HEAR - Turtle Beach: Still Too Much Risk Too Little Return

2023-09-01 14:20:36 ET

Summary

• Turtle Beach Corporation shares have underperformed, making it a potential buying opportunity at the right price.
• The financial performance of the company remains troubled with few catalysts for improvement.
• Turtle Beach stock is not cheaply priced, and the risks outweigh the potential returns.

It’s been about 2 ½ months since I suggested that it would be prudent to continue to avoid shares of Turtle Beach Corporation ( HEAR ). In that time, the shares have lost about 3.9% against a gain of about 3.2% for the S&P 500 (SP500). I like to see underperformance, because it’s always better to buy when prices are depressed. The fact that I’ve done well trading in and out of this stock over the years indicates that I’d be happy to buy back in at the right price. I’ll determine whether or not it makes sense to buy back in based on the latest financial results, and the current valuation.

The weekend is upon us, and I’m assuming you’re busy trying to decide which supermodel you’re going to have a very small dinner with tonight. Because you’re so busy, I’m going to present my thoughts about Turtle Beach in a short “thesis statement” paragraph. This will give you more than you get from a title and bullet points, but much less than you get from the whole enchilada. You’re welcome.

So I would recommend continuing to avoid HEAR stock. The financial performance remains troubled in my view, and there are few catalysts for financial improvement on the radar in my view. The stock may very well be sold, and that may net shareholders a nice 22% return . The problem, from my point of view, is that that might not happen, and the buyout may turn into the financial equivalent of Waiting for Godot . In the meantime, an investor will watch their capital languish while there are far better risk adjusted returns available to them. Finally, none of this would be terrible if it weren’t for the fact that the shares are not cheaply priced. Investors are not seeking “returns,” but “risk adjusted returns.” The risks here are too great, and the returns too paltry, in my view.

Financial Snapshot

The latest financial results have been less bad than they were this time last year, but they’re still bad in my estimation. For instance, while revenue for the first six months of 2023 was higher by about 13%, or $11.5 million, net income improved a mere $1.67 million. This is because of cost of revenue. More importantly, the company is still losing money, with net loss for the first two quarters of the year coming in at $22.6 million. Better than the $24.3 million loss last year, but not significantly so in my estimation.

Things look even worse if we compare the most recent period to the pre-pandemic era. Although revenue for the first half of this year was about 15% higher than it was in 2019, net income is down by about $23.3 million from that period. This is because cost of revenue, selling and marketing, R&D, G&A, are higher by 26%, 38%, 160% and 86% respectively. Put another way, when your sales rise $13.25 million, and your expenses rise by $37 million, that’s bad.

I will admit that the capital structure is actually much stronger now than it has been in some time, with cash representing fully 24% of total liabilities, which is up from 14% this time last year. So, the business continues to struggle in my view. Net income peaked in 2018, and has been volatile, trending downward since then. I’d be willing to buy, though, at the right price.

The Stock

If you’re a regular, you know that I’m about to drone on about the fact that, unless we have the resources of someone who’s refer to derivatives as “weapons of mass financial destruction” while happily selling puts , we very much do buy stocks and not companies. For instance, Turtle Beach generates revenue by selling headsets and the like. The stock, on the other hand, is a slip of virtual paper that gets traded around in the public markets and is impacted by the mood of the crowd, and that is affected by a host of things ranging from the ongoing appetite for “stocks” as an asset class, to central bank policies, to ever-changing views about the future profitability of the enterprise. These views change at a much more rapid pace than anything at the firm.

If you expected me to not blather on about this, prepare to have your expectations subverted, because that’s exactly what I’m about to do. Let’s imagine the tail of two Turtle Beach investors. One bought this stock on August 23, and the other bought a mere 2 days later. The former is down about 3.8% since then. The one who bought on August 25 is actually up about 3.4%. Not enough changed at the firm to account for this 7%+ variance in returns. I should also point out that the person who bought shares when they were cheaper did much better.

This is one of the reasons why I try to buy shares cheaply. They come with less risk because they have far less to drop in price, and they offer greater potential reward, because it’s easier for the companies of these stocks to outperform the lower expectations that cheap shares imply.

My regulars know that I measure “cheap” in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, sales, and the like. We obviously can’t look at the P/E ratio of this stock, because of the complete absence of earnings, but we can judge what the market is paying for $1 of sales, for instance. When I last wrote about this stock, the P/S ratio was .772. Today, that measure has barely budged, per the following:

The market is also paying nearly $2.57 for $1 of book value. I consider this to be objectively expensive, but it’s been worse for this company, per the following:

As I wrote above, in addition to looking at simple ratios, I also look at more complex measures of valuation. In particular, I want to try to unpack the assumptions currently embedded in price. If you read me regularly, you know that I rely on the work of Professor Stephen Penman, and increasingly Mauboussin and Rappaport to do this. This approach uses stock price itself as a source of information. This method involves "reverse engineering" the assumptions that cause the current price.

Using this approach, the market is currently forecasting a fairly low growth rate of ~11.7% for Turtle Beach Corporation going forward. This is objectively optimistic in my view, and it’s exemplified by the analyst community that is suggesting that next year this company will swing from a loss of $.36 to EPS of $.26 per share . That is not consummate “Wall Street Glass Half Full” thinking. That’s “Glass Is Perpetual Liquid Machine” thinking in my view.

Given the above, I’m going to continue to avoid the shares, and I may change this view if and when the firm returns to profitability. I may miss out on some upside if the stock gets “taken out,” but the risk of this not happening is too great for the potential returns. In my view, it’s best when investors seek risk-adjusted returns, and the risks here don’t make any potential returns worth it in my view.

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