Turtle Beach Corporation (HEAR)

After pausing my nascent investing blog career in early 2017, I’m back for hopefully regularly scheduled programming. At first glance I may be setting myself up for some easy article ideas and an eventual “What I got wrong on HEAR” article by picking a company that has already been a 10 bagger this year. Despite the successes, I think the market has it wrong currently on Turtle Beach (HEAR).

My thesis is that even with unbelievable success driven by the battle royale boom in gaming (Fortnite and PUBG being the most famous), this isn’t a one-time blip. The stellar 2018 has allowed HEAR to completely turn around their balance sheet; setting the stage for continued growth in PC gaming headsets (targeting 10-20% market share in the next few years), untapped markets (China), and other gaming hardware items (mice, keyboards, etc.).

At current levels the market is pricing in a greater than 50% drop in FCF and net income next year. I feel the boom in sales in 2018 has simply increased a user base that on average refreshes products every 2 years. HEAR will continue to lead this market and with a brand new capital structure that has nearly eliminated all debt, HEAR will have optionality to invest in their identified growth markets and/or return capital to shareholders. Irrational expectations and very high short interest has created a great margin of safety and an attractive value proposition for investors.

Turtle Beach (HEAR)

The company sells gaming headsets compatible with the popular gaming consoles: PlayStation 4 (PS4) and Xbox One. HEAR is the market leader in the console headset market and it really isn’t close. They currently have 6 of the top 10 selling console headsets. This includes the #1 selling console headset for PS4 and Xbox One, #1 and #2 Xbox One wireless headset, #1 PS4 wireless headset, and #1 chat headset for Xbox One and PS4. They currently have a 45% market share in the U.S. and Canada and a 51% market share in the U.K. The PC market was mentioned above as a growth platform going forward, but if you combine the PC and Console market share currently, HEAR is at 34% in the U.S. That is larger than the share of the next three competitors, combined.

What has happened in 2018?

On a macro level:

The gaming world has received a huge jolt from battle royale style games. Battle royale games are a multiplayer, online format where the winner is the last man/woman standing. The most popular of these are Fortnite and PlayerUnknowns Battleground (PUBG). The headsets are key for these games as they help the player pick up on audio cues, which is imperative for competitiveness in the format. Prior to the battle royale games, about 25% of gamers used a headset; 80% of battle royale gamers use a headset. This has led to an increase in total units sold, YTD through September, of 51.3%. Capitalizing on this trend, HEAR’s projected FY2018 revenues are expected to come in 81% higher than 2017.

The popularity of the Battle Royale format hasn’t been lost on the industry as a number of companies are delivering games with Battle Royale formats:

  • Call of Duty: Black Ops 4 has a Battle Royale mode, Blackout
  • Red Dead Redemption 2 launched on October 26th and achieved $720mm of sales in its first 3 days, scoring the highest rating of any game in the past decade, and HEAR mgmt. mentioned on the 3Q18 call that there are rumors of a battle royale mode in 2019.
  • Battlefield V launches on November 20th and features 8 multiplayer modes, one of them being a battle royale mode

The maker of Fortnite, Epic Games, has also attracted interest as it completed a $1.25bn financing round, which will likely bring new seasons and games looking to capitalize on the 80 million players per month that Fortnite currently draws.

An amazing stat from a HEAR earnings call, “There are 148 million eSports enthusiasts around the globe, and 22% of American male millennials watch eSports, putting it virtually equal with baseball and hockey in terms of viewership among that demographic.” HEAR has partnerships with a number of eSports teams.

On a micro level:

The battle royale boom has allowed HEAR to totally repair its balance sheet, positioning the company to take advantage of attractive growth opportunities.

As of 12/31/17, this is what the HEAR cap structure looked like:

  • $38.5mm Revolving Credit Facility
  • $10.9mm Term Loans
  • $21.9mm Subordinated Notes
  • $18.9mm Series B Preferred Stock at an 8% interest rate

The capital structure is 180 degrees different today thanks to an exchange of shares and warrants to retire the preferred stock and allocation of Free Cash Flow ($41mm YTD 9/30/18) towards debt reduction. Today the capital structure looks like this:

  • $3.5mm Revolving Credit Facility
  • $12.5mm Term Loans
  • $10.4mm Subordinated Notes (Will be paid off by end of 1Q19)

On the 3Q18 call, management said they will have the cash available to repay ALL remaining debt if they choose to do so in 1Q19.

The company has continually beat and raised guidance. Going into 4Q 2018, the company is guiding to 4Q Revenue of $94mm and Net Income of $16.7mm, both +18% YoY. This will bring FY2018 Revenue of $270mm, +81% YoY, and EPS of $2.55 (as of 11/14/18 the stock closed at $13.66).

Why is the market wrong?

As I mentioned above, currently the market is valuing HEAR as if sales will completely revert back to pre-battle royale levels. This is just not going to happen. While we are not going to see an 80% top-line growth number in 2019, and may even see a modest decline, HEAR is positioned with a clean balance sheet to drive profitable growth beyond 2020. Management has identified adjacent growth initiatives and now has the balance sheet to pursue these. Additionally, the battle royale trend is here to stay.   HEAR’s customers, on average, refresh their headsets every 23 months so we simply have a much higher base that will be re-entering the market every two years. Along with this, it is likely that new customers entered at low price points and will trade up and sooner: from surveys, the company has observed that Fortnite players (80mm monthly) that play greater than 3 hours per week replace at a faster rate than the average gamer.

What’s it worth?

In HEAR we have a market leader/giant with a clean balance sheet, identified growth plans in adjacent markets, and secular tailwinds that are likely to continue. The market is currently valuing HEAR as if earnings and revenue are likely to fall off a cliff. At a current market cap (fully diluted) of $222mm, the company is trading at a 23% FCF yield on projected FY18 numbers.

After a normalization year in 2019, with revenue off slightly from 2018, I would expect HEAR to deliver continued growth as it continues to dominate the console headset market while building market share in the PC headset market. The PC market increases HEAR’s addressable market by about 50% and the company will begin targeting a 10-20% market share in the next couple years. The company has already secured shelf space with retailers for this and initial reviews are very positive. Below is the Turtle Beach Atlas Elite review from PCMag.

Screen Shot 2018-11-13 at 9.47.08 PM

Over time HEAR will look to expand the addressable market by another 50% by entering PC headset markets outside of core markets, specifically China. Finally, add another $1bn of addressable market share through non-headset gaming products like keyboards, mice, and others.

Conclusion

The market is dismissing HEAR as a one-hit wonder when in fact it has a good margin of safety built into the story given current valuations. FCF and EBITDA could both fall 50% and HEAR would be trading around a 10% FCF yield and less than 10.0x EV/EBITDA. Another factor to consider is that a large number of shares are sold short, >75%, which has caused a lot of volatility in the name, likely cherry picked by speculators who only see the 1,000% return YTD. I’m not going to give an absolute value for the company, but I love the margin of safety currently at a >20% FCF yield to FY18 projections.

Thank you for reading!

Disclaimer: I currently own shares of Turtle Beach (HEAR). This is article is opinion only and not a recommendation to buy.

The Wheels on the Bus, Blue Bird Corporation (BLBD) (BLBDW)

One of my favorite books I’ve read in the past few years is Mohnish Pabrai’s The Dhando Investor. Since reading this I’ve devoured all of the great articles and YouTube videos that are out there outlining Mohnish’s value philosophy (I posted links to some of my favorites at the bottom)*.

This article is due in part to Mohnish. One of his larger holdings is in GM and not directly through the common stock but through the company’s 2019 warrants. The warrants trade under the ticker GM/B and give the right to buy GM common stock at $18.33 per share. In essence it is a levered bet, so instead of buying 27 shares with $1000 you can control 54 shares with the same amount of capital. I really liked this idea and it follows Mohnish’s saying of “Heads I win, Tails I don’t lose much.” I’ve never gotten myself around to buying the GM warrants, although I’ve been very close many times. This did, however, inspire me to purchase the company I’ll be writing about today.

Blue Bird Corporation (BLBD) manufactures and designs school buses. The North American Type C and D bus market is controlled by three players: Blue Bird, Thomas Built Buses, and IC Bus. Blue Bird the only independent company of the three. Thomas Built Buses is owned by Daimler and IC Bus is owned by Navistar. In 2016 the market share was divided as such: Thomas Built Buses 35%, IC Bus 34%, and Blue Bird 31%. I think it is safe to say that the North American Type C and D bus market has a fairly deep moat around it. Schools have trusted Blue Bird since the 1920s and its dealership networks are very entrenched (leading to 90% of sales). Not only do I think the company has a pretty deep moat around it, I also love the warrants available under the ticker BLBDW. Each warrant gives the right to purchase 0.5 shares for $5.75, (2 warrants for 1 share at $11.50).

As of market close on 1/27/17, the underlying common stock was at $16.95, implying a market cap of $383mm. The warrants were trading at $2.75.

The bus industry hit a trough in 2011, as there were only 23,821 Type C/D registrations, significantly below the mean since 1985 of 30,500 annual registrations. As the industry has recovered, Blue Bird has consistently gained market share. In 2010, Blue Bird had a 23% market share, rising to 31% in FY2016. This has been driven by the company’s significant dealer network within the U.S. as well as leadership in the alternative fuels space, offering propane, gas, and CNG buses. In FY2016 Blue Bird’s sales of propone vehicles increased 33%. I think Blue Bird’s leadership in alternative fuels will help drive outperformance for the company going forward.

It is important to note that Blue Bird has a large majority shareholder, private equity firm American Securities. They own 53% of the common stock and it is worth mentioning that they attempted to purchase the other 47% in the summer of 2016. American Securities had offered to pay $12.80-13.10/share for the remaining shares it didn’t own, an offer that was rejected by a special committee formed by the Board of Directors.

Blue Bird is projecting 2017 sales to rise 6% to $980-1,010mm, EBITDA to rise to $72-76mm and FCF to rise to $38-42mm. At an EV/EBITDA of 6.5x, a FCF Yield of ~10%, and a forward P/E less than 12x, the stock and warrants seem very attractive. Given Blue Bird’s position in an industry that has a deep moat and multiple avenues for future growth (alternative fuel buses, sales to the commercial market, potential for development of an electric vehicle) I feel that shares and warrants present a great value at current prices.

*

https://www.youtube.com/watch?v=IOoaNYQHaYY  (Mohnish Pabrai at lecture BC)