This article is about Turtle Beach Corporation (HEAR) and why I think this stock could be a good BUY. 

I will start with my style on how to analyze a stock. I search for companies in my scope of knowledge. In the best case, I use or have used their services or products. This is true for turtle beach, a few friends and I bought their headphones, they offer good quality for a low price.

After I identified an interesting and familiar company, I contemplate different multiples. By doing this, I identify which companies might be undervalued and are worth further analysis and intrinsic valuation. Subsequently, I search for catalysts that are not priced in by analysts or the market. Moreover, a close look at earnings and revenue estimates is an essential part of my analysis, to identify too low expectations or potential for upside surprises. Eventually, I look at the last quarterly result of the company. If I am still interested in the company and I consider the risk-reward-ratio to be good, I discount future cash flows to determine the fair value. 

2019 Q4 Earnings Report

“Based on preliminary unaudited information, Turtle Beach expects to report fourth-quarter 2019 sales between $100 million and $102 million compared to $111.3 million reported in the fourth quarter of 2018. For the full year 2019, sales are expected to be between $233 million and $235 million compared to $287.4 million in 2018.”

“Preliminary diluted earnings per share for the fourth quarter are expected to be between $0.64 and $0.75 compared to $1.33 in the fourth quarter of 2018. For the full year 2019, preliminary diluted earnings per share are expected to be between $0.40 and $0.50 compared to $2.74 in 2018. Preliminary adjusted diluted earnings per share for the fourth quarter are expected to be between $0.67 and $0.78 compared to $1.33 in the fourth quarter of 2018². For the full year 2019, preliminary adjusted diluted earnings per share are expected to be between $0.57 and $0.69 compared to $3.05 in 2018.” Source: Seeking Alpha PR Newswire

Revenues are expected to decline by 8% to 10% YoY in Q4 of 2019 and by approximately 18% for the full year of 2019. The stock dropped by more than 10% following the preliminary report. This report decreased future expectations as I will layout later in this analysis. The actual earnings report for Q4 2019 is expected to be on the 12^th of March, Turtle Beach will deliver the precise Revenue, Earnings and guidance for 2020. I am especially looking forward to the guidance, I expect it to beat estimations by analysts and the stock to move up accordingly.

Multiples

All of Turtle Beach's are fairly low compared with the industry average. Turtle Beach has a trailing PE of 4.1, a price to book ratio of 2.2 and a price to sales ratio of 0.38. The reason for these multiples is worsening fundamentals. The market tends to overreact, to the downside as well as to the upside. Is this also the case for turtle beach? (HEAR) is down nearly 80% from its high in 2018. Due to the release of Fortnite, the demand for headsets skyrocketed and revenue & earnings surprised to the upside. Since then numbers have normalized again. I was asking myself is: was this strong downward move justified? 

Catalysts

I like to invest in gaming-related stocks because I know the potential those have. With the increasing buying power of millennials and gen z, the potential market for online gaming increases as well. When new online multiplayer games are launched, the demand for headsets inclines. 

Another important factor for headphone sales is the release of gaming consoles. People tend to upgrade their hardware when buying a new console. In the fourth quarter of 2020, Microsoft will start to sell its new XBOX series X and Sony its Playstation 5. It is unlikely that the release will be pushed back. Both companies are eager to stick to this time-plan, to take advantage of higher customer spending during the Christmas season. These launches will increase sales of Turtle Beach and it could lead to a blow-out Q4 in 2020. A second, more long-lasting catalysts are multiplayer online battle arena (MOBA) and massively multiplayer (MMO) games. These game categories are expected to grow with a CAGR of 14,52 % to 2021 and a headset is a prerequisite for sufficient communication in-game. 

Before the release of new online games, it is rather hard to tell, if the game will be a success. The first game of the DOTA series e.g. was only a fan-made modification of Warcraft III. League of Legends was released by Riot Games in autumn 2009, only three years after two students created the company. But I will take a guess on some future releases.

Following, I will mention a few promising games which will be released in 2020 and beyond:

New World

New World will be Amazons (AMZN) first big step into gaming. The game is categorized in the MMORPG (massively-multiplayer online role-playing game) genre, competing with World of Warcraft. The release is expected to be in May 2020.

Lord of the Rings MMO

Besides New World Amazon is developing a Lord of the Rings MMO in cooperation with Athlon Games. Even though no release date is set, the game could be a massive success due to Amazon financially backing the game and a nostalgic following of Lord of the Rings.

Magic: Legends – Perfect World Entertainment

Magic: Legends is related to the card game Magic and will be released in 2021 on Xbox, Playstation, and PC.

Project A – Riot Games

Project A is one of the first new multiplayer of Riot Games since the release of League of Legends. It will be an FPS (First-person shooter).

GTA VI

While it is not officially confirmed, there are several rumors about GTA IV.

There are a bunch of new releases in 2020 and beyond.

