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Parametric Sound Corporation (NASDAQ:HEAR)

Q2 2014 Earnings Conference Call

August 11, 2014 16:30 ET

Executives

Brendon Frey - IR

Juergen Stark - CEO

John Hanson - CFO

Analysts

Sean McGowan - Needham & Company

Mark Argento - Lake Street Capital Markets

Rob Stone - Cowen and Company

Ryan MacDonald - Northland Securities

Operator

Welcome to the Turtle Beach Corporation Second Quarter 2014 Conference Call. (Operator Instructions). I would now like to turn the call over to your host, Brendon Frey with ICR. Please go ahead, sir.

Brendon Frey

Thank you. Good afternoon everyone and welcome to Turtle Beach Corporation’s Second Quarter Fiscal 2014 Earnings Call to discuss the financial results. Before we get started, we will be referring to the press release filed today with details of the results which can be downloaded from the Investor Relations page of our website at www.corp.turtlebeach.com. Shortly after we end this call, a recording of the call will be available as a replay in the Investor Relations section of the Company’s website.

Please be aware that some of the comments made during our call may include forward-looking statements, they involve risks and uncertainties regarding our operation and future results that could cause Turtle Beach Corporation’s results to differ materially from management’s current expectations.

We encourage you to review the Safe Harbor statement contained in today’s press release and on our filings with the Securities and Exchange Commission including without limitations our annual report on Form 10-K and other periodic reports as well as proxy statement on schedule 14-A filed in connection with our merger with Turtle Beach which identifies specific risk factors that may affect actual results or events to differ materially from those described in forward-looking statements.

We also note that this call contains non-GAAP financial information. We’re providing that information as a supplement the information prepared in accordance with accounting principles generally accepted in the United States or GAAP, you can find a reconciliation of these metrics to our reported GAAP results in the reconciliation table provided in today’s earnings release.

And now, I’ll turn the call over to Juergen Stark, the Company’s Chief Executive Officer.

Juergen Stark

Thank you and thanks everyone for joining us on the call today. With me is John Hanson, our Chief Financial Officer. We’re excited to be with you all again today to share the continued progress we have made in the second quarter to advance the growth of our company. Similar to the format of our first quarter earnings call I will cover the business highlights, John will cover the financial performance and outlook and then we will open up the call to take your questions. With our second quarter performance we achieved our first half revenue targets while executing several strategic initiatives that have positioned the company for the holiday season and for future growth.

We moved quickly to capitalize on the consumer excitement generated by the launch of Xbox One and PlayStation 4 last November by launching several new products for both consoles. This helped fuel our sell-in particularly during Q1 when we shipped our first officially licensed Xbox One headsets to our retail accounts. You will recall we led the industry with the first headsets for both platforms. Retailer demand for our Xbox One headsets was very strong and as I disclosed on our last call we executed shipments more quickly than expected resulting in approximately $4 million of revenue expected in Q2 being pull forward into Q1.

Consumer response to our newest headsets which include two PlayStation 4 models and our first three models of Xbox One compatible headsets released in March has been positive and initial sell-through has been solid. In keeping with Turtle Beach’s long history of leading the gaming headset category we introduced a number of industry firsts in June at E3, the largest gaming industry trade show in the country.

Our new offerings further enhance the user experience by expanding gamer’s ability to control game and chat audio. Many of these new console headsets introduced new technology that will differentiate our products during the holidays and beyond. The Elite 800 for PlayStation 4 is our new flagship wireless headset. We believe it is the most technologically advanced headset ever produced. The Elite 800 has several firsts for gaming console headsets including the first time active noise cancellation is being used to improve the quality of outbound chat audio as well as to block out external noise so the gaming experience is more immersive.

The Elite 800 also uses duel invisible microphones for voice pickup which provides a sleek boom free look that is not available on any competing gaming headsets. We also announced the first fully wireless headset for the Xbox One, the Stealth 500x which we believe is likely to be the only fully wireless headset available for the Xbox One this year. This is a significant technological achievement as it requires integration into the audio outputs from the Xbox One console which have changed significantly from the Xbox 360. Wireless headsets are preferred by gamers because of the freedom of movement and flexibility they provide.

We also introduced a Tournament Audio Controller or TAC as call it that sets a new standard for console and PC professional gaming with unique features for audio control, video streaming and broadcast. The TAC along with our partnerships with Twitch and MLG gives us a product that caters to the growing popularity of both tournament gaming and video game streaming.

With the Elite 800 and Stealth 500x we’re also delivering the first console gaming headsets to utilize DTS Headphone:X 7.1 Surround Sound which is a new advanced form of surround sound processing that provides even more accurate directional sound in an array of presets uniquely in our headsets that allows users to match their audio mix to different game and media types.

