Turtle Beach (HEAR) – Potential Company Sale – 40% Upside

Current Price: $17.87

Target Price: $25+

Upside: 40+%

Expiration Date: 4 months

This idea was shared by Brooks.

Summary

Turtle Beach (HEAR) is a $300mm gaming accessories company that develops and markets gaming headsets, keyboards, mice, microphones, and other accessories. The company sells to business customers primarily in the US and Europe. Ten days ago, Turtle Beach reached an agreement with The Donerail Group (owns 8.7% in HEAR), an activist that has hounded the company for over a year. The agreement includes the addition of three Donerail directors to the company’s board and the formation of a strategic committee “for the purpose of overseeing an expanded and wide-ranging process to identify a buyer for the Company“.

Over the last years, the company has run several strategic review processes and received a number of bids, including the two most recent ones from Donerail which came last year at 100% above the current price. Management owns 6.9% and has been clearly reluctant to sell the company until recently. However, the current strategic review is quite different from the previous ones and is much more likely to be successful:

• the strategic review is clearly set up to sell the company and was initiated by the activist, who now owns 3/8 board seats. It also received support from another large holder SCW Capital Management (owns 3% of HEAR);
• the Strategic Committee is split evenly between two incumbent Turtle Beach directors and two Donerail members, an encouraging sign of the company’s willingness to sell;
• Donerail’s managing partner Will Wyatt (former partner in Starboard Value) will also be allowed to attend Committee meetings and have input into the sale process;
• the company has received inbound interest from multiple parties in the last few weeks and is also reaching out to strategic and financial buyers that have previously shown interest as well. Recently, media reports surfaced that Turtle Beach was engaged in discussions with at least two strategic buyers;
• the agreement also states that if the company is not sold in 120 days, HEAR will appoint another Donerail’s nominee to the board and together with the activist select one more, a fifth new director. This provides an inherent catalyst as a fourth Donerail appointee, specifically Will Wyatt or Wesley Calvert, and a mutually selected appointee will be elected to the Board in four months if the company has not been sold. I don’t foresee Turtle Beach remaining public long if four or potentially five board members are affiliated with Donerail;
• management’s incentives are somewhat aligned. Turtle Beach’s CEO Juergen, also Chair of the Board, owns 4.0% of the stock, the majority of which is in the form of options, so he would receive a nice payday if the business were to get sold. The CEO has mentioned in the most recent Q1 conf. call that he considers the company to be undervalued: “I believe for a while that the public markets don’t value us properly…”;
• HEAR now trades at 7.1x NTM EBITDA, below the historical levels, and public peer valuation (8.4x-14x NTM EBITDA). A strategic buyer that could utilize Turtle Beach’s brand power would likely be willing to pay north of 10x 2023 EBITDA, which would mean a deal price in at least the high $20s/share. A 9.5-11x EBITDA multiple on 2023 numbers of $50mm would fetch a $30 price tag, still below Donerail’s previous purported offers. An acquisition from a global player would also make sense as it would help Turtle Beach penetrate markets where it currently has a smaller proportion of market share, such as Asia.
• Recent transactions in the space point to these multiples as conservative in a takeout. In October 2021, GN Store Nord bought SteelSeries, a software-enabled gaming gear provider, for 22x run-rate 1H21 Adjusted EBITDA. Razer’s controlling shareholders closed on a take private of the company at a $3.1 billion valuation or roughly 2x 2021 revenue just weeks ago. Additionally, HP acquired HyperX, which competes in many of the same product areas as Turtle Beach, in February 2021. I think somewhere in the high $20s per share is a solid target for a takeout price.

The opportunity exists likely due to previous bids not leading to a sale, perception of Turtle Beach as a Covid winner, recent poor Q1 earnings, and the general market selloff.

Risks

The obvious risk is that the strategic review process does not lead to an announced sale. However, there are multiple interested parties, and the company is actively marketing itself for sale to new prospective buyers. Financial buyers may be less willing to bid given the cash flow lumpiness that may not support as much debt despite Turtle Beach being net cash currently. If a deal fails to materialize, downside should be semi-protected given the stock trades just over 5x 2023E EBITDA at its current levels, although that $50mm of consensus EBITDA seems a bit generous.

Another key risk is that discretionary headset purchases fall on the macro backdrop at the same time as the stay-at-home gaming surge leads to fewer than expected repeat headset purchasers from newbie gamers deciding not to join in on the typical ~2 year headset replacement cycle. Q1’22 earnings were poor as revenue came in barely above Q1’19 levels and fell almost 50% YoY compared to record Q1’21 levels. Industry data suggests the U.S. video game accessory market declined 16% YoY in Q1, with the console headset market off over 35%, so Turtle Beach took a bigger drawdown than rest of the industry. Still, management maintained full year guidance at flat on the top line relative to 2021 but dropped full year guided EBITDA margins from 10+% to 9-11%. I think concerns about a slowdown are largely reflected in the current price and should be short-term issues not hugely relevant to a long-term prospective acquirer.

Timeline

Prior to what was shaping up to be a proxy contest this year, Turtle Beach sent out a public letter that includes a helpful timeline providing an overview of the background.

