Turtle Beach: Digging The Hole Even Deeper

| About: Turtle Beach (HEAR)

Summary

Turtle reverse-merged into a company holding old, unwanted technology. After holding on a couple of years, Turtle finally realizes it's a losing proposition and announces restructuring plans for the division.

With cash dwindling to $1 million, Turtle is left to try to squeeze profit from the troubled gaming headset division.

Turtle's headsets are largely ignored by reviewers and many are doomed to discount bins. Meanwhile, gamers are playing on their phones, eliminating the need for consoles and headsets.

Net revenues in the first half of the year are down dramatically from 2013. Net losses have more than doubled.

Return on equity and profit margins are far worse than the rest of the industry. Institutional ownership is extremely low. Additionally, Turtle has disclosed a material weakness in financials.

Turtle Beach (NASDAQ:HEAR) has forgotten Will Rogers' famous quote: "If you find yourself in a hole, stop digging."

The San Diego, California headset company has dug itself into a money pit that necessitates the desperate restructuring of its HyperSound business. But in our view, the effort will only prolong the misery, as Turtle creeps toward further decline. Let's look at nine reasons TheStreetSweeper expects more Turtle troubles.

1. Reverse Merger Grabs Old, Unwanted Technology

Turtle became publicly traded in January 2014 via a reverse merger stock swap with Parametric Sound Corp. (PAMT), whose technology centered on directing sound waves in a narrow beam.

MDB Capital underwrote Parametric just prior to the merger. TheStreetSweeper has written about the decline of other companies underwritten by MDB Capital, including Uni-Pixel (NASDAQ:UNXL) and Resonant (NASDAQ:RESN).

Parametric had traded as a penny stock until it conducted a 5-for-1 reverse stock split in early 2012. Parametric received the money-losing HSS technology through a 2010 spin-off from LRAD Corp., which had grown tired of the unappreciated tech. LRAD CEO Tom Brown said, "we have been unsuccessful in developing a market for HSS, [and] we have no current plans to invest further resources in it."

That technology has been around nearly two decades now and has been very slow to commercialize. In 2014, the Food and Drug Administration cleared HyperSound for marketing to people who wanted
improved "clarity and comprehension of sounds."

This is where the odd story gets even odder.

2. HyperSound Gets Off To A Bad Start

So with the FDA's clearance in hand, Turtle might have been expected to rush off to target audiologists or consumers with hearing impairment. But no. They went after gamers.

Turtle chose to commercialize by launching HyperSound embedded in displays of Activision's videogame Call of Duty: Advanced Warfare in around 1,000 Best Buy stores.

By then, the 11-year-old Advanced Warfare series was showing signs of decline, Forbes warned Activision investors. Franchise fatigue had set in for many fans, and they demanded something new and different - but HyperSound didn't fit the bill.

The bad news had just begun for Turtle's effort. Best Buy soon endured a drop in customer traffic, despite aggressive, expensive promotions. Within two years of Turtle's display launch, the retailer closed 50 stores, and has continued to quietly close stores through the present.

In short, after HyperSound had been abandoned, Turtle turned around and mis-marketed it. But it took a long time before Turtle decided the other guys were right.

3. Guess What Gets Restructured?

Fast forward to recent days. Now Turtle has decided it's time to restructure - something that is virtually always the beginning of the end.

Indeed, Turtle announced Sept. 26 the restructuring of its money-gobbling legacy product HyperSound.

Though the announcement may have surprised investors, there were plenty of signs that Turtle was getting fed up - or at least should have been getting fed up - with this technology the company hitched itself to just before its IPO. In fact, the company has repeatedly noted that HyperSound has done nothing but create operating losses:

Our HyperSound business has not generated significant revenues, has a history of operating losses, expects additional losses and may not achieve or sustain profitability. [source]

Our HyperSound business has incurred operating losses since the spin-off of Parametric Sound Corporation from LRAD Corporation in 2010, and we expect additional losses in the near-term as we continue to expend significant resources on personnel, consultants, intellectual property protection, research and development, marketing, production and administration. [source]

Even as HyperSound continued to drag on the company, leaders talked up the technology.

CEO Juergen Stark said during the Q1 2015 earnings call:

The quarter was also highlighted by good progress for the launch of our HyperSound healthcare products scheduled for later this year.

Turtle seemed to shift focus from the weird idea of marketing HyperSound to gamers to:

...executing the successful launch of our HyperSound hearing product. Our groundbreaking in-home solution for helping people with hearing loss to better understand and enjoy TV, music and other media.

But Turtle seemed to shift focus again months later. The Q4 2015 earnings call concentrated on the headset business (initially held by the parent holding company) and away from the bothersome legacy product...So we should have expected that restructuring announcement that came about two months later.

There will be lots of slicing and dicing, considering the company last year invested a whopping $11.6 million to commercialize HyperSound and add some headsets to its lineup.

So if HyperSound ever had a speck of potential we can safely assume it's just about all gone. And potential isn't the only thing that's coming up short.

4. Cash-Poor

Imagine having to operate a business on one-sixth the cash that was available just six months ago. That's Turtle's situation. Turtle is running out of cash:

Click to enlarge

(Source: Company SEC filing)

The company had about $12 million in revolving and term loans on June 30, 2016. Excess borrowing availability is $4.9 million. But it looks like some sort of capital raise will be needed in the future.

But what is the potential for the remaining business - gaming headsets?

5. Headsets: Once Moldy, Now Ignored

Turtle's headset business has been troubled and still looks uncertain.

Just last October, the company had to recall ~$6 million worth of its next-generation gaming headsets due to mold problems.

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(Source: US Consumer Product Safety Commission)

With this recall well behind Turtle Beach, its headsets still weren't mentioned in the 2016 headset review by PC Gamer:

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(Source: PCGamer, click for more)

The headsets were also excluded from the review shown below:

(Source: wiki.ezvid, click to view list)

And Turtle's product barely squeaked by to earn last place in PCMag's review:

The reviewer commented: "Turtle Beach's Ear Force Stealth 450 is an affordable and functional wireless gaming headset, but it's a solid example of getting what you pay for. It doesn't sound bad and it doesn't feel cheap, but it pales in comparison with the Editors' Choice Logitech Artemis G933. If you really want a wireless headset, the G933 or the Skullcandy PLYR 1 ($149.99 at Amazon) are much better options, though more expensive."

Click to enlarge

(Source: PCMag; click for more)

*6. Bargain Basement Discounts

Fierce competitors' new cutting-edge products often send older, less desirable products straight to the discount bin. And that's what Turtle is enduring with some of its products, according to an Amazon search:

Click to enlarge

In some cases, customers were picking up Turtle's headsets at discounts as steep as 47%.

7. Smartphone Trend Weakens Opportunity

Entertainment Software Association has been tracking an interesting trend. The group found that a whopping 36 percent of the most frequent gamers play on their smartphones.

That means Turtle products will face additional challenges as more and more gamers play video games on their smartphones, turning up their noses at video consoles that require headsets.

If that trend continues as expected, Turtle could see a continuation of another unfortunate trend...

8. Losses Increase

Turtle is seeing increasing net losses. While net revenue did increase 26% in the first half of the year, net losses more than doubled:

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(Sources: Company SEC filings - here, here, here)

While the industry is recording horrible profit margins over the past 12 months, Turtle's are even worse:

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When we look at how many dollars of profit Turtle generates for each dollar of shareholders' equity, we find that return on equity is poor:

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(Source: MacroAxis)

The institutions must have seen all the signs, and decided they don't want Turtle.

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(Source: Nasdaq)

9. Material Weakness Revealed

Last, but not least, Turtle revealed in its most recent 10-Q (see page 35) that the company has "identified a material weakness in [its] internal control over financial reporting" that has not yet been remedied. This is not only a confidence-killer but could lead to issues such as late filings, restatements, and even suspension or delisting from the Nasdaq.

Conclusion

Turtle is not a growth stock or a turnaround stock. This reverse-merger company can't seem to stop digging even as it faces continuing losses, low cash, institutional apathy, miserable returns, unremarkable products, and a restructuring of its legacy business.

Turtle stock is quickly turning into turtle soup. We think adventurous consumers will soon be able to scoop up a cold cupful for just $0.85 per share, which we see as a very reasonable valuation.

Disclosure: I am/we are short HEAR.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.