The Tournament Audio Controller also has DTS Headphone:X another first for this category. We also announced the XO One to fill out the lower end of our Xbox One portfolio. This headset will utilize our own Xbox One headset adapter which we have also advanced to include several unique new features. These innovations add capabilities which make it difference to gamers. They enable our customers to play better and enjoy a more immersive gaming experience leading in innovation and capabilities that matter to end users is at the very essence of what makes us different and what we strive to do as a company on every product in every category.

As I noted on our last call an important ingredient in our success will be expanding our portfolio of next generation headsets. With the introduction of the Stealth 500x the XO One and 3 Call of Duty Advanced Warfare headsets for the Xbox One, our portfolio of officially licensed Xbox One headsets will increase from 3 to 7 in time for the holidays.

With the new Elite 800 the Stealth 400, the P12 and our Call of Duty Advanced Warfare headset for PlayStation 4, our PS4 portfolio increases from 2 to 6 headsets. In addition to our new Call of Duty Advanced Warfare licensed headsets, at E3 we also unveiled our new Disney Infinity Gaming headsets which will launch with the Marvel Superheroes Edition of Disney Infinity 2.0.

The multi-platform headset leverages our partnership with Marvel to align us at retail with one of the most successful new game franchises in the industry. In conjunction with the debut of our Elite 800 gaming headset we announced our Elite membership program, an exclusive offering available for tournament professionals and competitive gamers. This will be a great vehicle for us to further engage and communicate with our elite gaming customers by offering them exclusive Turtle Beach and Partner product and services, early access to news and product information, concierge services and a range of unique member only opportunities at major league gaming tournaments and other industry events.

We believe that our new product introductions, new partnerships and Value Added Elite Membership Program further strengthen our industry leading position and set us up to drive sustained long term growth in our gaming headset business.

Bolstering our positive long term view for our headset business is the strong initial performance of the next generation consoles. While neither Sony nor Microsoft has updated their worldwide console sales figures since April. In June DFC Intelligence increased their 2014 unit sales forecast for both consoles. NPD Retail data continues to show that the new consoles are posting sales that are significantly higher than prior generation launches.

These are strong signs of the overall health of the gaming industry and speak to the significant long term growth opportunities for Turtle Beach as we expect both consoles to drive the proliferation of multi-player gaming and the resulting demand for high quality headsets. As you can see there are several reasons to be excited about the future of our gaming headset business including our growing product portfolio and the underlying success of the new consoles. At the same time as I’ve stated in the past we’re very early into a transition cycle and visibility on key metrics such as headset attachment rate is limited and difficult to predict.

Attach rates are a key driver of the overall gaming headset market size and growth and a key variable behind our 2014 forecasts. On our Q1 call we had only a few weeks of headset of Xbox One headset shipments under our belt so I said that we would provide more color as the year progressed and I will do that now. Let me start with how we measure attach rates. We look at headset sales for the full year as a percentage of the active install base of consoles at year-end.

Roughly 22% to consumers on previous generation consoles owned a headset based on 2013 data. Note that the numbers I’m citing are typically U.S. based where we have the most detailed retail tracking and we use that as a proxy to global activity. At the peak on previous generation consoles these annual attach rate numbers were roughly 24% for Xbox 360 and 14% for PlayStation 3. The PlayStation platform has traditionally had lower attach rate than the Xbox platform which emphasize multi-player gaming sooner and marketed it more aggressively. The attach rates on the old generation consoles are tracking roughly in-line with our expectations so far at mid-year.

Attach rates on new generation consoles which began from a base of zero, are tracking somewhat below our expectations for the first half of the year. There are two primary contributors. On Xbox One wide spread availability of the Microsoft headset chat adapter is leading some consumers to prolong the life of their older headsets reducing the number of consumers that are purchasing a new headset for their Xbox One console and holding down the initial attachment rate.

We anticipated some sales of the standalone adapter but year-to-date actual sales are higher than we expected. On PlayStation 4 we anticipated that as multiplayer gaming became more popular it would cause the headset attach rate to increase over the historical levels of the PlayStation 3. While PS4 attach rate has indeed increased it has not increased as much as we expected to in the first half of 2014. We believe this is in-part due to the very small number of new multiplayer game launches for the PlayStation 4 so far. If the attach rates for both the platforms remain below our expectations through holidays it would trend us towards the low end of our guidance ranges.

To give you some sense of the sensitivity, we estimate that a 1% change in attach rate on next gen consoles has a $5 million to $7 million impact on our revenues for the year at our current market share. So needless to say we pay very close to $0.10 to the trajectory of these attach rate curves.

All that said two developments in the second half of the year may increase the trajectory of the upward curve on attach rates. First there are a dozen major multiplayer game titles scheduled to launch in the second half of the year which will drive retail traffic in gaming headset purchases. Second, we believe our new next gen console headsets have differentiated features at compelling price points that will help drive headset sales over adapters and increased attach rates as consumers head into the stores over the holidays.

