Bears Have A Point, But Turtle Beach Still Looks Too Cheap Here
https://seekingalpha.com/article/4234235-bears-point-turtle-beach-still-looks-cheap
Summary
HEAR shares skyrocketed in 2018, as Fortnite led to a massive increase in demand for gaming headsets.
The stock has pulled back over 50% from its highs - and remains heavily shorted as bears see a one-time bump that will fade in 2019.
Bears might be right - but at this point, HEAR is incorporating much of that risk.
The options market offers a particularly attractive bullish position on HEAR.
Gaming headset maker Turtle Beach (HEAR) was one of the more interesting stock market stories of 2018. The company started the year seemingly at death's door. HEAR stock traded well under $1. The company had a market capitalization in the ~$25 million range for most of the first quarter.
Revenue was heading in the wrong direction, with sales falling 14% in 2017. Turtle Beach was showing some growth in Adjusted EBITDA, but mostly from cutting $10 million-plus annual losses in its unprofitable HyperSound business. Turtle Beach had to execute a reverse stock split in April to get its share price back above $1. The company closed 2017 with net debt of about $65 million and a leverage ratio near 6x (even excluding preferred stock). Even granting that year-end revolver balances are seasonally high (inventory and accounts receivable usually aren't converted to cash until Q1), even solvency didn't seem guaranteed.
And then Fortnite took off. The game's "battle royale" mode stoked enormous demand for gaming headsets. The market exploded, and Turtle Beach, as the market leader, saw its revenue follow:
Turtle Beach Revenue & Adjusted EBITDA Growth, Q1-Q3 2018
Quarter Revenue Growth Adjusted EBITDA Growth
Q1 +185% NM (+$5.3M vs -$6.2M)
Q2 +218% NM (+$9.8M vs -$2.8M)
Q3 +107% +433%
YTD +154% NM (+$32.7M vs -$5.7M)
HEAR shares soared. At one point, on a split-adjusted basis, the stock had gained over 2,000%. Even with a sharp pullback from August highs, Turtle Beach shares still rose 688% in 2018. But the gains brought in short-sellers as well:
Chart HEAR Percent of Shares Outstanding Short data by YCharts
And the bear/short case here makes some sense. There isn't going to be a Fortnite that hits every year. 2018 revenue and profits are potentially unsustainable - yet at the highs, HEAR was trading in the range of 10x EBITDA guidance, a multiple that suggested continued growth. This is a company that historically was barely profitable: total EBITDA from 2013 to 2016 was under $9 million. Bears argued (and argue) that once the one-time demand from Fortnite fades, and Turtle Beach has to lap much tougher comparisons in 2019, growth likely will turn negative - and HEAR stock will follow.
But at $15, the short case is much weaker - and the bull case starts to look intriguing. A sub-5x multiple to 2018 EBITDA guidance prices in something close to peak earnings this year. Historical profitability in the headset business is better than it looks. Fortnite no longer is the only 'battle royale' game in town. And Turtle Beach has retired the preferred stock and significantly cleaned up its balance sheet.
Looking closely at the valuation, even a huge drop in profitability is getting close to priced in. And because of the huge short interest, the options market provides an interesting trade through which a bullish position can either provide 50%+ returns - or result in owning HEAR at a price close to that supported by pre-Fortnite numbers.
Back to 2017
The core of the short case here is that 2018 results essentially are a one-off. Even management has admitted a huge boost from Fortnite: On the Q2 conference call, CEO Juergen Stark estimated a roughly $20 million per quarter benefit from new gamers brought in by battle royale games. That ~$80 million benefit suggests, on its own, revenue growth of about 54% this year. Industry figures cited by HEAR mean the boost could be even higher. On that call, Stark cited estimates that the headset market in the U.S. and Canada was up 78% in Q1 and 97% in Q2.
Obviously, that kind of market growth isn't sustainable. And it's that tailwind that is driving Turtle Beach's huge numbers through the first nine months of the year. Meanwhile, guidance for Q4, with the company in the Q3 release targeting revenue growth of just 18% year over year, seems to imply that the tailwind already is moderating significantly.
So the qualitative short case here is that results are going to return to 2017 levels relatively soon. Fortnite has brought in new gamers and new headset customers, but it won't do so every year. It's even possible that 2019 results could be worse than 2017, if demand pulled forward leaves a bit of a vacuum, and fixed-cost deleverage sends margins falling further. However the exact numbers play out in 2019 and beyond, the argument would then be that at some point, Turtle Beach is going to be what it was. And that could send it back toward the ~$25 million market cap at which it traded - a still-significant decline from the current ~$250 million figure. (Turtle Beach guided for 16.5 million fully diluted shares in Q4 in its most recent presentation, so the actual figure is higher than might be reported on public data sites.)
