that the continued incremental demand is a result of higher gamer engagement, some new gamers continuing to come into the market and some level of non-gaming purchases of the headsets. We haven't rerun the survey. And when people buy headsets, we don't -- we can't tag them to the purpose, obviously, without actually conducting a detailed consumer survey. So I would expect that portion of it to have come down some, but still be a factor in the higher demand.

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

Thank you very much. We wish everybody safety and good health in these unprecedented times. We look forward to speaking with our investors and analysts when we report our full year results next year.

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