Turtle Beach (NASDAQ:TBCH) Q3 2020 Earnings Call

0:00 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. Following their prepared remarks, the management team will open up the call for any questions. Before we go further, I would like to turn the call over to Sean McGowan of Gateway Investor Relations. Turtle Beach's IR Advisor. As he reads the company's safe harbor, that provides important cautions regarding forward-looking statements. Sean, please go ahead.

0:39 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. Thank you very much. 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.

1:37 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 it will be discussing non-GAAP financial information.

2:23 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?

2:47 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 our lead in council gaming headsets, drive growth in PC accessories, maintain a healthy balance sheet, and execute well in this unusual and dynamic environment.

3:33 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, makeshift 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 three key drivers of our strong top line results. 1. The market for console gaming headsets continues to be very strong. Using NPD data for North America, sell-through is up 46% year-over-year in dollars for Q3.

4:18 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. 2. 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 council 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%.

5:04 In fact, excluding the increase in units we've 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.

5:57 These are phenomenal headsets, the best we've ever produced at these compelling price points. Both new 600 models, Xbox and PlayStation, are already in the top four 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 eight of the top eight selling Council 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, three Rocket ELO models that have received rave reviews.

6:44 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 Council Gaming headsets bestsellers for years. The $99 Elo Air wireless model, for example, leverages all of the capabilities in our industry-leading Stealth 600s 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 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 into holiday 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.

7:56 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?

8:09 Hey, thanks, Jordan, 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.

8:56 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 six 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.

9:47 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 Thank you for joining us. This increase was driven by several factors.

10:36 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 air freight costs 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.

11:26 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 air freight 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 air freight 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 nine month ended September 2019.

12:16 Net income in the third quarter of 2020 was $17.8 million compared to a net loss Thank you for joining us. 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 for the comparable quarter as the diluted share count is higher in profitable quarters than in quarters with a net loss.

13:08 Adjusted net income for the third quarter of 2020, which excludes changes in the fair value of contingent consideration and modest acquisition integration costs, with $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 three consecutive years, strengthening our balance sheet and positioning us for growth.

13:56 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 27%. Now turning to the balance sheet. At September 30, 2020, we had $27.3 million of cash and cash equivalents with zero 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.

14:46 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 Jurgen for some additional comments.

14:58 Jurgen? 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 esports, 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.

15:43 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%, Thank you for joining us.

17:03 They were available as it did in the first 12 weeks of PlayStation 4. And Microsoft has said that it is seeing record-breaking demand for Xbox Series X and S. The market research firm DFC forecasts a 55% increase in Council unit sales globally in 2021 versus 2020. and also forecast 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 council unit sales. Given the step function change in realism with this generation of councils, I expect these new councils will do very well, which is a good long-term trend for our council accessories business.

17:59 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 three 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 two of the models use our new proprietary Titan optical switches, which provide response rates up to 100 times faster than mechanical keys. Ridiculously fast. and yes, that matters to serious high-end gamers.

18:55 We also launched two new PC gaming 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 Rocket brand. Of course, the Rocket brand and products are very strong in the original core market, Germany, and we are making good progress expanding into other key markets. In the US, for example, I'm very pleased to see that we have outperformed the market by gaining market share in PC gaming headsets, Keyboards and Mice in Q3, all three of our targeted product categories.

19:50 As I've 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 five-year tagger 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 some significant shifts in timing of shipments into retail.

20:49 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 would purchase earlier this year, which occurred as expected. Thank you for joining us. based on earlier retail holiday purchasing, as John mentioned.

21:41 And there are a few shifts in timing of expenses as well. Roughly 2 million of air freight 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 air freight costs to enable revenues and some impacts from the portfolio expansions we are investing in. Note that given the supply chain initiatives we started two years ago we now get more than half of our product supply from outside China.

22:34 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.

23:28 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.

24:14 Thank you, sir. To ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. And our first question will come from John Godden with Lake Street Capital. Please proceed.

24:33 Hey, guys. Thanks for taking my question. Congrats on the nice quarter. First, as it relates to the new console launches, can you kind of refresh us on the demand taken over the coming years of that increase in demand for headsets and maybe some historical headset attach rates? and then down that line, is there any reason to think that those historical trends would be different for these new council launches this year? Thanks.

25:02 Sure. So, you know, normally the trend with new council launches for accessories is that accessories are down the year of the launch as consumers start to wait for the new councils. And then as the councils launch in Q4, demand picks up for accessories again. So you get some, you know, 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 two years for accessories as people, you know, reaccessorize their new consoles. This year, those normal trends are clearly out the window because of the stay-at-home orders driving, you know, one quarter that's nearly double and one quarter that's up Thank you for joining us.

26:11 In second, with companies pulling in some of their holiday orders to try to ease up on supply chains, is there any reason to expect potential capacity constraints with your logistics partners going through the rest of the quarter?

26:28 That's a great question. Logistics, frankly, have been a challenge, part of the operations and supply chain challenge since Q2. Everything from securing air freight, 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. Air freight 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.

27:14 Okay. And then last one for me as far as new investments go and capital allocation. Just as you look out, you know, maybe to the next six to 12 months, where do you guys think, you know, you're going to be able to earn a higher return on that capital going forward now that you've been generating significant amount of proof cash flow? Thank you.

27:32 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 in investing in the business will be the priority for use of our capital.

28:14 Awesome. Thanks, guys.

28:16 Thanks, John.

28:17 Great. Thank you, John. Thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone. Our next question comes from Elliot Albert with DA Davidson. Please proceed.

28:30 Great. Thank you. 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 air freight, that would be helpful.

28:56 Sure. 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, you know, 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 two points, is air freight, which we expect to have several million of again in Q4 just to keep up with demand.

29:50 But otherwise, our guidance reflects in the full year gross margins referenced, reflects kind of a normal Q4 with a bit of additional cost for air freight.

30:06 Okay, helpful. And then continued traction with the non-gamers. Last quarter you talked about the three 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. What is that demand looking like? Are there ASPs below the core gamer, and how is the refresh cycle different than your core consumer?

30:34 Good question, Elliot. So the data we referenced last quarter of roughly the third 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 one-third was higher engagement by existing gamers, one-third was new gamers coming into the market and one-third 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 for my comments, the market was up 46%.

31:26 And so the market has slowed down, but continues to way out past last year. So we believe that the continued incremental demand is a result of higher gamer engagement. Some new gamers continue 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 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. Great. Thank you. Thanks, Elias. Thank you.

32:11 Thank you. Currently this concludes our question and answer session. I would now like to turn the call back over to Mr. Stark for closing remarks.

32:20 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