Juergen Stark - CEO, President and Director John Hanson - CFO, Treasurer and Secretary.

Mark Argento - Lake Street Capital Markets.

Good afternoon, ladies and gentlemen, and welcome to the Turtle Beach Third Quarter 2017 Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded.

Before we get started, we'll be referring to the press release filed today that details the company's third quarter results, which can be downloaded from their Investor Relations page at corp.turtlebeach.com. On that website, 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 website 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 risk 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 statement 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-K, annual report on Form 10-Q and other periodic reports, which identify specific risk factors that also may 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 the reconciliation of these metrics on the reported GAAP results in the reconciliation tables provided in today's earnings release and presentation.

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

Juergen?.

Good afternoon, everyone, and thank you for joining us. Our third quarter financial performance was highlighted by significant gross margin expansion and prudent expense management, which drove strong growth in adjusted EBITDA and EPS that exceeded our outlook.

We believe these results are beginning to underscore the profit potential of our business as the leading console gaming headset brand and provider, now that we are largely unencumbered by HyperSound marketing and development costs. Third quarter sales were slightly impacted by orders from some large customers that shifted from September into October.

Due to the high velocity of holiday shipments that began in late September, the shift was identified as a possibility in our third quarter outlook.

While this timing difference had no impact on our full year outlook, other factors, including reduction in run rate inventory levels for some retailers and a slightly reduced outlook for headsets, have led us to slightly lower our full year revenue forecast.

However, we continue to expect a strong holiday quarter, with increased revenues and significant EBITDA expansion for both the holiday quarter and full year, which I will walk you through after John discusses our financial performance in more detail. One of the great products that drove our Q3 performance is our Recon 50X.

According to NPD, this was the top-selling gaming headset industry-wide during the third quarter, and our Stealth 420X+ was the top-selling wireless headset for Xbox One. We also continued to experience strong growth in our Recon Chat headsets, a product line we launched just last May.

In fact, based on combined sales of our Recon Chat for Xbox One and its predecessor, Recon 30X, we were the market leader in Xbox Chat headset segment by revenue in the third quarter. Based on combined sales of our PS4 Recon Chat headset and its predecessor, P4C, we had the highest selling PS4 Chat headsets in the market in September.

Of course, these specific products are part of our industry-leading portfolio of console gaming headsets for every level of gamer. This performance helped Turtle Beach maintain its leading market share. According to recent NPD U.S.

retail data, Turtle Beach finished the first 9 months of 2017 at a strong 40% revenue share and a 34% unit share of the console gaming headset market. For the month of September 2017, Turtle Beach was at 42% revenue share compared to 41% in September 2016.

Finally, from January to September, Turtle Beach, again, had a greater revenue share than the next 3 competitors combined. And all 4 of the top 4 third-party console gaming headsets were Turtle Beach.

In the U.K., the largest console gaming market outside of the U.S., according to Chart-Track, year-to-date, September 2017, we have grown our #1 market share in revenues and units to 48% versus 45%, and 42% versus 34%, respectively.

Before speaking more about our third quarter performance and our 2017 outlook, I'd like to turn the call over to John to review our financial results.

John?.

Thanks, Juergen, and good afternoon, everyone. Net revenue in the third quarter of 2017 was $36 million compared to $38.4 million in the third quarter of 2016.

As Juergen mentioned, the decline was largely due to the shift in orders from some large customers out of September and into the fourth quarter as part of a change in their holiday loading patterns. As we have previously discussed, holiday shipping begins in late Q3, and significant orders can slip into Q4, as was the case here.

Partially offsetting the decline, our international sales increased 23%, driven by market share growth in the U.K. and Europe that Juergen mentioned. Gross margin in the third quarter improved to 34.9% compared to 10.2% in the year-ago quarter. However, excluding a $7.1 million HyperSound-related charge, gross margin in the year-ago quarter was 28.7%.

This improvement was due to a mix shift toward higher-margin models as well as product cost reductions, driven by our supply chain and logistics teams. Gross margin in the headset segment increased to 34.3% compared to 33.3% in the year-ago quarter.

Headset margins were positively impacted by product cost savings, driven by our supply chain and logistics teams and product mix. Operating expenses in the third quarter were reduced to $10.7 million compared to $46.7 million or $13.6 million when excluding $33.1 million in HyperSound-related charges in the year-ago quarter.

This equates to a 21% reduction and was due to our continued focus on cost management across the entire business. HyperSound-related operating expenses in the third quarter of 2017 were approximately $150,000 and are expected to continue to decline going forward as we complete the transition to a license model.

In October, we did sign our first HyperSound license agreement with Waves, a French company with HyperSound experience, who will take up the manufacturing of the HyperSound commercial retail display product.

Net loss improved significantly to $0.5 million or $0.01 per share compared to a net loss of $44.8 million or $0.91 per share in the third quarter of 2016. Excluding $0.81 per share in HyperSound-related charges, net loss in the third quarter of 2016 was $4.7 million or $0.10 per share.

The improvement was primarily driven by our cost management initiatives. Adjusted EBITDA also improved significantly to $3.3 million compared to $0.5 million in the year-ago quarter.

Cash flow from operations for the first 9 months of 2017 was roughly $6 million higher than the first 9 months of last year, which has allowed us to reduce our borrowings under our revolving credit facility. Now turning to the balance sheet. We ended the quarter with cash and cash equivalents of $0.5 million compared to $3.3 million 1 year ago.

As a result of our $60 million revolving credit facility, we generally don't hold large cash balance. Inventories at September 2017 were essentially unchanged compared to a year ago, but considering we are expecting a strong holiday season, we believe we are entering the holiday season with a healthy level of working capital.

Total outstanding debt principal at September 30, 2017, was $59 million compared to $59.9 million at September 30, 2016. The debt consisted of $24.8 million of revolving debt, $12.9 million in term loans and $21.2 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 compared to 2016. Now I'll turn the call back over to Juergen for some additional comments on the business and our updated outlook.

Juergen?.

World War II coming this Friday, tomorrow, and Star Wars Battlefront II coming on November 17. These titles, along with some other promising new releases, are what is driving industry forecasters to predict a strong holiday season for console gaming.

In the current fourth quarter, NPD predicts physical spending will be up 13%, video game hardware up 25% and video game software to increase 18%. Finally, according to NPD, there is a strong 2017 holiday outlook for AAA game titles.

NPD is forecasting that the top 5 selling titles this fourth quarter will combine to generate at least 20% more packaged consumer revenues than the top 5 1 year ago. So with this in mind, for the fourth quarter of 2017, we expect net revenue to range between $82.6 million and $87.6 million compared to $82.2 million in the fourth quarter of 2016.

Adjusted EBITDA is expected to be in the range of $16.7 million to $18.7 million compared to $16.1 million in the fourth quarter of 2016. Net income for the fourth quarter is expected to range between $0.25 and $0.29 per share compared with $0.29 per share in the fourth quarter of 2016.

For the full year 2017, we now expect net revenue to range between $152 million and $157 million, down from prior guidance of $157 million to $162 million and compared to $174 million in 2016. A few key assumptions to call to your attention.

Several retailers have reduced their run rate inventory levels during the year, with some large retailers planning further reductions for Q4, effectively shrinking sell-in, independent of sell-through.

We've recently -- we've slightly reduced our outlook for the overall industry headset sales and our sales based on preliminary indications that surge in headset sales that accompanied the release of Destiny 2 did not sustain into October, of course, without visibility yet as to how November will perform with the 2 exciting major launches coming.

This outlook also reflects an approximate $6 million to $7 million year-over-year decline in old-gen headsets, bringing our old-gen business to essentially 0 in 2017. We expect new-gen headset revenues of approximately $146 million to $151 million, approximately $6 million in other headset and accessory revenue and no material revenue for HyperSound.

Baked into this assumption is some degree of market share loss, particularly in some price brackets where we have enjoyed extremely dominant share. We expect consolidated gross margins in 2017 to improve to at least 32%, up from greater than 30% in our prior outlook. This compared to 24.5% in 2016.

The strong expected improvement reflects lower operations costs and continued cost of goods improvement but some loss of operating leverage due to lower first half revenues in 2017 as well as some airfreight charges in the fourth quarter of 2017.

We still expect to generate $11 million to $13 million in consolidated adjusted EBITDA compared to $4 million in 2016. A more favorable product mix and supply chain and logistics-driven product cost improvements allow us to hold our adjusted EBITDA guidance despite a modest reduction in our sales forecast.

HyperSound is still expected to have a roughly $1 million negative impact on EBITDA, which is factored into these estimates. Net loss in 2017 is expected to range between $0.06 and $0.10 per share based on $49.3 million diluted shares outstanding.

This would be comparable to a loss of $0.33 per diluted share in 2016 as it excludes goodwill and intangible asset impairment charges, HyperSound restructuring reserves and other restructuring charges of $1.46 per share in the 2016 comparative period.

Before turning the call over to your questions, I'd like to reiterate our priorities as we think about 2018. We expect to maintain our strong leadership in the console gaming segment by continuing to push the envelope of gaming headset quality, design and performance.

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.

As one of the strongest and best known brands in gaming, over time, we also -- we will also continue to take a look at opportunities across the $100 billion global gaming landscape. In the meantime, we look forward to reporting the progress of our all-important holiday season.

I'd like to close by thanking the fantastic and dedicated team of colleagues at Turtle Beach. I'm proud to work with you every day and appreciate your hard work personally and on behalf of gamers everywhere. Operator, we're now ready to take questions..

[Operator Instructions]. And our first question comes from the line of Mark Argento from Lake Street Capital..

I just wanted to touch on a couple of things. One, overall market demand in Q4, it sounds like today retail is being a little cautious in the category or at least deleveraging its inventory. And then, two, maybe -- I know you touched towards the end, Juergen, in terms of the international opportunity. I know Razer has filed to go public.

I think they're a big PC gaming, do a little bit of console. Maybe you could touch on that briefly..

Sure, Mark. Nice to have you on the call. So retail demand. There are 3 key things, kind of, that are factored into our guidance. The first is, we have had retailers that have reduced their run rate channel inventory through the year, and several look like they're going to do that during Q4.

So what that means is they're going to attempt to end the year at a lower run rate inventory than they have normally done in the past. This, by the way, from a business standpoint, for them, makes complete sense, because if they can run the business with higher turns, that's good for them.

It doesn't have any impact on sell-through, obviously, but it does create a difference between sell-through, market demand and sell-in.

And that's the -- that obviously affects our sales number, and that's in the multiple millions of dollars, that adjustment in our forecasting model, because, obviously, our model forecasts through a variety of very detailed means, expected market demand, but then our sell-in is calculated based on our expectation for where each retailer that we supply will target to end with their channel inventory.

That's number one. Number two, we had a great September, as all the market data has shown. Both the market and our share performance and our sell-in performance and all that kind of met our expectations, our sell-through performance. But the first couple of weeks of October were somewhat softer than we expected.

And we don't have market data on October, so it's hard to tell what drove that. And obviously, October tends to be a little bit of a flatter month because the big game launches happen in November. So -- but we're still factoring that in, and obviously, we don't know what November is going to do.

And every year, we see patterns where, on one hand, consumers tend to wait to get the holiday sales and to participate in holiday shopping. So it's a little bit hard to interpret, but we've at least factored in a great September, a somewhat softer October and then our best estimate to what we expect with these game launches for November and December.

Okay. So does that answer your question on the retail demand? And then I'll quickly turn to your Razer question..

Yes, that's great..

Okay, sure. And obviously, all that's been factored into our revised forecast. Razer, yes, they're apparently going to be looking to IPO in the Hong Kong market, I believe. They're not a big competitor today, by the way. They are largely in the PC gaming business, as you mentioned.

And frankly, I think it's great, and I wish them success going public because it will shine a light on the value of a leading gaming headset brand or a gaming brand in general. And we're one of the strongest brands in gaming. So they have a company that's got a public valuation out there as a comp, we think, is fantastic.

So I wish them all the best with their IPO..

Great. And then just getting back to the numbers a little bit. I know despite the -- kind of the retail de-stock, it looks like your EBITDA number for the full year still kind of bracketing that 11 and 13 [indiscernible].

So maybe, John, Juergen, you could kind of walk through how you guys are -- how you're finding the leverage in the model to be able to keep the EBITDA going..

Sure. I'll maybe summarize, and, John, you can jump in. So we -- obviously, we've overperformed on EBITDA for each of the 3 quarters, including a significant beat in Q3. So some of that is flowing forward into our annual forecast, of course. Our margins have tended to be stronger.

We'll have some airfreight charges that, in the past, have more occurred in Q3 than will occur in Q4.

There's a lot of puts and takes between these 2 quarters, but as you can see from our full year outlook, we're forecasting to be significantly better on gross margins, driven by product mix, supply chain-driven, cost of goods improvements that we continue to make every single year and just other operating efficiencies, including some of the actions we took earlier in the year to reduce OpEx costs, including -- and above gross margin costs..

Yes. Just to follow on here. We run a comprehensive set of initiatives and programs month-to-month and every year here, in and around, poking at our cost structures to make sure that we optimize across the entire business. And so we're seeing the value and benefit of that..

[Operator Instructions]. And at this time, that concludes our question-and-answer session. I will now like to turn the call back over to Mr. Stark for closing remarks..

Thank you very much. As I mentioned, we look forward to speaking with our investors and analysts when we report our fourth quarter and full year results in March. 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..