Turtle Beach: As The TAM Expands The Risk Increases

Summary

• Turtle Beach has made use of very strong tailwinds over the past 3 years to grow its way out of financial distress.
• The purchase of ROCCAT is a good use of capital and expands the potential TAM of Turtle Beach into the PC headset market.
• With a 40 percent share in U.S. market it will be hard to significantly increase share domestically.
• Temporary gamers from the pandemic may not replace headsets at the historical cadence.

Photo by Kerkez/iStock via Getty Images

Recommendation

Turtle Beach has had a great run, but the growth pulled forward from the pandemic will start to show as people begin to venture outside and other entertainment options become available. The market for gamer peripherals is here to stay though, with Grand View Research predicting global peripheral sales will rise from $5.1b in 2020 to $7b in 2025. Turtle Beach’s current 40 percent share in the U.S. console headset market limits the potential for domestic growth and has forced TB to look at other markets for growth, raising execution risk. In addition, the risk of losing share from either a fall in quality, consumer preferences, or low-cost producers makes the potential downside in Turtle Beach high.

Source: Esport Observer

Company background and recent developments

Turtle Beach (NASDAQ:HEAR) designs and markets headsets for gaming consoles and PCs. The company launched its first gaming headset in 2005 (the X51) and has consistently been the #1 brand in the U.S. console headset market. The company went public through a reverse merger with Parametric Sound Corporation in 2014 and has nearly doubled revenue in the proceeding 6 years. TB got a stranglehold on the U.S. console headset market during the rise of online multiplayer gaming (with games like Call of Duty and FIFA) in the late 2000s and early 2010s. Initially focused on the Xbox 360 and PC, it released its first PlayStation headset in 2009. TB has held over 40 percent market share in U.S. console headsets as the markets grown from $350m in 2014 to $600m in 2020 (CAGR of 12 percent).

Source: Table created by author with data from 10-K

The industry has been impacted by two key events that have dramatically increased demand for TB’s headsets. First, in the second half of 2017 Fortnite was released, a free to play battle royal style game that dramatically increased demand for headsets (mostly reflected in 2018 numbers). This led to a 93 percent rise in revenue for TB in 2018. Then, after revenue normalized in 2019, the pandemic in the first quarter of 2020 forced individuals inside and dramatically reduced entertainment options. This meant lapsed gamers jumped back into gaming and casual gamers started playing more consistently. All in all, revenue jumped 53 percent and TB generated $40m of net income.

Given the limited size of the gamer headset market and TB’s large market share (in the U.S.), they began expanding into other markets. The acquisition of ROCCAT in May of 2019, for $12.7m, gave them a foothold in the PC gamer market and access to the $3.4b global PC accessories market. ROCCAT, which focuses on PC headsets, keyboards, and mice, is well known in Germany’s gaming community but TB has plans to expand the brand into other geographic markets. ROCCAT generated $24m in 2020 and operates at close to breakeven according to management. Additionally, in January 2021, TB purchased Neat Microphones for an undisclosed amount. Neat specializes in selling high quality USB microphones which has an estimated TAM of $700m. Management didn’t disclose details on the acquisition but an estimate from Zoominfo has Neat's annual revenue at approximately $5m.

Source: ProSound

Analysis

To assess TB as a potential investment candidate I focused on a few key questions. Most businesses can be assessed by looking closely at a small number of significant factors in detail. For TB, answering whether it will keep share in the console headset market (as it continues to grow) and execute on its expansion into other peripherals, is all I need to know to get comfortable with the business. The dilution factor, discussed below, is just larger given TB’s small cap nature and more of a consideration for the valuation. I’ll go over them below before I assess the risks, perform a valuation, and finish with a conclusion:

• Can TB keep its market share above 40 percent in its key gamer market and participate in the continued expansion of the industry?
• Can management successfully steer the business into PC peripherals and the digital microphone business?
• How much dilution will occur from continued stock comp awards to management?

Turtle Beach’s market share

Turtle Beach generates a significant portion of its revenue from selling console headsets in the U.S., it also has a large share in the U.K but the market is much smaller. Combined, the countries makeup over 80 percent of TB’s 2020 revenue. Newzoo estimates the 2020 global market for console headsets is around $1.7b, with Europe and the U.S. making up around 75 percent. In short, most of Turtle Beach’s revenue comes from two countries and holding share in these regions is essential to future performance.

