Parametric Sound About To Unlock Intellectual Property Value Through Merger With Turtle Beach

Dec.24.13 | About: Turtle Beach (HEAR)

I have been a follower of Parametric Sound (NASDAQ: PAMT) for the last couple of years due to my fascination with its proprietary technology. As the quarters rolled forward the popularity of shares rose and fell with the hopes shareholders carried for the ultimate commercialization of its world-class disruptive technology. While there has been much written about the pending merger with Turtle Beach, it was not until the company's recent presentation at the Wedbush Securities investor conference on December 10th in New York City that I began to fully appreciate what this merger means to both entities and how tremendous value from both entities will be unlocked by joining forces.

I would start by encouraging everyone to listen to and view the company's presentation at the Wedbush conference (presentation/webcast), which can be found at parametricsound.com. Below I have included two of the critical slides. Perhaps the most important slide for shareholders is how they expect to get to $300 million in sales next year and become a $1 billion firm in five years. When these numbers came out of the proposed new CEOs mouth from Turtle Beach I was shocked. More shocking was that the more I listened the more I learned how this was quite feasible and that the entire investment opportunity at these levels is extremely compelling. Now the only thing standing in the way of course is shareholder approval of the proposed merger this Friday, December 27th.

In my honest opinion, the shareholder vote to approve this merger on Friday will become the catalyst Parametric shareholders have been waiting for to take this stock to the next level. As a result, you will combine two companies, each with breakthrough, proprietary audio technology. Turtle Beach is an established industry leader with infrastructure including sales and marketing capabilities and global distribution. Parametric has established itself with one of the best research and development teams on the globe with the IP to bring disruptive technology to multiple billion dollar industries in the audio community. Together they have the technology and marketing muscle and diversification strategy across several large industries to become a powerhouse in the industry.

(click to enlarge)Click to enlarge What is Turtle Beach?

Turtle Beach has been a market leading, established business focused on the audio technology industry for 35 years. It began by selling synthesizers and PC audio until 2005 when it essentially invented the gaming headset market. Today it is the leader in the industry with ~53% market share. It has built strong brand loyalty with gamers and has compiled such accolades as having 9 of the 10 best selling 3rd party headsets in the U.S. and 5 of the top best selling 3rd party gaming headsets in the U.S. since 2005. Turtle Beach is currently only 1 of 2 companies licensed to produce and sell Xbox One headsets. They have established global distribution of its products with over 27,000 storefronts in 44 countries.

What's special about Turtle Beach's technology?

A common misconception among the general public is that all audio headsets are the same. This could not be further from the truth. First, two way communication is achieved, so I can communicate with my friend sitting in another state while playing Call of Duty. Next, the sounds that come through the headphones are gaming specific meaning that while I am playing Call of Duty I can hear enemy footsteps. Interestingly during the Wedbush presentation, the CEO mentioned that gamers with Turtle Beach headphones often refer to a killing during Call of Duty as, "I just got Turtle Beached," meaning that a gamer just got killed because he was able to hear footsteps that other users using "normal" headphones could not. It is not only very cool, but the reason for its dominating 53% market share.

What is Parametric Sound?

Parametric Sound has developed proprietary, disruptive audio technology with extensive R&D capabilities. They are just on the cusp of commercialization, but have technology designed to break through several industries including healthcare. Think a person with hearing impairment who can better tune into their TV through this technology.

What's special about Parametric Sound's technology?

Parametric Sound has developed "Hypersound." Think a light bulb as opposed to a flashlight. Normal sound, or the light bulb, fills the room. It sounds good and everyone hears the TV for example, but it's nothing special. With Parametric Sound's technology, the sound can be targeted at a specific area or person much like a "high powered flashlight." We all know there is no comparison between watching HDTV as opposed to "normal" TV. The same will be true in the future for the masses about how we feel about our television's audio capability.

A few examples: Getting back to a person with a hearing impairment. The sound can be focused entirely at this person enhancing the quality of the sound exponentially. For example, a user can set one beam on the left side of the room and one of the right, and point them to the person sitting in the middle. Automatically you have created 3D sound. It sounds like you are wearing headphones.

Here are a few statistics on the healthcare industry specifically for hearing loss. Over 48 million Americans suffer from hearing loss with 360 million more worldwide living with disabling hearing loss. The global wholesale hearing aid market is $4 billion with 10-11 million units sold annually. Many of these folks are great candidates to enjoy the technology.

