Description

Summary:

• Turtle Beach is the leading manufacturer of gaming headphones for console gamers. The company is reaching an inflection point with strong activist involvement from multiple parties. The Donerail Group, an investment firm founded by former Starboard Value PM William Wyatt, previously made two offers in 2021 to acquire the entirety of the company, one for $36.50 and one for $32.86, both rejected by the board. Following these events, Donerail initiated a proxy battle and presently has 5/7 board seats and 2/3 seats on the value enhancement committee. Since taking control of the board, Donerail has made progress on several operational improvement initiatives, leading to significant cost reductions and margin expansion. 

• Going forward, it appears likely that the company gets sold at an attractive premium to a strategic acquirer or private equity firm, as precedent transactions for similar companies have been completed at higher multiples than the company currently trades for. The downside is protected by a cheap valuation, clean balance sheet, strong cash flow generation and significant brand value with a loyal customer base. 

Company Overview: 

Turtle Beach Corporation sells gaming headsets through their Turtle Beach product lineup as well as keyboards, mice and other computer accessories through their ROCCAT brand. The company also has a small presence in the flight simulation gaming market, selling flight sticks and rudders for flight simulation and air combat games. 

~80% of the company’s revenue comes from console gaming headset sales and the remaining ~20% comes from the computer peripherals and flight simulation gaming products. The majority of revenue comes from U.S. sales – YTD in 2023, 73% of revenue has come from North America, 22% from Europe and the Middle East and 5% from Asia Pacific. 

Notably, the company has strong brand value and market presence amongst gamers. Turtle Beach is the definitive market leader for console gaming headsets, which comprise the majority of its revenues at 80%. The company estimates that as of Q3 2023 they have 37% market share in the console gaming headset market. 9 of the top 20 best-selling gaming headsets are sold by Turtle Beach. The company offers a product lineup going from lower-priced headsets for casual gamers all the way up to $200+ ultra-premium headsets for serious gamers. The company has positive reviews for its products on several premier technology media publications such as IGN and PC Magazine. 

Financial Overview:

• Summary Capitalization and Valuation Multiples:

Note: Fully detailed projections and assumptions included below in the Valuation section.

• 2018: 92.7% YoY revenue growth in 2018 driven by the late-2017 release of Fortnite, a popular battle royale game which rapidly gained popularity and became the top-grossing console video game in 2018. The Fornite craze drove record Xbox and Playstation sales, with 4Q 2018 Gaming revenue up 39% YoY at Microsoft. 

• 2020: 53.5% YoY revenue growth caused by onset of the Covid-19 pandemic and subsequent lockdowns which drove video game engagement to an all time high. Turtle Beach uses FCF to repurchase ~$37M of debt during 2019 and 2020. 

• 2021 / 2022: (34.4%) YoY revenue decline driven by beginning of chip shortage. causing shortages and undersupply of Xbox and Playstation consoles amidst a high-demand environment. Because new console sales drive sales of Turtle Beach Headsets, HEAR inventory levels begin to build-up, causing working capital to balloon. As the chip shortage eased in the back-half of 2022, Turtle Beach inventory levels also saw normalization. 

Situation Overview / Activist Investor Backgrounds:

In 2021, The Donerail Group, a special situations HF/PE firm led by former Starboard Value Head of Event Driven Investing William Wyatt, submitted an LOI for $36.50 / share and $32.86 / share. Turtle Beach issued multiple statements arguing against Donerail’s ability to consummate a transaction and stating that their offer was essentially too low. In 2022, Donerail in conjunction with another large shareholder, SCW Capital Management, ran a proxy campaign against MGMT and the BOD. They also withdrew their previous offers and issued an activist letter. The company reached an agreement with the shareholder group, putting 3 of Donerail’s directors on the BOD and 2 more contingent on a successful sales process. After an unsuccessful sales practice, the contingent directors were eventually put on the BOD. In 2023, another activist group, Immersion Corp under the HoldCo of Toro 18 Holdings, purchased ~7% of shares. Toro 18 is led by Immersion CEO Eric Singer and renowned Raging Capital Management investors William Martin and Frederick Wasch, who are also Immersion Directors. Toro 18 proposed the addition of Martin and Singer to Turtle Beach’s BOD and the creation of a new value enhancement committee. In May, the current CEO stepped down and William Wyatt joined the board. The company also created a new value enhancement committee and hired a new financial advisor in Jefferies. To conclude, Donerail, who previously bid $32.86 / share and $36.50 / share, now has 5/7 of the BOD seats and 2/3 seats on the value enhancement committee. Given the number of well-capitalized competitors, precedent transactions and significant operational improvements driven by new management, we find this setup to be highly compelling. Well-capitalized competitors include Corsair Gaming ($CRSR), Microsoft Corporation ($MSFT), LogiTech ($LOGI), HP ($HPQ), etc. 

• July 19th, 2021: The Donerail Group releases a letter disclosing they own ~4% of shares outstanding and criticizing management for rejecting a tender offer with secured financing issued at a significant premium, they did not disclose the offer price.

• August 23rd, 2021: Turtle Beach issues a statement responding to Donerail stating that they failed to submit a list of diligence items, a marked up NDA and expressed concerns regarding Donerail’s ability to consummate a transaction.

• December 15th, 2021: Donerail issues a statement that they have provided the board with an offer to aid the them in strategic review, terms under which Donerail would feel comfortable signing an NDA and that they remain interested in acquiring the company, but would submit a revised LOI at a lower price than $36.50 / share (original offer).

• December 20th, 2021: Turtle Beach responded stating that the board is open to strategic alternatives but that it “necessitates a careful weighting of intrinsic value of the Company’s business against a one-time, near-term exit price” and included internal communications with Wyatt.

• December 22nd, 2021: Donerail announced that its revised offer was for $32.86 / share and elaborated that many prospective financing partners wish to remain private without a signed NDA because of the board’s history of releasing internal communications.

• March 2nd, 2022: In conjunction with another larger shareholder SCW Capital Management, The Donerail Group issued a letter to shareholders stating their intention to nominate a full slate of candidates for election and wage a proxy war. They also stated they withdrew their most recent offer and are “now 100% committed to turning around the company”.

• April 29th, 2022: Donerail released their correspondences with management and the board in this press release and a detailed activist letter criticizing operational performance as well as a lack of credibility in the previous sales process. Included below is an example email demonstrating Wyatt’s frustration. In the email chain there is also an email that details Wyatt’s potential financing partners.

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• May 16th, 2022: the company reaches an agreement with the Donerail shareholder group to appoint 3 members of the Donerail slate to the board and following the event Turtle Beach was not sold in a 120-day period, the addition of a Donerail principal to the board and a mutually selected director. The agreement also created a value enhancement committee to continue pursuing a sales process.

• August 8th, 2022: the company announced the conclusion of their sales process stating that they held discussions with 109 parties and that while “financial parties submitted preliminary indications of interest to acquire the company” that none of them were satisfactory to warrant continued engagement.

• October 26th / December 6th, 2023: The company adds Donerail directors Julia Sze and Terry Jimenez to the BOD.

• March 23rd, 2023: Toro 18 Holdings, HoldCo for Immersion Corporation ($IMMR), discloses a position of ~ 7% of shares outstanding and states that they intend to engage in communications with management to drive shareholder value. They propose to management the election of Eric Singer and Bill Martin to the BOD.

• March 28th, 2023: The company adopts a poison pill.

• April 3rd, 2023: Toro issues statement that the “CEO, lead independent director and Chair of the Nominating and Governance Committee seem intent to continue the status quo and based on a call with them, the Reporting Persons now have a sense of who may need to be targeted by the Reporting Persons at the 2023 Annual Meeting, absent more meaningful engagement.”

• April 3rd, 2023: The company issues a counterproposal to Toro 18.

• May 1st, 2023: The company announces that CEO Juergen Stark is stepping down and will not run for BOD reelection, along with director William Keitel.

• May 8th, 2023: Wyatt appointed to the BOD and the company announces the creation of a new value enhancement committee to consider strategic alternatives consisting of directors Wyatt, Jimenez and Wolfe.

• May 8th, 2023: Toro issues a statement that they are pleased with recent developments and are trimming their position from 8.1% to 4.9%.

• May 12th, 2023: Brian Stech announces that he would not be running for reelection at the 2023 annual meeting.

• June 16th, 2023: The company announces the termination of its poison pill.

• June 21st, 2023: The company appoints former Head of Global Sales, Chris Keirn, to the Interim CEO position.

