Turtle Beach's (HEAR) CEO Juergen Stark on Q2 2016 Results - Earnings Call Transcript

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Turtle Beach Corporation (NASDAQ:HEAR) Q2 2016 Earnings Conference Call August 9, 2016 10:00 AM ET


Juergen Stark - CEO

John Hanson - CFO


Mark Argento - Lake Street Capital

James Medvedeff - Cowen & Company

Alex Silverman - Special Situations Fund


Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Second Quarter 2016 Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. Before we get started, we will be referring to the press release filed today with details of results which can be downloaded from the Investor Relations page of our website at corp.turtlebeach.com. In addition, a recording of this call will be available on the Investor Relations of the Company's website later this evening.

Please be aware that some of the comments made during our call may include forward-looking statements within the meaning of the federal securities laws. Statements about our beliefs and expectations containing words such as may, will, could, believe, expect, anticipate and similar expressions constitute forward-looking statements. These statements involve risks and uncertainties regarding our operations 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 statements and risk factors contained in today's press release and in our filings with the Securities and Exchange Commission, including without limitation our most recent Annual Report on Form 10-K, our most recent quarterly report on Form 10-Q and our other periodic reports, which identifies specific risk factors that also may cause actual results or events to differ materially from those described in forward-looking statements.

We do not undertake to publicly update or revise any forward-looking statements after the date of this conference call. We also note that on this call we will be discussing non-GAAP financial information. We are providing that information as a supplement to information prepared in accordance with accounting principles generally accepted in the United States or GAAP. You may 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 CEO. Juergen you may begin.

Juergen Stark

Thank you and good morning everyone. First I will hear some highlights of another strong quarter before passing the call to our CFO John Hanson who will provide details on our Q2 financial performance. I will then expand upon our operations and speak more about our increased outlook for 2016. The strong performance of our headset business has continued through our second quarter. Not only was headset net revenue up 29% versus the year ago quarter, our Next-Gen sales grew by 80% versus the same period. Next-Gen headsets also comprised 91% of our net revenue in the second quarter and was a driver of 840 basis point expansion in our headset gross margin and 240 basis point expansion in our consolidated gross margin. Sell through of our Next-Gen portfolio continues to be very strong both domestically and in Europe, in fact in NPD data has confirmed that our market share grew even higher during first half of the year, not an easy feat given our already strong market share.

So the first half of 2016, the overall console market is up a healthy 20% on a unit basis, total Beach is up 27% on a units basis during the same period and we own all of the top five selling third-party headsets year-to-date in 2016. Given this momentum in our Next-Gen headset business we expected to represent over 90% of sales in 2016, we are again raising our 2016 outlook and believe we remain well positioned as we approach our important holiday season. In our HyperSound business, we experienced lower-than-expected sales due to the continued slower ramp in the Audiology’s channel. We’ve also continued to find that it's taking significantly more effort than anticipated to get hearing healthcare offices to integrate HyperSound Clear 500P into their daily office workflow. However, we carefully managed our spent, continued to refine the sales approach and have begun to actively test and pursue alternate sales channels to sell this breakthrough living room audio product.

In June, we also unveiled HyperSound Glass, the world's first transparent directional speaker. Our HyperSound Glass video demonstration on YouTube already has over 130,000 views. We believe the technology is extraordinary and we are already beginning commercial licensing discussions. In today's earnings release, we also announced the engagement of Piper Jaffray to explore strategic options for the HyperSound business. As we said in the earnings press release, we are testing and pursuing alternative more consumer and retail oriented channels for our HyperSound Clear product. We’re also developing and seeking FDA clearance for [indiscernible] [00:05:19] capability as an upgrade which we believe will be of high interest to the audiology channel and may help drive further sales there. We continue to believe there are strong additional future potential for HyperSound technology across other segments as well. But we have a limited resource in capital and the cost associated with the healthcare business will continue to require the devotion of significant resources. So we are evaluating business model modifications and strategic alternatives in an effort to enable HyperSound to fully realize its potential. I will have more to say about this process and other developments in our business following John's remarks on the quarter. Needless to say, we are very pleased with our Q2 financial performance including our strong sales and profit growth in headsets and our diligent cost management.

Now I will turn the call over to John. John?

John Hanson

Thank you Juergen and good morning to everyone. Jumping right into the numbers, net revenue in the second quarter of 2016 increased by 30% to $29.4 million compared to $22.6 million in the same year-ago quarter. The increase was attributable to a 29% increase in headset sales due to continued robust sell through of our Next-Gen headset portfolio. Gross profit in the second quarter increased 50% compared to the year ago quarter to $5.1 million. Gross margin was 17.4% compared to 15% in the second quarter of 2015, an 840 basis point improvement in headset gross margin to 24.5% was partially offset by amortization cost associated with the launch of HyperSound Clear 500P which resulted in negative HyperSound gross profit in the quarter. Keep in mind that gross margins historically have run lower in the non-holiday period based on fixed operating costs.

Our higher margin Next-Gen headsets contributed 91% of revenue in the second quarter, up from 65% during the same period in 2015. As a reminder, we have recognized between $3 and $4 million in fixed costs relating to supply chain, logistics, depreciation, amortization and stock compensation expense in each of the past six quarters. The amortization portion is expected to modestly rise sequentially in the final two quarters of 2016 primarily due to amortization of the HyperSound healthcare product. As such, consolidated gross margins are expected to be lower in the non-holiday quarters due to fixed cost deleveraging as well as the seasonality of the headset business that are expected to expand for the full year driven by higher revenues during the holiday season.

Operating expenses in the second quarter were $45.6 million compared to $16 million in the year ago quarter. In accordance with US GAAP accounting rules, the second quarter of 2016 included a $31.2 million non-cash goodwill impairment charge relating to the HyperSound acquisition. Excluding the impairment charge, operating expenses declined 9% to $14.4 million compared to the same period of 2015. The year-over-year decrease was driven by our continued cost management effort across the entire business. Net loss in the second quarter was $42.6 million or a negative $0.86 per diluted share compared to a net loss of $9.9 million or a loss of $0.23 per diluted share in the year ago quarter. Excluding the $0.63 per share non-cash goodwill impairment charge, net loss in the second quarter was $11.4 million or a negative $0.23 per diluted share. The year ago quarter included a $3.1 million income tax benefit, approximately $0.07 per diluted share versus $0.3 million benefit in the second quarter of 2016 due to the valuation allowance recorded in the third quarter of 2015.

The second quarter of 2016 also included approximately 7 million incremental diluted shares compared to the year-ago quarter primarily due to the February 2016 follow-on public offering of common stock and concurrent private placement. Adjusted EBITDA on a consolidated basis improved to a loss of $6.3 million compared to adjusted EBITDA of a loss of $8.2 million in the year ago quarter, the 23% improvement was primarily driven by strong Next-Gen headset sales and cost reduction initiatives partially offset by a $0.7 million negative impact from foreign exchange. This was due to the sharp decline in the British pound following the Brexit vote. Had it not been for this unexpected impact, we would have exceeded every metrics of our Q2 guidance. Adjusted EBITDA for the headset business was a loss of $3 million in the second quarter compared to a loss of $5.2 million in the year ago quarter representing a 43% improvement.

Looking at the first half results, let me provide just a couple of highlights from our headset business. Next-Gen headset sales accounted for 90% of total headset sales in the first half of the year, up from 64% last year. Consolidated gross margin in the first half were 15.9% of total revenues, up from 15.4% last year. But our headset gross margins in the first half were 22.5%, a 600 basis point higher than the first half of last year. The net loss per share in the first half of 2016 was $1.14 or $0.49 excluding the goodwill impairment charge compared to $0.49 in the first half of last year. Consolidated adjusted EBITDA in the first half of this year was negative $12.6 million compared to negative $18 million in the first half of last year. In the headset business, adjusted EBITDA in the first half was negative $6.2 million compared to a negative $11.8 million last year.

In fact, trailing 12-month EBITDA for our headset business as of the end of Q2, is approximately $8 million higher than 12 months ago. Please recall, with revenues expected to increase in the remainder of the year as we enter our peak selling season for handsets in Q4 and assuming continued improvement in gross margins and OpEx, we would naturally expect to flow through more EBITDA in the headset business in the latter part of the year. Now turning to the balance sheet, we ended the quarter with cash and cash equivalents of $1.2 million compared to $7.1 million at December 31, 2015. As a result of the availability under our $60 million revolving credit line, we generally do not hold a large cash balance. Outstanding principal debt at June 30 was $41.5 million compared to $68.1 million in December 31, 2015. The decrease in debt was due to a 25.3 million reduction in our revolving credit facility which was driven primarily by receipts from strong holiday sales and our February 2016 follow-on public offering.

The debt as of June 30 included $7.2 million of borrowing under our revolving credit facility. Historically, the outstanding balance fluctuates throughout the year being close to zero in the early year before it ramps up ahead of the holiday. At the end of the second quarter, the revolver balance is to getting the show the holiday increase, consistent with our expectation and goal. Subordinated debt total $18.3 million and term loans totaled $16 million. The addition of a term loan and subordinated debt in 2015 provide the company permanent capital reducing our dependency on the ABL revolver. Continued strong headset sales, solid consumer response to our Elite Pro headset along with our just announced holiday products are driving us to buy more inventory in advance of the upcoming holiday season.

So in June, we amended our credit agreements with the term loan and ABL lenders. The amendments provide among other things a temporary reduction of the existing loan availability block for the period of June 17, 2016 through October 31 of 2016. This temporary reduction enhances our borrowing base by $3 million through September 30 and by $1.5 million through October 1 through October 31, 2016. Internally, we look at cash plus accounts receivables less accounts payable as one measure of our liquidity. At approximately a positive $300,000 this is approximately $3 million higher than the second quarter last year. Taking into consideration, the availability on our line of credit and our expectation to be EBITDA positive on a consolidated basis in 2016, we believe we have sufficient capital to fund our business plan. This is further supported by our continuing cost and expense management in the first half of the year, which we expect will continue throughout 2016.

And now I will turn the call back over to Juergen for some additional comments on the business and our updated outlook. Juergen?

Juergen Stark

Thanks John, we are particularly pleased by the success of every model in our New-Gen headset line-up. Those of you who have been following us closely over the last couple of years will recall the surprisingly rapid adoption of New-Gen consoles which caught many industry analysts and observers by surprise resulted in faster than expected declines in Old-Gen headsets before the installed base of new consoles was large enough to offset the decline. This led to lower than expected overall sales in 2014 and 2015 and impacted us disproportionately to others headset makers given that we had by far the largest line-up of Old-Gen products and by far the largest Old-Gen headset revenues. The console transition drove us to end-of-life 16 Old-Gen models and design, develop and launch 17 Next-Gen models in under three years. Not only did we accomplish that, but those 17 models reflect a level of innovation that we believe rivals the rest of the industry combined. This includes being first to market with both Xbox One and PlayStation 4 headsets, first to market with wireless headset for Xbox One. We had the first gaming headsets with DTS Headphone:X surround sound and the first with our innovative unique superhuman hearing feature.

In our Elite Pro line, we completed a ground up science-based gamer input driven redesign of the professional gaming headset and audio controller which is now adopted by two of the best professional gaming teams in the world. All of this, while we transitioned our entire portfolio from Old-Gen to New-Gen. It was our belief and expectation that when the New-Gen install base was large enough and the Old-Gen sales dropped sufficiently we would be able to show strong net growth in headset sales and that is in fact what has happened. So we're very pleased. As I mentioned in my opening remarks, strong sell through in our headset business continued in our second quarter. This was supported by recent domestic NPD data that shows Turtle Beach continue to outpace a healthy double-digit growing gaming headset market in both retail units sold and revenue share. While the console headset market is up 18% in revenue during the first six months of 2016, we gained 19% year over year.

Looking at domestic data on a unit spaces, while the console headset market is up 20%, we gained 27% year over year in the first six months of 2016. A few final points regarding our domestic share. We ended the first six months of 2016 with 40.7% consolidated revenue share, up 20 basis points from the same time last year. And on a unit share basis for the same comparative time periods we are up 190 basis points to 31.8%. As intended, our Recon series has driven very strong share gains in the under $50 retail price segment explaining part of the difference in units and dollar growth dynamics. In the UK, Chart-Track data shows that the console market in the second quarter was up 11% in dollars, while Turtle Beach 17%. Our dollar share in the UK console headset market in the second quarter was 44.9%, up 250 basis points from the same time last year.

Keep in mind since, since we are the industry leader, these growth rates are on a level of volume and revenue that is three to six times larger than others in the console gaming headset category. Among several other leading product positions, we continue to have the top third-party models domestically in the gaming industry as confirmed by NPD for the first six months of 2016. All of the top five selling third-party headsets were Turtle Beach. And our XO FOUR Stealth continue to be the highest selling third-party headset followed by our XO ONE headset. Launched in October 2015, PX24 remain the largest selling third-party PlayStation 4 headset so far in the first half of 2016 as measured by revenue followed by the Stealth 500p, our feature rich wireless PlayStation 4 headset. In the UK, are 50X product was the bestselling headset in the first half of the year.

At this point, several million gamers from entry level to hardcore are now enjoying our New-Gen headset products and the related innovations. On the subject on new products, in early June we launched our Elite Pro product line at retail. This line-up includes the Elite Pro Tournament Gaming Headset, Elite Pro Tactical Audio Controller or TAC and the Elite Pro accessories. Our Elite series products including our existing Elite 800 fully wireless headsets reflect the highest level in gaming audio quality, innovation and performance. Through our new partnership with OpTic Gaming announced in May, OpTic championship Call of Duty, Halo and Counter-Strike global offensive teams have been using the Elite Pro headset TAC and other Elite Pro accessories. OpTic won their first two major tournaments using our Elite Pro headset and just recently won a third the major title.

Following our main partnership with OpTic, we doubled down on our commitment to competitive gamers by partnering with another top professional sports organization Faze Clan, Faze Clan is one of the world's largest and most well-known esports and gaming entertainment brand. As of June, they are now also using Turtle Beach’s Elite Pro tournament gaming headset line as their official audio gear of choice. We believe the Elite Pro is evidence of our position as true innovators in the market and has allowed us to deliver a powerful one-two punch by teaming up with not one but two of the biggest and best esports teams with Face and OpTic.

Moving onto some other new products, at this year's Electronic Entertainment Expo or E3 we showcased our all-new Stealth 350VR headset. This gaming headset delivers a virtual reality audio solution, loud and clear with a 30-plus hour battery powered amplification, variable base boost and a light ergonomic built for VR design that provides clearance for the VR headbands and cables. The 350VR’s neodymium speakers are designed to provide a rich expansive audio experience with crisp highs and thundering lows, while smooth fabric wrapped memory foam over ear cushions ensure a comfortable fit. We are planning to launch Stealth 350VR this fall for an MSRP of $79.95. We also debuted Turtle Beach Stream Mic, a first of its kind professional desktop microphone for gamers streaming directly from their consoles council.

With the Stream Mic players can live stream gameplay from their Xbox One and PlayStation 4 as well as from a PC or Mac thanks to universal plug and play compatibility. The Turtle Beach Stream Mic will elevate your Twitch, YouTube and MLG.tv streams to a whole new level and is also planned to launch this fall for an MSRP of $99.95. Before I turn to HyperSound let me discuss two more macro items for the headset business. At E3 this year, Microsoft unveiled two new consoles at its Xbox briefing with Nintendo and Sony both announcing before the show that their new hardware would not be featured this year. Microsoft unveiled Xbox One S which is a slimmer and 40% smaller version of the Xbox One with a starting price of $299 and was released on August 2. Microsoft concluded its presentation with the announcement of Project Scorpio, a console that will support 4K gaming and high fidelity VR and is expected to launch at holiday of 2017.

Sony has also confirmed the existence of PlayStation Neo which is an upgrade that will offer 4K gaming and optimized VR through PlayStation VR, the release date and pricing of Neo have yet to be released. With these upgrades, it’s clear to us that virtual reality can be an exciting and potentially significant new market segment for our headset business. Given our anticipated launch of the Stealth 350VR, we believe we are well-positioned to serve this market. And since these upgrades are just upgrades, we do not expect them to be disruptive to our headset portfolio. In fact, we expect and are pleased to see the consoles keeping consumer interest in driving the overall console gaming market.

Second, view on international markets, as John mentioned, Britain's surprising referendum and move out of the European Union in June caused a sharp decline in the British pound impacting our results by $700,000 purely in terms of Forex impact. Last year, we experienced a severe slowdown in our international business due to the strong dollar. Year-to-date this year, our UK and European businesses have done well and outpaced market growth as I described. Of course we have and our continuing to evaluate the impact of Brexit and the potential for further decline of the pound on our full-year results. In this case unlike last year, the euro is not directly impacted and have has even strengthened relative to the pound. So the impact is expected to be isolated to the UK where we are direct with many retailers.

In addition to the straight currency impact, the strong US [indiscernible] margins in regions where our product costs are driven in dollars. In Q2, our European business showed growth of over 20% and tracked above our internal plans. We undertook some changes to our distribution model to more directly manage our business in terms of core markets which we expect to offset some of the impact of the strong dollar going forward. In fact, just last June, just last month we announced the restructuring of our distribution channels across mainland Europe, as part of the plan we started in 2015. Our category and channel landscape is evolving quickly across the region and we've developed a business strategy in an effort to help us stay ahead of the market evolution. Exertis and Koch Media have taken on distribution duties for France and Benelux respectively and additional territory partners for Germany, Spain and Italy are expected to be signed in the weeks ahead.

This is a significant move for Turtle Beach as we look to take steps in our European business and further underlines our ambition to further our growth in the UK and across Europe. We've been making strong gains over the last three years and feel that these new distribution partnerships will help us achieve our long-term goals. Distribution in the Nordic territories will remain with our current distribution partner in those territories Nordic Game Supply. All that said, the continuing impact of Brexit vote is a factor in our more conservative estimate on quarter over quarter growth for Q3 and Q4 relative to Q1 and Q2. We remain committed to the international market and believe we have significant growth opportunities overseas. This includes a recovery in Europe and over time, we believe China remains a large untapped market that we will pursue as we achieve our goals of improving profitability in our core markets.

Now moving to our HyperSound business, we experienced a challenging quarter of sales due to the expensive training and resources necessary to build market awareness in the hearing healthcare channel. As we’ve communicated in the past, many hearing healthcare offices are so focused on selling hearing aids that it is taking more effort and training to get them to integrate HyperSound Clear 500P into their daily office workflow. This is a challenge that frankly we underestimated. However, we continue to carefully manage our spend while refining the sales approach, as well as testing, experimenting and finding the most effective route to scaling the number of fully active offices in a highly focused way. We are also developing and seeking FDA clearance with respect to the Tinnitus feature as an upgrade, which we believe will have strong interest and be a good fit with the Audiology channel.

As I stated on our last earnings call, we were executing a diligent set of market tests for HyperSound Clear 500P in May. May was American Speech-Language Hearing Association's better hearing and speech month and we organized a targeted media campaign to drive awareness and test various marketing efforts in two specific geographic regions, Southern California and Florida's Gulf Coast. This included a combination of digital radio, newspaper and PR efforts. Viewers, listeners and readers were directed to the HyperSound website, which includes details on the nearest hearing healthcare office that offers the product.

We learned or saw evidence of several important factors. First, advertising was highly effective, particularly in the Sunday newspaper. We generated a 5x increase in inbound consumer calls after running advertisements. Second, measuring our website traffic flow generated by these market campaigns indicated that a large portion of the potential prospects did not proceed further once we listed specific audiology doctor’s offices as the place to purchase. We've also gotten anecdotal indication that consumers may be first thinking of retail channels when they consider upgrading their TV audio rather than doctor’s offices.

On the other hand, 40% of the consumers that visited a participating office and received a demo proceeded to purchase the product, further supporting the strong conversion we've seen since launching the product. While the number of consumers in these test markets were small, the data was highly useful in shaping our strategy.

During the quarter, we also spoke about preliminary data from our latest clinical study, suggesting HyperSound Clear 500P has the potential to alleviate Tinnitus. The study was conducted to assess whether HyperSound’s higher frequency directed audio could help patients suffering from the disease. With promising preliminary results from that study, we are awaiting FDA clearance with respect to the Tinnitus future. And if cleared, expect to have the HyperSound Clear 500P product software changes ready to go in late Q3 or early Q4. We believe this upgrade to the HyperSound Clear 500P product will be a better fit with the hearing healthcare channels that sell Tinnitus products because patients come in specifically for Tinnitus relief.

We believe this offering is a better fit into their workflow and the product does not compete directly with the core Hearing Aid business. So if we receive FDA clearance, our plan is to introduce the Tinnitus feature to the audiology channel as soon as possible. We believe we can ultimately be successful in the audiology channel, given sufficient time, advertising funds and sales resource to train offices and encourage them to adjust their workflow towards selling HyperSound systems. We also believe that the Tinnitus feature addition will be a much better fit with this channel as I mentioned.

However, we don't believe we currently have sufficient funds to support what is required in terms of advertising training resources or time. So, in parallel, we are also seeking to actively expand sales in the new channels. In order to test other channels beyond hearing health offices, we plan to initiate two test pilots in the retail market for our HyperSound healthcare product. Later this month, we will be featuring HyperSound Clear 500P with the personnel demonstrating the technology at a major consumer electronics retailer in the Chicago area. We will also have tests with multiple home Pro AV providers, where we have received inbound interest.

As I mentioned in my opening in early June, we achieved another significant breakthrough with our HyperSound technology, revealing that we are now able to create directional audio using a transparent pane of glass. The advancements the HyperSound team is making with directional audio are simply amazing. We think they are some of the biggest breakthroughs in audio technology to come along in decades. Being able to create highly directional audio using glass opens up many potential opportunities, including integrating in the desktop monitors to commercial displays, desktop speakers and automotive dashboard glass to provide warnings directed specifically at the driver. Pretty much anywhere there is glass, there is potential for audio with this technology.

As we progress the technology, this would also open up licensing possibilities to external parties looking for ways to integrate this type of audio technology into their products. Again, it's still an early development and the applications are simply ideas on the drawing board, but at the same time having HyperSound directional audio work on glass is very exciting. We showed it publicly for the first time at E3 and the consumer and industry reaction was what you would expect from such a stunning audio technology.

As we explore new more consumer and retail oriented sales channels for the HyperSound Clear 500P product, while seeking FDA clearance for the Tinnitus capability for the hearing healthcare professional channel, we are elevating business model modifications and strategic options for HyperSound, particularly given our desire to provide HyperSound with the resources and time required to fully develop the opportunity. As such, we've engaged Piper Jaffray to lead the exploration of strategic alternatives. No decision has been made regarding any specific alternative and we currently do not intend to comment further regarding the review process until a specific alternative is approved or as otherwise required by law. With all that in mind, I'd like to now address our financial outlook for the third quarter and full year 2016.

Given the exploration of strategic options for HyperSound, I want to be clear that the following assumes the HyperSound business has retained and its business model remains unchanged. There is a wide range of possible outcomes following the completion of the review process and we believe all outcomes would result in significantly reduced spending going forward. However, until we cleared the outcome, it is assumed the HyperSound business will continue to operate in its current form, generating a small amount of revenue and EBITDA, losses not to exceed 12 million in 2016.

Starting with Q3, as we expect net revenue -- we expect net revenue to increase 4% to approximately 37.5 million, compared to 35.9 million in the third quarter of 2015. Please keep in mind that the upcoming third-quarter comparables are against Q3 of 2015 where we started sell-in of our Recon series headsets and the PX24 headset which have and continue to sell very well. So we are forecasting more normalized year-over-year revenue growth going forward, given those comps. That said, we also continue to expect headset gross margin to increase from last year.

In Q2 of 2016, we reduced our operating expenses in both HyperSound and headset business and expect to continue with this cost management. As such, we expect consolidated OpEx to be slightly lower than last year's third quarter. As a result, consolidated adjusted EBITDA is expected to improve to negative 2 million compared with negative 3.3 million in the third quarter a year ago. Net loss for the third quarter is expected to be approximately $0.16 per diluted share, compared to a net loss of $0.38 per share in the third quarter of 2015.

Please keep in mind that the third quarter of 2015 included a 10.5 million or $0.25 per diluted share non-cash valuation allowance. We are again raising our full-year outlook and now expect net revenue to increase 3% to 9% in a range between 168 million to 178 million, up from 165 million to 175 million in our previous outlook stated in May and compared to 162.7 million in 2015. Included within these expectations is anticipated 24% to 30% growth, up from 18% to 23% growth in new-gen headset revenues to 154 million to 161 million range, which was 147 million to 153 million previously, a 60% to 70% decline in old-gen headset revenues to 8 million to 10 million and approximately 1 million to 2 million in HyperSound revenues, which was 5 million to 7 million previously and approximately 5 million in other headset and accessory revenue.

The reduction in expected HyperSound revenue is due to the aforementioned slower than expected ramp in the hearing healthcare offices and the lower spend on sales and marketing. So today's increase in guidance, despite lower-than-expected HyperSound revenues shows just how strong our headset business is expected to perform. We also continue to expect our headset gross margins to improve to 30% for the year. We now expect to generate 0.5 million to 2.5 million in positive consolidated adjusted EBITDA in 2016, up from 0 to 2 million in our May outlook and an implied loss in our March outlook. This compares to a consolidated adjusted EBITDA of negative 11.4 million in 2015, so clearly a significant improvement, consistent with our stated priority to improve profitability and reach positive consolidated EBITDA.

As I mentioned in HyperSound business, subject to the outcome of the aforementioned strategic review, we currently expect to hold our net investment to below 12 million in 2016, and we are maintaining that view, despite significantly lower revenue expectations. While the strategic process plays out, we plan to carefully manage our spend, potentially even if there are additional investments we can make to attempt to grow more rapidly.

Net loss in 2016 is expected to range between 1.08 and 1.12 cents per diluted share, based on 48.6 million shares outstanding. Excluding the $0.63 per share impairment, net loss in 2016 is now expected to range between negative $0.45 and negative $0.49 per diluted share, up from negative $0.46 to $0.50 per diluted share in the May outlook and compared to a net loss of $1.96 per diluted share in 2015. Excluding the tax valuation expense and goodwill impairment, net loss in 2015 was $0.58.

For the remainder of 2016, with a product portfolio transition largely behind us as well as the expected final drop in lower margin old-gen headset sales, strongly growing new-gen headset sales and the strategic process initiated for our groundbreaking HyperSound technology, we believe we are well positioned to drive top line growth and increase profitability. Thanks as always to a fantastic team of colleagues at Turtle Beach for the continued contributions and dedication.

Operator, we are now ready to take questions.

Question-and-Answer Session


[Operator Instructions] And our first question comes from Mark Argento with Lake Street Capital. Your line is open.

Mark Argento

I had a bunch of questions, but I think they are all answered now. So a comprehensive job with the prepared remarks. I guess really what it boils down to is obviously seeing a lot of strength in the headset business, you got the balance sheet to be able to execute against that opportunity here. I know you’ve made some adjustments to some of the covenants recently, John, maybe you can walk us through how you feel about the balance sheet here and its ability to make sure you can get product into the market for the strong sell-through season.

John Hanson

Sure, Mark. So the amendment where we freed up a portion of the block here, ahead of the holiday, peak holiday season, certainly allows us to now to deliver on the product and bring the product forward into inventory to hit the projections that we have a range of projections that we have for the headset business. So we feel real good about getting that done and having the ability to ensure that we’ll have appropriate product which will avoid any potential stock-outs or delays. So the actions that we took do in fact position us to be able to meet the current demand that we see from the retailers and distributors.

Mark Argento

And when do you typically, when do you start to see orders coming in, what’s the lead time you have, typically in front of the holiday season?

John Hanson

Yes. So. Go ahead, Juergen.

Juergen Stark

John, I can maybe start and you can add on. So we have holiday plans, Mark, that get discussed in pretty good level of detail with all the top retailers, both in the US and Europe. So we kind of, we put together plans, including their expectations, our expectations at a model level and that helps guide us alongside what is now I think three years of highly detailed market sell-through data tracking. So we've got the sales team that knows by week, by model what the expected seasonality curve looks like, and then obviously for new products, the sales rate and we compare that to the retail expectations and that is really what provides us with the forecast, we used to plan inventory and receipts and all that and that’s done on highly collaborative way with the top retailers.

And then as we go into the holiday season, we track weekly sell-through for the top retailers in the US. They track it and we kind of adjust as we go along. In holiday, really, there are no far advanced orders, it's really run based on, I would say half monthly sell-through rates where they may adjust some of their purchases and we adjust our inventory levels, our buffer stock, all of that. That's kind of how the process works. So there is a lot of adjusting that happens in Q4, and keep in mind, we've got, we had very good first half of the year obviously. That's about 30% of our year, if you take into consideration what's left here from a revenue standpoint and we’re excited with -- obviously that bodes well for the holiday, but that gets managed, the actual outcome that will then get managed week-to-week as we go through the holiday period.

Mark Argento

Great, that's helpful. And then just maybe give us an update in terms of the adapters for Xbox, is that continuing in the vein, how does that kind of fit into the expectations for the year.

Juergen Stark

Yes, they continue to sell. I think the last number I saw was 20,000 in June or something like that, they are fully baked into our numbers, they are just part of the competitive dynamic. There is one positive there, which is our two bestselling headsets, two of our best-selling headsets, XO4 and XO1, both have the adapter, our own version with some enhanced features obviously, but one of the things that we like frankly is that it’s clear that gamers like to have the ability to control the audio, right there at the controller versus just using the 3.5 millimeter jack where you can get audio but you have no ability really to control. So it’s not a huge volume any more with the adapters, but they still out there, they’re still selling.

Mark Argento

Thanks, guys. Appreciate it.


Thank you. [Operator Instructions] Our next question comes from James Medvedeff with Cowen & Company. Your line is open.

James Medvedeff

Sorry, I did have it on mute. Good morning. I agree that that was a very thorough presentation of all those stuff. So, can you break down the HyperSound EBITDA investments into the various categories like variable production costs, or COGS, R&D, SG&A and so forth?

Juergen Stark

John, do you want to provide the rough breakout? Most of it’s OpEx obviously.

James Medvedeff

So I think it was the last time you told us that the HyperSound had a specific amount of fixed COGS, which was 1.2 million I believe?

John Hanson

I think we were talking about the amortization for HyperSound.

James Medvedeff

Yes, correct.

John Hanson

Excuse me, I apologize for that. So the amortization for HyperSound, you should think about it on a quarterly basis is about $1 million.

James Medvedeff

1 million, okay. And then just kind of directionally, is the rest of the $12 million invested more in R&D or more in sort of building up and addressing the sales opportunity in the channel?

Juergen Stark

It's a mix of sales and marketing, we do have a small sales team that calls on the audiology offices. They’re now being repurposed without adding to the staffing to also cover some of these retail tests with a Chicago large retailer that I mentioned. So we're kind of using the resources we have to kind of double team and cover some of the new channels as well. Some marketing spend, not at a ton, we’re not doing any large expenses in terms of marketing campaigns. They are more focused marketing efforts including, there will be some effort to help support the Chicago retail trial and then we've got, about half a team is R&D and including the guys who are working on the HyperSound glass, working on product enhancements, working on Tinnitus, working on software. So rough staffing would be half R&D, half sales and marketing and obviously G&A is largely an expense that’s an allocation from essentially corporate.

James Medvedeff

Understood, okay. That's good color. Switching gears, can you talk about, I know it's not the best time of the year, because this is not going to be that indicative, but channel inventory, you say it's about a five monthly kind of sell-through that the customers, that the retailers provide and then reorder. I'm just wondering what kind of visibility you have on inventory that is out in the channel right now?

Juergen Stark

Yes, James. I'm actually glad you asked. It's something that we track for our large retailers, we have good visibility, every week, we look at sell-through, we calculate a weeks of supply, weeks on hand that again, this is for the top retailers and so we have very good visibility to it. We have an expectation of where each of the retailers, where we would want them to be and we know where they want to be. In some cases, they will be going a little heavy, but we know when that is, for example, when we put in new displays or something like that, so it gets tracked very actively and our view is that the channel inventory level in aggregate is roughly where we would expect it to be and we -- actually, we try hard to keep it in balance and not have our revenue levels. The artificially high or low based on higher low channel inventory. Obviously, we have had as we talked about in the last earnings call, very high revenue flow through and retail inventory levels that were too low in earlier Q2, we had some stock-outs, we used air freight ticket products to shelf to try to minimize that, but kind of everything at this point is running the way we would expect it to with levels where we would expect, including our own inventory levels.

James Medvedeff

Are you still producing any of the old generation headsets or has production been shut down?

Juergen Stark

Mostly, no. There are maybe some final production runs where we know we've got some, maybe Black Friday specials, that type of thing on old-gen, but if that is still going on, it would be ending quite soon and it may have already ended frankly. The rest of the -- and it would be limited to a couple of models. Again, something that we very, very carefully track to make sure that while we would expect ourselves to be kind of the last supplier of old-gen, the retailers are most likely to keep our stuff on shelf. We know who is going to keep some old-gen on shelf for holiday, what promotions they are planning to run and mostly collaboratively plan with us and so any inventory or supply would be aligned with those plans.

James Medvedeff

Okay, kind of following up on that and this will be my final question, I understand new-gen is 90% plus of sales for the full year and that sort of was in the first half and even higher in Q2, but going forward when old-gen kind of leaves the model, what's left is then the accessories and other stuff, so in Q2, can you say how much was old-gen?

Juergen Stark

Inventory level, John, do you have that?

James Medvedeff

Sorry, revenue.

Juergen Stark

Yes, we’ve actually said old-gen revenues were around 5%, new-gen was like 90%, John, correct me if I get this wrong, old-gen was like 5% and then other accessories, et cetera were about 5%.

James Medvedeff

Great, perfect. Thank you very much.


Thank you. And our next question comes from Alex Silverman with Special Situations Fund. Your line is open.

Alex Silverman

Good morning. Really fantastic numbers out of headset. Just to kind of continue old-gen, new gen, I went back, looked at my notes, it looked like old-gen was about 10% or 11% in Q4 of last year, assuming that shrinks down to somewhere about where it is, that would be a 5 point drag. Given the revenue growth you're seeing and backing out Q3, your guidance, middle of the guidance this quarter up just slightly in Q4 or even flat. Are you being conservative here because who knows what the holiday looks like or are you being conservative just to, is there something else going on?

Juergen Stark

Yes. There are three factors, Alex. The first is that the year-over-year comps are somewhat, for Q3, and especially Q4, are now going to compare to a very successful Q4 last year where we had launched kind of the final suite of new-gen products, the Recon series and the PX24. So we're not projecting forward 30% or 20% year-over-year growth because we’re now normalizing a comp to reflect a portfolio change that started hitting in later Q3 and then was obviously fully baked into Q4 last year. That's number one.

Number two, we are being a little bit cautious, because of the Brexit. And we're still -- while the impact we believe will be limited to the UK, we still are trying to get a read of where is the pound going to settle, I think it dropped more again in the last week. What's they going to do to pricing and just, we’re just being conservative, we’re not seeing a market impact right now yet, by the way, on sell-through, we watch it every week, sell-through, so it doesn't look like the market or the consumers there are kind of having a reaction, but pricing may be forced to change, given the exchange rate and as you know, the 4x component is really the small part of the impact, it's really the impact on pricing and price elasticity in the market that we’re trying to get a handle on.

And then number three, just the macroeconomic environment, including with the elections and all of that, Q4 is 50% of our quarter and that can move a lot of revenue around. And so we’re just taking a cautious view as we head into that, based on some of the uncertainty in the US and in Europe with the kind of the macroeconomics.

Alex Silverman

Very reasonable. Great, thank you guys.


Thank you. At this time, this concludes our question-and-answer session, I would now like to turn the call back over to Mr. Stark for closing remarks.

Juergen Stark

Okay, just want to thank everybody again for joining us, very pleased with the outcome for the quarter and again thank the fantastic team of people at Turtle Beach for their continued support and dedication. Thanks, everybody. Have a good day.

John Hanson

Thank you.


Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your line at this time. Thank you for your participation. Everyone, have a great day.

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