Turtle Beach Corp 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our operations should be read together with our unaudited condensed consolidated financial statements and the related notes included in Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the related notes included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 4, 2021 (the "Annual Report.") This Report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this Report are indicated by words such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “estimates,” “projects,” “strategies” and similar expressions or negatives thereof. Caution should be taken not to place undue reliance on any such forward-looking statements because they involve risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such statements. Forward-looking statements are based on the beliefs, as well as assumptions made by, and information currently available to, the Company's management and are made only as of the date hereof. The Company undertakes no obligation to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise, except as required by the federal securities laws. In addition, forward-looking statements are subject to certain risks and uncertainties, including those described elsewhere in this Quarterly Report on Form 10-Q (including the effects related to the coronavirus ( “ COVID-19 ” ) pandemic) that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections. Business Overview Turtle Beach Corporation (“Turtle Beach” or the “Company”), headquartered in White Plains, New York and incorporated in the state of Nevada in 2010, is a premier audio and gaming technology company with expertise and experience in developing, commercializing and marketing innovative products across a range of large addressable markets under the Turtle Beach®, ROCCAT® and Neat Microphones® brands. Turtle Beach is a worldwide leader of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers (“PC”), tablets and mobile devices. Under the ROCCAT brand, the Company creates award-winning keyboards, mice, headsets, mousepads, and other computer accessories. The recently acquired, Neat Microphones brand creates high-quality USB and analog microphones for gamers, streamers, and professionals that embrace cutting-edge technology and design. Business Trends Gaming Headset Market Gaming headsets are part of a $184 billion global software and accessories gaming market. The global gaming audience now exceeds global cinema and music markets with over 2.9 billion active gamers worldwide. Gaming peripherals, such as headsets, keyboards, mice and controllers are estimated to be a $8.3 billion business globally with 80% of that market in the Americas and Europe where the Company’s business is focused. Gaming headsets are expected to represent about $3.3 billion global market in 2021, or around 39% of the total gaming peripherals market. Competitive esports is a global phenomenon where professional gamers train and compete to win prize money, partner with major brands, and attract/gain dedicated fans–similar to traditional professional sports. There were approximately 398 million esports viewers in 2019, and that was expected to surge to roughly 436 million viewers by 2020 (9.6% YOY), according to a report from Newzoo. This is expected to go up to 465 million viewers (YoY increase of 8.7%). Of those 465 million projected viewers, 236 million are expected to identify as “occasional viewers” and 230 million are expected to consider themselves “esports enthusiasts”. Many gamers play online where a gaming headset (which typically includes a microphone allowing players to communicate in real-time) provides a more immersive experience and a competitive advantage in the industry’s most popular games and franchises. PlayStation® and Xbox ® consoles continue to be dominant gaming platforms in North America and Europe for games that drive headset usage. Consistent with a historical pattern of major new console launches every 7-8 years, Microsoft and Sony released their next generation consoles, Xbox ® and PlayStation®5, just ahead of the 2020 holiday season. Demand for the new consoles has been very strong and exceeded supply which is a good indicator of the enthusiasm for the latest consoles. Further, industry guidance suggests that with the launch of the new systems, and continued sales of the current consoles, combined console hardware sales will set records in 2021 and 2022. In 2020, the Nintendo Switch™ completed its third full year in the market with more than 70 million units sold through the end of December 2020, during which there has been an expanding library of games and an increased number of multiplayer chat-enabled games. In addition, Nintendo launched a follow-on product, the Nintendo Switch™ Lite, which is the handheld-only version of their popular gaming console. While gaming on mobile/tablet devices represents about 50% of the global gaming market, and headsets can be used for mobile gaming, console and PC gaming are by-far the largest drivers of gaming headset use. 20 PC Accessories Market The market for PC gaming headsets, mice and keyboards grew in 2020 to $3.6 billion. The same gaming, work-from-home, and school/learn-from-home factors associated with COVID-19 that benefitted the accessories market also resulted in headsets, keyboards, mice and other accessories developed for PC gaming having increased consumer demand. In 2021, the demand for such PC gaming accessories is forecasted to increase to $3.8 billion. PC gaming in the U.S. has seen a resurgence in popularity the past few years and continues to be a main gaming platform internationally, driven by big AAA game launches, PC-specific esports leagues, teams and players, content creators and influencers, cross-platform play, and more. While most games are available on multiple platforms, gaming on PC offers advantages that include improved graphics, increased speed and precision of mouse/keyboard controls, and the ability for customization. Gaming mice and keyboards are engineered to provide gamers with higher-end performance and a superior gaming experience through benefits including faster response times, improved materials and build quality, programmable buttons and keys, and software suites to customize and control devices and settings. PC gaming mice come in a variety of different ergonomic shapes and sizes, are available in both wired and wireless models, offer options for different sensors (optical and laser) and responsiveness, and often feature integrated RGB lighting and software to unify with the lighting on other devices for a visually pleasing PC gaming appearance. Similarly, PC gaming keyboards deliver a competitive advantage by registering keystrokes faster than others, offer options for mechanical key switches that feel and sound different, and utilize customizable lighting. PC and console gaming markets are also driven by major game launches and franchises that encourage players to buy equipment and accessories. On Xbox ® , PlayStation®, and PC flagship games like Call of Duty®, Destiny, Star Wars: Battlefront, Battlefield, Grand Theft Auto, and battle royale games like Fortnite, Call of Duty Warzone, Apex Legends and PlayerUnknown’s Battlegrounds, are examples of major franchises that prominently feature online multiplayer modes which encourage communication and tend to drive increased gaming headset sales. Many of these established franchises launch new titles annually leading into the holidays and which can cause an additional boost to the normally strong holiday sales of gaming accessories. Microphone Market The microphone market is estimated to be approximately $2.3 billion in size with roughly $700 million of that estimated to be for digital USB microphones. The market for high-quality microphones, specifically digital microphones is experiencing significant growth as consumers on YouTube, Twitch and other popular platforms are gravitating toward using high-quality professional equipment for their workstations. Additionally, with the increasing trend toward remote work furthered by stay-at-home orders, the need for a great sounding desktop microphone has become an important tool for working from home, as well as learning from home and staying connected with family and friends. The 2021 acquisition of Neat Microphones expands Turtle Beach’s reach into the global microphone market, including, in particular, the market for digital/USB microphones which are often used by gamers, streamers, and influencers who also use other PC accessories. COVID-19 Outlook During 2020, as the pandemic created stay-at-home guidance, the gaming accessory market experienced a significant surge in demand as existing gamers began gaming more and new gamers entered the market. In addition, the increase in working from home and learning from home created additional demand for accessories, particularly gaming headsets which work well for video and audio calls. As a result, the Company’s 2020 revenues exceeded historical levels as the overall gaming and headset markets experienced an unprecedented surge in demand. Going forward, the effects of the global pandemic and the measures being taken in response are uncertain and difficult to predict. While there were likely certain one-time purchases caused by the stay-at-home orders, we believe millions of new gamers have joined the market which should create an ongoing, larger installed base of players. Supply Chain and Logistic Outlook The ongoing global economic recovery from the COVID-19 pandemic has created significant challenges for global supply chains resulting in inflationary cost pressures and component shortages. We have also experienced logistical challenges related to transportation delays and have incurred incremental costs for commodities and components used in our products as well as component shortages that have negatively impacted our sales and results of operations. We expect that these challenges will continue to have an impact on our businesses for the foreseeable future. As a result, we continue to take proactive steps to continue to limit the impact of these challenges and, are working closely with our suppliers to manage availability of products and implement other cost savings initiatives. 21 Key Performance Indicators and Non-GAAP Measures Management routinely reviews key performance indicators including revenue, operating income and margins, and earnings per share, among others. In addition, we believe certain other measures provide useful information to management and investors about us and, our financial condition and results of operations for the following reasons: (i) they are measures used by our board of directors and management team to evaluate our operating performance; (ii) they are measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made are often viewed as either non-recurring or not reflective of ongoing financial performance or have no cash impact on operations; and (iv) they are used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by adjusting for potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense). These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (“GAAP”) and, given the limitations of these metrics as analytical tools, should not be considered a substitute for gross profit, gross margins, net income (loss) or other consolidated income statement data as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators: • Adjusted EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash) and certain special items that we believe are not representative of core operations. • Cash Margin is defined as gross margin excluding depreciation and amortization, and stock-based compensation. Adjusted EBITDA (and a reconciliation to Net income, the nearest GAAP financial measure) for the three and nine months ended September 30, 2021 and 2020, are as follows: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in thousands) Net income $ 2,623 $ 17,794 $ 13,182 $ 22,443 Interest expense 101 103 271 355 Depreciation and amortization 1,393 1,464 3,865 3,967 Stock-based compensation 1,498 1,572 5,225 3,977 Income tax expense (benefit) (1,819 ) 6,424 (339 ) 7,886 Acquisition-related settlement - - - (1,702 ) Change in fair value of contingent consideration - 175 - 510 Business transaction expense 39 37 289 381 Non-recurring business costs 2,842 - 4,468 - Adjusted EBITDA $ 6,677 $ 27,569 $ 26,961 $ 37,817 22 Comparison of the Three Months Ended September 30, 2021 to the Three Months Ended September 30, 2020 Net income for the three months ended September 30, 2021 was $2.6 million with Adjusted EBITDA of $6.7 million, compared to net income of $17.8 million with Adjusted EBITDA of $27.6 million for the prior year, due to lower revenue as compared to higher demand from the stay at home orders and channel replenishment, increased logistics costs caused by supply chain challenges and increased operating expenses to support PC product portfolio expansion and entry into new product categories. Comparison of the Nine Months Ended September 30, 2021 to the Nine Months Ended September 30, 2020 Net income for the nine months ended September 30, 2021 was $13.2 million with Adjusted EBITDA of $27.0 million compared to net income of $22.4 million with adjusted EBITDA of $37.8 million for the prior period due to certain brand development and product portfolio expansion investments and increased costs as a result of supply chain and logistic challenges. Results of Operations The following table sets forth the Company’s statements of operations for the periods presented: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in thousands) Net revenue $ 85,307 $ 112,494 $ 256,924 $ 227,181 Cost of revenue 56,034 66,358 164,086 141,033 Gross profit 29,273 46,136 92,838 86,148 Operating expenses 27,783 21,916 78,625 56,984 Operating income 1,490 24,220 14,213 29,164 Interest expense 101 103 271 355 Other non-operating expense, net 585 (101 ) 1,099 (1,520 ) Income before income tax 804 24,218 12,843 30,329 Income tax expense (benefit) (1,819 ) 6,424 (339 ) 7,886 Net income $ 2,623 $ 17,794 $ 13,182 $ 22,443 Net Revenue and Gross Profit The following table summarizes net revenue and gross profit for the periods presented: Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in thousands) Net Revenue $ 85,307 $ 112,494 $ 256,924 $ 227,181 Gross Profit $ 29,273 $ 46,136 $ 92,838 $ 86,148 Gross Margin 34.3 % 41.0 % 36.1 % 37.9 % Cash Margin (1) 34.7 % 41.8 % 36.7 % 39.0 % (1) Excludes depreciation and amortization, and stock-based compensation 23 Comparison of the Three Months Ended September 30, 2021 to the Three Months Ended September 30, 2020 Net revenue for the three months ended September 30, 2021 was $85.3 million, a $27.2 million decrease from $112.5 million in the elevated comparable prior year period brought on by stay-at-home orders and channel replenishments. For the three months ended September 30, 2021, gross profit as a percentage of net revenue decreased to 34.3% from 41.0% in the comparable prior year period. The decrease was primarily due to unfavorable business mix and higher logistics costs. Comparison of the Nine Months Ended September 30, 2021 to the Nine Months Ended September 30, 2020 Net revenue for the nine months ended September 30, 2021 was $256.9 million, a $29.7 million increase from $227.2 million in the comparable prior year period as consumer demand for console headsets remained at elevated levels early in the year, and retailers increased channel levels in response to on-going global supply chain concerns. For the nine months ended September 30, 2021, gross profit as a percentage of net revenue decreased to 36.1% from 37.9% in the comparable prior year period. The decrease was primarily due to margins that were negatively impacted by increased costs as a result of higher logistics costs, partially offset by volume-driven fixed cost leverage. Operating Expenses Three Months Ended Nine Months Ended September 30, September 30, 2021 2020 2021 2020 (in thousands) Selling and marketing $ 14,301 $ 11,857 $ 41,524 $ 29,064 Research and development 4,520 3,260 12,929 8,688 General and administrative 8,962 6,799 24,172 19,232 Total operating expenses $ 27,783 $ 21,916 $ 78,625 $ 56,984 Selling and Marketing Selling and marketing expenses for the three and nine months ended September 30, 2021 totaled $14.3 million and $41.5 million, respectively, compared to $11.9 million and $29.1 million for the three and nine months ended September 30, 2020, respectively. This increase was primarily due to certain digital marketing initiatives to support PC product portfolio expansion and entry into new product categories. Research and Development Research and development costs for the three and nine months ended September 30, 2021 were $4.5 million and $12.9 million compared to $3.3 million and $8.7 million for the three and nine months ended September 30, 2020. The year-over-year increases were primarily due to additional resources and infrastructure to support product expansion. 24 General and Administrative General and administrative expenses for the three months ended September 30, 2021 totaled $9.0 million compared to $6.8 million for the three months ended September 30, 2020 as a result of higher professional fees. General and administrative expenses for the nine months ended September 30, 2021 totaled $24.2 million compared to $19.2 million for the nine months ended September 30, 2020. The year-over-year increase was primarily due to increased professional fees and the inclusion of acquired NEAT-related headcount, partially offset by lower variable compensation costs. Income Taxes Income tax benefit for the three months ended September 30, 2021 was $1.8 million at an effective tax rate of (226.2%) and income tax benefit for the nine months ended September 30, 2021 was $0.3 million at an effective tax rate of (2.6%). Income tax expense for the three and nine months ended September 30, 2020 was $6.4 million at an effective tax rate of 26.5% and $7.9 million at an effective tax rate of 26.0%, respectively. The effective tax rate for the three and nine months ended September 30, 2021 was primarily impacted by discrete stock-based compensation related tax benefits of $(2.3) million attributable to stock option exercises and restricted stock vestings, Research and Development (“R&D”) credits and the reduced tax rate on our Foreign Derived Intangible Income (“FDII”). These tax benefits were partially offset by the impact of disallowed compensation and state income tax expense on the estimated annual effective tax rate. During the third quarter of 2021, we substantially completed a federal R&D study for the 2018-2020 tax years, recognizing tax benefits of $0.5 million, net of reserves. In addition, we completed an analysis of our foreign sales and recognized a tax benefit of $0.8 million on our FDII. Liquidity and Capital Resources Our primary sources of working capital are cash flows from operations and availability under our revolving credit facility. We have funded operations and acquisitions in recent periods with operating cash flows. The following table summarizes our sources and uses of cash: Nine Months Ended September 30, 2021 2020 (in thousands) Cash and cash equivalents at beginning of period $ 46,681 $ 8,249 Net cash provided by (used for) operating activities (10,279 ) 32,638 Net cash used for investing activities (7,045 ) (3,918 ) Net cash used for financing activities (937 ) (9,343 ) Effect of foreign exchange on cash (362 ) (361 ) Cash and cash equivalents at end of period $ 28,058 $ 27,265 Operating activities Cash used for operating activities for the nine months ended September 30, 2021 was $10.3 million, a decrease of $42.9 million as compared to cash provided by $32.6 million for the nine months ended September 30, 2020. The decrease is primarily the result of lower gross receipts combined with increased raw material procurements and product purchases to maintain inventory levels consistent with expected demand, supply chain challenges and new product introductions. Investing activities Cash used for investing activities was $7.0 million for the nine months ended September 30, 2021 and related to certain capital investments, including $2.5 million related to the Neat Microphones acquisition, compared to $3.9 million for the nine months ended September 30, 2020. Financing activities Net cash used for financing activities was $0.9 million during the nine months ended September 30, 2021 compared to $9.3 million during the nine months ended September 30, 2020. Financing activities during the nine months ended September 30, 2021 primarily included stock option exercise proceeds of $4.4 million and repurchases of common stock of $4.9 million. Financing activities during the nine months ended September 30, 2020 consisted of net repayments on our revolving credit facility of $15.6 million and stock option exercise proceeds of $2.2 million. 25 Management assessment of liquidity Management believes that our current cash and cash equivalents, the amounts available under our revolving credit facility and cash flows derived from operations will be sufficient to meet anticipated cash needs for working capital and capital expenditures for at least the next twelve months. In addition, the Company monitors the capital markets on an ongoing basis and may consider raising capital if favorable market conditions develop. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. Foreign cash balances at September 30, 2021 and December 31, 2020 were $5.0 million and $5.9 million, respectively. At-the-Market Common Stock Issuance  On August 7, 2020, the Company entered into an ATM Equity Offering Sales Agreement (the “Sales Agreement”) with BofA Securities, Inc. (the “Sales Agent”). Pursuant to the terms of the Sales Agreement, the Company may sell from time to time through the Sales Agent shares of the Company’s common stock, par value $0.001 per share, having an aggregate offering price of up to $30 million. The Company intends to use the net proceeds from the offering, after deducting the Sales Agent’s commissions and the Company’s offering expenses, to support its strategic growth plans, as well as for general corporate purposes. There was no activity under this agreement during the nine months ended September 30, 2021. Revolving Credit Facility On December 17, 2018, Turtle Beach and certain of its subsidiaries entered into an amended and restated loan, guaranty and security agreement (“Credit Facility”) with Bank of America, N.A. (“Bank of America”), as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing asset-based revolving loan agreement. The Credit Facility, which expires on March 5, 2024, provides for a line of credit of up to $80 million inclusive of a sub-facility limit of $12 million for TB Europe, a wholly-owned subsidiary of Turtle Beach. In addition, the Credit Facility provides for a $40 million accordion feature and the ability to increase the borrowing base with a FILO Loan of up to $6.8 million. On May 31, 2019, the Company amended the Credit Facility to provide for, amongst other items, (i) the addition of TBC Holding Company LLC, a wholly-owned subsidiary of VTB, as an obligor and (ii) the ability to make investments in TB Germany GmbH, a wholly-owned subsidiary of TB Europe, of up to $4 million in connection with the acquisition of ROCCAT and up to an additional $4 million annually. The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes. Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of America or the LIBOR rate, plus in each case, an applicable margin, which is between 0.50% to 1.25% for base rate loans and between 1.25% to 2.00% for U.S. LIBOR loans and U.K. loans, and between 2.00% to 2.75% for the FILO loan. In addition, Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.25% to 0.50% and letter of credit fees and agent fees. As of September 30, 2021, interest rates for outstanding borrowings were 3.75% for base rate loans and 3.00% for LIBOR rate loans. As of September 30, 2021, there were no outstanding borrowings under the Credit Facility. The Company is subject to quarterly financial covenant testing if certain availability thresholds are not met or certain other events occur (as defined in the Credit Facility). At such times, the Credit Facility requires the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio of at least 1.00 to 1.00 as of the last day of each fiscal quarter. The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including the Company’s ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates, and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company’s assets. As of September 30, 2021, the Company was in compliance with all financial covenants under the Credit Facility, as amended, and excess borrowing availability was approximately $54.6 million. Critical Accounting Estimates Our discussion and analysis of our results of operations and capital resources are based on our consolidated financial statements, which have been prepared in conformity with U.S. GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of contingent assets and liabilities. Management bases its estimates, assumptions and judgments on historical experience and on various other factors that it believes to be reasonable under the circumstances. 26 Different assumptions and judgments would change the estimates used in the preparation of the condensed consolidated financial statements, which, in turn, could change the results from those reported. Management evaluates its estimates, assumptions and judgments on an ongoing basis. See Note 2, “Summary of Significant Accounting Policies,” to the unaudited condensed consolidated financial statements contained herein for a complete discussion of recent accounting pronouncements. We are currently evaluating the impact of certain recently issued guidance on our financial condition and results of operations in future periods. Item 3 - Qualitative and Quantitative Disclosures About Market Risk Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. The Company’s market risk exposure is primarily a result of fluctuations in interest rates, foreign currency exchange rates and inflation. The Company has used derivative financial instruments, specifically foreign currency forward and option contracts, to manage exposure to foreign currency risks, by hedging a portion of its forecasted expenses denominated in British Pounds expected to occur within a year. The effect of exchange rate changes on foreign currency forward and option contracts is expected to offset the effect of exchange rate changes on the underlying hedged item. The Company does not use derivative financial instruments for speculative or trading purposes. As of September 30, 2021 and December 31, 2020, we did not have any derivative financial instruments. Foreign Currency Exchange Risk The Company has exchange rate exposure primarily with respect to the British Pound and Euro. As of September 30, 2021 and December 31, 2020, our monetary assets and liabilities that are subject to this exposure are immaterial, therefore the potential immediate loss to us that would result from a hypothetical 10% change in foreign currency exchange rates would not be expected to have a material impact on our earnings or cash flows. This sensitivity analysis assumes an unfavorable 10% fluctuation in the exchange rates affecting the foreign currencies in which monetary assets and liabilities are denominated and does not take into account the offsetting effect of such a change on our foreign currency denominated revenues. Inflation Risk The Company is exposed to market risk due to the possibility of inflation, such as increases in the cost of its products. Although the Company does not believe that inflation has had a material impact on its financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on the Company’s ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net revenue if the selling prices of products do not increase with these increased costs.