Source: Created by author with data from 10K

Source: Newzoo

TB managed to gain a large share of the U.S. market for console headsets due to a first mover advantage. They built a trusted brand at the onset of mass online multiplayer gaming (mainly on the Xbox 360 & PS3), with gamers playing games like Call of Duty and FIFA. To their credit, TB has continued to innovate and, with a headset cycle of around 2 years, gamers have consistently repurchased TB branded headsets over the past decade. The market for headsets has become increasingly saturated however, with businesses like Sony, Logitech, Sennheiser, Corsair, Razer, and others entering the industry. Without a first mover advantage in other regions, TB has been unable to obtain market share like its #1 position in the U.S. and U.K.

The Turtle Beach brand has significant value in the U.S. and U.K markets. Most headsets offer very similar quality and functionality, and although TB’s prices are reasonably competitive, they aren’t a low-cost provider by any stretch. Yet, they’ve still managed to maintain an extremely impressive share due to their brand. In the early 2010s Turtle Beach was synonymous with a console headset. People used the term Turtle Beach instead of headset (“let me go grab my Turtle Beaches”), think WD40 for lubricant, Google for internet search, and Band Aid bandages.

However, I’m skeptical whether TB can keep or increase this share moving forward. One of the big reasons the other brands mentioned above can hold market share is the customer cares little about the price as it’s a small part of their budget. I honestly couldn’t tell you what Band Aids or WD40 costs, but I know it’s a small enough amount where I’m not going to search the store or internet for a cheaper option (and the brands signal quality). Headsets, with a price range of $50 and up, are a different proposition. Cost is most certainly a factor and with more and more comparable products becoming available, price becomes an increasingly important consideration.

On the flip side, management has held share since going public and a 6-year track record proves that the thesis above has been wrong for an extended period. I would argue that the competition has increased as the expected TAM expansion draws in additional capital. Pair this with the rise of counterfeit/ultra-cheap options and I think holding share will be difficult. Even if management does hold share, in trying to assess an investment based on probabilities, I see a higher chance of a loss in share than a significant gain. This doesn’t mean Turtle Beach won’t grow, with the global market set to expand they should grow with it, but given their concentration in the U.S. I predict they’ll grow slower than the rest of the industry.

Other gaming peripherals

Management has made two acquisitions with the specific goal of expanding Turtle Beach’s TAM and setting the business up for future growth. Normally I’m skeptical of using TAM as an excuse for acquisitions and expansion, but in this case I think the strategy is rational and has added value in the case of ROCCAT (for Neat it is too early to tell and management hasn’t disclosed any financial information).

ROCCAT was purchased for $12.7m in May 2019. The business generated $24m of revenue in 2020 and operated at breakeven according to management. A ~0.5x sales multiple (on 2020 revenue) seems like great value and the earnings should come as revenue grows and fixed costs are spread across a larger revenue base. ROCCAT generates most of its revenue in Germany in the PC peripheral market, with a focus on headsets, keyboards, and mice. Given their narrow geographical footprint, it seems likely that Turtle Beach can use their distribution network to rollout ROCCAT products in other markets. Management also made the decision to keep ROCCAT as a separate brand and not relaunch ROCCAT as a Turtle Beach PC brand. Instead, management will phase out the Turtle Beach PC branded headsets and now market PC headsets under one brand, ROCCAT. I think this was the correct decision as PC gamers and console gamers are very different and they take pride in the fact they use different brands (similar to iPhone and Android users).

Source: 9T05Toys

ROCCAT will be growing off a small base, with the brand’s sales accounting for only 7 percent of TB’s revenue in 2020, but low-teens growth appears reasonable while beginning to generate earnings in the near future. There’s potential for explosive growth if ROCCAT successfully launches in other markets without any operational hiccups and gains traction as a brand.

Given the limited information disclosed on the Neat acquisition, it’s fair to assume it currently makes up a very small portion of revenue (immaterial for disclosure purposes). I’m a little more skeptical of management’s decision to move into the microphone space as it appears outside of their core business. The only real detail provided was a potential $700m TAM for digital microphones and a new product launch in 2021. I don’t anticipate Neat will generate significant cash flow for the business in the near term but there is potential for long-term success. I haven't included Neat in my analysis, instead assuming neither value added or destroyed from the transaction (I just don't know).

Stock dilution

Stock compensation isn’t necessarily bad but assessing the incentives for management and the impact of stock comp on current owners is a must (non-cash expense that dilutes ownership so not included in the cash flow statement). I like to look at the proxy statements and just see what jumps off the page. Also, with small cap companies dilution can be more significant and needs to be accounted for in the valuation. The 2017 proxy statements show a burn rate (total awards granted compared to stock outstanding) of nearly 4 percent. This a significant amount of stock being issued annually and eats away at an investor’s ownership stake. A lot of these grants are options though, so the shareholders receive some cash when the options are exercised (the strike price of the option), so effective dilution is less than headline rate in the table below.

Source: Proxy statement

A simple example might help show the impact of stock compensation and how it impacts shareholders:

Let’s assume you own 5 percent of TB at the beginning of 2020 and you make 0 purchases, TB buys back 0 stock, and the company has a burn rate of 4 percent (they issue 4 percent of stock to management annually through restricted stock). After the shares have been issued in year 1, you now own 4.8 percent of TB (assuming all restricted stock vest and are exercised within a year). After 5 years, your ownership stake will have been diluted to ~4.1 percent.

The 2018 and 2019 proxy statements don’t show the same table, but the issuance of stock compensation has continued. In 2018, Mr. Stark alone was awarded over 260,000 thousand shares (150,000 restricted stock that vests in 4 years and 112,000 stock options that expire in 10 years with a strike price around $3). 2019 was more of the same with Mr. Stark receiving 150,000 shares split between options and restricted stock. The options appear to be issued with a strike price around the trading stock price. This means Mr. Stark is rewarded for any increase in the stock price over the 10 years (options have a 10-year life).

There’s nothing wrong with paying for performance and Mr. Stark and the management team has done a good job leading the company out of financial distress (in 2017 the company had $5m in cash and $70m in debt) and through the supply chain mayhem at the beginning of the pandemic. It should also be noted he’s been CEO since 2012, so Mr. Stark was a significant part of the reason they were in financial distress in the first place. In summary, management compensation looks high and Mr. Stark will get paid regardless of whether investors do (even below average market returns will give a large payday with the structure of the option package). We'll account for the dilution in the valuation section below.

Risks

Most of the key risks for TB have been discussed above in the analysis section but we’ll rehash them here. First, keeping current share in the U.S. is essential. The market is projected to grow over the long-term, and even if there’s a normalization in demand over the next year or so, the console headset industry should allow for reasonable growth. However, with a 40 percent share already, TB is the hunted in a growing industry that is now attracting plenty of capital. The Turtle Beach brand should help protect against the attempts of others to gain share, but, despite the history, I’m not convinced they’ll be able to hold them off as other brands now deem the TAM large enough to be worth their time and capital.

Second, the expected 2-year replacement cycle could end up surprising investors a year or so from now. A lot of gamers brought headsets over the last year and won’t replace them as quickly as TB’s historical data shows (or not replace at all). The lapsed and casual gamer who bought a headset over the last year is likely now itching to get back to some form of normalcy and is unlikely to replace their headset in the normal replacement cycle (1 to 2 years). Extrapolating recent data could spell trouble a year or two down the line.

Expanding into new peripherals, even if the correct decision, leads to higher execution risk and means management will have their attention focused across multiple different areas. I think the ROCCAT purchase was good value, the product looks sleek, and from the reviews the quality appears good. But, growing the business will require management to execute at a high level, and leveraging their network to make PC gamers in other geographic regions aware of the brand will take time and a significant ad budget.

Valuation

The valuation will use a DCF with a forecast period of 10 years and a terminal growth value. A sensitivity will be shown on the terminal growth and discount rate due to their large impact on the output. I’ve detailed key base case assumptions below:

Revenue

Given the pandemic fueled rise in revenue during FY20, growth in FY21 will be difficult, with management forecasting revenue of $370m (3 percent growth). This appears a little optimistic to me given the 50 percent increase in FY20, driven by the pandemic (the Fortnite ramp in demand lead to an 18 percent drop in revenue for FY19). I’ve predicted an 8 percent drop in revenue in FY21, acknowledging the structural changes to the industry and the continued growth of ROCCAT, but also recognizing the extreme demand spike from the pandemic. From this new base of ~$330m, revenue is forecast to grow at CAGR of 5 percent for the rest of the 10-year forecast period ($550m in FY30).

Cost of sales

Gross margin has been forecast at 34 percent throughout the forecast period. Gross margin has been as high as 37 percent during years with peak demand, but in a more normalized demand environment margins have hovered around 34 percent. ROCCAT and Neat could push this down if there’s any issues in ramping up production and getting the products into new stores.

Operating expenses

Opex has been forecast at 23 percent of sales throughout the forecast period. The average over the last 7 years has moved around from 35 to 22 percent. Given the scale the business has now achieved and the consistent revenue growth we’re predicting, 23 percent appears reasonable.

Dilution

Dilution is normally a small part of the model but given the discussion above it warrants inclusion. To account for dilution, the model assumes an average increase in shares outstanding of 2 percent each year (with no cash received). This is to estimate the effects of the stock comp discussed above (not a perfect estimate but a reasonable guess). I’d expect the burn rate to get lower as the recent stock performance now allows for less stock to be issued to pay management (a share has a lot more value than it did 3 years ago). Through 2030, this leads to 3.5m increase in the share count.

Discount and terminal growth rate

10 percent discount rate has been used (I like to use a consistent rate to discount cash) and a 3 percent terminal growth rate has been used. The gaming peripherals market should continue to grow with the gaming market in general and a 3 percent terminal growth value seems fair, given the long-term tailwinds in the industry such as the rise of Esports.

Below is the output P&L along with a sensitivity on the discount and terminal growth rate:

Source: Tables created by author

The DCF yields a value of approximately $28 (or ~$420m market cap) and TB currently trades around $30. The value is very sensitive to the assumptions above, but the tables should help give an idea of the projected performance and a rough idea intrinsic value.

Creating the model and thinking through the assumptions helps me understand the business and can help me see things I might have missed if I’d just normalized free cash flow for the financials. The assumptions I use are very general and I’m trying to be roughly rather right that precisely wrong. All this to say, the model is to force myself to go through the process and help me understand how the business and financial performance come together, not to find a precise intrinsic value.

Conclusion

My wiring makes it hard for me to get comfortable investing in businesses which have had significant tail winds which are expected to continue indefinitely (just makes me nervous). Given the significant demand spike from the pandemic I’m finding it hard to get behind growth in 2021, with management forecasting around $370m in revenue. The replacement cycle also worries me longer-term. I do think a lot mid 20s and up gamers who jumped back in the during the pandemic will put their headsets down come the summer and not be a part of the replacement cycle revenue. I know management factors this into their forecasting but underestimating this impact is very possible. In my option the business is appropriately valued but the downside risk is large.

Finally, using a discount rate around 10 percent in the current market hasn’t allowed me to find too many opportunities. I’m happy to wait for something that makes sense to me, knowing I’ll miss out on some opportunities along the way but will hopefully avoid a permanent loss of capital. Thanks for reading and let me know your thoughts.

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Analyst’s 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.

Comments

[FortuneFavorstheBrave]

Thanks Matt and others for your opinions. I have been long this stock for some time and made a good run, scaling in and out a bit. Still think there is more to come. Given the size and growth of their markets, your case seems too bearish to me. Gaming is big and there is a case to do a billion in sales in the not too distant future, selling about 12 million products annually at a price of 80. EBITDA margin could well be 15% which should solve for >1 bio in equity value, adding current assets and intermediate cash flows could give about 1,35 bio in equity value in 3 years time. Sharecount would probably be 22 mio so equates to USD 61 per share. Not meant to be precise but a plausible scenario.
Have a look at their updated presentation that imo offers quality products, business and team:
turtlebeachcorporation.gcs-web.com/...
I think that 35 to 40 USD per share is currently about right now but would see 15-30% annual growth to that for the years ahead and possibly 50-60 per share (ongoing dilution is indeed a concern). Given their business, size and balance sheet, this does qualify as a buyout candidate.

[Matt Nicholson Lewis, CFA]

@FortuneFavorstheBrave Thanks for reading and the comment. The scenario you layout looks very reasonable to me. Maybe I'm being slightly too conservative, but the way I was looking at was as follows:

- Share in U.S. around 40% and CAGR of 4% through 2030 (~$900m U.S. market in 2030). Feel given the larger base, current demand spike, and high share growing fast in U.S. will be tough.
- Europe grow 9% CAGR with ROCCAT having a bigger impact on a smaller base. U.K was 7% CAGR for similar reasons
- Other (predominantly Asia) I estimated at 4% CAGR. I'm a little more skeptical on growth in Asia. TB doesn't have much or a footprint there and even though the market is growing fast, the options (a lot local to Asia), makes me think it will be hard for TB to really capture much of the market (this is probably where i'm being most conservative).

My EBITDA margins averaged around 11 or 12% throughout the forecast period but given you prediction of more growth and scale, 15% is a possibility (and achieved in 2020).

Agree on the buyout potential as well but probably see that more as a bonus (don't want to invest based on a potential takeover). Appreciate the well thought out thesis!

[Admiral Risky]

@Matt Nicholson Lewis, CFA

"Other (predominantly Asia) I estimated at 4% CAGR. I'm a little more skeptical on growth in Asia. TB doesn't have much or a footprint there and even though the market is growing fast, the options (a lot local to Asia), makes me think it will be hard for TB to really capture much of the market (this is probably where i'm being most conservative)."

This won't be the case at all. If you're interested, you could spend a bit more time researching this space. Companies like $HEAR don't go into Asia/China markets "alone", they partner with an omni-channel, warehouse, logistic, marketing companies like $BZUN to lead the expansion for them. For example: Nike, Microsoft, Starbucks, IKEA, Farfetch etc. ALL partner with $BZUN and they proxy run their e-commerce operations in China for them.

Not to sound too tart, but a 4% CAGR for that market is a flagrant miscalculation.

[Matt Nicholson Lewis, CFA]

@Admiral Risky Appreciate the insight into the Asia. Maybe this is an area I overlooked given its current small size.. I do have a couple of questions for you on the expected growth:

1. The market for console headsets has been growing in Asia and TB generated $14m in 2020. Newzoo has global console headset market at $1.7b and 75% coming from the Americas and Europe. This means around ~$425m is current Asia market (remaining 25%)? TB has $14m in revs in 2020 (assuming all Other revenue is Asia console headsets), which gives them ~3% share? If we assume 10% CAGR for market for 10 years that gets us to $1.1b market size. If share stays constant that would get us $33m in Asia in 2030? The number I have is closer to $25m so not a huge impact on the model.

2. Understand about the partnering/JV aspect in Asia, but just as TB holds share year after year in the U.S., isn’t there a risk that they can’t steal enough share from the more prominent brands in Asia? What do you think TB’s share in Asia can be?

3. From what I can find management hasn’t really spoken about Asia too much on the conference calls or in the 10K? They mentioned ROCCAT expanding there but not much on TB in the region. Is there somewhere they discuss the Asia expansion plans in more detail?

4. What’s your expectations for growth in the region and how do you see it playing out?

Thanks.

[Bob Kleinberg]

Outstanding article and analysis. Thank you.

[Matt Nicholson Lewis, CFA]

@Bob Kleinberg Thank you for reading and the positive feedback.

[juangoicoa]

$HEAR valuation is undemanding by any metric: Revs growth, margins and FCF present an outstanding vehicle to "play" the gaming growth.

The first thing you want to see in a company is a superb core product, not only in US but in China, which should be the market to be in the coming years. JD.com reviews could be desired by any brand (similar to Iphone standard reviews). Since this is THE market you want to be, it should be easy for them to take 5/10% of that market, that would represent 20% plus extra sales for the company.

The other thing that could be an opportunity is the heavy burden, it has too much opex, they need more scale.... or this also could be an opp for any company that could make a take over of the company.

I'm a little afraid that this company was mentioned to me by a friend at 25 price, but I would expect to double my investment in no more than 12 months.

[Admiral Risky]

Good to see more write-ups on $HEAR. With respect to growth expectations, it's important to realize that Asia and specifically China is the "new" geography they are going to be focused on. It is the largest gaming market in the world and it is in the midst of it's first ever full-scale console upgrade/release cycle (consoles were banned until 2015).

In terms of revenue generation, Asia is currently a negligible part of $HEAR's revenue stream in comparison to $CRSR where 20% of their rev is from the Asia region -- so lots of growth potential.

New consoles were released this week in China and already completely sold out within 20 minutes of pre-orders. Channel checks we've performed on Turtle Beach's official stores on both JD.com and Alibaba's Tmall indicate a continued heightened amount of purchases and inventory directed to those storefronts.

There is also the new development that came out days ago suggesting shareholders are pushing $HEAR management for a sale. Given HyperX was acquired for $425M and $HEAR's market cap is circa $430M we feel confident holding the firm at these levels.

[Oracle of germany]

@Admiral Risky if they would sell, do you have any Suggestion for the possible selling price?

[Admiral Risky]

@Oracle of germany
Some past M&A deals/offers in the space $HEAR operates:

.:Logitech:.
~2018 Plantronics $PLT >$2.2B (fell through - $PLT wanted more)
~2018 Blue Microphones $117M
~2017 Astro Gaming $85M
~2016 Jaybird $50M

.:Others:.
~2016 Skull Candy $197M
~2014 Beats $3B

Given some of the past p/s, p/e, and p/fcf multiples these other companies have gone for under far harsher market conditions (especially when compared to today's money printing environment), I'll just say that I like $HEAR's positioning should they consider a sale :-).