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 2, 2022 (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. ROCCAT is a gaming keyboards, mice and other accessories brand focused in the PC peripherals market. Neat Microphones is a microphones brand focused on using cutting edge technology and design to create high quality USB and analog microphones for gamers, streamers, and professionals. Business Trends We participate in the $189 billion global software and accessories gaming market. The global gaming audience now exceeds global cinema and music markets with over 3 billion active gamers worldwide. Gaming peripherals, such as headsets, keyboards, mice, microphones, controllers, and simulation are estimated to be a $8.8 billion business globally with over 80% of that market in the Americas and Europe where the Company’s business is focused. Competitive esports is a global phenomenon where professional gamers train and compete to win prize money, partner with major brands, and attract dedicated fans – similar to traditional professional sports. There were approximately 490 million esports viewers in 2021, and that is expected to increase to roughly 641 million viewers by 2025, according to a report from Newzoo. Of those 641 million projected viewers, approximately 318 million are considered “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. Through 2021 and 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 created an ongoing, larger installed base of players. Console Headset Market The global market for console headsets in 2021 was approximately $1.7 billion. 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 latest next generation consoles, Xbox ® Series and PlayStation®5 platforms just ahead of the 2020 holiday season. Demand for the new consoles has continued to be very strong and exceeded supply which is a good indicator of the enthusiasm for the latest consoles. The demand for gaming consoles is forecasted to continue to be strong in 2022 with the additional supply of PlayStation®5 and Xbox ® Series platforms expected to help the overall console market reach single digit percentage growth in 2022. Nintendo has sold over 100 million units of the Nintendo Switch™ since its release in early 2017. Nintendo continues adding and expanding their library of games with an increased number of multiplayer chat-enabled games. Nintendo also sells the Nintendo Switch™ Lite, a follow-on product that offers gamers the hand-held only version of their popular gaming console. 16 While gaming on mobile/tablet devices represents about 52% 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. PC Accessories Market The market for PC gaming headsets, mice, and keyboards is estimated to have grown in 2021 to $3.8 billion. The same gaming, work-from-home, and school-learn-from-home factors associated with the COVID-19 pandemic that benefitted the accessories market also resulted in increased consumer demand for headsets, keyboards, mice, and other accessories developed for PC gaming in recent years. In 2022, this increased demand for such PC gaming accessories is expected to continue. 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, popular teams and players, content creators and influencers and cross-platform play. While most games are available on multiple platforms, gaming on PC offers advantages including improved graphics, increased speed and precision of mouse/keyboard controls, and the ability for deeper customization. Gaming mice and keyboards are engineered to provide gamers with high-end performance and a superior gaming experience through features such as 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 consistent PC gaming appearance. Similarly, PC gaming keyboards often deliver a competitive advantage by registering keystrokes faster than others and offer options for mechanical and optical key switches that feel and sound different and offer 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 that encourage communication and tend to drive increased gaming headset demand. Many of these established franchises launch new titles annually leading into the holidays and as a result can cause an additional boost to the normally strong holiday sales for gaming accessories. Microphone Market As of 2021, the microphone market is estimated to be $2.3 billion in size of which roughly an estimated $700 million is for digital USB microphones. The market for high-quality microphones, specifically digital microphones, has experienced significant growth as content creators on YouTube, Twitch and other popular platforms are gravitating toward using high-quality professional equipment for their workstations. Additionally, with the sustained trend to remote work, the need for a well-performing desktop microphone has become an important tool for working and learning from home, as well as staying connected with family and friends. Turtle Beach’s acquisition of Neat Microphones in 2021 expanded the Company’s reach into the global microphone market, including, in particular, the market for digital/USB microphones that are often used by gamers, streamers, and influencers with other PC accessories. Other Gaming Accessories Market During 2021, the Company expanded into the gaming simulation and gaming controller markets with the launch of the VelocityOne Flight™ simulation control system and the Xbox ® Recon Controller, respectively. These markets will increase our total addressable market by $1 billion, with third-party game controllers at roughly $600 million and PC/console flight simulation hardware at roughly $400 million in global market. Supply Chain and Logistic Outlook The ongoing global economic recovery from the COVID-19 pandemic as well as a surge in imports and high demand for electronics, 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. 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 17 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 indicator s: • 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 (loss), the nearest GAAP financial measure) for the three months ended March 31, 2022 and March 31, 2021, are as follows: Three Months Ended March 31, 2022 2021 (in thousands) Net income (loss) $ (6,476 ) $ 8,838 Interest expense 109 97 Depreciation and amortization 1,504 1,042 Stock-based compensation 1,537 1,786 Income tax expense (benefit) (2,639 ) 2,766 Business transaction expense - 162 Non-recurring business costs 232 639 Adjusted EBITDA $ (5,733 ) $ 15,330 Comparison of the Three Months Ended March 31, 2022 to the Three Months Ended March 31, 2021 Net loss for the three months ended March 31, 2022 was $6.5 million with Adjusted EBITDA of ($5.7) million, compared to net income of $8.8 million with Adjusted EBITDA of $15.3 million for the prior year, due to lower revenue as compared to prior year’s stay-at-home orders and government stimulus payments as well as increased logistics costs caused by supply chain challenges. Results of Operations The following table sets forth the Company’s statements of operations for the periods presented: Three Months Ended March 31, 2022 2021 (in thousands) Net revenue $ 46,662 $ 93,053 Cost of revenue 32,633 58,198 Gross profit 14,029 34,855 Operating expenses 22,316 22,575 Operating income (loss) (8,287 ) 12,280 Interest expense 109 97 Other non-operating expense, net 719 579 Income (loss) before income tax (9,115 ) 11,604 Income tax expense (benefit) (2,639 ) 2,766 Net income (loss) $ (6,476 ) $ 8,838 18 Net Revenue and Gross Profit The following table summarizes net revenue and gross profit for the periods presented: Three Months Ended March 31, 2022 2021 (in thousands) Net Revenue $ 46,662 $ 93,053 Gross Profit $ 14,029 $ 34,855 Gross Margin 30.1 % 37.5 % Cash Margin (1) 31.4 % 38.1 % (1) Excludes depreciation and amortization, and stock-based compensation Comparison of the Three Months Ended March 31, 2022 to the Three Months Ended March 31, 2021 Net revenue for the three months ended March 31, 2022 was $46.7 million, a $46.4 million decrease from $93.1 million in the elevated comparable prior year period brought on by stay-at-home orders and government stimulus payments. For the three months ended March 31, 2022, gross profit as a percentage of net revenue decreased to 30.1% from 37.5% in the comparable prior year period. The decrease was primarily due to higher freight costs, a more normalized level of promotional credits and volume-driven fixed cost deleveraging, partially offset by favorable business mix. Operating Expenses Three Months Ended March 31, 2022 2021 (in thousands) Selling and marketing $ 10,829 $ 11,545 Research and development 5,252 3,993 General and administrative 6,235 7,037 Total operating expenses $ 22,316 $ 22,575 Selling and Marketing Selling and marketing expenses for the three months ended March 31, 2022 totaled $10.8 million compared to $11.5 million for the three months ended March 31, 2021. This decrease was primarily due to lower revenue-based expenses and certain marketing initiatives. Research and Development Research and development costs for the three months ended March 31, 2022 were $5.3 million compared to $4.0 million for the three months ended March 31, 2021. The year-over-year increases were primarily due to additional global resources and infrastructure to support product expansion. General and Administrative General and administrative expenses for the three months ended March 31, 2022 totaled $6.2 million compared to $7.0 million for the three months ended March 31, 2021. The year-over-year decrease was primarily due to lower variable employee cost and professional fees. 19 Income Taxes Income tax benefit for the three months ended March 31, 2022 was $2.6 million at an effective tax rate of 29.0% and income tax expense for the three months ended March 31, 2021 was $2.8 million at an effective tax rate of 23.8%. The effective tax rate for the three months ended March 31, 2022 was primarily impacted by certain non-deductible costs and state income tax expense, offset by the deduction for foreign derived intangible income and stock option exercises. 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: Three Months Ended March 31, 2022 2021 (in thousands) Cash and cash equivalents at beginning of period $ 37,720 $ 46,681 Net cash provided by (used for) operating activities (13,348 ) 21,087 Net cash used for investing activities (611 ) (4,780 ) Net cash provided by financing activities 361 696 Effect of foreign exchange on cash (422 ) (719 ) Cash and cash equivalents at end of period $ 23,700 $ 62,965 Operating activities Cash used for operating activities for the three months ended March 31, 2022 was $13.3 million, a decrease of $34.4 million as compared to cash provided by operating activities of $21.1 million for the three months ended March 31, 2021. The decrease is primarily the result of lower gross receipts. Investing activities Cash used for investing activities was $0.6 million for the three months ended March 31, 2022, which was related to certain capital investments, compared to $4.8 million for the three months ended March 31, 2021, which included $2.5 million related to the Neat Microphones acquisition. Financing activities Net cash provided by financing activities was $0.4 million during the three months ended March 31, 2022 compared to $0.7 million during the three months ended March 31, 2021. Financing activities during the three months ended March 31, 2022 and March 31, 2021 consisted of stock option exercise proceeds. 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 short-term and long-term funding for working capital and capital expenditures including amounts to develop new products, fund future stock repurchases and to pursue strategic opportunities. 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 March 31, 2022 and December 31, 2021 were $5.6 million and $10.2 million, respectively. 20 At-the-Market Equity Offering Sales Agreement  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 three months ended March 31, 2022. 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 “first-in, last-out” (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 March 31, 2022, interest rates for outstanding borrowings were 4.00% for base rate loans and 3.00% for LIBOR rate loans. As of March 31, 2022, 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 March 31, 2022, the Company was in compliance with all financial covenants under the Credit Facility, as amended, and excess borrowing availability was approximately $48.7 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. 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. For a discussion of the critical estimates that affect the condensed consolidated financial statements, see “Critical Accounting Estimates” included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report. 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. 21 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 March 31, 2022 and December 31, 2021, 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 March 31, 2022 and December 31, 2021, 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 inflationary pressures, including higher labor-related costs, increases in the costs of the goods and services we purchase as part of the manufacture and distribution of our products, increased costs from supply chain and logistic headwinds and increased costs in our operations generally. Such inflationary pressures have been and could continue to be exacerbated by higher oil prices, geopolitical turmoil, and economic policy actions. In 2022, we have experienced a higher rate of inflation than in recent years resulting in higher cost of goods, selling expenses, and general and administrative expenses. Such increases will have a negative impact on the Company’s profit margins if selling prices of products do not increase with the increased costs.