Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
(Amendment No. 1)
(Mark one)
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to  

Commission File Number: 001-35465
http://api.tenkwizard.com/cgi/image?quest=1&rid=23&ipage=12810391&doc=11 
TURTLE BEACH CORPORATION
(Exact name of registrant as specified in its charter)
 
Nevada
27-2767540
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
 
 
11011 Via Frontera, Suite A/B
San Diego, California
92127
(Address of principal executive offices)
(Zip Code)
 
(888) 496-8001
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  ý Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ý Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨                            Accelerated filer ¨    
Non-accelerated filer ¨                             Smaller reporting company ý
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes ý No
The number of shares of the registrant’s Common Stock, par value $0.001 per share, outstanding on October 31, 2018 was 14,239,589.

 

INDEX


 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
Item 1.
Financial Statements (unaudited)

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
PART II. OTHER INFORMATION
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 5.

 
 
 
Item 6.
 
 
SIGNATURES


1


EXPLANATORY NOTE

On March 13, 2019, the Audit Committee of the Board of Directors (the “Audit Committee”) of Turtle Beach Corporation (the “Company”), after considering the recommendations of management and consulting with BDO USA, LLP, the Company’s independent registered public accounting firm, concluded that our unaudited condensed consolidated financial statements included in the quarterly reports on Form 10-Q for the interim periods ended June 30, 2018, and September 30, 2018 (the “Initial Filings”) should not be relied upon because the Company had improperly accounted for the fully-funded warrants issued in connection with the Company’s exchange of Series B Preferred Stock on April 23, 2018. The warrants are exercisable for a fixed number of shares of the Company’s common stock, except that the warrant holders have the right to receive cash in connection with the completion of a transaction defined as a Fundamental Transaction under the warrant agreement. Upon subsequent review, the Company determined that the proper accounting treatment for the warrants due to this possible future cash conversion option was as a financial instrument obligation rather than as an equity instrument, as originally reported. Accounting for the warrants as a financial instrument obligation results in the Company reporting a liability equal to the fair value of the warrants at the time of the transaction, with subsequent changes in fair value reported quarterly in earnings based on a Black-Scholes mark-to-market valuation.

We are filing this Amendment No. 1 to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018 (“Form 10-Q/A”), which was filed with the United States Securities and Exchange Commission (“SEC”) on November 6, 2018 (the “Original Filing”), to reflect restatements of the Condensed Consolidated Balance Sheet at September 30, 2018, the Condensed Consolidated Statements of Income (Loss) for the three and nine months ended September 30, 2018, and Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2018, and the related notes thereto.

The following sections in the Original Filing are revised in this Form 10-Q/A, solely as a result of, and to reflect, the restatement:
Part I - Item 1 - Financial Statements
Part I - Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
Part I - Item 4 - Controls and Procedures
Part II - Item 1A - Risk Factors
Part II - Item 6 - Exhibits

Pursuant to the rules of the SEC, Part II, Item 6 of the Original Filing has been amended to include the currently-dated certifications from our principal executive officer and principal financial officer, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002. The certifications of the principal executive officer and principal financial officer are included in this Form 10-Q/A as Exhibits 31.1, 31.2 and 32.1.

For the convenience of the reader, this Form 10-Q/A sets forth the information in the Original Filing in its entirety, as such information is modified and superseded where necessary to reflect the restatement. This Form 10-Q/A should be read in conjunction with our filings with the SEC subsequent to the date of the Original Filing, in each case as those filings may have been, or with respect to the Initial Filings will be, superseded or amended.


2


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.
Turtle Beach Corporation
Condensed Consolidated Balance Sheets

 
September 30,
2018

December 31, 2017
 
(unaudited, restated)
 
 
ASSETS
(in thousands, except par value and share amounts)
Current Assets:
 

 
 

Cash and cash equivalents
$
6,178

 
$
5,247

Accounts receivable, net
28,995

 
50,534

Inventories
73,348

 
27,518

Prepaid expenses and other current assets
5,194

 
3,467

Total Current Assets
113,715

 
86,766

Property and equipment, net
4,019

 
4,677

Intangible assets, net
1,091

 
1,404

Other assets
698

 
1,404

Total Assets
$
119,523

 
$
94,251

LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)
 
 
 

Current Liabilities:
 
 
 

Revolving credit facility
$
3,523

 
$
38,467

Term loans
750

 
4,173

Accounts payable
49,014

 
13,459

Other current liabilities
14,631

 
11,451

Total Current Liabilities
67,918

 
67,550

Term loans, long-term portion, net of unamortized debt issuance costs of $667 and $759
11,083

 
6,789

Series B redeemable preferred stock

 
18,921

Financial instrument obligation
10,967

 

Subordinated notes - related party, net of unamortized discount of $609 and $1,075
14,784

 
20,836

Other liabilities
2,313

 
2,312

Total Liabilities
107,065

 
116,408

Commitments and Contingencies
 
 
 
Stockholders Equity (Deficit)
 

 
 

Common stock, $0.001 par value - 25,000,000 shares authorized; 14,229,736 and 12,349,449 shares issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
14

 
12

Additional paid-in capital
168,920

 
148,082

Accumulated deficit
(156,077
)
 
(170,048
)
Accumulated other comprehensive loss
(399
)
 
(203
)
Total Stockholders Equity (Deficit)
12,458

 
(22,157
)
Total Liabilities and Stockholders Equity (Deficit)
$
119,523

 
$
94,251













See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

3



Turtle Beach Corporation
Condensed Consolidated Statements of Operations
(unaudited)

 
Three Months Ended 
 
Nine Months Ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018

September 30,
2017
 
(restated)
 
 
 
(restated)
 
 
 
(in thousands, except per-share data)
Net revenue
$
74,427

 
$
35,975

 
$
176,118

 
$
69,439

Cost of revenue
43,925

 
23,437

 
110,310

 
48,384

Gross profit
30,502

 
12,538

 
65,808

 
21,055

Operating expenses:
 
 
 
 
 
 
 
Selling and marketing
8,517


5,586


21,264


15,564

Research and development
1,400


1,336


4,056


4,423

General and administrative
4,063


3,499


11,911


11,740

Restructuring charges

 
241

 

 
509

Total operating expenses
13,980


10,662


37,231


32,236

Operating income (loss)
16,522

 
1,876

 
28,577

 
(11,181
)
Interest expense
1,093

 
2,042

 
4,356


5,717

Other non-operating expense (income), net
99

 
(252
)
 
8,883


(517
)
Income (loss) before income tax
15,330

 
86

 
15,338

 
(16,381
)
Income tax expense
398

 
578

 
762

 
1,098

Net income (loss)
$
14,932


$
(492
)

$
14,576


$
(17,479
)
 
 
 
 
 
 
 
 
Net income (loss) per share:
 
 
 
 
 
 
 
Basic
$
1.07

 
$
(0.04
)
 
$
1.10

 
$
(1.42
)
Diluted
$
0.91

 
$
(0.04
)
 
$
1.05

 
$
(1.42
)
Weighted average number of shares:
 
 
 
 
 
 
 
Basic
14,019

 
12,347

 
13,263

 
12,332

Diluted
16,229

 
12,347

 
13,828

 
12,332

 





















See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

4



Turtle Beach Corporation
Condensed Consolidated Statements of Comprehensive Income (Loss)
(unaudited)

 
Three Months Ended 
 
Nine Months Ended
 
September 30, 2018
 
September 30, 2017
 
September 30, 2018
 
September 30, 2017
 
(restated)
 