Please keep in mind that because of the seasonality of our business we’re less than 30% of the way through our sales year, we can see substantial changes in key industry metrics including attach rate as we move through the third quarter and into the holiday and we absolutely expect attach rates to rise overtime with Xbox One reaching the mid-20s or higher and PlayStation 4 reaching at least the mid-teens and hopefully higher as that platform attracts more multiplayer gaming.

So the attach rate color I just provided is intended to give you a sense of what we’re seeing so far albeit very early into the transition cycle.

Finally as I’ve mentioned before we pay close attention to our market share as an indication of how well we’re performing and whatever underlying overall market conditions exist. We’re very well pleased than in the first half of the year our console gaming headset revenue share has grown in every major market including in the U.S., UK and key international markets when compared to the same period of 2013.

Turning now to some of our other growth initiatives beginning with PC gaming, we have recently taken several important steps to expand our share of this large underpenetrated market. At E3, we unveiled Star Wars and Blizzard Heroes of the Storm PC gaming headset which help raise our brand visibility among PC gamers and provide additional products to our retailer starting in the Q4 holiday sales window. Heroes of the Storm a new Blizzard title that draws characters from their highly successful Warcraft, the Diablo and StarCraft franchises is expected to be the largest PC game launch of the year. As an added incentive to purchase to consumers, anyone who purchases our Heroes of the Storm headset prior to the game launch will be enrolled in a closed beta of the game.

The Star Wars headset aligns us with an incredible entertainment franchise that is popular worldwide and is entering a new period of fill, television and video game publishing activity. We’re really excited about both headsets and about the opportunity for us to work with these great brands. At E3, we also introduced the Recon 320 headset which is a Dolby Surround Sound headset for PC. Together these three new headsets expand and improve our PC product portfolio going into the holidays. This coming week at Gamescom, a trade show in Germany we’re introducing a range of PC gaming keyboards, mice and gaming mouse pads in a licensing partnership involving our long time distribution partner NGS.

NGS will manufacture the accessories and distribute under the Turtle Beach brand at Turtle Beach quality levels for which Turtle Beach will receive a licensing fee. These new accessories will help us expand distribution of our PC gaming headsets by offering a more robust PC product portfolio to retailers. This was a key part of our PC share game strategic.

In the United States our PC revenue for the first six months of 2014 is actually up 62% year-over-year combined with this kind of momentum I’m confident that the launch of our new PC headsets and accessories will enable us to grow our share of the PC market globally.

Now to China, a market that could easily present the largest growth opportunity in the world for our gaming headset business over the next few years. China has an estimated 500 million people playing games annually and the growth of active players in China increased at a compound annual growth rate of 56% from 2008 to 2013. We expect China to be an important market for our PC headsets and we anticipate launching many of our new PC headsets into that market over the next six months. Gameplay in China has historically been dominated by mobile and online PC gaming due to a government ban on consoles.

In January of this year the Chinese government changed the policy and lifted the ban. Microsoft followed quickly and announced their intent to introduce the Xbox One to China is September of 2014. We believe this development significantly increases our long term prospects in China and we have taken a number of steps to quickly capitalize on these rapidly evolving opportunity.

We’re in discussions with many of our existing partners about coordinated China launch activity leveraging our strong Xbox One portfolio. We also have signed an agreement to begin marketing our console headsets alongside the Xbox One launch and are in process on securing additional partnerships for expanded distribution. In the next 30 days we anticipate incorporating our China based business in Shanghai and introducing a localized version of the Turtle Beach brand.

We’re very excited about the developments in China and the opportunity they present over the next few years for our gaming headset business.

I would like to now turn to HyperSound, our disruptive, directed audio technology. We made further progress in the commercial segment. Sales of HyperSound to businesses for retail merchandising as we continue to test, learn and refine our sales strategy during the second quarter. We’re working to close some high profile large footprint U.S. installations of HyperSound including a top national retailer, a premier video game franchise and a large consumer electronics brand which will contribute to revenues but more importantly will raise the visibility as HyperSound as a valuable commercial retail marketing solution.

At the same time our teams have been working to develop HyperSound 2.0, featuring a new emitter design that delivers better performance and audio clarity than the original version and can be manufactured more quickly and more cost effectively. I’m very pleased to share that they completed these tasks on schedule and that this new technology will be introduced in 2015 with the launch of our HyperSound Solution for the hard of hearing.

The reduction in manufacturing costs across multiple components are significant for example we have reduced the cost of the film used in each emitter by over 80%. Note that the completion of the 2.0 HyperSound design was based on multiple additional technology innovations, innovations in materials, in manufacturing techniques and in digital signal processing all of which of course we have filed patents on.

Our preparations for the launch of our hearing health product are also gaining momentum. We have renewed recently a collaboration with two leading audiologists who are laying the groundwork for broader engagement with the audiology and scientific communities.

Keep in mind that the profound benefits of ultrasound based audio are relatively unknown in the audiology community. So we’re making preparations accordingly. We have also added new talent to the team that brings us relevant healthcare experience. Expect more specifics on these items as we approach 2015.

Finally our investments into HyperSound on research and long term development front are also paying off. Our engineers have made additional technology breakthroughs that I’m very eager to share once they get closer to commercialization. I’m very pleased with how the team has progressed both the underlying technology for HyperSound and our readiness to launch additional products in 2015.

Of course across all of our technology development HyperSound and headsets we’re aggressively filing patents to protect our innovation. At this point we have 30 patents granted and another 60 patents pending. On the strategic front we have officially changed the name of our company to Turtle Beach Corporation on May 27th to better align with the business post-merger.

We now feel our overall corporate identify including our name, and our ticker symbol here HEAR reflects our strategy to improve customers audio experience so that they can hear better when they are playing video games, listening to music or experiencing ultra sound based audio in commercial or consumer environment.

As a demonstration of our confidence and commitment to the business we recently agreed with our largest shareholders to extend the locked up agreement for over 72% of our shares by 8.5 months to next April.

With that I will now turn it over to John for comment on the financials.

John Hanson

Thank you Juergen. Good afternoon everyone and thanks for joining us today. In my presentation I will be discussing the combined Turtle Beach and Parametric results for the second quarter as well as the first six months of 2014 which we believe is the better barometer of our overall recent performance due to the timing of the Xbox One roll out. It is important to note that results for the year ago period represent Turtle Beach headset business on a standalone basis.

That revenue totaled $22.3 million compared to 24.5 million in the second quarter of 2013, the decrease in revenue was driven primarily by the timing of approximately $4 million in shipments of the company’s new Xbox One headsets which moved into the first quarter of 2014 as discussed on our first quarter call.

A large proportion of this shipped occurred in international market. For the first six months of 2014 revenue increased 12.1% to 60.6 million compared with 54 million for the same period a year ago driven by strong consumer response to the company’s Xbox One and PlayStation 4 compatible headsets.

Gross profit in the second quarter was 4.8 million compared to 6.3 million in the second quarter of 2013, gross margin declined to 21.7% compared to 25.8% in the second quarter of last year due to higher trade marketing and promotional credits and non-recurring cost associated with packing and shipping the Microsoft adapter in-time for the Xbox One headset audio and Titanfall game launches.

Excluding the non-recurring cost, gross margin would have been 24.2%, for the first six months of 2014 we achieved a gross margin improvement of 50 basis point to 28.2% compared with the same period a year ago driven by an increased penetration of higher margin headsets partially offset by the aforementioned non-recurring cost associated with packing and shipping the Microsoft adapter. Excluding the non-recurring cost gross margin would have been approximately 32.6% for the first six months of 2014. Operating expenses in Q2 totaled $14 million which was a 16% increase year-over-year due primarily to HyperSound operating expenses of approximately $2 million, higher non-cash expenses for depreciation, amortization and stock compensation of $1 million partially offset by lower business transaction expenses of $1.2 million.

In Q2, 2014 the company was able to release 0.5 million in business transaction expense approval as we finalized Parametric merger cost. For the first six months of 2014 operating expenses totaled 30.8 million compared to 20.9 million in 2013, the increase was due primarily to HyperSound operating expenses of approximately $4 million, higher business transaction expenses associated with the Parametric merger of $3 million and higher non-cash expenses for depreciation, amortization and stock compensation expense of 1.8 million.

Our operating expenses year-to-date are in-line with our expectations and consistent with our plans to invest in the commercialization of HyperSound. Adjusted EBITDA in Q2, 2014 was a negative 6.8 million for the combined business as compared to negative 3.3 million in 2013. The headset business delivered negative adjusted EBITDA of 4.8 million for the quarter which compares to 3.3 million of negative adjusted EBITDA in 2013. The decline was primarily due to higher trade marketing and promotional credits and the non-recurring Microsoft adapter packing and shipping cost. The company invested approximately $2 million in HyperSound for the quarter as compared to zero in 2013. For the first six months of 2014 adjusted EBITDA on a consolidated basis totaled a negative $4 million which compares to a negative 1.3 million in 2013.

Year-to-date the headset business has delivered a positive adjusted EBITDA of 0.2 million as compared to a negative adjusted EBITDA of 1.3 million in 2013. Excluding the non-recurring Microsoft adapter expenses of approximately 2.8 million, the headset business substantially improved adjusted EBITDA year-over-year. The company has invested approximately $4 million in HyperSound on a year-to-date basis and consistent with our plans.

Please note that we have provided a reconciliation of GAAP reported results to adjusted EBITDA in the accompanying tables at the end of the press release we issued today. Now turning to the balance sheet as of June 30, 2014. Cash and cash equivalents totaled $9 million compared to 5.5 million as of March 31, 2014. Outstanding debt was 40.8 million which consisted of 19.2 million drawn down from our revolver 7.3 million of subordinated note and 14.3 million in Series B preferred stock. This compared to debt of 60.7 million as of March 31, 2014.

Total inventory as of June 30, 2014 was 37.5 m, a decrease of 13.8% as compared to the same period in 2013. There were approximately 41.9 total shares issued and outstanding as of June 30, 2014.

Moving on, accounts receivable decreased 1.5 million to 15.2 million at June 30, 2014 due to lower sequential revenue and strong cash collections in the quarter consistent with historical trend. Total inventory decreased $6 million to 37.5 million at June 30, 2014 due to Xbox One product sales and proactive inventory management initiatives. We continue to be pleased with the progress we’re making to reduce our inventory investment which continues to be a priority for the company.

Now turning to our full year outlook. We’re maintaining our previous forecast which call for headset revenues to be in the range of 210 million to 230 million and revenues from HyperSound in the range of 1 million to 4 million. Total company gross margins for 2014 are expected to be in the 30% range. Full year adjusted EBITDA for headsets is expected to be in the range of 30 million to 35 million. The company remains committed to investing approximately 10 million in HyperSound in 2014 in order to capitalize on the broad array of expected future opportunities for this technology.

Total company Adjusted EBITDA for 2014 therefore is expected to be in the range of $20 million to $25 million.

And now I would like to pass the call back over to Juergen for some closing remarks.

Juergen Stark

Thanks John. Let me also just note that we have a new investor presentation up on our corporate website. I’m very encouraged by the first half performance and pleased with how our entire team have continued to execute on our operational and strategic objectives to capitalize on the introduction of new gaming consoles and develop and commercialize our HyperSound technology. We continued our leadership in the gaming headset industry with our first to market compatible products and successfully announced an expanded offering of Xbox One and PlayStation 4 compatible products with differentiated features at E3 in June.

For this coming holiday we will have the largest assortment of next generation compatible headsets available combined with the best looking real estate at retail thanks to our 16,000 in-store kiosks and enhanced merchandising and point of sale materials and of course we continue to invest in research, product development and sales of HyperSound products that drive long term growth in areas outside of headset.

I would like to end by thanking our great team of dedicated colleagues globally who help make our vision become a reality every day.

With that we will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). The first question comes from Sean McGowan from Needham & Company.

Sean McGowan - Needham & Company

Couple of questions, one can you share with us Juergen what that share, the market share that you’re seeing? You said it was up compared to a year ago, can you share what it is so far this year?

Juergen Stark

Yes. We’re not going to disclose along the way because it moves along quarter-to-quarter. You will recall Sean that we said our goal is to stay at roughly 50% market share and that’s what we’re doing.

Sean McGowan - Needham & Company

And then in terms of your outlook for the balance of the year, what are you seeing regarding retailer demand or headset that maybe aren’t compatible with the new systems and are you seeing like more rapid than expected tail off of demand for those product? I guess the flip side of that is so what gives you confidence that the full year outlook will still be unchanged from what it was?

Juergen Stark

Sean you’re asking about old gen headsets.

Sean McGowan - Needham & Company

Yes and how it relates to demand for new gen?

Juergen Stark

Yes, old gen attach rates in our business overall in that segment which by the way are forecasted and anticipated obviously would go down, are in-line with our expectations. So in my comments before attach rates as careful as we’re trying to be provide any color given how early we’re in the process is simply to state that the attach rates are lower than we expected at this point in time, it's 30% into the year and if those trends would continue and the trajectory of the curves would continue that way we would end up at the low end of our guidance but of course as I stated a lots more headset launch is coming, portfolio that’s much more differentiated in the second half than it was in the first half, could widely vary those estimates.

Sean McGowan - Needham & Company

All right plus the content that would create the demand, that hasn’t really been seen yet?

Juergen Stark

Yes exactly, that’s my first point I think we have seen two or so major launches and there is like a dozen AAA launches coming at the back half.

Sean McGowan - Needham & Company

Okay. And regarding HyperSound do you expect in our next quarterly call to have some detail about some of these contracts or is that something that will come after the end of the year?

Juergen Stark

Yes, we will provide some detail as we kind of land some of these more major contracts. I will tell you that as interest as we’re on the revenue side. Our absolute top priority is securing some name brand major retail deployments of HyperSound as kind of a proof of concept than a proof of value and that’s what we’re making -- while we have completely kind of rescrub the pipeline we’re going after larger deals, we have scrubbed out a lot of the smaller ones, that’s our real focus and I’m quite pleased on the progress on that front.

Operator

The next question comes from Mark Argento from Lake Street Capital.

Mark Argento - Lake Street Capital Markets

Question on visibility, I know in your prepared remarks Juergen you mentioned always difficult to predict given the transition cycle. What are you hearing from some of the retailers in terms of their expectations for the holidays and when did they have to start locking in kind of order flow so you make sure you got the right amount of product the and the right SKUs and all that and can you -- and do you expect to have more visibility by obviously next quarter or maybe you could just help us understand that the order pattern and what you’re hearing at retail at this point?