But at $15, even if Turtle Beach does go back to where it was, the downside isn't nearly as large as it might seem. The biggest reason why is the balance sheet. Again, Turtle Beach had as much as $60 million-plus in debt plus a $20 million-plus liability in the preferred stock. In April, it retired the preferred stock in exchange for common stock and warrants. And in December, the company announced it had paid off its term loan and subordinated debt - which totaled over $30 million at the end of 2017.
There still is an unspecified revolver balance - but again, that revolver spikes in Q4. At the end of Q1 2018, the facility had just $2.6 million in borrowings, according to the 10-Q. And so it seems quite possible that, 12 months later, Turtle Beach will end Q1 2019 with net cash on the balance sheet, given what should be stronger cash conversion from larger Q4 sales.
That alone is an enormous change from a valuation standpoint. HEAR's enterprise value was in the range of $75 million at least at the lows last year (depending on how an investor treated the preferred and the revolver); that EV now all accrues to the equity. And so if an investor argues that 2018 is a pure outlier - that Turtle Beach in 2019 and beyond will look much the same as it did in 2017 and before - the stock still should be much higher simply due to the balance sheet improvements. That same ~$75 million-plus enterprise value, with a clean (or maybe cash-positive) balance sheet, suggests HEAR in a worst-case full reversal still is worth closer to $5. And, actually, there's an argument that the bear-case valuation for HEAR is even higher.
Will 2018 Kill 2019 And 2020?
What's interesting about 2017 results is that something similar actually happened before. In 2012, Turtle Beach generated revenue of $207 million and Adjusted EBITDA of $47.4 million, according to the proxy statement accompanying its reverse merger with Parametric Sound.
That fact might seem to strengthen the bear case:
Turtle Beach EBITDA Source: Author from HEAR filings; 2018 figure is company guidance
Profits promptly fell off a cliff for the next several years. If that repeats - perhaps because big years pull forward demand from subsequent periods - even a sub-5x EV/EBITDA and ~6x P/E multiples are going to be too high.
But there is a case that - to use the reputedly most dangerous words in investing - this time might be different. For one, last time Turtle Beach seems to have badly misread its market. In the spring or summer of 2013 (the exact date isn't clear), Turtle Beach gave Craig-Hallum its financial projections for a fairness opinion. The company at the time (p. 74 of the proxy) projected Adjusted EBITDA of $40.6 million in 2013, down only 17%, followed by explosive growth: $56.7 million, $82.8 million, and $100.4 million in 2014, 2015, and 2016, respectively.
2013 guidance would be pulled down repeatedly, with Stark later blaming delays from Microsoft (MSFT) in supplying the needed adapters and software for the Xbox One. But it also seems likely (we have minimal commentary, as Turtle Beach wasn't public until early 2014) that the company's overly optimistic projections of market growth impacted spend. (Headcount has come down from 2014 levels, though it's not clear how much of that is on the headset side.)
And while consolidated numbers look worse, the news in the headset business wasn't quite as bad as the chart above suggests. 2014 Adjusted EBITDA was just $2 million - but according to the 10-K that included a ~$10 million investment behind HyperSound (Parametric's legacy technology). The headset business generated about $12 million, despite "significant gains in market share" from headsets released directly by Microsoft and Sony (SNE).
2015 was worse: The headset business generated just ~$2.4 million in profit, which was more than offset by HyperSound's loss of $13.8 million. HEAR's 10-K cited increased promotional credits to move inventory on 'old-gen' consoles, and strong dollar pressure overseas. In 2016, however, with the old-gen headwind gone, gross margins expanded sharply (540 bps) and headset Adjusted EBITDA bounced back to $14 million-plus. The figure dropped to $12.6 million in 2017, as HyperSound is restructured (just a $1 million loss) and revenue falls amid inventory tightening at key customers.