 
 
(restated)
 
 
 
(in thousands)
Net income (loss)
$
14,932

 
$
(492
)
 
$
14,576

 
$
(17,479
)
 
 
 
 
 
 
 
 
Other comprehensive income (loss):

 
 
 
 
 
 
 
Foreign currency translation adjustment
(81
)
 
111

 
(196
)
 
269

Other comprehensive income (loss)

(81
)
 
111

 
(196
)
 
269

Comprehensive income (loss)
$
14,851

 
$
(381
)
 
$
14,380

 
$
(17,210
)









 




























See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

5



Turtle Beach Corporation
Condensed Consolidated Statements of Cash Flows
(unaudited)

 
Nine Months Ended
 
September 30, 2018
 
September 30, 2017
 
(restated)
 
 
 
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
 

 
 

Net income (loss)
$
14,576

 
$
(17,479
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
2,944

 
3,000

Amortization of intangible assets
230

 
259

Amortization of debt financing costs
956

 
1,181

Stock-based compensation
1,409

 
1,187

Accrued interest on Series B redeemable preferred stock
501

 
1,067

Paid-in-kind interest
1,747

 
1,844

Deferred income taxes
714

 
417

Provision for (reversal of) sales returns reserve
1,097

 
(2,209
)
Provision for doubtful accounts
373

 
49

Provision for obsolete inventory
2,273

 
1,914

Loss on disposal of property and equipment
93

 

Unrealized loss on financial instrument obligation
8,410

 

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
19,463

 
32,205

Inventories
(48,103
)
 
(26,085
)
Accounts payable
35,223

 
17,537

Prepaid expenses and other assets
(1,727
)
 
(733
)
Income taxes payable
431

 
669

Other liabilities
2,748

 
(5,532
)
Net cash provided by operating activities
43,358

 
9,291

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Purchases of property and equipment
(2,046
)
 
(2,584
)
Net cash used for investing activities
(2,046
)
 
(2,584
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Borrowings on revolving credit facilities
205,810

 
98,165

Repayment of revolving credit facilities
(240,753
)
 
(109,277
)
Repayment of capital leases

 
(4
)
Proceeds from term loan
3,265

 

Repayment of term loan
(2,485
)
 
(1,443
)
Repayment of subordinated notes - related party
(8,265
)
 

Settlement of Series B redeemable preferred stock
(1,390
)
 

Proceeds from exercise of stock options and warrants
4,097

 

Repurchase of common stock to satisfy employee tax withholding obligations
(141
)
 

Debt financing costs
(405
)
 

Net cash used for financing activities
(40,267
)
 
(12,559
)
Effect of exchange rate changes on cash and cash equivalents
(114
)
 
142

Net increase (decrease) in cash and cash equivalents
931

 
(5,710
)
Cash and cash equivalents - beginning of period
5,247

 
6,183

Cash and cash equivalents - end of period
$
6,178

 
$
473

 
 
 
 
SUPPLEMENTAL DISCLOSURE OF INFORMATION
 
 
 
Cash paid for interest
$
1,062

 
$
1,364

Cash paid for income taxes
$

 
$

Exchange of Series B redeemable preferred stock
$
18,032

 
$


See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

6



Turtle Beach Corporation
Condensed Consolidated Statement of Stockholders Equity (Deficit)
(unaudited)

 
Common Stock
 
Additional Paid-In Capital
 
Accumulated Deficit
 
Accumulated Other Comprehensive Income (Loss)
 
Total
 
Shares
Amount
 
 
 
 
 
(in thousands)

Balance at December 31, 2017
12,349

$
12

 
$
148,082

 
$
(170,048
)
 
$
(203
)
 
$
(22,157
)
Cumulative effect of the adoption of ASC 606


 

 
(605
)
 

 
(605
)
Net income


 

 
14,576

 

 
14,576

Other comprehensive income


 

 

 
(196
)
 
(196
)
Issuance of common stock in exchange for Series B redeemable preferred stock, net of issuance costs
1,307

1

 
15,474

 

 

 
15,475

Issuance of restricted stock
44


 

 

 

 

Repurchase of common stock and retirement of related treasury shares
(6
)

 
(141
)
 

 

 
(141
)
Issuance of common stock upon exercise of warrant
77


 
778

 

 

 
778

Stock options exercised
459

1

 
3,318

 

 

 
3,319

Stock-based compensation
 

 
1,409

 

 

 
1,409

Balance at September 30, 2018
14,230

$
14

 
$
168,920

 
$
(156,077
)
 
$
(399
)
 
$
12,458






























See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

7

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)


Note 1. Background and Basis of Presentation
Organization
Turtle Beach Corporation (“Turtle Beach” or the “Company”), headquartered in San Diego, California, is the market share leader in gaming headsets and has been an innovator in premier audio technology for over 40 years. The Turtle Beach® brand is a highly regarded provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers, tablets and mobile devices. In addition to its gaming headset business, the Company acquired and developed an innovative and patent-protected sound technology that delivers immersive, directional audio called HyperSound®.

Turtle Beach was incorporated in the state of Nevada in 2010 and the Company’s stock is traded on the Nasdaq Global Market under the symbol HEAR.

VTB Holdings, Inc. (“VTBH”), a wholly-owned subsidiary of Turtle Beach and the parent holding company of Voyetra Turtle Beach, Inc. (“VTB”) and Turtle Beach Europe Limited (“TB Europe”), together the headset business, was incorporated in the state of Delaware in 2010 with operations principally located in Valhalla, New York. VTB was incorporated in the state of Delaware in 1975.

Basis of Presentation
The accompanying interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), have been condensed or omitted pursuant to those rules and regulations. The Company believes that the disclosures made are adequate to make the information presented not misleading. The results of operations for the interim periods are not necessarily indicative of the results of operations for the entire fiscal year.

The December 31, 2017 Condensed Consolidated Balance Sheet has been derived from the Company’s audited financial statements included in its Annual Report on Form 10-K filed with the SEC on March 7, 2018 (“Annual Report”).

These financial statements should be read in conjunction with the annual financial statements and the notes thereto included in the Annual Report that contains information useful to understanding the Company's businesses and financial statement presentations.

Reverse Split

On April 6, 2018, the Company effected a one-for-four reverse stock split of its common stock pursuant to which every four shares of common stock outstanding immediately prior to the reverse split were combined into one share of common stock. As a result of the reverse split, all outstanding share amounts and computations using such amounts in the Company’s financial statements and notes thereto have been retroactively adjusted to reflect the reverse stock split.

Restatement

On March 13, 2019, the Audit Committee of the Board of Directors (the “Audit Committee”) of Turtle Beach Corporation (the “Company”), after considering the recommendations of management and consulting with BDO USA, LLP, the Company’s independent registered public accounting firm, concluded that its unaudited condensed consolidated financial statements included in the quarterly reports on Form 10-Q for the interim periods ended June 30, 2018, and September 30, 2018 (the “Initial Filings”) should not be relied upon because the Company had improperly accounted for the fully-funded warrants issued in connection with the Company’s exchange of Series B Preferred Stock on April 23, 2018.


8

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

The warrants are exercisable for a fixed number of shares of the Company’s common stock, except that the warrant holders have the right to receive cash in connection with the completion of a transaction defined as a Fundamental Transaction under the warrant agreement. Upon subsequent review, the Company determined that the proper accounting treatment for the warrants due to this possible future cash conversion option was as a financial instrument obligation rather than as an equity instrument, as originally reported. Accounting for the warrants as a financial instrument obligation results in the Company reporting a liability equal to the fair value of the warrants at the time of the transaction, with subsequent changes in fair value reported quarterly in earnings based on a Black-Scholes mark-to-market valuation.

As a result of these terms regarding the possible future cash payment, the Company has accounted for the warrants issued in connection with the retirement of the Series B Preferred Stock as a financial instrument obligation that is marked to market each period, with subsequent changes in fair value reported in earnings. The fair value of the warrants upon issuance and at September 30, 2018, was $2.6 million and $11.0 million, respectively. This Form 10-Q/A for the period ended September 30, 2018 reflects a $0.2 million increase in net income from the reported amounts for the quarter resulting in net income of $14.9 million, or a diluted earnings per share of $0.91, compared to net income originally reported of $14.7 million, or diluted earnings per share of $0.91.

Impact of the Restatement

The following table presents the Company’s condensed consolidated statements of income (loss) as previously reported, restatement adjustments and the condensed consolidated statements of income (loss) as restated for the three and nine months ended September 30, 2018:

Condensed Consolidated Statements of Operations (unaudited)
 
Three Months Ended 
 
Nine Months Ended
 
As Reported
 
Adjustment
 
As Restated
 
As Reported
 
Adjustment
 
As Restated
 
(in thousands, except per-share data)
Operating income (loss)
16,522

 
$

 
$
16,522

 
28,577

 
$

 
$
28,577

Interest expense
1,093

 

 
1,093

 
4,356

 

 
4,356

Other non-operating expense (income), net
308

 
(209
)
 
99

 
473

 
8,410

 
8,883

Income (loss) before income tax
15,121

 
209

 
15,330

 
23,748


(8,410
)
 
15,338

Income tax expense
398

 

 
398

 
762

 

 
762

Net income (loss)
$
14,723

 
$
209

 
$
14,932

 
$
22,986

 
$
(8,410
)
 
$
14,576

 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss) per share:
 
 
 
 
 
 
 
 
 
 
 
Basic
$
1.05

 
$
0.02

 
$
1.07

 
$
1.73

 
$
(0.63
)
 
$
1.10

Diluted
$
0.91

 
$

 
$
0.91

 
$
1.56

 
$
(0.51
)
 
$
1.05

Weighted average number of shares:
 
 
 
 
 
 
 
 
 
 
 
Basic
14,019

 

 
14,019

 
13,263

 

 
13,263

Diluted
16,229

 

 
16,229

 
14,757

 
(929
)
 
13,828



9

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

The following table presents the condensed consolidated balance sheet as previously reported, restatement adjustments and the condensed consolidated balance sheet as restated at September 30, 2018:

Condensed Consolidated Balance Sheet (unaudited)
 
September 30, 2018
 
As Reported
 
Adjustment
 
As Restated
 
(in thousands)
Total Current Liabilities
$
67,918

 
$

 
$
67,918

Term loans, long-term portion
11,083

 

 
11,083

Financial instrument obligation

 
10,967

 
10,967

Subordinated notes - related party
14,784

 

 
14,784

Other liabilities
2,313

 

 
2,313

Total Liabilities
96,098

 
10,967

 
107,065

Stockholders' Equity (Deficit)
 

 
 
 
 

Common stock
14

 

 
14

Additional paid-in capital
171,477

 
(2,557
)
 
168,920

Accumulated deficit
(147,667
)
 
(8,410
)
 
(156,077
)
Accumulated other comprehensive loss
(399
)
 

 
(399
)
Total Stockholders' Equity (Deficit)
23,425

 
(10,967
)
 
12,458

Total Liabilities and Stockholders' Equity (Deficit)
$
119,523

 
$

 
$
119,523


The following table presents the Company’s condensed consolidated statement of cash flows as previously reported, restatement adjustments and the condensed consolidated statement of cash flows as restated for the nine months ended September 30, 2018:

Condensed Consolidated Statements of Cash Flows (unaudited)
 
Nine Months Ended
 
As Reported
 
Adjustment
 
As Restated
 
(in thousands)
Net income (loss)
$
22,986

 
$
(8,410
)
 
$
14,576

 
 
 
 
 
 
Unrealized loss on financial instrument obligation
$

 
$
8,410

 
$
8,410

 
 
 
 
 
 
Net cash provided by operating activities
$
43,358

 
$

 
$
43,358


Note 2. Summary of Significant Accounting Policies
The preparation of consolidated annual and quarterly financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. The Company can give no assurance that actual results will not differ from those estimates.

The Company’s significant accounting policies are included in Note 1 of the Annual Report. As described further in “Recent Accounting Pronouncements” below, on January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers. Turtle Beach’s transition to the new revenue standard did not result in a material adjustment to opening retained earnings and the Company expects the adoption of the new standard to have an immaterial impact to its results of operations on an ongoing basis.


10

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements - (Continued)
(unaudited)


Revenue Recognition and Sales Return Reserve

Net revenue consists primarily of revenue from the sale of gaming headsets and accessories to wholesalers, retailers and to a lesser extent, on-line customers. These headsets function on a standalone basis (in connection with a readily available gaming console, personal computer or stereo) and are not sold with additional services or rights to future goods or services. Revenue is recorded for a contract through the following steps: (i) identifying the contract with the customer; (ii) identifying the performance obligations in the contract; (iii) determining the transaction price; (iv) allocating the transaction price to the performance obligations; and (v) recognizing revenue when or as each performance obligation is satisfied.

Each contract at inception is evaluated to determine whether the contract should be accounted for as having one or more performance obligations. Revenue is recognized when obligations under the terms of a contract with our customer are satisfied; generally this occurs at a point in time when the transfer of risk and title to the product transfers to the customer. Our standard terms of delivery are included in our contracts of sale, order confirmation documents, and invoices. The Company excludes sales taxes collected from customers from “Net Revenue” in its Consolidated Statements of Operations.

Certain customers may receive cash-based incentives (including cash discounts, quantity rebates, and price concessions), which are accounted for as variable consideration. Provisions for sales returns are recognized in the period the sale is recorded based upon our prior experience and current trends. These revenue reductions are established by the Company based upon management’s best estimates at the time of sale following the historical trend, adjusted to reflect known changes in the factors that impact such reserves and allowances, and the terms of agreements with customers. We do not expect to have significant changes in our estimates for variable considerations.

Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for such goods or services. The new guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. In 2018, the Company adopted ASU 2014-09 using the modified retrospective approach, and recorded a net decrease to beginning retained earnings of $0.6 million reflecting the cumulative impact of adoption. The impact to beginning retained earnings was due to certain price concessions and right of return arrangements recorded as part of the transaction price determination. Results for reporting periods beginning January 1, 2018 are presented under Topic 606, Revenue from Contracts with Customers, while prior period amounts were not adjusted and continue to be reported in accordance with the Company’s historic accounting under Topic 605, Revenue Recognition.

In February 2016, the FASB issued ASU No. 2016-02, Leases, that introduces the recognition of a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term, and a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis for all leases (with the exception of short-term leases). The guidance will be effective for public companies for annual reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company has not yet selected a transition method or determined the effect on its consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, to provide clarity and reduce diversity in practice and cost and complexity when applying the guidance to a change to the terms or conditions of a share-based payment award. This update provides that an entity will not have to account for the effects of a modification if: (i) the fair value of the modified award is the same immediately before and after the modification; (ii) the vesting conditions of the modified award are the same immediately before and after the modification; and (iii) the classification of the modified award as either an equity instrument or liability instrument is the same immediately before and after the modification. The Company adopted these amendments in the first quarter of 2018, which did not have a material impact upon our financial condition or results of operations.
In June 2018, the FASB issued ASU 2018-07, Improvements to Non-employee Share-Based Payment Accounting, that expands the scope of Topic 718, Compensation—Stock Compensation, to include share-based payments issued to non-employees for goods or services and substantially aligned the accounting for share-based payments to non-employees and employees. The amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning

11

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements - (Continued)
(unaudited)


after December 15, 2020. Early adoption is permitted. The Company is evaluating the effect that this guidance will have on the financial statements and related disclosures.

In August 2018, the FASB issued ASU No. 2018-13, Changes to the Disclosure Requirements for Fair Value Measurement, that removes certain disclosure requirements related to the fair value hierarchy, modifies existing disclosure requirements related to measurement uncertainty and adds new disclosure requirements. The new disclosure requirements include disclosing the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The provisions of this ASU are effective for years beginning after December 15, 2019, with early adoption permitted. Certain disclosures in the new guidance will need to be applied on a retrospective basis and others on a prospective basis.

Note 3. Fair Value Measurement
The Company follows a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

Level 1 — Quoted prices in active markets for identical assets or liabilities.
Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for markets that are not active, or other inputs that are observable or can be corroborated by observable market data.
Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
Financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, and debt instruments. As of September 30, 2018 and December 31, 2017, there were no outstanding financial assets and liabilities recorded at fair value on a recurring basis and the Company had not elected the fair value option for any financial assets and liabilities for which such an election would have been permitted.

The following is a summary of the carrying amounts and estimated fair values of our financial instruments at September 30, 2018 and December 31, 2017:
 
September 30, 2018
 
December 31, 2017
 
Reported
 
Fair Value
 
Reported
 
Fair Value
 
 (in thousands)
Financial Assets and Liabilities:
 
 
 
 
 
 
 
Cash and cash equivalents
$
6,178

 
$
6,178

 
$
5,247

 
$
5,247

Revolving credit facility
3,523

 
3,523

 
38,467

 
38,467

Term loans
12,500

 
12,087

 
11,721

 
11,329

Subordinated notes
15,393

 
17,178

 
21,911

 
22,442

Financial instrument obligation
10,967

 
10,967

 

 


Cash equivalents are stated at amortized cost, which approximates fair value as of the consolidated balance sheet dates, due to the short period of time to maturity; and accounts receivable and accounts payable are stated at their carrying value, which approximates fair value due to the short time to the expected receipt or payment. The carrying value of the revolving credit facility equals fair value as the stated interest rate approximates market rates currently available to the Company, which are considered Level 2 inputs. The fair values of our term loans and subordinated notes are based upon an estimated market value calculation that factors principal, time to maturity, interest rate and current cost of debt, which is considered a Level 3 input. The liability-classified warrants reported as a financial instrument obligation are classified within Level 3 because the Company uses a Black-Scholes pricing model to estimate the fair value based on inputs that are not observable in any market.


12

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 4. Allowance for Sales Returns
The following table provides the changes in our sales return reserve, which is classified as a reduction of accounts receivable:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
 (in thousands)
Balance, beginning of period
$
5,044

 
$
2,153

 
$
5,533

 
$
4,591

Reserve accrual
5,607

 
2,146

 
14,048

 
4,228

Recoveries and deductions, net
(4,021
)
 
(1,917
)
 
(12,951
)
 
(6,437
)
Balance, end of period

$
6,630

 
$
2,382

 
$
6,630

 
$
2,382

Note 5. Composition of Certain Financial Statement Items
Inventories
Inventories consist of the following:
 
September 30, 2018

December 31, 2017
 
 (in thousands)
Raw materials
$
1,836

 
$
837

Finished goods
71,512

 
26,681

Total inventories
$
73,348

 
$
27,518

Property and Equipment, net
Property and equipment, net, consists of the following:
 
September 30, 2018

December 31, 2017
 
 (in thousands)
Machinery and equipment
$
1,568

 
$
1,396

Software and software development
306

 
383

Furniture and fixtures
568

 
525

Tooling
3,626

 
1,968

Leasehold improvements
1,326

 
1,318

Demonstration units and convention booths
9,494

 
11,719

Total property and equipment, gross
16,888

 
17,309

Less: accumulated depreciation and amortization
(12,869
)
 
(12,632
)
Total property and equipment, net
$
4,019

 
$
4,677


13

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements - (Continued)
(unaudited)


Other Current Liabilities
Other current liabilities consist of the following:
 
September 30, 2018
 
December 31, 2017
 
 (in thousands)
Accrued vendor expenses
$
242

 
$
652

Accrued royalties
3,814

 
2,848

Accrued employee expenses
3,055

 
2,510

Accrued freight
1,423

 
130

Accrued customer fees
965

 
738

Accrued expenses
5,132

 
4,573

Total other current liabilities
$
14,631

 
$
11,451

Note 6. Goodwill and Other Intangible Assets
Acquired Intangible Assets
Acquired identifiable intangible assets, and related accumulated amortization, as of September 30, 2018 and December 31, 2017 consist of:
 
September 30, 2018
 
Gross Carrying Value
 
Accumulated Amortization
 
Net Book Value
 
 (in thousands)
Customer relationships
$
5,796

 
$
4,448

 
$
1,348

Foreign currency
(1,058
)
 
(801
)
 
(257
)
Total Intangible Assets
$
4,738

 
$
3,647

 
$
1,091

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
Gross Carrying Value
 
Accumulated Amortization
 
Net Book Value
 
 (in thousands)
Customer relationships
$
5,796

 
$
4,173

 
$
1,623

Foreign currency
(899
)
 
(680
)
 
(219
)
Total Intangible Assets
$
4,897

 
$
3,493

 
$
1,404

In connection with the October 2012 acquisition of TB Europe, the acquired intangible asset related to customer relationships is being amortized over an estimated useful life of thirteen years with the amortization being included within sales and marketing expense.

Amortization expense related to definite lived intangible assets of $0.1 million and $0.2 million was recognized for the three and nine months ended September 30, 2018, respectively, and $0.1 million and $0.3 million for the three and nine months ended September 30, 2017, respectively.


14

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

As of September 30, 2018, estimated annual amortization expense related to definite lived intangible assets in future periods is as follows:
 
 (in thousands)
2018
$
91

2019
307

2020
258

2021
217

2022
182

Thereafter
293

Total
$
1,348

Note 7. Revolving Credit Facility and Long-Term Debt
 
September 30, 2018
 
December 31, 2017
 
 (in thousands)
Revolving credit facility, maturing March 2023
$
3,523

 
$
38,467

 
 
 
 
Term Loan Due 2018

 
1,923

Term Loan Due 2019

 
9,798

Term Loan Due 2023
12,500

 

Less: unamortized deferred financing fees
667

 
759

Total Term Loans
11,833

 
10,962

 
 
 
 
Subordinated notes - related party
15,393

 
21,911

Less: unamortized debt discount
609

 
1,075

Total Subordinated notes
14,784

 
20,836

Total outstanding debt
30,140

 
70,265

Less: current portion of revolving credit facility
(3,523
)
 
(38,467
)
Less: current portion of term loans
(750
)
 
(4,173
)
Total noncurrent portion of long-term debt
$
25,867

 
$
27,625

Total interest expense, inclusive of amortization of deferred financing costs, on long-term debt obligations was $1.0 million and $3.4 million for the three and nine months ended September 30, 2018, respectively, and $1.5 million and $4.2 million for three and nine months ended September 30, 2017, respectively. This includes related party interest of $0.5 million and $1.7 million for the three and nine months ended September 30, 2018, respectively, and $0.6 million and $1.8 million for the three and nine months ended September 30, 2017, respectively, incurred in connection with the subordinated notes.
Amortization of deferred financing costs was $0.3 million and $1.0 million for the three and nine months ended September 30, 2018, respectively, and $0.4 million and $1.2 million for the three and nine months ended September 30, 2017, respectively. In connection with the Company’s amendment and restatement of its Credit Facility (as noted below), the Company incurred $0.4 million of financing costs that have been deferred, added to the remaining unamortized financing costs and will be recognized over the term of the respective agreement.
Revolving Credit Facility
On March 5, 2018, Turtle Beach and certain of its subsidiaries entered into an amended and restated loan, guaranty and security agreement (“Credit Facility”) with Bank of America, N.A. (“Bank of America”), as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing asset-based revolving loan agreement. The Credit Facility, which expires on March 5, 2023, provides for a line of credit of up to $60 million inclusive of a sub-facility limit of $12 million for TB

15

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Europe, a wholly-owned subsidiary of Turtle Beach. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes.
The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments.

Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of America or the LIBOR rate, plus in each case, an applicable margin, which is between 0.50% to 1.25% for U.S. base rate loans and between 1.50% to 2.25% for U.S. LIBOR loans and U.K. loans. As of September 30, 2018, interest rates for outstanding borrowings were 5.75% for base rate loans and 3.88% for LIBOR rate loans. In addition, Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from 0.25% to 0.50%, and letter of credit fees and agent fees.

The Company is subject to monthly financial covenant testing for so long as revolving commitments or obligations are outstanding. The Credit Facility requires the Company and its restricted subsidiaries to maintain on the last day of each month a fixed charge coverage ratio of at least 1.10 to 1.00, a consolidated leverage ratio of greater than 3.00 to 1.00, as well as a limit to Capital Expenditures and HyperSound Division Net Operating Disbursement (as defined in the Credit Facility).

The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including the Companys ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Companys assets.
As of September 30, 2018, the Company was in compliance with all financial covenants under the Credit Facility, as amended, and excess borrowing availability was approximately $55.8 million.
Term Loans
Term Loan Due 2018

On December 29, 2014, the Company amended the Credit Facility with Bank of America to enter into an additional loan (the “Term Loan Due 2018”) for the repayment of $7.7 million of then existing subordinated debt and accrued interest. The Term Loan Due 2018 resulted in modified financial covenants while it was outstanding, had an interest rate of LIBOR plus 5% and was subject to equal monthly installments beginning on April 1, 2015 and ending on October 1, 2018, reflecting a six-month waiver. On March 5, 2018, the Company repaid the remaining $1.3 million principal balance.

Term Loan Due 2019

On July 22, 2015, the Company and its subsidiaries, entered into a term loan, guaranty and security agreement (the “Term Loan Due 2019”) with Crystal Financial LLC, as agent, sole lead arranger and sole bookrunner, Crystal Financial SPV LLC and the other persons party thereto (“Crystal”), which provided for an aggregate term loan commitment of $15 million with an interest rate per annum equal to the 90-day LIBOR rate plus 10.25%. Under the terms of the Term Loan Due 2019, the Company made payments of interest in arrears on the first day of each month beginning August 1, 2015, and repaid the principal in monthly payments that began January 1, 2016, inclusive of a nine month waiver, with a final payment on June 28, 2019, the maturity date. On March 5, 2018, the Company entered into an amended, extended and restated term loan with Crystal that replaced the Term Note Due 2019.

Term Loan Due 2023

On March 5, 2018, the Company and its subsidiaries, entered into an amended, extended and restated term loan, guaranty and security agreement (the “Term Loan Due 2023”) with Crystal, as agent, sole lead arranger and sole bookrunner and the Lenders from time to time party thereto, which replaced the then existing Term Loan Due 2019 and provides for a maximum aggregate term loan of $12.5 million, at an interest rate per annum equal to the 90-day LIBOR rate plus 6.75%. As of September 30, 2018, $12.5 million was outstanding with the additional $3.3 million borrowed on May 2, 2018. Under the terms of the Term Loan

16

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Due 2023, the Company is required to make payments of interest in arrears on the first day of each month and will repay the principal in monthly payments beginning April 1, 2019, with a final payment on March 5, 2023, the maturity date.

The Term Loan Due 2023 is secured by a security interest in substantially all of the Company and each of its subsidiaries’ working capital assets and is subject to the first-priority lien of Bank of America, as agent, under the Credit Facility, other than with respect to equipment, fixtures, real property interests, intellectual property, intercompany property, intercompany indebtedness, equity interest in their subsidiaries, and certain other assets specified in an inter-creditor agreement between Bank of America and Crystal.

The Company and its subsidiaries are required to comply with various customary covenants including, (i) maintaining a fixed charge coverage ratio of at least 1.10 to 1.00, (ii) maintaining a Consolidated Leverage Ratio (as defined in the Term Loan Due 2023) to be measured on the last day of each month while the term loans are outstanding of no more than 3.00:1, (iii) not making capital expenditures in excess of the amount stated therein in any year until December 31, 2023, (iv) restrictions on the Company’s and its subsidiaries ability to prepay its subordinated notes, pay dividends, incur debt, create or suffer liens and engage in certain fundamental transactions and (v) an obligation to provide certain financial and other information.

The Term Loan Due 2023 contains customary representations, mandatory prepayment events and events of default, including defaults triggered by the failure to make payments when due, breaches of covenants and representations, material impairment in the perfection of Crystal’s security interest in the collateral and events related to bankruptcy and insolvency of the Company and its subsidiaries. Upon an event of default, Crystal may declare all outstanding obligations immediately due and payable (along with a prepayment fee), impose a default rate of an additional 2.0% to amounts outstanding and may take other actions including collecting or taking such other action with respect to the collateral pledged in connection with the term loan.

As of September 30, 2018, the Company was in compliance with all the financial covenants of the Term Loan Due 2023.

Subordination Agreement
On November 16, 2015, as a condition precedent to the Company’s lenders permitting the Company to enter into the November Note, discussed below, the Company entered into a subordination agreement with and among Bank of America and Crystal, pursuant to which the parties agreed that the Company’s obligations under any subordinated notes would be subordinate in right of payment to the payment in full of all the Company’s obligations under the Credit Facility, the then existing Term Loan Due 2019 and the current Term Loan Due 2023. This November 2015 subordination agreement replaces the 2014 subordination agreement entered as part of its initial credit facility with Bank of America.
Subordinated Notes - Related Party
During 2015, the Company issued a $5.0 million subordinated note (the “April Note”), subordinated notes (the “May Notes”) with an aggregate principal amount of $3.8 million and a subordinated note (the “June Note”) with an aggregate principal amount of $9.0 million to SG VTB Holdings, LLC, the Company’s largest stockholder (“SG VTB”), and a trust affiliated with Ronald Doornink, the Chairman of the Company's board of directors (the “Board”). The subordinated notes were issued with an interest rate of (i) 10% per annum for the first year and (ii) 20% per annum for all periods thereafter, with interest accruing and being added to the principal amount of the note quarterly.
On July 22, 2015, the Company amended and restated each of its outstanding subordinated notes (the “Amended Notes”). The obligations of the Company under the Amended Notes are subordinate and junior to the prior payment of amounts due under the then existing credit facility and term loans. In addition, the stated maturity date of the Amended Notes was extended to September 29, 2019, subject to acceleration in certain circumstances, such as a change of control in the Company. The Amended Notes were issued with an interest rate per annum equal to LIBOR plus 10.5% and were paid-in-kind by adding the amount to the principal amount due. Further, as consideration for the concessions in the Amended Notes, the Company issued warrants to purchase 0.4 million of the Company’s common stock at an exercise price of $10.16 per share.

On November 16, 2015, the Company issued a $2.5 million subordinated note (the “November Note”) to SG VTB, the proceeds of which, as set forth in the amendment to the Term Loan Due 2019, were applied against the outstanding balance of the Term Loan Due 2019. The November Note was issued with an interest rate of 15% per annum until its maturity date, which was September 29, 2019, and was subordinate to all senior debt of the Company.


17

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

In consideration of the credit extended under the November Note, VTB and VTBH entered into a Third Lien Continuing Guaranty, (as amended, the “Third Lien Guaranty”), under which they guarantee and promise to pay to SG VTB, any and all obligations of the Company under the November Note. To secure the Company’s obligations under the November Note and the Third Lien Guaranty, the Company entered into a Third Lien Security Agreement, dated as of November 16, 2015, pursuant to which Stripes was granted a security interest upon all property of the VTB and VTBH until the payment in full of the Amended Notes and November Note or the release of the guarantee or collateral, as applicable. Concurrent with entering into the November Note and Third Lien Guaranty, the Company also issued a warrant to purchase 0.3 million shares of the Company’s common stock at an exercise price of $8.00 per share.

On March 5, 2018, the Company amended and restated the Amended Notes with an aggregate principal amount of $18.9 million and the November Note with an aggregate principal amount of $3.5 million. The amended subordinated notes bear in-kind interest at a rate of (i) LIBOR plus 9.1% per annum until March 5, 2020 (or, solely with respect to the November Note, until September 5, 2018) or until its maturity date, which is June 5, 2023, provided that its principal amount is reduced by a specified amount by the six month anniversary of the restatement effective date and (ii) LIBOR plus 10.5% per annum (or, solely with respect to the November Note, 15.0% if the prepayment described above does not occur) until its maturity date.

On May 4, 2018, the Company satisfied the repayment provision of the November Note with a $3.3 million repayment with funds from the Term Loan Due 2023. Further, the Company paid down an additional $5.0 million on August 3, 2018, and $5.0 million on October 12, 2018, with funds from operations to reduce the outstanding balance to $10.4 million.

SG VTB is an affiliate of Stripes Group LLC (“Stripes”), a private equity firm focused on internet, software, healthcare IT and branded consumer products businesses. Kenneth A. Fox, one of our directors, is the managing general partner of Stripes and the sole manager of SG VTB, and Ronald Doornink, our Chairman of the Board, is an operating partner of Stripes.

Note 8. Income Taxes

In order to determine the quarterly provision for income taxes, we use an estimated annual effective tax rate (“ETR”), which is based on expected annual income and statutory tax rates in the various jurisdictions. However, to the extent that application of the estimated annual effective tax rate is not representative of the quarterly portion of actual tax expense expected to be recorded for the year, we determine the quarterly provision for income taxes based on actual year-to-date income (loss). Certain significant or unusual items are separately recognized as discrete items in the quarter during which they occur and can be a source of variability in the effective tax rates from quarter to quarter.

Internal Revenue Code (the “Code”) Section 382 (“Section 382”) potentially limits the utilization of certain tax deductions and other tax attributes, including net operating losses, following an ownership change as defined in the Code. If the Company becomes subject to Section 382, net operating losses generated prior to the date of the ownership change may be used to offset taxable income through the date of change without limitation and the utilization of any remaining net operating losses would potentially be limited prospectively from such date. Based on recent trading activity in its common stock, the Company has been assessing the potential impact of Section 382 and believes that an ownership change as defined in the Code may have occurred subsequent to September 30, 2018, which could potentially limit the utilization of certain tax deductions and other tax attributes, including net operating losses. The Company is assessing the impact of any potential limitation.

The following table presents our income tax expense (benefit) and effective income tax rate:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
 (in thousands)
Income tax expense
$
398

 
$
578

 
$
762

 
$
1,098

Effective income tax rate
2.6
%
 
672.1
%
 
5.0
%
 
(6.7
)%

Income tax expense for the three and nine months ended September 30, 2018 was $0.4 million at an effective tax rate of 2.6% and $0.8 million at an effective tax rate of 5.0%, respectively. Income tax expense for the three and nine months ended September 30, 2017 was $0.6 million at an effective tax rate of 672.1% and $1.1 million at an effective tax rate of (6.7)%,

18

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

respectively. The effective tax rate was primarily impacted by the full valuation allowance on domestic earnings, foreign entity tax benefits and certain state tax expense.

The Company is subject to income taxes domestically and in various foreign jurisdictions. Significant judgment is required in evaluating uncertain tax positions and determining the provision for income taxes.

The Company recognizes only those tax positions that meet the more-likely-than-not recognition threshold, and establishes tax reserves for uncertain tax positions that do not meet this threshold. Interest and penalties associated with income tax matters are included in the provision for income taxes in the condensed consolidated statement of operations. As of September 30, 2018, the Company had uncertain tax positions of $2.3 million, inclusive of $0.8 million of interest and penalties.

The Company files U.S., state and foreign income tax returns in jurisdictions with various statutes of limitations. The federal tax years open under the statute of limitations are 2013 through 2016, and the state tax years open under the statute of limitations are 2012 through 2016. The U.S. Internal Revenue Service (“IRS”) has completed its examination of the Company's 2015 federal tax return, and all matters arising from such examinations have been resolved.

Note 9. Stock-Based Compensation
Total estimated stock-based compensation expense for employees and non-employees, related to all of the Company’s stock-based awards, was comprised as follows:


Three Months Ended

Nine Months Ended

September 30,

September 30,

2018

2017

2018

2017

 (in thousands)
Cost of revenue
$
69

 
$
20

 
$
400

 
$
(66
)
Selling and marketing
47

 
18

 
102

 
74

Research and development
26

 
68

 
89

 
188

General and administrative
445

 
264

 
818

 
991

Total stock-based compensation
$
587

 
$
370

 
$
1,409

 
$
1,187


The following table presents the stock activity and the total number of shares available for grant as of September 30, 2018:
 
(in thousands)
Balance at December 31, 2017
387

Additional shares authorized
1,500

Options granted
(534
)
Restricted stock granted
(280
)
Forfeited/Expired shares added back
150

Balance at September 30, 2018
1,223


19

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Stock Option Activity
 
Options Outstanding
 
Number of Shares Underlying Outstanding Options
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Term
 
Aggregate Intrinsic Value
 
 
 
 
 
 (In years)
 
 
Outstanding at December 31, 2017
1,740,103

 
$
6.20

 
6.64
 
$
6

Granted
534,245

 
7.53

 
 
 
 
Exercised
(458,784
)
 
7.23

 
 
 
 
Forfeited
(150,494
)
 
7.64

 
 
 
 
Outstanding at September 30, 2018
1,665,070

 
$
6.21

 
7.58
 
$
23,505,738

Vested and expected to vest at September 30, 2018
1,600,740

 
$
6.14

 
7.51
 
$
22,749,634

Exercisable at September 30, 2018
646,358

 
$
7.34

 
5.33
 
$
8,248,872

Stock options are time-based and the majority are exercisable within 10 years of the date of grant, but only to the extent they have vested. The options generally vest as specified in the option agreements subject to acceleration in certain circumstances. In the event participants in the plan cease to be employed or engaged by the Company, then all of the options would be forfeited if they are not exercised within 90 days. Forfeitures on option grants are estimated at 10% for non-executives and 0% for executives based on evaluation of historical and expected future turnover. Stock-based compensation expense was recorded net of estimated forfeitures, such that expense was recorded only for those stock-based awards expected to vest. The Company reviews this assumption periodically and will adjust it if it is not representative of future forfeiture data and trends within employee types (executive vs. non-executive).
Aggregate intrinsic value represents the difference between the estimated fair value of the underlying common stock and the exercise price of outstanding, in-the-money options. The aggregate intrinsic value of options exercised was $8.6 million for the nine months ended September 30, 2018.
The Company uses the Black-Scholes option-pricing model to estimate the fair value of options granted as of the grant date. The following are the assumptions for options granted during the nine months ended September 30, 2018.
Expected term (in years)
6.1
Risk-free interest rate
2.3% - 3.0%
Expected volatility
37.9%- 39.5%
Dividend rate
0%
Each of these inputs is subjective and generally requires significant judgment to determine.
The weighted average grant date fair value of options granted during the nine months ended September 30, 2018 was $3.14. The total estimated fair value of employee options vested during the nine months ended September 30, 2018 was $0.6 million. As of September 30, 2018, total unrecognized compensation cost related to non-vested stock options granted to employees was $2.6 million, which is expected to be recognized over a remaining weighted average vesting period of 2.9 years.

20

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Restricted Stock Activity
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
Nonvested restricted stock at December 31, 2017
41,867

 
3.89

Granted
280,247

 
20.13

Vested
(43,964
)
 
9.17

Nonvested restricted stock at September 30, 2018
278,150

 
19.42

As of September 30, 2018, total unrecognized compensation cost related to the nonvested restricted stock awards, which will be recognized over a remaining weighted average vesting period of 2.9 years was minimal.

Stock Warrants
In connection with and as consideration for the concessions in the Amended Notes, the Company issued to SG VTB and a trust affiliated with Ronald Doornink, the Chairman of the Board, warrants to purchase an aggregate 0.4 million shares of the Company’s common stock at an exercise price of $10.16 per share. The warrants are exercisable for a period of five years beginning on the date of issuance, July 22, 2015. The exercise price and the number of purchasable shares of common stock are subject to standard anti-dilution adjustments and do not carry any voting rights as a stockholder of the Company prior to exercise. During the nine months ended September 30, 2018, warrants to purchase an aggregate 0.1 million shares were exercised.

In connection with the November Note, the Company issued warrants to purchase 0.3 million shares of the Company’s common stock at an exercise price of $8.00 per share to SG VTB. The exercise price and the number of purchasable shares of common stock are subject to standard anti-dilution adjustments and do not carry any voting rights as a stockholder of the Company prior to exercise. The warrants are exercisable for a period of ten years beginning on the date of issuance and do not entitle the holder to any voting rights or other rights as a stockholder of the Company prior to exercise.

The warrants issued in connection with the Amended Notes and the November Note entitle the holder to purchase a stated amount of shares of common stock at a fixed exercise price that are not puttable (either the warrant or the shares) to the Company or redeemable for cash, and as such are classified within equity. The shares issuable upon exercise of the warrants are also subject to the “demand” and “piggyback” registration rights set forth in the in the Company’s Stockholder Agreement, dated August 5, 2013, as amended July 10, 2014.


21

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 10. Net Income (Loss) Per Share

The following table sets forth the computation of basic and diluted net income (loss) per share of common stock attributable to common stockholders:
 
Three Months Ended

Nine Months Ended
 
September 30,

September 30,
 
2018

2017

2018

2017
 
 (in thousands, except per-share data)
Net income (loss)
$
14,932

 
$
(492
)
 
$
14,576

 
$
(17,479
)
Unrealized gain on financial instrument obligation
(209
)
 

 

 

Net income (loss) - diluted
$
14,723

 
$
(492
)
 
$
14,576

 
$
(17,479
)
 
 
 
 
 
 
 
 
Weighted average common shares outstanding — Basic
14,019

 
12,347

 
13,263

 
12,332

Plus incremental shares from assumed conversions:
 
 
 
 
 
 
 
Dilutive effect of restricted stock
52

 

 
24

 

Dilutive effect of stock options
1,209

 

 
408

 

       Dilutive effect of warrants
949

 

 
133

 

Weighted average common shares outstanding — Diluted
16,229

 
12,347

 
13,828

 
12,332

Net income (loss) per share:
 
 
 
 
 
 
 
Basic
$
1.07

 
$
(0.04
)
 
$
1.10

 
$
(1.42
)
Diluted
$
0.91

 
$
(0.04
)
 
$
1.05

 
$
(1.42
)

Incremental shares from stock options and restricted stock awards are computed using the treasury stock method. The weighted average shares listed below were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented or were otherwise excluded under the treasury stock method. The treasury stock method calculates dilution assuming the exercise of all in-the-money options and vesting of restricted stock, reduced by the repurchase of shares with the proceeds from the assumed exercises and unrecognized compensation expense for outstanding awards.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Stock options
69

 
1,533

 
35

 
1,572

Warrants

 
765

 
319

 
765

Unvested restricted stock awards
185

 
42

 
71

 
34

Total
254

 
2,340

 
425

 
2,371



22

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 11. Segment and Geographic Information

The following tables show our net revenues, operating income and total assets by our reporting segments:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018

2017
Net Revenues
 (in thousands)
Headset
$
74,406

 
$
35,947

 
$
176,079

 
$
69,291

HyperSound
21

 
28

 
39

 
148

Total
$
74,427

 
$
35,975

 
$
176,118

 
$
69,439

 
 
 
 
 
 
 
 
Operating Income (Loss)
 
 
 
 
 
 
 
Headset
$
16,512

 
$
1,819

 
$
28,678

 
$
(9,779
)
HyperSound
10

 
57

 
(101
)
 
(1,402
)
Total
16,522

 
1,876

 
28,577

 
(11,181
)
Interest Expense
1,093

 
2,042

 
4,356

 
5,717

Other non-operating expense (income), net
99

 
(252
)
 
8,883

 
(517
)
Income (loss) before income tax
$
15,330

 
$
86

 
$
15,338

 
$
(16,381
)

 
September 30,
2018
 
December 31,
2017
Total Assets
 (in thousands)
Headset
$
119,525

 
$
94,114

HyperSound (1)
40,225

 
26,787

Eliminations
(40,227
)
 
(26,650
)
Total
$
119,523

 
$
94,251


(1) At September 30, 2018, HyperSound assets excluding eliminations, totaled less than $0.1 million.

The following table represents total net revenues based on where customers are physically located:
 
Three Months Ended

Nine Months Ended
 
September 30,

September 30,
 
2018

2017

2018

2017
 
 (in thousands)
North America
$
52,702

 
$
23,320

 
$
131,653

 
$
47,371

United Kingdom
9,462

 
5,204

 
21,119

 
9,182

Europe
8,916

 
5,947

 
18,021

 
9,884

Other
3,347

 
1,504

 
5,325

 
3,002

Total net revenues
$
74,427

 
$
35,975

 
$
176,118

 
$
69,439



23

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 12. Commitments and Contingencies
Litigation
The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Although the amount of any liability that could arise with respect to these actions cannot be determined with certainty, in the Company’s opinion, any such liability will not have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity.

