Shareholders of Parametric Sound Corporation (PAMT) have been eagerly awaiting the recently filed definitive proxy statement for its pending merger with Turtle Beach, which was announced on August 5th. Prior to the filing of the proxy, there was little information available on Turtle Beach - just a few high level numbers given out on conference calls. There was a reason for that: the truth behind Turtle Beach is that it's a deteriorating (and quite possibly distressed) company conducting a merger with Parametric Sound out of desperation. In this article, we will show that Parametric Sound is an excellent short sale candidate due to the deteriorating business of Turtle Beach and the extreme overvaluation of the combined company.
Turtle Beach's Business is Deteriorating
The most alarming disclosure from the proxy statement is the rapid deterioration of the Turtle Beach business. According to page 74 of the proxy (here), Turtle Beach was projecting 2013 EBITDA of $40.6 million when the merger was being negotiated between the parties. This was a 15% decline from the $47.8 million of EBITDA it earned in 2012, per page 139 of the proxy. Later, on August 5th after the merger was announced, the companies held a joint conference call in which the CEO of Turtle Beach lowered estimates to a "range of $32 million to $40 million," or a midpoint of $36 million. This new level of EBITDA represents an almost 25% year over year drop in profitability. Of course, the news only gets worse. In a conference call held November 4th , the CEO of Turtle Beach revealed that "the adapter and related software required to make our headsets fully functional with the new Xbox One console, will not be ready at launch" and that "as a result, the 2013 outlook for revenue and EBITDA provided on August 8th will be revised." While we don't know where 2013 EBITDA will end up, it's safe to say that he would not have made this statement if revised estimates were not lower than the bottom of the already lowered range indicated on August 5th. Here's a graphical representation of Turtle Beach's EBITDA:
Turtle Beach Actually Looks Distressed
While it should be clear from the above that Turtle Beach is suffering poor performance, what's not clear is that the company may actually be financially distressed. There are numerous signs of distress in the proxy statement beyond just the collapsing profits, which fell from +$4.1 million in the first half of 2012 to -$5.6 million in the first half of 2013, as can be seen on page 135. This profitability collapse resulted in the tripping of debt covenants. For instance, on page 141, we learned that "Turtle Beach was not in compliance with its fixed charge coverage ratio as of June 30, 2013 and December 31, 2012." Likewise, on page 53, we learned that as a condition to approving the merger with Parametric Technologies, Turtle Beach's lenders required that "Parametric raise at least $5,000,000 in debt or equity capital" and that "Turtle Beach raise $10,000,000 in debt or equity capital, which would be used to prepay an equivalent portion of its credit facility." Clearly, Turtle Beach is in distress when it is tripping its debt covenants and those same lenders require money to be raised in order to approve a merger. Moreover, on page 142, we learned that when it came time to raise the new capital, Turtle Beach was unable to find a third-party lender and it had to issue Subordinated Notes to "certain affiliated investors, including the Stripes Group and the Chief Executive Officer," and that the interest on the notes was a usurious "10% per annum for the first year and … 20% per annum for all periods thereafter" (page D-42).
The conditions and lending rates that Turtle Beach had to abide by are not indicative of a healthy company, and instead point to significant financial distress.
Acquisitions Hid Declining Performance In 2012
Turtle Beach wants investors to believe that the gaming console cycle, which includes new consoles from both Sony and Microsoft this year, is to blame for the company's struggles. For instance, on the August conference call, the CEO stated "consumers obviously in anticipation of the new consoles, they buy less consoles, less games, less accessories right until the new consoles hit." Likewise, on the last conference call, the CEO stated that in 2013 there will be an "expected pre-console transition, downturn for the industry." At first blush, the financials in the proxy statement appear to support this contention, with profitability continuing to grow through the end of 2012, reaching a record $26.5 million of net income in 2012. However, this is again misleading because it does not account for Turtle Beach's acquisition of its European distributor, Lygo. The properly adjusted pro forma earnings, on page D-25 of the proxy, which adjust Turtle Beach's earnings as though the acquisition had taken place at the start of 2011, show that net income actually started to decline in 2012 and that it fell from $23 million in 2011 to $18.3 million in 2012. This suggests that the company's excuse regarding the console cycle lacks merit.
Parametric Management Is Cashing Out
So why would Parametric pursue an acquisition with a floundering company like Turtle Beach? Personal enrichment, of course. As a result of the merger, special golden parachute payments will be triggered for the executive management of Parametric. For instance, we can see on page 77 that Kenneth Potashner, the Chairman, will be entitled to over $2.8 million of payments that are triggered on a change of control. The proxy also reveals that he will continue on with a board seat following the merger, which is likely to be a cushy and lucrative endeavor for him.
Two Desperate Parties?
Lest we only criticize the business outlook for Turtle Beach, we think it is also important to recognize that Parametric Sound was also in a very weak negotiating position. For instance, on page 48 of the proxy, the company revealed that "representatives of Houlihan Lokey contacted and held varying levels of discussion with a total of 13 parties other than Turtle Beach regarding a transaction involving Parametric. During this time period, all such parties advised representatives of Houlihan Lokey that they were not interested in pursuing an acquisition of Parametric." Following the agreement with Turtle Beach, Parametric conducted an additional sales process, the "go shop" period, during which "Houlihan Lokey contacted 49 prospective buyers…[and] None of these prospective buyers, or any other parties, expressed interest in making an acquisition proposal for Parametric." (p. 58) In fact, it appears that the only other proposals Parametric received during this period were for two licensing agreements. In short, Parametric conducted an exhaustive sales process and the only real interested party was Turtle Beach, which is paying nothing in cash and which appears to be in financial distress.
The Valuation Looks Extreme
While all of the above considerations suggest that both Turtle Beach and Parametic are struggling, Parametrics stock is truly a great short due to its extreme overvaluation, which suggests significant downside. Based on the pro-forma number of shares outstanding, we believe that the combined market cap of the company is $669 million and that the enterprise value of the company is $730 million. This represents a multiple of approximately 27x 2013E EBITDA, as can be seen below:
In contrast, the peer group to Parametric trades at only 8.4x EBITDA and to the best of our knowledge, none of these companies is experiencing financial distress:
Based on the average peer multiple, which may be generous due to the poor business conditions and apparent financial distress at Turtle Beach as well as the tepid interest in Parametric, we believe that the fair value for Parametric's stock is approximately $3.93 per share or 75% below the current stock price:
Until the recent filing of the proxy statement, there has been a paucity of information available about Turtle Beach and, by extension, about Parametric. Now that the proxy has been filed, we can easily see that it's not a pretty picture. The profitability of Turtle Beach is eroding, the business appears to be in financial distress, and there was only one suitor with true interest for Parametric. To top off this bad fundamental news, the valuation of the combined company looks extreme. We are short and recommend shorting Parametric Sound with a target price of $3.93 per share or 75% below the most recent share price.