Backing out HyperSound, the headset business outside of 2012 and 2018 looks far more stable (2012 and 2013 figures are Turtle Beach only, as the merger closed in January 2014):
Turtle Beach Adjusted EBITDA Source: Author from HEAR filings; 2018 figure is company guidance
If we toss 2015, the Headset business generated $12 million to $14 million-plus each year. And it was a reasonably stable business in terms of sell-through as well, with revenue movements driven by inventory movements at retailers. Best Buy (BBY) and GameStop (GME) are two of the top three customers (Walmart (WMT) is the other); each accounts for 13-16% of revenue, per the 10-K. Both retailers have tightened inventory of late, which affected HEAR revenue, but Turtle Beach's sell-through remained rather stable over the last few years:
Turtle Beach sales
Source: Turtle Beach Q4 2017 earnings slides
Peer comparisons are tough: There aren't a lot of independent hardware plays left out there, and larger comps like GoPro (GPRO) and Fitbit (FIT) are EBITDA-negative. But a ~stable debt-free business should reasonably merit at least a 6-8x multiple. An average of ~$13 million in EBITDA suggests a share price in the range of $5-7. Stretch a bit and assume the company decides to sell out to someone like Logitech (LOGI): with synergies and cash on the balance sheet come 2019, HEAR maybe gets to $10 at an ~8-9x acquisition multiple.
That sounds like a pretty good bear case at $15. But, again, this is a case of trying to find the floor; of trying to determine what HEAR is worth if 2018 really is driven just by Fortnite and the headset business is going to revert back to its norms. In that model, the uber-bear case still is something like $5 and fair value is probably closer to $8.
The Bull Case
Again, there's no argument that Fortnite has been a huge help to 2018 numbers. It is quite possible - in fact, it's likely - that 2019 numbers come down. Right now, consensus estimates project a 9.4% decline in revenue next year, albeit at a wide range. The most bullish analyst (of four) estimates ~2% growth; the most cautious a 22% decline. All four see EPS (with an even wider range: $0.90-$2.25) declining, with a higher tax rate one headwind as HEAR exhausts its deferred tax assets this year (as discussed on the Q3 call).
But HEAR at $15 is pricing in a decline, which it wasn't at $30+. And a decline in 2019 doesn't mean earnings and sales have permanently peaked - nor does it suggest that Turtle Beach's performance immediately returns to 2013-2017 levels.
For one, this is a better business than perhaps some realize. In 2017, it had 42% dollar share in console headsets, according to data cited in the 10-K. That figure should be even higher in 2018, given that Turtle Beach outgrew the torrid market in the first half (though it's possible share has eroded in Q4). The headset business here isn't a flash in the pan or some upstart betting on unproven technology. It's the leader in consoles, and has been for this entire decade (dollar share figures from previous 10-K's were consistently over 40%).
Secondly, the market strength seen in 2018 isn't going to stop just because Fortnite is lapped. Here's how CEO Stark put it on the Q3 call:
Clearly, battle royale is not a fad; it’s a new different type of multiplayer experience applicable to a variety of games new and old. If more consumers are driven into the genre, it’s a positive for Turtle Beach, regardless of which games consumers play. It’s important to remind the investment community that we don’t sell Fortnite, we sell gaming headsets. Our business is not driven by what specific games people play; it’s driven by people playing with headsets.
So, if the new Call of Duty: Black Ops, Red Dead and Battlefield launches do well, that’s great for our business. And given that the majority of the core gaming headset market is driven by replacement and upgrading, this large influx of new gamers brought into the mix by titles like Fortnite and PUBG, moving on to games like Call of Duty: Black Ops, Red Dead Redemption and Fallout 76 this fall and eventually to other new games coming in 2019 should drive a significant increase in the size of the core gaming headset market going forward.
Fortnite itself may be a fad (though a $1.25 billion capital raise for developer Epic in late October suggests otherwise). But the 'battle royale' trend it started now is being copied by Activision Blizzard (ATVI), Take-Two Interactive (TTWO), Electronic Arts (EA), and other publishers. eGaming continues to grow, adding another potential catalyst to demand. Even if the demand seen in 2018 can't be replicated, the headset market is going to be larger in 2019 and 2022 than it was in 2014 and 2017.
And so 2019 results can fall year-over-year against 2018 - and, again, I believe that's a likely outcome, even pre-tax. But the console market should be growing again from that lower base. Turtle Beach itself should have an easier time capitalizing on the market as well, with lower inventory disruption at key customers and no console shifts to deal with. (Competition obviously is an enormous risk, but so far so good on that front.)
There are additional growth catalysts as well. On the Q3 call, Stark estimated the refresh cycle at about 20-24 months (though with a wide range; some gamers keep headsets for years, others break them regularly), which means the 2018 cohort could help sales in 2020-2021. Turtle Beach is moving into the PC market with its Atlas brand. That market is roughly ~half that of the console category, per Stark, and the company only is targeting 10-20% market share. Still, even that 10% figure adds over 10% to current revenue (assuming ~40% market share in consoles) and likely a bit more to profits given fixed-cost leverage and incremental margins.
