Turtle Beach (HEAR) was one of the hottest tech related stocks to own just a few months ago. However, about a month ago I wrote an article on why their valuation was too stretched and investors should be cautious. Since that article was published on August 8, the stock has been down ~40% and investors should begin to take a closer look at valuation.

Yes, the video game market remains a hot territory to be in with battle royal games such as Fortnite amassing 140 million downloads in a short period of time. Turtle Beach is the largest player in the console gaming headset market and saw revenues grow over 200% this past quarter. They are slowly becoming profitable and have retained their title as the best in the industry.

ChartHEAR data by YCharts

The significant rise in the stock over the past few months was met with a lot of profit taking and re-rating. The company has a cleaned up their balance sheet and management’s guidance raise this past quarter demonstrates their underlying confidence in business trends. Valuation has stepped back down to more realistic levels, and as the video game market continues to be on a roll with the retailer’s favorite holiday season coming up, investors should begin to take another close look at Turtle Beach.

Q2 Earnings Highlights and Guidance

Turtle Beach reported a very strong Q2 earnings, with revenues increasing 218% to $60.8 million for the quarter compared to $19.1 million last year. The success stories of both Fortnite and PUBG further demonstrate video games dedication to gaming equipment and accessories.

Turtle Beach is able to differentiate themselves by focusing heavily on the gaming market, compared to other competitors such as Logitech (LOGI) which focuses more on the broader headphone market. Turtle Beach offers gaming headphones at varying ASPs, which enables gamers to select their realistic price point.

Source: Company Presentation

Q2 saw gross margins increase from 33.0% to 33.3%, with net income rising to $6.3 million compared to a net loss of $7.1 million last year. EPS was $0.40 compared to an EPS loss of $0.57 last year. Adjusted EBITDA was $9.8 million for the quarter. Turtle Beach was able to show profitability which gave investors a lot of confidence in their future performance. This may have been one of the drivers for the rapid uptick in the stock price over the past few months.

Management noted that gross margin, net income and adjusted EBITDA were all at the highest levels for any Q2 since the company went public in 2014. This surely demonstrates that when their main market (gaming) is doing well, the business has room to succeed.

Management provided guidance for another strong Q3, with revenues expected to grow 81% to $65 million, EPS of $0.44, and adjusted EBITDA of $11 million. In addition, the company significantly raised their full-year guidance, as shown in the chart below.

Source: Company Presentation

The updated guidance increased expected revenue by nearly 50%, which is unheard of in almost every other industry. Management pointed directly to Fortnite and PUBG as drivers of this strong growth.

Adjusted EBITDA is also guided to expand to $45 million, or nearly 4x y/y and close to double of what management originally projected. The update guidance range likely shows little optimism, but more related to management’s confidence in the business. The heightened investor focus on this name likely caused management to have more conservatism, if anything, in their projections. A company with this much momentum that misses earnings would have little hope of avoiding a major downfall.

You Can’t See The Future, But Can You HEAR It?

This past quarter, Turtle Beach noted they expanded their leadership position in the US/Canada console headset market, increasing to 45.5% share compared to 39.8% share last year. They also have the top-five best selling headsets in the marketplace and noted they are larger than the next four competitors combined. The gaming market is being gamed by Turtle Beach and their stronghold on the market is not likely to go away anytime soon.

In Electronic Arts’ (NASDAQ:EA) latest earnings release, they noted Fortnite claimed the top spot in iOS mobile gaming rankings, but battle royale games continued to gain solid market share across console, PC, and mobile (Source: Company Presentation). EA also has their new Battlefield game being released in the upcoming months and management seems optimistic about their sales forecast. Historically, EA has dominated in the sports video game market, but as gamers continue to move more towards the battle royale games, EA is even trying to get in on the game. This ultimately has a positive effect for Turtle Beach as it expands their addressable market to gamers who have typically bought EA licensed games.

Also coming out to the market this fall is Red Dead Redemption and Call of Duty Black Ops 4. Both of these games are expected to have a similar battle mode as Fortnite and PUBG, known as a battle royale. The producers behind the two games coming out this fall are very confident in expected demand, which could ultimately end up working in Turtle Beach’s favor.

One of the biggest issues I have with Turtle Beach is their market penetration. Being the clear market leader approaching a 50% share in the US/Canada market, how much more room is there for this company to grow? For example, let’s assume freemium games such as Fortnite and PUBG die off from being the hottest gaming trend and video games in general begin to peak. How quickly is the company able to shift away from the gaming console market and/or cut costs to maintain their profitability?

With annualized revenues reaching $250 million, Turtle Beach is the largest player and has the most to lose. If another freemium game was released that required some other gaming accessory, would the use of gaming headphones get pushed to the side? Over the long term, I believe the video game industry is here to stay. I think Turtle Beach will ultimately be the long-term winner, but investors need to be ready to ride a rocky road throughout the seasonal industry caused by both holidays and game releases.

Valuation

Valuation is no longer as much of a mystery as it was a month ago when the stock was trading above $30 a share. As a reminder, last year Skullcandy, another headphone manufacturer (though it does not compete in the video game/console market), was acquired for roughly 6x forward EBITDA (Source: The Street).

ChartHEAR EV to EBITDA (Forward) data by YCharts

The above competitor groups display several names across the gaming peripherals market that sell hardware. These names have differing growth characteristics; however, underlying fundamentals are comparable. The average forward EV/EBITDA of the peer group is ~12.4x, well above HEAR’s. However, HEAR’s ratio is artificially low given that management calls for FY18 EBITDA of $45 million.

Given we are halfway through the year, I will assume Q1/Q2 of FY19 will grow 40% y/y. For reference, Q2 adjusted EBITDA was $9.8 million, an increase of $12.6 million y/y. Using a 40% growth rate, Q1/Q2 adjusted EBITDA for 2019 would be $7.4/$13.7 million (compared to Q1/Q2 2018 adjusted EBITDA of $5.3/$9.8 million).

Management is guiding for $45 million for the year, with $30 million coming in Q3/Q4. Adding in my projected Q1/Q2 2019, we get an adjusted EBITDA of $51.1 million.

Based on Friday’s closing price of $20.70, they had a market cap of ~$286 million. With net debt of $16.8 million, this gives HEAR an enterprise value of ~$303 million. Using my above adjusted EBITDA projection, this results in an EV/EBITDA multiple of ~5.9x.

This adjusted EBITDA projection shows that HEAR may be slightly undervalued given the ~40% correction over the past month. HEAR appears to be a bit undervalued, and using the Skullcandy acquisition as a baseline of 6x EBITDA, HEAR appears to have bottomed out. Investors should look to sharpen their pencils around this name over the coming weeks as the stock looks ripe for a strong rebound heading into the holiday season.

Disclosure: I am/we are long HEAR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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