The CEO did not discuss capabilities to break the automotive sector, but I would be the first supporter of this technology in my car so I can listen to Pearl Jam and not Mickey Mouse Playhouse that my kids are playing in the back seat during my two hour ride to Aunt Eileen's.

I think it is important to point out the biggest arguments this transaction faces from the non-believers. The recent financial performance has a negative trend.

Financials

Revenue:

2012: $207 million at TTM: $202 million

Gross Profit Margin:

2012: 36% at TTM: 32%

EBITDA

2012: $47 million at TTM: $27 million

On the surface the decline in margin does not look good, but I'm glad that the CEO during his presentation addressed this issue head on. 1) The natural observation is that over the last couple of years gamers have been anticipating the release of the new PlayStation4 (PS4) and Xbox One (I too would not go out a buy any accessories for my new PS4 until I bought the new console). Additionally, the company has had to spend extra time and money to build the next generation of products and distribution 2) The company has therefore been forced to manage inventory and sell old models and eliminate SKUs at significantly discounted rates to turn inventory to cash and roll out the new products. Additionally, the company has also worked on the process for an improved process in selling refurbished units.

As the CEO stated during his presentation he considers the combination of enhanced demand for product in 2014 due to the roll-out of new consoles along with the one-time events related to inventory to be the key drivers that will now lead to much improved margins in 2014 and beyond. Remember, this is the same management team that took over in 2010 and grew the business from under $100 million to over $200 million in less than three years from 2010 to 2012.

The demand for the PS4 and Xbox One have been widely reported and staggering with each selling 1 million units in just the first day. By December 1st the PS4 already sold over 2.1 million units. Analysts forecast 21 million PS4 and Xbox One sales through 2014 and 40 million through 2015. Also interesting to note only 22% of U.S. Xbox and PS gamers currently use a headset. As the gaming consoles become more interactive and the games continue to push toward play online, the necessity for a headset will become more widespread.

Why the merger makes sense

From the company presentation, the combined companies present "an audio innovation company with deep audio technology expertise and relevant experience developing and commercializing audio technology across a range of large addressable market."

This merger makes a lot of sense to me for several reasons. They need each other to leverage their existing businesses. Turtle Beach has done an excellent job of building a brand and amassing a market leading position in the gaming headset industry, but as with all businesses, you need diversification. Parametric Sound has the proprietary technology and R&D capability to create new high-tech products for industries that Turtle Beach has not or perhaps could not have otherwise participated in. Likewise, Turtle Beach has cash flow, brand and global distribution to immediately give access to Parametric Sound's audio technology that has yet to be commercialized.

As a result, the goal of the combined companies is to grow revenue to $1 billion in five years. Initially this growth will come from the gaming industry rebound of new consoles and international expansion. Turtle Beach is also levering its gamer following to launch audio headphones with increased audio capability for the media industry, which is driven by the growth in mobile devices. The NY Daily News wrote an excellent article on the new i30 headset series that they are coming out with. Afterwards, management expects breakthroughs in the healthcare and commercial industries in 2015 for the Hypersound technology in conjunction with continued growth in the gaming sector.

(click to enlarge)Click to enlarge Valuation

On slide 24 of the company presentation a detailed pro forma capitalization is provided. Here are my takeaways which I will use toward coming up with my valuation post merger.

Total debt (including $13.5M preferred and a $30M revolver which should go to $0 in Q1): $77.5M

Shares out post merger: 43.2M

Cash: $11.7M

Share Price: $12.00

Market Cap: $584.2M

Enterprise Value: $584.2M

As opposed to articles I have read, I do not think it is fair to use the TTM EBITDA number for the reasons I discussed above. I therefore took the average EBITDA over the last 3 years of ~$44M.

Current EV/EBITDA: 13.3x (based on $44M average over last 3 years)

I have taken the projected $300 million in revenue in 2014 and applied an EBITDA margin of 22.5% equaling $67.5 million. I then used a multiple of 18 to get to a potential value of $1.215 billion today.

This equals a price target of $28.25 per share in 2014.

Conclusion

From management's presentation my sense towards the investment opportunity has become clearer. I would expect volatility in the share price due to much uncertainty based on what has been projected above versus what has been delivered. My estimation thought, due to the new management team's presentations in public forums on the combined companies, is that they have a good grasp on what the vote will look like and almost positive it will go through. The first quarter of 2014 will be a telling tale as to what the financial trend will look like going forward. I anticipate the PS4 and Xbox One launches along with holiday sales will blow the numbers away. I am following closely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.