• The saga began in April 2021 when Donerail sent a proposal to acquire HEAR for $34.50 per share, a 14% premium at the time. However, Donerail had no verified financing and did not respond to Bank of America’s repeated requests for financing details.
• In July 2021, Donerail released their first public letter, claiming that the offer detailed an ability to finance the deal; the letter also claimed that the Board confirmed the credibility of Donerail’s financing package but told them the offer wasn’t high enough. Days later, Donerail sent a revised proposal for $36.50 per share but with no verified financing again.
• On December 15th, Donerail released a second public letter, again stating their proposals contained financing details and that the Board had undue concerns surrounding their ability to get the deal done.
• On December 20th, Donerail sent a revised proposal at $32.86 per share, a 30% premium at the time (again no financing according to Turtle Beach).
• On March 2nd, Donerail withdrew this final offer and announced an intention to nominate a full slate to the Board, saying that the Board turned down their request to sign an NDA.
• In mid-March, Donerail rejected Turtle Beach’s proposal for a settlement that would have seen two mutually agreed candidates join the Board and countered with a proposal to add three of their own candidates to the board and form a strategic review process. Donerail’s proposal was backed by another large holder, SCW Capital Management (owns 3%).

Activist Involvement

The Donerail Group is a value activist fund that launched in 2020 and has been involved with Turtle Beach since February 2021. They have reportedly attempted to acquire HEAR several times at prices about double the current market price, yet Turtle Beach’s management has consistently stated that Donerail hasn’t provided any verified financing to back up their offers. Donerail is led by former Starboard Value Partner Will Wyatt, and, as of the May 20^th proxy, Donerail and affiliated shareholders owned 8.7% of Turtle Beach.

Donerail launched with $300mm and has never completed an acquisition; the firm’s offers for Turtle Beach would have likely amounted to more than Donerail’s entire AUM. They have also traded calls in the days leading up to and following their public statements.

Company Overview

Turtle Beach is a recognizable name in gaming that dominates the console gaming headset market in the United States, boasting a 12-year track record of 40+% market share. They carry a full line of products to cater towards everyone from entry level gamers to esports enthusiasts. Their first mover advantage in key geographical markets, innovation, and strong brand has enabled them to lead the headset category. The company operates a capex light business model in which it outsources manufacturing. Most products are sold through large retailers, such as Walmart, Target, and Amazon, both online and in-store.

Headsets have historically accounted for nearly all of Turtle Beach’s revenue, which has led to extreme cyclicality as headset purchases typically follow the release of new gaming consoles or popular games. In 2018, Fortnite’s immense popularity led to a 93% increase in sales while EBITDA margins rose from 6.5% to 20.3% as the collaborative nature of the game helped increase headset penetration. Revenue fell 18% in 2019 before exploding again by 54% in 2020 on the backs of the stay-at-home gaming surge. Despite the cyclicality, the company has grown nicely over the last five years.

Previous potential buyers have cited cyclicality due to an overreliance on console gaming headsets as a reason for passing on a potential acquisition of Turtle Beach. The company has attempted to reduce this cyclicality and reliance on the headset market by diversifying through acquisitions and building new products. In 2019, they acquired ROCCAT which expanded their presence in mice and keyboards, while in 2021 the company bought Neat microphones, a seller of USB microphones. This year, the company is shooting for $100mm of revenue and positive EBITDA in non-headset categories, which would account for 27% of revenue at the midpoint of guidance. 2022 guidance for revenue is of $366mm (equal to 2021 actual) +/- 5% with EBITDA margins in the 9-11% range. Turtle Beach has no debt and a $24mm cash balance as of Q1’22. Most non-headset revenue comes from the PC segment.

Management targets a 10-20% revenue CAGR target with EBITDA margins in the “10+%” range over the long term. The revenue target seems a bit ambitious at the upper end given the already massive share within the headset market and the 7-8% expected growth of the gaming gear industry; they will likely have to rely on acquisitions to hit the mid or upper range of their target. While they have grown the top line nicely, there has been considerable dilution as they issue a good chunk of stock to executives, with about 40% dilution in the last five years.

Takeout Price

I don’t give too much weight to Donerail’s previous offers in the mid-30s per share given the lack of verified financing and multiple compression in the market and sector since last year. However, Turtle Beach should still have considerable upside from current levels in a takeout scenario. Management’s guidance for 2022 implies anywhere from $31-43mm of EBITDA, while consensus is at $35mm. Given the cyclicality of revenue, historical earnings have also been lumpy.

The cumulative EBITDA margin over the past five years is 12.3%, which is in line with 2023 consensus at $50mm of EBITDA and a 12.2% margin, while management’s target is 10+%. EBITDA to FCF conversion over the past five years has only been about 57% somewhat due to inventory buildup mainly in the last few quarters, so I’d expect conversion to improve going forward given the capex light model.

Turtle Beach has traded at a mean of 8.3x NTM EBITDA over the last five years. The company currently trades at a discount to that figure as well as to global comps.

Takeout sensitivity table: