Juergen Stark - CEO John Hanson - CFO.

Mark Argento - Lake Street Capital.

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Second Quarter 2017 Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions]. As a reminder, this conference may be recorded.

Before we get started, we will be referring to the press release filed today that details the company's second quarter results which can be downloaded from the Investor Relations page at corp.turtlebeach.com. On that Web site, you will also find an earnings presentation that supplements today's results.

Finally, a recording of the call will be available on the Investor Relations section of the company's Web site later this evening. Please be aware that some of the comments made during this call may include forward-looking statements within the meaning of the federal securities laws.

Statements about the company's 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 the company's operations and future results that could cause Turtle Beach Corporation's results to differ materially from management's current expectations.

The company encourages you to review the Safe Harbor statements and risk factors contained in today's press release and in their filings with the Securities and Exchange Commission, including without limitation, their most recent quarter report on Form 10-Q, Annual Report on Form 10-K and other periodic reports, which identify specific risk factors that may also cause actual results or events to differ materially from those described in forward-looking statements.

The company does not undertake to publicly update or revise any forward-looking statements after the date of this conference call. The company also notes that on this call, they will be discussing non-GAAP financial information.

The company is providing that information as a supplement to information prepared in accordance with accounting principles generally accepted in the United States or GAAP. You can find a reconciliation of these metrics to their reported GAAP results and the reconciliation tables provided in today's earnings release and presentation.

And now, I’ll turn the call over to Juergen Stark, the company's Chief Executive Officer.

Juergen?.

Good afternoon, everyone, and thank you for joining us. I’m pleased to report that our second quarter results once again exceeded our expectations. Recall that first half revenues were lower than last year as expected, due to the drag from 2016 holiday channel inventory which is now fully behind us.

We believe the fact that we were able to significantly expand our gross margins and reduce our operating loss leaves us very encouraged about our prospects and profitability in the seasonally stronger second half of the year.

In fact, we are raising our full year outlook based upon our performance to-date as well as our expected performance in various market drivers lining up for the remainder of 2017. I will address these in more detail during my closing remarks.

As you know, our vision is to continue to be the number one gaming headset brand in the world by delivering high-quality innovative headsets that provide gamers with a more immersive experience and a competitive advantage. We have winning products for every gamer; entry level to professional and everything in between.

In our long history of delivering groundbreaking innovative products that drive the industry forward continues this year.

For example, our new Recon Chat headsets launched a few months ago feature a unique open ear-cup so that gamers can hear game audio from the TV or home entertainment system with both ears and enjoy crystal clear chat audio through the headset while also sporting a lightweight and reversible glasses friendly design.

These new chat headsets have already propelled us to a number one revenue share position in the chat headset category for both Xbox and PlayStation per U.S. NPD reports.

At the other end of the spectrum, our Elite Pro headsets, including the recently launched PC version, featured groundbreaking innovations like our patented glasses friendly design, cooling ear pads and adjustable headband tension. These headsets continue to drive eSports teams and players to seek us out for partnership opportunities.

We recently renewed our partnership with OpTic Gaming and our recent announcements of partnerships with Astralis, Splyce and others are a testament to the professional appeal of those great headsets.

And coming this fall, we are launching four new core wireless headsets for Xbox One and PlayStation 4 consoles which I will describe in more detail after we discuss Q2 financials. These initiatives helped Turtle Beach maintain its leading market share. According to NPD U.S.

retail data, Turtle Beach finished the first six months of 2017 at a strong 40% revenue share and at a 33% unit share of the console gaming headset market. For the month of June, 2017, Turtle Beach was at 44% revenue share compared to 41% in June 2016.

Finally, from January to June, Turtle Beach again had a greater revenue share than the next three competitors combined, and five of the top 10 headsets by revenue as well as all four of the top 4 third-party headsets were Turtle Beach.

In the UK, the largest console gaming market outside of the U.S., according to Chart-Track year-to-date June 2017 data, we have maintained our clear number one market share in revenues and units at 44% and 36%, respectively. Our operational execution also continued to be strong in all areas of the business.

We grew adjusted EBITDA while improving net earnings despite lower revenue. This was primarily driven by our decision late last year to transition HyperSound to a licensing model and our simultaneous successful reduction in operating expenses that were shared between those businesses.

We have also continued to drive supply chain and cost of goods improvements and diligently managed expenses in all areas of the business, as evidenced by our over-performance relative to our guidance for Q1 and Q2. Before speaking more about our second quarter performance and our 2017 outlook, I’d like to turn the call over to John.

John?.

Thanks, Juergen, and good afternoon, everyone. Net revenue in the second quarter of 2017 was 19.1 million compared to 29.4 million in the second quarter of 2016.

The decline was largely to the spillover – was due largely to the spillover impact of lower sales of marquee games during the 2016 holiday season leading to higher than normal channel inventory in the first half of 2017, as well as a softer overall console gaming accessory market.

The excess retail inventory impacted shipments in our first half due to the fact that our first half typically accounts for less than one quarter of our full year sales. As Juergen will discuss in more detail shortly, inventories are now back to historical levels and in some cases below the prior year period.

So we feel channel inventory levels are now fully normalized. Gross margin in the second quarter improved significantly to 33% compared to 17.4% in the year-ago quarter.

The increase was due to cost in the year-ago quarter associated with the launch of HyperSound Clear 500P that did not reoccur as well as the supply chain and logistics improvements in our headset business. These improvements are part of a continual process within our organization to drive cost efficiencies.

Gross margin in Q2 of 2017 also included approximately 0.7 million in savings related to royalty and tariff refunds and recoveries that we did not expect to reoccur. Excluding this benefit, gross margin was approximately 29.2%.

Gross margin in the headset segment also increased significantly to 33.3% compared to 24.5% in the year-ago quarter, again reflecting supply chain cost improvement initiatives and a more favorable year-over-year new gen product mix, as well as lower levels of returns compared to a year ago.

Excluding the aforementioned royalty and tariff refunds, headset gross margin was 29.6%. Operating expenses in the second quarter were reduced to 11.3 million compared to 45.6 million or 14.4 million when excluding a 31.2 million asset impairment charge associated with HyperSound in the year-ago quarter.

This 22% reduction was due to a continued focus on cost management across the business. HyperSound-related operating expenses in the second quarter of 2017 were 0.4 million and are expected to decline further going forward, as the business has recently transitioned into a license model.

Net loss improved significantly to 7.1 million or a negative $0.14 per share compared to a net loss of 42.6 million or a negative $0.86 per share in the second quarter of 2016. Excluding the $0.63 per share non-cash goodwill impairment charge, net loss in the second quarter of 2016 was 11.4 million or a negative $0.23 per diluted share.

The improvement was primarily driven by lower HyperSound investments related to the transition to a license model and our cost management initiatives. Adjusted EBITDA also improved significantly to a negative 2.8 million compared to a negative 6.3 million in the year-ago quarter.

Cash flow from operations for the first six months of 2017 was 8.4 million higher than the first six months of last year, which has allowed us to reduce borrowings under our revolving credit facility. Now turning to the balance sheet. We ended the quarter with cash and cash equivalents of 1.2 million, unchanged compared to a year ago.

As a result of our $60 million revolving credit facility, we generally don’t hold a large cash balance. Inventories at midyear decreased by 25% year-over-year not as much as sales but considering we are expecting sales in the second half to be up modestly, the reduction shows we are going into the second half with a leaner level of working capital.

Outstanding principal debt at June 30 was 39.7 million compared to 41.5 million on the same date in 2016. The debt consisted of 5.2 million of revolving debt, 13.9 million in term loans and 20.6 million in subordinated debt.

Taking into consideration our $60 million line of credit and our expectation to be significantly more profitable on a consolidated basis in 2017, which Juergen will discuss in more detail shortly, we believe we have sufficient capital to fund our business plan and support senior debt repayment.

In fact, our average revolver balance in 2017 is expected to decline. Now, I’ll turn the call back over to Juergen for some additional comments on the business and our updated outlook.

Juergen?.

Thanks, John. With the first half of the year behind us, we look forward to ending the year on a strong note. I’d like to spend some time laying out the anticipated drivers underlying this expectation and our increased outlook. First, addressing channel inventory.

I mentioned on our last call that we expected retail inventory to roughly normalize by the end of Q2. Indeed that has taken place and as of the end of July, retail channel inventory across our largest customers is actually somewhat below the same period a year ago.

So we expect Q3 and Q4, which drive over 75% of our annual revenues, to provide more normal year-over-year comps. Second, we’ve introduced and announced the slate of exciting new products. As I noted in my introductory remarks, our Recon Chat headsets launched in Q2 are doing well and we expect our leadership in that category to continue.

We also recently launched our new XO Three and Recon 150 headsets, both of which are based in refresh of our highly popular XO Four headset and at an appealing price point of $66.95. They hit the sweet spot for high quality wired headset in the mid tier.

These headsets feature a robust and comfortable design, our signature high-quality game and chat audio. We also used big 50-millimeter speakers in this price tier whereas others use smaller 40-millimeter drivers.

While those small speakers might be cheaper, we feel our larger 50-millimeter drivers deliver a better gaming audio experience because they have over 50% more surface area to create deeper, more engaging game audio. Gamers know that speaker size matters.

I spoke in my opening about our drive to deliver the best gaming headsets with innovations that create a more immersive gaming experience and give gamers a competitive advantage.

In September, we’re going to redefine wireless gaming audio with the upcoming launch of our STEALTH 600 and 700 wireless headsets for Xbox One and PlayStation 4, both of which we believe offer an amazing set of features at the prime retail price points of $99 for the 600s and $149 for the 700s.

All four headsets feature our signature high-quality audio, unmatched comfort including our patented Pro Specs glasses friendly design and our exclusive superhuman hearing capability. The STEALTH 700s also offer additional premium features like active noise-cancelling, Bluetooth connectivity with app-based settings and more.

The STEALTH 600 and 700 for Xbox One also lead in innovating by being what we expect will be the first headsets available at retail incorporating Microsoft’s new Xbox wireless technology that enables a direct connection to the Xbox One console just like a wireless game controller; no wires, no USB adapters, no base station or separate transmitter.

Similar to our market leadership in launching the very first wireless headsets for Xbox One several years ago, we expect to lead the market with this exciting new headset capability. And with Xbox One X, the new premium Xbox One launching at holiday, we think these headsets are a perfect match for that new premium console.

Interestingly, this new Xbox wireless direct connectivity also enables these headsets to connect to new gaming PCs and laptops that feature Microsoft’s integrated wireless capability. As I mentioned in our prior calls, we are laying the groundwork this year for a more aggressive push in the PC gaming headsets, and this is a key element.

Third; at holiday, PlayStation 4 Pro will have been in the market for about a year and the upcoming Xbox One X, I just mentioned, is announced to launch for the holiday selling season. It’s important to note that both console upgrades have backwards compatibility.

In fact, not only are they compatible with existing titles but because of the console’s update introduced by both Microsoft and Sony, older gen games made for the earlier versions of Xbox One and PlayStation 4 will actually play better.

We think this is very important because this marks the first time that the console videogame business has seen introduction of two new console systems with complete backward and forward compatibility.

And it’s the first time that both Sony and Microsoft will have a two-tier product offering which may allow them to offer more competitive pricing on their lower tier models and attract new gamers into the console market. Finally and importantly, according to recent NPD data there’s a strong 2017 holiday outlook for the AAA game titles.

In the fourth quarter, the predict at least four titles will exceed $100 million in packaged consumer sales and the top five selling titles will combine to generate at least 20% more packaged consumer revenues than the top five did one year ago. This includes Call of Duty World War II, Star Wars Battlefront II, Destiny 2 and Assassin's Creed Origins.

We believe strong consumer uptake of these titles will bode well for incremental sales growth for our headsets, especially as the games all include strong multiplayer campaigns that will require the use of a high-quality gaming headset for the best experience.

Given the solid lineup of expected new game launches, our strong new product lineup and our over-performance to guidance in the first and second quarters, we are increasing our full year outlook.

Before walking you through the full year, for the third quarter of 2017 we expect net revenue to range between 36 million and 40 million compared to 38.4 million in the third quarter of 2016.

Keep in mind that higher velocity of shipments begin in late September as holiday load-in starts and this can easily move millions of dollars in revenue into or out of Q3 from Q4 even with just a few days differences in order and shipment timing.

We also expect some retailers to being holiday shipments a few weeks later than last year moving some revenue into Q4. Obviously those timing differences have no impact on the year but do impact Q3. So we’ve reflected that in the wider revenue range.

Adjusted EBITDA is expected to improve to approximately 1 million compared to 0.5 million in the third quarter of 2016.

Net loss for the third quarter is expected to improve and range between negative $0.04 and negative $0.08 per share, which is most comparable to the net loss of negative $0.10 per share in the third quarter of 2016 as it removes the $0.81 per share in charges related to the HyperSound restructuring.

For the full year 2017, we now expect net revenue to range between 157 million and 162 million, up from 155 million to 160 million and compared to 174 million in 2016. A few key assumptions to call to your attention.