While this list may not be as strong as it was in the past, it still offers a row of potential big catalysts.

Analyst expectations

Despite the launch of the fifth-generation consoles analysts expect revenue of $227.74 million in 2020, this represents a decrease of roughly 5%.

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​Source: Yahoo Finance

In 2019 revenues decreased by approximately 18%, because there were no big catalysts. No new consoles got released and Fortnite was already two years old. Due to the launch of the new Xbox and Playstation, a further decline of 5% is unlikely. During 2019 Turtle Beach also acquired ROCCAT, to diversify its product portfolio with gaming mice and keyboards. This will also help to push revenues up. When looking at the past quarters, low revenue correlates with losses and high revenues with huge earnings, caused by lower average production costs. 

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​Source: created by the author

From the second half onwards the profitability is lower due to the acquisition of ROCCAT. But overall the diagram shows that approximately 40% of the yearly revenue is in Q4. I expect in particular the last quarter of 2020 to be exceptionally high.

Discounted Cashflow Analysis

While I start my stock analysis by looking at pricing strategies (multiples), I do a discounted cash flow analysis to look at the stock from a different perspective. If both methods indicate an undervaluation, I will add the stock to my portfolio. I chose a “high-growth” period of three years. Even though I disagree with a 5% revenue decrease, I used a growth-rate of -5% for 2020 and 3% for 2021 and 2022 to be reasonably conservative. 

(Click on image to enlarge)

​Source: created by the author

I adjusted the cost of debt slowly to the industry average and the effective tax rate to the marginal tax rate. The reinvestment rate is relatively high in 2020, a result of the recent acquisition.

Because there are different methods to determine beta and the market premium, I will explain how I came up with a return on equity of 8.3% for Turtle Beach.

rf = 1.04%      10 year treasury bill rate

rm = 5.5%      implied market premium (I used Buyback + Dividends as Cashflow)

β = 1.61          transformed unlevered peer-group beta by using Turtle Beach's market value of equity and debt

(Click on image to enlarge)

​Source: created by the author

Thereafter, I calculated the terminal value. I set the risk-free rate as growth rate. The debt to equity ratio is equal to the industry average. Over time Turtle Beach's ratios will approach the industry averages. Hence, I used the beta and cost of debt of the peer group.

(Click on image to enlarge)

​Source: created by the author

Lastly, I discounted the terminal value and added it to the present value of the FCFF in the high growth phase. By subtracting the market value of outstanding debt, which are mostly operating leases, I get the fair market value of equity. Divided by outstanding shares the value of equity is $22.74/share. That implies the share is undervalued by 72%. Even if you consider a default probability of 40% and assume an equity value of $0 in the default case, you end up with a Value of $13.64.

Risks

In the following segment of this article, I will list risk factors for Turtle Beach, which could lead to a decline in revenues and profits.

China tariffs

At the moment (HEAR) isn’t paying tariffs on its products, in the event of continued trade negotiations, this might change. All of their products are produced in China.

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​Source: Turtle Beach 10Q 2019 Q3

Headphones are a product on list 4B:

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​Source: www.strtrade.com

For list 4B products, a 15% tariff was planned, but it was pushed back due to phase 1 of the trade deal with China.

Player-base of online games

A decrease of player-bases of famous online games like DOTA 2 and PUBG will also lead to a lower interest in gaming headsets. While most of the biggest games are still reporting strong numbers, this is not certain going forward.

Saturated Market

Turtle Beach has a market share of over 40% for the tenth consecutive year in the North American console gaming headset market. Furthermore, this market is expected to grow by a CAGR of 6.8% to 2026, there are several competitors in the market. Some examples are Sennheiser, SteelSeries, Logitech, Razer. All of these competitors offer products at a similar price point, which can match the quality of Turtle Beach products.

Declining market share of console and PC gaming

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​Source: wepc.com

Smartphone & Smartwatch gaming continues to take market share of Console and PC gaming. Going forward this trend will most likely continue because Smartphones enable more people to enter into gaming. It is fairly easy to find a few minutes in break times or in between meetings to relax a little bit by playing games on the phone. This convenience attracts a specific target group, which might not have enough time for console/PC gaming.

These risks would lead to a continued down-turn for Turtle Beach and could even make its business redundant. From personal experience, I know that Turtle Beach products are not superior over its rival’s products regarding technical aspects. However, the price of their headphones is rather low and the current stock price makes Turtle Beach an interesting investment.

Conclusion

In the short-term HEAR does not seem very attractive, because it is still in a down-trend. But due to its high fair value, I expect the stock to recover over the next years. Caused by the small market-capitalization and high short-interest the stock might also continue to be volatile, but I like the solid balance sheet. They have no long-term debt and will benefit from the growth of online gaming. For patient investors, this stock offers a great risk-reward ratio. I will buy (HEAR) in tranches to be able to average down my cost basis and to not get hit that hard by a further stock decrease.