• June 22nd, 2023: The company announces new steps to “optimize best governance practices” including hiring a new financial advisor (Jefferies).

Recent Operational Improvements: 

• Gross Margin Expansion

  • Gross margins were historically 34.2%, 37.8% and 33.5% in 2016, 2017 and 2018 respectively. In 2022 due to the console shortage and inventory build-up driving “heavy competitive discounting” as well as high freight costs, gross-margin dropped to 20.5%. Since then, gross margin has inflected back upwards to 29.9% in Q3 2023 due to decreasing freight costs, SKU rationalization initiatives and product line improvements. 

    • SKU Rationalization: “Yes, I think when you look at the categories that we operate in, we've expanded pretty quickly over the last several years. And so we've taken action on those over the last couple of quarters to really rightsize, I would say, our portfolios in those areas to the point where we're seeing the sales consolidate into the higher-performing SKUs we selected to move forward with.” - Cris Keirn (Interim CEO) on Q3 2023 Transcript.

  • Product Line Improvements

    • Expansion into premium-tier headphone category raising ASP: “Our newly released Stealth Pro has already captured over 15% of the premium $200-plus price tier of the U.S. console gaming headset category during its first 2 months of sales in May and June, highlighting the power of the Turtle Beach brand” - Crisk Keirn (Interim CEO) on Q2 2023 Transcript.

• Operating Margin Expansion

  • GAAP EBITDA margins were 7.3% in 2017, 20.7% in 2018, and 7.6% in 2019. It appears that the cost structure became bloated during the peak years of 2020 and 2021, resulting in a (18.9%) GAAP EBITDA margin in FY 2022 amidst the downturn in revenue due to supply chain issues. The new management team and board are actively looking for ways to reduce OpEx going forward:

    • OpEx reduction: “Second quarter recurring operating expenses declined 8.2% year-over-year, which was primarily driven by continued proactive expense management. Over the past 6 quarters, our recurring operating expenses on an LTM basis have decreased $17.5 million or 19%” - John Hanson (CFO) on Q2 2023 Transcript.

    • Additionally, Turtle Beach had significant proxy war expenses in 2022 and 2023 - see the ~$20M add-back to adjusted EBITDA in 2022 and ~$6.5M in proxy and severance costs added back YTD in 2023. These expenses will normalize going forward.  

• Board Compensation

  • In one of their 2021 activist letters, Donerail outlines what they see as egregious board and management compensation.

    • “Together with the senior management team, the current Board has compensated themselves an estimated $65+ million in cash, stock options, restricted stock units and other forms of payment” (since 2014). 

    • “The facts tell a disappointing story. To substantiate its ongoing payments to management, the Board points to a number of “industry peers” that it has modeled compensation after, which is a typical industry practice. The problem is that we do not think that the Board’s approved “industry peers” are industry peers at all: the companies that have been chosen as “peers” are, on average, over 3.5x the size of the enterprise value of Turtle.”

  • We would expect to see management and board compensation costs decrease going forward after Donerail gaining majority board control and a new CEO in place. 

Valuation:

     Q4 2023 Projections:

• In November 2023 during the Q3 earnings release, management guided to $265-270M in FY 2023 revenue and has guided to and confirmed guidance for $8-10M in Adj. EBITDA for FY 2023. Due to the seasonality of the business around the holiday season, Q4 revenue is historically significantly higher than other quarters. This results in strong operating leverage historically in Q4, with Q4 being a large component of FY Free Cash Flow as inventory releases after management stockpiles inventory heading into the year-end. 

• Q4 2023 revenue growth and operating expense assumptions triangulate with management’s FY Revenue and Adj. EBITDA guidance. 

• Assuming a 25% corporate tax rate as per CFO commentary in Q2 2023. 

• Assuming a (10.0%) Working Capital decrease as a % of change in revenue driving a ~$5M operating cash flow increase in Q4 as per management commentary around expecting to see slight further inventory normalization post-2022 supply shortages. This may prove to be conservative, as inventory levels from 2016-2022 have dropped an average of ($17.8M) from Q3 to Q4 of the FY year as the holiday season ends. Any normalization of inventory in Q4 2023 as per historical patterns would drop straight to Op. FCF as upside in our model - one can see the historical inventory chart above which shows that Q4 inventory levels represent trough inventory in most FYs. 

      FY 2024-2024 Projections:

• Have revenue growing at 7.0% YoY, below management’s LT estimate of a 10% Revenue CAGR. 

• Assume gross margin steps up to 32.0% and 33.0% respectively in 2024 and 2025 as above mentioned operational improvements drive continued expansion. Note - this still represents a lower gross margin than historical years on an equivalent or greater amount of revenue. Any normalization of gross margins to the historical mid-30% range drives upside in our model. 

• R&D appears structurally higher post-Covid, perhaps as a result of a greater focus on ultra-premium headset categories and the resulting development expense. S&M expense is also kept elevated in our model at post-Covid levels. 

• The model assumes SG&A expenses normalize to 2020 levels due to the focus on compensation cost decreases. Any further normalization of SG&A to pre-Covid levels drives upside. 

• Capital expenditure projections based on historically steady spend as a percentage of revenue. 

• Slight improvements in working capital management projected (~$2M of annual operating cash flow increase driven by working capital release.) Levered FCF estimates for 2024 and 2025 are lower than 2023 numbers as working capital numbers will not benefit from the large inventory reduction seen in 2023 post-shortages. 

• Note: FY 2024 Adj. EBITDA in the model has upside if management guidance in Q3 regarding 2023 exit run-rate EBITDA is accurate. Model projects $18.5M in Adj. EBITDA in 2024, while management has softly guided to $28-33M in Adj. EBITDA in 2023:

  • “Additionally, we now expect to exit 2023 with a run rate EBITDA of approximately $28 million to $33 million, up from the previously communicated range of $25 million to $30 million.” - Cris Keirn on Q3 2023 call. As per an analyst question on the call, Keirn elaborates that this “run-rate” figure is what they think the business will produce in annual EBITDA post cost-reductions (This figure is not 4Q EBITDA annualized due to seasonality of business.)

• Management’s LT guide projects normalized Adj. EBITDA margins of 10%, with the model calculating implied Adj. EBITDA margins of 6.5% and 7.8% in 2024 and 2025 respectively. 

Catalysts:

• The largest catalyst appears to be a sale of the company post forming of the value enhancement committee and hiring of Jefferies as a financial advisor. Management has not commented on the status of the process, however has said they are encouraged by early engagement. Precedent transactions of similar consumer technology business include:

  • In 2021, GN Store Nerd, a Nordic private equity firm, purchased SteelSeries for  ~22x run-rate EBITA in 2021.

  • In 2021, Razer taken private by a consortium composed of Founders and CVC Capital Partners for ~31x LTM EBITDA.

  • In 2022, HP’s acquisition of Plantronics for ~28x LTM EBITDA.

• The Q4 2023 earnings release in March of 2024 and subsequent guidance provided for FY 2024 could be a catalyst as well. Our model projects Turtle Beach to generate $15.4M in LFCF in Q4 2023 alone given commentary around strong holiday demand in 2023 - this is 8.5% of the current market capitalization. Strong guidance for FY 2024 is expected as well given the market tailwinds, supply normalization and run-rate EBITDA comments by management. 

• Future Stock Buybacks: In March 2023, the company authorized a 2-year extension on a 2021 $25mm share buyback plan through April 9th, 2025. In the first nine months of 2023, the company repurchased $974,000 worth of stock.  There is currently $16.2M left on the repurchase plan. All repurchases came in 2Q23 at an average price per share of $11.34. The company does not currently issue any dividends.

Risks:

• Downside Case, No Sale

  • In the event that the value enhancement committee is not able to achieve the sale of the business to a strategic or financial buyer, there are few other hard catalysts to unlock value. This is mitigated by the projected strong operational performance causing a re-rate of the share price - in the event of no sale, the business is still a market leader in an industry with pricing power trading at an average ~10% FCF yield with a clean balance sheet and positive tailwinds. 

• Sharp Freight Cost Increase due to Red Sea Conflicts

  • For the past couple of weeks, Houthi Rebels in the Red Sea and Bab Al-Mandab Strait have been attacking merchant vessels. As a result, many vessels have had to reroute around the Southern Tip of Africa and the Cape of Good Hope. The graph included below gives us concern that freight carrier rate increases could cause gross margin compression:

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Catalyst

See Catalyst Section Above