The numbers reflect approximate 6 million to 7 million year-over-year decline in old gen headset sales bringing our old gen business to roughly zero in 2017.

We expect new gen headset revenues of approximately 151 million to 156 million, approximately 6 million in other headset and accessory revenues and no material revenue is planned from HyperSound.

Note that if we roughly adjust 2016 and 2017 new gen headset revenues for the 2016 holiday channel overhang, our guidance would indicate that we expect new gen revenue growth in the mid-single digits year-over-year. This is consistent with our long-term view of growth in the console gaming headset market.

We expect consolidated gross margins in 2017 to improve to better than 30% from 24.5% in 2017, reflecting lower operations costs and continued cost of goods improvement but some operating loss due to the lower first half revenue.

We now expect to generate 11 million to 13 million in consolidated adjusted EBITDA, up from 10 million to 12 million and compared to 4 million in 2016. HyperSound is expected to have a roughly 1 million negative impact on EBITDA which is factored into these estimates.

Net loss in 2017 is now expected to range between negative $0.06 and negative $0.10 per share from negative $0.08 to negative $0.12 per share earlier based on 49.3 million diluted shares outstanding.

This would be comparable to a loss of negative $0.33 per diluted share in 2016, as it excludes goodwill and intangible asset impairment charges, HyperSound restructuring reserves and other restructuring charges in the 2016 comparative period. Our assumptions for the industry remain similar to our last two quarterly calls.

To summarize, DFC's latest June 2017 estimate forecast Xbox and PlayStation unit sales slowing slightly and the installed base rising about 17% this year. We assume attach rates for headsets will rise, leading to mid to high single-digit unit growth in the overall console headset market.

While not accounted for in our outlook explicitly, we think new hardware launches could also boost sales, particularly because they enable lower pricing of the economy models of Xbox One and PlayStation 4. All-in-all, assuming good sales of marquee game titles, we see a very strong holiday season for our headset business.

Before turning the call over to your questions, I’d like to make some brief comments on our priorities and longer-term outlook. Our priority going into the 2017 was to continue to improve the profitability of our business. Success on that front will significantly improve our balance sheet and create flexibility for growth initiatives in the future.

Our performance in the first half and guidance for the year indicate that we are well on track to meet that goal. We also said we would continue to develop our eSports presence and lay the groundwork for future growth opportunities in PC headsets, China and new categories like VR.

Our long-term objective is to leverage these additional growth opportunities to drive double-digit revenue growth given our expectation that the console gaming headset market will grow in the mid-single digits over the coming years.

We made several recent announcements related to PC gaming, both in terms of product introductions and eSports partnerships. PC gaming continues to be one of the most competitive and demanding segments in eSports. In July, we introduced our groundbreaking Elite Pro Tournament gaming headset to PC gamers with the all-new Elite Pro PC addition.

With so many console gamers, pro players and teams already enjoying the Elite Pro since its debut last year, we knew we needed to extend this offering to gamers playing on PCs.

To fortify our development of the PC market, in June we announced a new multiyear partnership with Astralis, one of the most prolific Counter-Strike Global Offensive, or CS GO for short, teams in the world.

Through this new partnership, Astralis is using our new Elite Pro PC Edition gaming headset and other Turtle Beach accessories as their gaming audio gear of choice as they continue to dominate the competitive CS GO scene.

In addition, Astralis’ players will join OpTic Gaming as a key part of Turtle Beach’s future product development process, ensuring the needs of gamers the world over are being met in the next generation of Turtle Beach performance gaming audio products across PC and console platforms.

In June, we announced a partnership with Splyce, one of the most dominant eSports teams in the world. We strengthened our presence in Australia with our partnership with SYF GAMING, a strong multigame eSports team. We also recently announced a new partnership with the China-based eSports team Eclipse Club.

China is the biggest gaming market in the world with PC gaming accounting for more than half of the total gaming audience and we’re excited to have a partner like Eclipse to highlight the importance of audio to gamers in China. This is part of our plan to begin to lay the groundwork for us in China for the coming years.

These partnerships helped continue to build upon Turtle Beach’s place at the forefront of performance gaming audio with elite players across the world.

We have clear leadership in the console gaming segment based on great product and a portfolio that appeals to all levels of gamers; but also based upon our brand which scores very highly on measures like favorite gaming headset and unaided awareness in overall gaming headsets.

In fact, market research from 2015 and 2017 indicate we outscore other third-party headset brands by far in those metrics. That brand and the products, like Elite Pro that represent in, create an opportunity for us to grow in eSports, PC gaming China and new categories like VR in the future.

We look forward to reporting our progress as the year unfolds. I’m really proud of the great team we have here and thank each and every one of them for their continued dedication and contributions. Operator, we’re now ready to take questions..

Thank you. [Operator Instructions]. Our first question comes from the line of Mark Argento of Lake Street Capital..

Good afternoon. Nice quarter. Just had a handful of questions here in no particular order. So updated guidance good to see. John, maybe you could help us better understand kind of free cash flow.

What type of free cash flow you think you can generate off of that guidance, the revenue and EBITDA? And I’m assuming you used any excess cash flow to pay down debt..

Yes, absolutely, Mark. Certainly that’s our goal and what we said as one of our key priorities for this year was to improve the balance sheet. So that is absolutely our intent. So in terms of free cash flow we think about as EBITDA less CapEx. Our CapEx, as we’ve said before, it’s approximately $4 million per year.

And so we would expect to be – we would expect to generate free cash flow in the $7 million to $9 million range for the full year..

Great, that’s helpful. And – go ahead..

Mark, go ahead..

And I assume you’d use the majority of that to pay down debt..

Yes, over time obviously. As we said, we also are positioning ourselves to fund some growth initiatives. So that cash flow would be used and we would balance the repayment of debt along with funding the growth areas that we’ve been positioning here in 2017 that Juergen discussed in detail..

All right.

Then you got a current headcount number and where do you guys stand today relative to say like a year ago in terms of total employees?.

Yes, headcount around 135 people and that’s lower than last year, because we had about 35, 40 people for HyperSound and we’ve made those reductions obviously and also slimmed down the headset business in a couple of areas, particularly from the shared cost area..

Okay. And then I know you had talked a little bit in terms of the guidance for Q3 relative to the full year. The likelihood that retailers might wait a little bit later to load into the channel, what – maybe you could peel the onion on that a little bit.

What are you seeing from guys? And then maybe dovetail that into – I know the slate for first-person shooters is pretty solid here in September, October.

Does that – the later load-in kind of correspond with that?.

Obviously, we have a very tight relationship with our large retailers. We do a lot of planning because we’re a large part of their headset business, generally the majority of it for holiday. So we – that includes collaborating on a rough schedule of shipments going into the holidays.

And we know one or two retailers used to or at least in the last few years began load-in in the middle of September and they’ve indicated right now for planning purposes that they’re planning to start loading in, in early October. And there’s no huge driver to that by the way other than them just planning their own logistics.

One of the things that happens with some of these retailers is you have essentially gigantic logistics traffic jams that start in late October and November. And so it’s just a matter of how they’re planning, who’s shipping when. And that’s why we put a little bit – brought up a range on Q3.

And frankly, Q3 revenues whether something moves between Q3 or Q4 based on a few days of shipment differences makes no difference to the year. That’s why we’d encourage everyone to look at the back half as a unit and not get overly focused on Q3..

Great. Thanks, guys..

Thanks, Mark..

Thank you, Mark..

Thank you. [Operator Instructions]. Our next question comes from Matt Campbell of [indiscernible]. Your line is open..

Juergen, good quarter and it’s nice to see the guidance. Just curious, one of your competitors was just acquired, I think, and how are you – how does that play out in the marketplace? Is there an opportunity for us to gain more share? What are you seeing..

Are you asking about Logitech’s purchase of Astro?.

Yes..

Yes, so they – a couple of thoughts. First of all, we think it’s very good to have the importance and the potential of the console gaming market be reinforced with that. And it’s not surprising because the gaming market overall globally is about 100 billion and console segment is about a third of that. So it’s an important segment and category.

And it’s also at front and center for eSports. It’s been and is likely to continue to be the key driver of VR adoption in the future. So we know it’s an important segment and a good company like Logitech making an acquisition we think just reinforces that. And Astro, they’re a good small competitor that play at the high end.

They’re about one-third our market share and size we think. And it’s in a category that we dominate and we’ve had large well-branded competitors for many years. We got our strategy and we execute it and we’ve done very well. So we don’t think anything will change on that front..

That’s great. Good work on growing your gross margins..

Thanks, Matt..

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..

Great. Ladies and gentlemen, thank you again for joining. We look forward to speaking with our investors and analysts when we report our third quarter results in late October or early November. Thank you very much..

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation..