Turtle Beach: Demand Shock Tailwind Wearing Off

|
About: Turtle Beach Corporation (HEAR)
by: Joseph Kowaleski
Summary

Turtle Beach's revenue declined 32% y/y this latest quarter, signaling a drop in demand related to Fortnite popularity cooling off.

Turtle Beach resides at the crossroads of consumer electronics and gaming; both industries are subject to numerous headwinds.

Turtle Beach is not cheap at 7.5x forward earnings, the company is now declining off a cyclical cash flow peak.

Turtle Beach was well positioned to take advantage of the Fortnite demand shock; but long-term industry headwinds are too strong to overcome.

Thesis

I wrote about Turtle Beach (HEAR) in May, titled Turtle Beach: Terrible Business, No Reason To Own Shares. Shares are down 13% since, while the broader market is flat. The article received many scathing comments from the bulls, and was perhaps a bit too aggressively titled. But, the general thesis still remains the same. I felt as if much of the analysis in regards to the company was neglecting the strong bearish argument. I called what investors witnessed a "fundamental bubble." Meaning, the company benefited from a brief pop due to a demand shock. The stock gain was warranted based on fundamentals, but only over the short term.

Chart Data by YCharts

The company's parabolic move in early 2018 is not dissimilar to other bubble-like moves such as Bitcoin. It's not entirely fair to compare a real business like Turtle Beach to a questionable asset like Bitcoin. But, the demand shock the company received due to an emergence of "Battle Royale" gaming improved business for Turtle Beach.

Source

We can also draw comparisons between the popularity in Fortnite and price action in Turtle Beach shares over the previous 3 year period. While the graphs are not perfect overlays, the correlation is strong.

Chart Data by YCharts

While some video game companies have been winners over the long term, the industry has its challenges. In this quality article, Wolf Report dives into the challenges central to the gaming industry. The most poignant arguments are the constant evolving nature of the industry and absence of moats. While the article focused on game makers like Take-Two (TTWO) and Activision Blizzard (ATVI), the same principle applies to Turtle Beach. Turtle Beach is a gaming consumer electronics company, so it experiences two separate industry headwinds.

Turtle Beach is at the crossroads of gaming and consumer electronics. One of my bearish points is that Apple (AAPL), in all reality the greatest consumer electronics company in the world, is struggling to find growth in its iPhone business. The smartphone market is much larger than the gaming headset market, and the iPhone is the marquee product. The hardware business is super competitive and has low barriers to entry.

We can see an obvious correlation between the popularity of Fortnite and price action of Turtle Beach. In what reality would this trend reverse? Video games lose mainstream relevance over time. Turtle Beach's success was a demand shock, not a long term trend.

Source

The industry as a whole has been growing for some time, video games have outpaced the film and music industries for 8 years now. Turtle Beach had sat out this trend up until last year. The industry as a whole has grown, but competitive moats are difficult to come by for gaming companies.

Earnings

While Turtle Beach's most recent earnings report only slightly missed revenue expectations, those expectations were not exactly stellar. The company reported a loss of $0.06 per share on revenue of $41.3 million, down 32% year over year.

2019 is shaping up to be the second biggest year for console gaming headsets ever, second only to last year ... As you may recall, 2018 saw a large influx of new console gaming headset users. Both new and existing gamers who adopted headsets to play Battle Royale games like Fortnite, PUBG and more. These first time buyers drove record headset sales last year. We also gained market share despite our already strong share due to what we believe is our ability to keep our products in stock through the dramatic sales increase and our 50-plus percent market share in the entry level headset price tiers. As a result we grew revenues 93% year-over-year in 2018.

-CEO Juergen Stark Q2 Earnings Call

Undoubtedly, Turtle Beach was well positioned to take advantage of the demand shock. But, if we're buying part of the business today, we're only entitled to part of the company's future cash flows. When we look towards the future, we see headset sales peaked in 2018. 2019 was the second best year for gaming headsets, and if I would be willing to bet 2020 will be the third best.

Valuation

The bulls love to bring up the company's rock-bottom valuation. But, the p/e ratio is not reflective of the company's future cash flow.

Image result for cash flow curve

Source

Turtle Beach's trailing p/e is 3.5, and its forward p/e is 7.5. Should the stock price remain stable, the p/e will continue to rise as Turtle Beach is on the downswing of cash flow curve. The company's free cash flow is only positive over the first half of 2019 because of the largest decrease in accounts receivable. This is not a surprise, as demand has fallen for the company's products, buyers need less inventory. The company has stabilized inventory levels recognizing that the demand shock is trailing off.

The company expects revenue to decline by about 15% over the year as the Fortnite trend fades. Turtle Beach has always had a relatively successful holiday season in terms of sales.

If we think about cash flow on a curve, we see that the company's stock price will appear cheapest at the top of the curve, as profits are expected to decline from the peak. What's worse for Turtle Beach is that the curve was distorted by cyclical demand. This is a common phenomenon in parts of the semi-conductor industry.

Source

Turtle Beach is cheap for the same reasons that a company like Micron (MU) is cheap. Turtle Beach supplies a commoditized product in an environment of pure competition, thus it will ebb and flow with the laws of supply and demand. The airline industry is also poorly regarded in terms of investors because of the competition. But, when we think about what it would take to replicate a company like Micron, or to start our own airline, these businesses have much greater difficulty to recreate. Replicating Micron would require significant technological prowess, and airlines would require significant capital investment.

Turtle Beach, on the other hand, is a consumer electronics company in which production could be outsourced for cheap. The company reportedly has about 46% market share and trades at 140 million dollar market cap. The company has no way to differentiate itself from the competition even if there were significant market cap to pursue.

Chart Data by YCharts

Compare a 140 million dollar market cap to the 45 billion dollar market cap at Micron, or the 38 billion dollar market cap of the largest airline, Delta (DAL). These commoditized industries still command huge market caps, even compared to the undisputed leader of gaming headsets.

This is not a backwards approach of valuing the business. Investing in these types of cyclical businesses requires understanding of the other factors that will influence the company beyond its control.

Qualitative Analysis

I find much of the bullish ideas pale in comparison to the industry headwinds. For example, the company's Roccat acquisition.

Turtle Beach acquired Roccat for $15.6 million in cash plus up to $3.3 million in earnout payments. The company expects revenues from Roccat products to be well over $30 million in 2020, and that the acquisition will be accretive to net income and earnings per share in 2020.

Source

The vested interests of Roccat would not give their business away at 0.5x sales if the company was wildly profitable. Roccat is another consumer electronics business that faces an environment of pure competition. G&A synergies are likely the only benefit that either company will receive from the acquisition.

The company has made many good moves such as cleaning up its balance sheet and cutting investments into the failing HyperSound business. Despite these successes, Turtle Beach will not be able to overcome secular headwinds.

Source

Turtle Beach already has a lion's share of industry yet lacks the advantageous of a monopolistic enterprise. Turtle Beach is competing in a heavily commoditized industry that disallows participants to differentiate and innovate.

Conclusion

Turtle Beach's success stems from the company's positioning to take advantage of the Battle Royale trend. But, as evidenced by the revenue decline in the most recent quarter, that massive tailwind is fading.

Video game companies are subject to extreme changes in consumer demand. Turtle Beach headsets appear highly correlated to the rise and subsequent falling of Fortnite.

Investors may be intrigued by a company in a growing industry trading at 7.5x forward earnings. But, as I have presented, companies like Turtle Beach lack the ability to fortify a strong moat. Turtle Beach's success from the Fortnite demand shock is trailing off. It is highly unlikely, Turtle Beach will garner huge traction like the Fortnite tailwind. Thus the company will be relegated to a hamster wheel of cyclical downturn well into the future.

With that in mind, the chance that Turtle Beach outperforms the broader market is slim to none. Considering the additional risks of owning an individual stock, investors should look elsewhere in the quest for alpha. I am very bearish on the stock over the long term, but considering that near term earnings are expected to be solid, the stock could pop to the upside. But, looking at the long term, the company will be facing several headwinds. Long-term investors should steer clear.

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