Description

Turtle Beach (“HEAR”) is the largest manufacturer of headsets for video gaming consoles. The Company has been one of the largest beneficiaries of the immense popularity of Battle Royale video games generally and Fortnite specifically.  The social nature of this new “Battle Royale” category is increasing the market for video games to younger players, older players and female players. Furthermore, Battle Royale games and esports are driving adoption of headsets among video game players and driving use of more sophisticated headsets among the installed base.

Turtle Beach has grown from about $12mm of EBITDA to $54m over the course of the past year. This meteoric rise and fad like nature of video games has attracted a large short interest (65% of the free float according to Bloomberg). After getting destroyed by HEAR’S meteoric rise earlier year, the shorts have been recently bailed out by the technology and momentum market route (HEAR has dropped from the low to mid30s to mid-teens in a matter of weeks). I believe that the shorts (who have not covered) are confusing a bear market for brains and that HEAR stock should come close to doubling in the next year and perhaps much sooner. The market fears that once the Fortnite “craze” is over, despite recently crushing guidance, Turtle Beach will, well,…turtle. This ignores that the rise of headset usage goes beyond just one game.  It is not just Fortnite, but Red Dead Redemption 2, Call of Duty, and esports. October NPD data for video game sales was a record on the release of these titles. Purchasing a new game is likely a catalyst for buying a new headset.

At current levels, the Company trades for about 4.5x EBITDA and 6.5x earnings.  The Company will be net debt free by year end and has a CapX light business model.  Even if you assume EBITDA gets cut in half, the market would only be valuing HEAR at only around 9x EBITDA. The stock is a long. I believe that it will appreciate back to the mid20s and beyond as Fortnite has changed the gamer dynamic permanently both growing the category and creating a need for quality headsets both to communicate with others and hear enemies approaching.

Turtle Beach is the market leader in the gaming headset market with about 43% market share. Their share is smaller in the low growth PC game market (which is a revenue opportunity for them to leverage their brand awareness), so overall share is in the mid 30s (up from 30% a year ago).  The total gaming market itself is about $135 billion in size, so spend on headsets compared to the entire category is tiny and could show considerable growth. Console and mobile gaming are both growing in the mid-teens while PC gaming is growing in the low single digits. Headset themselves are an almost $3 billion category with the US and Europe accounting for 70% of the market. Since headsets are a relatively small part of overall spend, but drive gamer enjoyment/engagement exponentially, it is easy to see these numbers continue to grow. Fortnite revolutionized multi-player gaming to a wider and more youth and female friendly audience. The ability to communicate to your teammates and hear approaching combatants’ footsteps and other noises makes headsets a must have accessory for gamers. Turtle Beach has 4 of the top 5 selling 3rd party headsets. They are the number 1 gaming headset provider for the Xbox and Sony PlayStation. They have higher revenue share than the next three players combined. Headset sales are up 84% year to date driven by 80% headset usage in the Battle Royale category.

Value investors are often looking at companies that are also rans in their industries that trade at low multiples, deep cyclicals, companies that did bad acquisitions, or over leveraged companies with solvency and covenant issues. There is frequently hair in the form of lawsuits and other legacy liability issues. Turtle Beach is a growth company that trades at value prices. Turtle Beach fit the over leveraged/failed merger category perfectly until Fortnite came along. Of course, the fear is that Fortnite is a fad that will fade. Most games fade, though a few like GTA and Madden have become repeatable franchises in their own rights. Fortnite has changed consumer behavior from what they want and expect from the gaming experience. In short, the collaborative multiplayer Battle Royale category is here to stay and so is increased usage of headsets.

At current levels, you are creating the industry leader for 4.5x 2018 EBITDA. Even if EBITDA gets cut in half as Fortnite tapers off, HEAR still trades at only around 9x EBITDA. We take the view that the industry has permanently shifted to increased use of headsets (similar to what has happened in the phone headset market) and that trend will outlive Fortnite to whatever the next big craze is (and there will be another craze because there always is). The company will be debt free and could even begin to pay material dividends with its FCF. Against that EBITDA is only $3-4mm of capital spending (display/listening stands for the stores). The business scales nicely and is deleveraging rapidly.

The consumer electronics business is notoriously competitive, but once you get scale and branding, it is very hard to dislodge market leaders. Plantronics (“PLT”) and Logitech have both been leaders in their respective categories for decades, albeit Plantronics is more of a B2B business. Headsets are one of the few categories that is fairly Amazon resistant as consumer want to try them on for fit and sound quality. Turtle Beach sells online, but the vast majority of sales come from traditional retailers like Best Buy and GameStop.

We recently met with Plantronics at a conference and Turtle Beach was a natural subject of conversation. Their management was awed by the growth. PLT has recently bought Polycom so they are an unlikely buyer as they are almost 90% in the B to B segment. Of note is that even though Plantronics is a relatively minor player in the gaming headset category and does almost no marketing, they have historically enjoyed materially better gross margins, perhaps as much as 800-1000bp though they would not be pinned down on a hard number. Plantronics uses off the shelf parts that are in the other headsets they make, increasing margins. What is interesting is that as Turtle Beach has scaled, gross margins have risen to the low 40s level (from the low 30s) where Plantronics claims to be. The Company does invest in propriety products. They have been expanding into more razor blade type addons that lets gamers customize their headset panels with favorite characters or sports teams. Hear also now makes disposable ear cushions which can be replaced.  The discomfort and bad look of worn out ear cushions should be familiar to anyone with a Bose headset. It is possible that PLT will spin off the consumer business in which case an acquisition of or reverse merger into Turtle Beach could make sense. If Plantronics or some other buyer with scale could capture an extra 500 bp of margin in an acquisition, that would translate to roughly $13.5mm in EBITDA on this year’s sales of $270mm. At 9x that is an extra $121.5mm in value or an extra $7.36 per share for a total takeout of over $37 on this year’s EBITDA.

Almost all of this year’s $54mm of EBITDA will convert to cash and burn through their NOLs. They will be a full tax payer next year. If they repeat this year’s results, you are looking at $2.32 of fully taxed EPS. 10x that number is $23.20, 20x is $46.40. It is hard to know exactly where to value this hyper grower, but it is not hard to see the market putting these multiples on the stock if management and the category continue to deliver. On the downside, If EBITDA falls back to the mid-teens and put a 10x multiple then the stock could fall back to the $10 range. While not pleasant from current levels, a lot has to go wrong and if they repeat anything close to this year, they will generate almost $3 pretax in cash flow and in the low to mid $2 range after tax. Cash that could be returned to shareholders in the form of dividends or buybacks since all the debt will be paid down. A 25% payout ratio would be almost 50 cents a share for a 3.33% yield. A 50% ratio doubles that to 6.66%.

In summary, this turtle is a hare.

Catalyst

Stable to increasing growth in headset sales and market share gains. Takeover by a larger industry player. Dividends and share buybacks with massive free cash flow per share.