Juergen Stark

As we stated in Q1 we will continue to try to do our best to just give you guy’s transparency on some of these key metrics because of this kind of transitional year. I would expect by the way this to be much easier next year once we have more -- the whole industry not just us has a more established pattern upon which to base numbers but you guys can expect an update on the Q3 call in terms of where we’re attach rate in some of these key metrics that drive the overall headset industry right.

So on retail, really the most significant event is E3, that’s where most companies announce their portfolio for the back half of the year, that’s right after E3 is where we do all the meetings with retailers and they take or don’t take various parts of the portfolio. We had in my opinion a tremendous show in E3 with the product portfolio and have had very good success with retailers on accepting the portfolio and ranging what we’re launching. So I think retail in general -- they were excited to see the consoles doing well, they are expecting accessories and games to do very well in Q4 and are excited about it and then our position at retail I believe is quite strong actually.

So for us the kind of our performance in terms of portfolio, market share, the things that we can directly control -- I am actually very positive and comfortable with. We still participate in industry which is in a transition and we got to do the best we can to capture the share along the way here.

Mark Argento - Lake Street Capital Markets

Are you seeing any -- I know in your remarks you had mention guys are maybe holding on to -- gamers are holding on to their legacy headset longer. On the Sony side of the equation they can do that right because the proprietary -- from what I understand the Microsoft, the Xbox, is there hard cutover that you’re going to at some point in time where you’re not going to be able to use an adapter, be able to do any backwards compatibility? Just trying to better understand how long somebody can hold off without having a step up and buy new headset potentially?

Juergen Stark

Yes, I’m glad that you asked that Mark. It's a really important point because all of the conversation in the call here has been about 2014 attach rates of what we’re seeing right? So let me just remind everybody that on PlayStation 3 or PlayStation 4 there are there PlayStation 3 headsets which work on PlayStation 4 so there is kind of no force stop lessons [ph] on that.

On Xbox in order to get a headset working on Xbox One you got to have either an adapter or go by a new headset basically. So our view and my comments about consumers buying the adapters and they are postponing essentially a headset sale, as far as I know there is no hard cutover, that technology won't go away, that technology won't go away. We don’t know what Microsoft’s plans are on availability of that adapter long term. My guess would be that it's kind of a bridging spread to give consumer some forward compatibility like they have on the PlayStation platform but for us I mentioned we do expect the attach rate at the end of the day to be in the mid-20s or potentially higher on Xbox and in the mid-teens and probably we hope higher because of multiplayer gaming on PlayStation. So to some extent whatever attach doesn’t happen this year, we should see it in the next year or two because people are not going to gain with an adapter, they are going -- overtime they will do the normal process of upgrading their gear so to speak with their new platforms either for the PlayStation or the Xbox.

Does that answer your question?

Mark Argento - Lake Street Capital Markets

That’s helpful. And just last, can you remind me -- I know you guys have historically done various tie-ends with some of the AAA titles I think either Socom [ph] or some of the other first person shooters and some of the different other game titles out there or game titles out there, what do you guys have in terms of third party or I should say marketing opportunities going into the holidays with some of the AAA titles out there? Some AAA launches?

Juergen Stark

So the first is Call of Duty, so we have been partnering with Activision for many years now and they are releasing Call of Duty Advanced Warfare which the whole industry is really excited about and we will have a lineup of licensed headsets for that platform. By the way I could ask this, so let me clarify something, a Call of Duty license headset does not only work on Call of Duty, it is just the headset that has been tailored to the look and feel of that franchise and therefore tends to appeal to kind of the Call of Duty fans, right, but it's not kind of unique or only work on the call, you can buy this general headset. So Call of Duty Advanced Warfare is one.

We obviously have our Titanfall headset which we launched in March that will continue and then we talked Heroes of the Storm and Star Wars for PC and Disney Infinity Marvel licensed headsets all three of which will be coming at holidays. And I will just note that those three are kind of outside of our core first person shooter games and so we’re very excited about those other three license deals. Heroes of the Storm is expected to be the biggest PC game of the year. Star Wars as you know is widely popular and retailers love it as a franchise even kind of just core gaming and the Disney Infinity 2.0 launches is expected to be really, really exciting so those are the licensed headsets we have coming.

Operator

The next question comes from Rob Stone from Cowen and Company.

Rob Stone - Cowen and Company

A few question if I may, the first one can you provide any color all on HyperSound revenue in the quarter, did you’ve some?

Juergen Stark

Yes we did have some. It's not super material, it's under a 100,000.

Rob Stone - Cowen and Company

Okay. So that’s going to be a heavily second half waited event as well in terms of coming into the 1 million to 4 million range?

Juergen Stark

Yes exactly and we have got some the deals that we have in the pipeline are multiple 100s of 1000s just in single deals. So our plan to get into the 1 million to 4 million range is to close subset of those deals which will put us into that range. I will restate though again that on the greater scheme of things it's more important to us to demonstrate the value proposition, broad retail deployment of HyperSound as a commercial beneficial sales tool because once we do that, I do expect that what’s happening today is kind of an evangelical sales process with a new kind of technology that no one is familiar with. Once we have some broader deployments I think the entire selling process will get easier and when one person has and someone else is going to want it and we’re very eager to get that kind of beneficial positive cycle started.

Rob Stone - Cowen and Company

The next topic I wanted to drill into a little bit is growth margin. If I take out just stock based compensation and amortization from the cost of goods that you reported year-to-date, I guess to about a 28.4% and I know there were some of the Microsoft adapter repacking stuff in there but to what extent is the growth margin particularly in this quarter also impacted by the very low volume and what are factors either product mix or otherwise that would help boast gross margin in the second half?

Juergen Stark

Sure -- you were talking about Q2 gross profit right, Rob?

Rob Stone - Cowen and Company

Yes I took a look at year-to-date 28.4 million and you’re trying to get to 30 million or so. Q2 looks quite low but if we take first half to be fair even things out that’s still both below the 30%, so to get to the 30% on the year that would imply higher than 30% in the second half we’re just looking for some granularity on how you expect to get there?

Juergen Stark

Just so we’re clear, the Microsoft adapter cost the company incurred in the first half of the year totaled 2.8 million and those cost were spread over the first and second quarter and so and are non-recurring, right. So we’re not going to have to incur those cost going forward as now that adapter has been integrated into the supply chain. So obviously that has a fairly substantial impact that was 2.5% margin impact in the second quarter.

And because of the lower revenue in the second quarter we also did not see the fixed cost leverage for our supply chain operations and that was another approximately 2% impact to the gross profit line and those cost as you know those costs are -- those cost because of the seasonality in our business they will go from what we consider an above benchmark rate or level and then it levels off and it becomes a benchmark cost over the whole year. So with the revenues in the seasonal load obviously those cost go down and you wind up getting fixed cost leverage in the second half of the year and so that’s why we do expect to be able to achieve the 30% margin that we have guided for based on where we’re on a year-to-date basis because we’re as we said ahead of our expectations so far.

Rob Stone - Cowen and Company

And just to be clear that 30% for the year is including or excluding the onetime Xbox adapter cost?

Juergen Stark

Including.

Rob Stone - Cowen and Company

Finally on OpEx you said you were right about where you wanted to be in the first half excluding stock comp and amortization it's running I guess a little bit below 24 million, how should we -- the revenue is pretty heavily second half weighted, how should we think about the waiting of your OpEx on the year?

Juergen Stark

So as we talked about this in the first quarter, from a sales expense line you know the real increase will be associated with commissions. The sales force and sale structure that we have in place today that’s not going to substantially grow to deliver on the revenues in the second half of the year but obviously the incentives that those folks are in, so you will see some uptick in the sales expense for the full year and I should say in the second half of the year relative to marketing. We typically see some slightly higher marketing in the second half of the year not substantially higher than the first and the first half of the year we have significant CES and E3 marketing investments. Those investments, we have talked about those before. Our multi-million dollar investments, you don’t have those investments from the second half which is why your marketing is more leveled throughout the year and then in terms of engineering obviously that work force is in-place, we would expect to see marketed consistencies.

So my perspective we will see slightly higher in the second half of the year and it will be sales commissions and slightly higher for marketing.

Operator

(Operator Instructions). The next question comes from Ryan MacDonald from Northland Securities.

Ryan MacDonald - Northland Securities

First off you talked, Juergen, you talked about in your prepared remarks about two major developments that you think that will really help improve attach rates potentially in the second half. I know one was you know the 12 AAA game releases in the second half. I guess first off, can you talk -- are those gaming releases more weighted towards fourth quarter versus third quarter and then can you clarify what that second development was that that was going to be helping the second half of the year? Thanks.

Juergen Stark

Yes I would be glad to. So yes the game launches, they all hit before holiday basically and so there are some major titles in Q3, but the majority of them are there is like four coming in Q3 and nine major titles just to be really specific but even the Q3 ones are launching, going into the holiday period. Remember that about 50% of our sales are in the holiday period and so that’s what at the end of the day will really matter to the attach rate that will drive the bulk of our revenues. So that’s on games and the other one was product, product portfolio. So right now as I’ve mentioned one of the trends that has attach rates in Xbox One below where we expect it is that the existence of this adapter and people buying the adapter instead of upgrading a headset.

Well the better the headsets are and the more unique features that the headsets have the more likely a consumer is going to be not stick with an adapter but get a headset. Wireless is an example, the DTS Audio capabilities and even the XO One headset which is at the lower end of our Xbox One portfolio actually will use our own adapter which we have added some features to, to encourage people to buy the XO One headset instead of the adapter. So those are kind of the two dynamics that we’re watching very carefully and we will drive the net result and outcome of attach rates at the end of the year.

Ryan MacDonald - Northland Securities

And with the expansion of the portfolio are the majority of those new headsets also going to be out in time for the major gaming releases kind of towards the end of the third quarter before the holiday season?

Juergen Stark

Absolutely, that’s why we run our whole business to do to make sure we’re there in time for holidays and that’s why I was thanking the team on the call for their excellence execution through this point in the year because essentially where we’re now drives when those price will launch and the team has done a phenomenal job.

Ryan MacDonald - Northland Securities

And then just switching gears a little bit to China, obviously there was the announcement of the preorders last week or week and a half ago. I mean have you gotten any visibility into how that preordering process for the Xbox One has gone or what kind of demand you’re starting to see in China and then also will then -- have you heard it that the Xbox adapter will also be on sale in China as well?

Juergen Stark

First of all it's a very exciting development but I will tell you it's also rapidly evolving. This is a week to week, we’re nailing down agreements, we’re getting more clarity on whose is launching, what where at what kind of volume and all that. So it's too early for me to be more specific about potential demand but as -- you will see announcements from us as we solidify some of those things here. In terms of the adapter we don’t have specifics, there is not a large install base of console headsets there anyways. So I don’t know that that’s going to be as much of a factor, right. There was an Xbox 360 and there are a large install base of Xbox 360 users that could bring their headsets forward. So it's not something that we think should be a major factor there.

I will though it's given the number of gamers there, it will take us some time for the market to develop obviously but Microsoft is moving very quickly, PlayStation 4 we expect will be coming thereafter and we have both an excellent team and leadership in place that’s running our Asia and China initiatives and just have made, given how fast this has hit us here and have made great progress with the pieces of what we have in motion there with some of our existing partnerships and we’re really excited for this launch both in the holiday and more importantly for what it does for the next couple of years.

Ryan MacDonald - Northland Securities

And due to the early nature of that developing business, does that mean that there has been really no revenue related to China for console gaming baked into guidance?

Juergen Stark

We had a little bit but it's mainly PC driven. So we do have China revenues based in but they are largely PC weighted. This is one of those things where if you look at the details of the forecast some things are up a bit, some things are a down a bit and so China while we expect it to be a positive is not a major driver of the financials this year.

Operator

Your next question comes from (indiscernible).

Unidentified Analyst

There is always a great deal of hope for Turtle, could you kind of give us what your vision is where this company will be in 3 to 5 years?

Juergen Stark

We have spent the whole call talking about 2014 but we pay a lot of attention to where we want the company to be in 3 to 4 years. We want to be an audio technology that has significant defendable franchises in multiple segments. Number one console gaming headsets that’s where we have the 50% market share, that’s where we have an outstanding team that continues to innovate and keep us on the forefront of those headsets and that our innovation and our quality level is what has earned us a 50% market share and we work every day to keep that market share and keep our industry leadership in that segment. That’s on console gaming headsets.

In 3 to 4 years I would expect us to have added significantly in the headset category by a PC gaming headsets and media headsets, media headsets you will recall we launched a first few models of holiday last year. It's a big segment, $3.7 billion and we’re learning with our kind of 1.0 product and working on 2.0 and as I have said multiple times it's not meaningful from a revenue standpoint yet, but in 3 to 4 years I would certainly expect it to be a big part of our business. That’s on headset sand then HyperSound, we have got the commercial segment which is buying HyperSound for retail, it plays in all kinds of business uses. I would expect that to be a meaningful part of our business over the next couple of years. That product shipping, it's unique, we have version 2.0 coming which makes further improvements and then healthcare on HyperSound. So as we have spoken about in the past HyperSound has profound benefits for people with hearing impairments.

There are a large population over 300 million globally that have hearing impairments that are severe enough to need a hearing aid and 80% of them don’t have a hearing aid. These are the people that are turning up their TV volume louder and louder and driving everybody else in the household nuts. In 2015 we will launch the world’s first living room add-on audio product that will enable those people to listen to TV at a normal volume, not everybody nuts and have a significantly better listening experience. This is an unknown phenomenon today. Audiologist don’t know about these ultrasound benefits and we’re very excited to kind of lead these category and enable this large population of people to enjoy listening and hearing their TV sets and longer term and again as I said in the past, I would expect that to be a potentially very large business over the next 3 to 4 years and I’m very pleased with the progress the team is making to get us ready to launch their product in 2015.

And then lastly as I’ve mentioned the HyperSound, it's relatively new undiscovered technology. We keep identifying new uses and have some breakthroughs that I’m not going to talk about yet but that lay the ground work for expanding into some new categories when you think about a longer time horizon like 3 plus years.

Okay, sorry for the long-winded answer but I do appreciate the question because we tend to focus on the quarter and the year but our long term vision is obviously a very important part of the company.

And with that I would like to thank everybody again for joining us today. We look forward to speaking with you again on our third quarter earnings call in November. Thanks again everybody.

Operator

Ladies and gentlemen that does conclude the conference for today. Again thank you for your participation. You may all disconnect. Have a good day.

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Source: Parametric Sound Corporation's (HEAR) CEO Juergen Stark on Q2 2014 Results - Earnings Call Transcript

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