What is interesting about HEAR at $15 - and notably different from $30 - is that bears can be right about 2019 and the stock still can be too cheap. To what extent that is the case depends on how, exactly, an investor runs the numbers. But the huge short interest has created an interesting opportunity to take advantage of all but the most bearish scenarios.
Valuation
It's tough to model revenue and profits going forward for a number of reasons. Market share matters, and in the Q4 2017 release, Turtle Beach originally guided for ~$157 million in revenue and $12 million in Adjusted EBITDA. The projections now are ~$270 million and ~$54 million. Backing out an additional $2.8 million in air freight costs in Q2 to meet demand, that suggests incremental EBITDA margins are about 40%.
Assuming the reverse is true (that Turtle Beach loses 40 cents of EBITDA for every lost dollar in revenue), we can create a *very* rough model of 2019 EBITDA depending on assumed revenue declines:
Revenue Scenario EBITDA
flat $54 million
-10% $43 million
-20% $32 million
-30% $22 million
-40% $11 million
If sales do fall, say, 20%, next year, HEAR still trades at about 8x 2019 EBITDA. (We'll model zero net cash here at the moment; given the debt paydown, that may be conservative, particularly by the end of next year.) Assuming the growth in the console headset market is real - thanks to new battle royale releases and eGaming - and some valuation for the opportunity in PC, that's not a bad multiple to pay. With capex at ~$3 million a year, and assuming a normalized 25% tax rate, that figure still suggests ~$1.30 in EPS and a current ~12x P/E multiple, with normalized free cash flow in the same range.
The bear case for HEAR - and particularly the short case for the stock - is starting to price in not only a 2019 decline, but from there either a stagnant headset market or substantial market share losses. In short, it's pricing in something close to a repeat of 2013-2014. But - again - this time should be different. Retailers, perhaps GME aside, are in a better position with cleaner inventory. Management is aware of the one-time boost: as noted, Stark himself has estimated the benefit from new gamers. He's also repeatedly pointed out that the company has met demand this year without adding substantial resources (which in turn would weigh on margins if/when that demand recedes).
The deceleration in growth in Q4 - just 18% against the 100%+ in the first nine months - seems to support the idea that the business has peaked and heading toward a southward turn once tougher comparisons arrive in Q1. But as Stark pointed out after Q3, the benefit from new gamers has been largely stable - but in the seasonally stronger fourth quarter, it's spread over a much larger base. Q1 2017 revenue was under $15 million; $20 million of Fortnite-stoked demand alone created 100%+ growth. Q4 sales were $80 million; that same ~$20 million adds just 25% to sales.
Admittedly, those numbers suggest a decline in the quarter outside of new gamers. But, again, a decline is priced in here - and it's certainly possible the Fortnite tailwind is fading. There are other, if smaller, catalysts to category growth on the way that aren't being considered in the focus on Q4 guidance.
So from here, $15 seems like a fair price to pay for HEAR - and perhaps even compelling for investors bullish on the eGaming/gaming trend. Bears can be right about 2019 - and wrong on the share price. Certainly, the short case seems much more difficult here.
Yet it persists - and combined with the low float, that creates some intriguing potential bullish positions in the options market. HEAR has decent liquidity for a stock its size (particularly for individual investors and even smaller funds) - and the premiums are quite attractive. The January 2020 expiration in particular offers some attractive opportunities:
HEAR options
Source: Nasdaq.com
At the bid, the January 2020 15 put offers a 55% return. Downside entails owning HEAR below $10. That's a reasonable ~8x the EBITDA modeled above even in the case of a 30% revenue decline in 2019. Even the 5 put returns almost 14% and requires HEAR's market capitalization to drop to about $73 million - in the range of 0.4x a bearish revenue model and ~1.4x 2018 EBITDA.
There are other possibilities at different expirations as well: For instance, the July 15 put, bid at $3.80 has open interest of 446 contracts and returns 34%. Investors can choose their own (or given the proper understanding, look to complex strategies; please be advised that those strategies can be much higher risk).
But HEAR has gotten to the point where the bear case looks increasingly priced in. There's a reasonable thesis that a) 2019 results are going to show a year-over-year decline and b) HEAR already is trading at low, and attractive, multiples to those lower numbers. Given high premiums, investors who believe that thesis can either gain very attractive returns - or own the stock at an effective price that all but incorporates the bear case.
Disclosure: I am/we are long HEAR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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