Shareholders Class Action: On August 5, 2013, VTBH and the Company (f/k/a Parametric) announced that they had entered into the Merger Agreement pursuant to which VTBH would acquire an approximately 80% ownership interest and existing shareholders would maintain an approximately 20% ownership interest in the combined company (the “Merger”). Following the announcement, several shareholders filed class action lawsuits in California and Nevada seeking to enjoin the Merger. The plaintiffs in each case alleged that members of the Company’s Board of Directors breached their fiduciary duties to the shareholders by agreeing to a merger that allegedly undervalued the Company. VTBH and the Company were named as defendants in these lawsuits under the theory that they had aided and abetted the Company's Board of Directors in allegedly violating their fiduciary duties. The plaintiffs in both cases sought a preliminary injunction seeking to enjoin closing of the Merger, which, by agreement, was heard by the Nevada court with the California plaintiffs invited to participate. On December 26, 2013, the court in the Nevada cases denied the plaintiffs’ motion for a preliminary injunction. Following the closing of the Merger, the Nevada plaintiffs filed a second amended complaint, which made essentially the same allegations and sought monetary damages as well as an order rescinding the Merger. The California plaintiffs dismissed their action without prejudice, and sought to intervene in the Nevada action, which was granted. Subsequent to the intervention, the plaintiffs filed a third amended complaint, which made essentially the same allegations as prior complaints and sought monetary damages. On June 20, 2014, VTBH and the Company moved to dismiss the action, but that motion was denied on August 28, 2014. On September 14, 2017, a unanimous en banc panel of the Nevada Supreme Court granted defendants’ petition for writ of mandamus and ordered the trial court to dismiss the complaint but provided a limited basis upon which plaintiffs could seek to amend their complaint. Plaintiffs amended their complaint on December 1, 2017 to assert the same claims in a derivative capacity on behalf of the Company, as a well as in a direct capacity, against VTBH, Stripes Group, LLC, SG VTB Holdings, LLC, and the former members of the Company’s Board of Directors. All defendants moved to dismiss this amended complaint on January 2, 2018, and those motions were denied on March 13, 2018. Defendants petitioned the Nevada Supreme Court to reverse this ruling on April 18, 2018. On June 15, 2018, the Nevada Supreme Court denied defendants’ writ petition without prejudice. The district court subsequently entered a pretrial schedule and set trial for November 2019.

Commercial Dispute: On July 20, 2016, Bigben Interactive S.A. (“BigBen”) filed a statement of claim before the Regional Court of Berlin, Germany against VTB, which statement of claim was formally serviced upon VTB on June 28, 2017.  The statement of claim alleges that VTB’s termination of a distribution agreement by and between BigBen and VTB breached the terms thereof and was invalid, and that BigBen is entitled to damages amounting to €5.0 million plus accrued interest thereon plus certain additional damages as a result of such invalid termination.  VTB filed its statement of defense with the court on September 21, 2017.  VTB maintains that its termination of the agreement was valid and that BigBen’s claims against it are without merit. VTB's statement of defense was submitted to the plaintiff. BigBen submitted additional written pleadings on January 4, 2018 and on April 19, 2018. VTB submitted further written pleadings on March 20, 2018 and March 29, 2018. VTB argues inter alia that the courts of Berlin do not have jurisdiction. On April 23, 2018, an oral hearing was held at the Regional Court of Berlin that focused exclusively on the question of jurisdiction. Following such oral hearing, the court rendered an interim judgment by which it accepted jurisdiction. On October 29, 2018, another oral hearing was held at the Regional Court of Berlin at which the merits of the case were discussed but no definitive position was taken by the court. The court has asked the parties to file further written submissions with a decision anticipated in early 2019.

The Company will continue to vigorously defend itself in the foregoing matters. However, litigation and investigations are inherently uncertain. Accordingly, the Company cannot predict the outcome of these matters. The Company has not recorded any accrual at September 30, 2018 for contingent losses associated with these matters based on its belief that losses, while possible, are not probable. Further, any possible range of loss cannot be reasonably estimated at this time. The unfavorable resolution of these matters could have a material adverse effect on the Company’s business, results of operations, financial condition or cash flows. The Company is engaged in other legal actions not described above arising in the ordinary course of its business and, while there can be no assurance, believes that the ultimate outcome of these other legal actions will not have a material adverse effect on its business, results of operations, financial condition or cash flows.


24

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Warranties

We warrant our products against certain manufacturing and other defects. These product warranties are provided for specific periods of time depending on the nature of the product. Warranties are generally fulfilled by replacing defective products with new products. The following table provides the changes in our product warranty reserve, which are included in accrued liabilities:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
 (in thousands)
Warranty, beginning of period
$
582

 
$
530

 
$
472

 
$
639

Warranty costs accrued
242

 
59

 
686

 
173

Settlements of warranty claims
(175
)
 
(109
)
 
(509
)
 
(332
)
Warranty, end of period

$
649

 
$
480

 
$
649

 
$
480

Note 13. Series B Redeemable Preferred Stock Exchange Transactions and Settlement

In September 2010, VTBH issued 1,000,000 shares of its Series B Redeemable Preferred Stock (the “Series B Preferred Stock”) with a fair value of $12.4 million. The Series B Preferred Stock was required to be redeemed on the earlier of September 28, 2030, or the occurrence of a liquidation event at its original issue price of $12.425371 per share plus any accrued but unpaid dividends.
On February 18, 2015, Dr. John Bonanno (“Dr. Bonanno”), the original holder of the Series B Preferred Stock filed a complaint in Delaware Chancery Court alleging breach of contract. According to the complaint, the Merger purportedly triggered a contractual obligation for VTBH to redeem Dr. Bonanno’s stock. Dr. Bonanno requested a declaratory judgment stating that he was entitled to damages, including a redemption of his stock valued at $15.1 million (equal to the original issue price of his stock plus accrued dividends) as well as other costs and expenses.

On April 23, 2018, the Company facilitated and entered into a series of transactions pursuant to which the Series B Preferred Stock was acquired from Dr. Bonanno by non-affiliate investors and subsequently retired. As part of the transactions, the Company entered into (i) an Exchange Agreement (the “Exchange Agreement”) with such non-affiliate investors pursuant to which the Company agreed to exchange the Series B Preferred Stock for an aggregate of 1,307,143 newly issued shares of the Company’s common stock and wholly-funded warrants exercisable for an aggregate of 550,000 shares of the Company’s common stock and (ii) a Settlement Agreement (the “Settlement Agreement”) with Dr. Bonanno.

Pursuant to the Settlement Agreement, Dr. Bonanno agreed to discontinue certain previously disclosed claims and actions against the Company related to the Series B Preferred Stock, as well as to provide a release of the Company with respect to all such claims and any other claims related to Dr. Bonanno’s ownership or disposition of the Series B Preferred Stock. In connection with and as consideration thereof, the Company agreed to pay Dr. Bonanno a cash sum of $1.0 million to settle non-redemption claims in connection with the matter, and to pay an additional $1.25 million if a change of control transaction meeting certain specified requirements is consummated within three years of the date of the Settlement Agreement.

Accordingly, on April 26, 2018, all exchanged shares of Series B Preferred Stock were retired, and no shares of Series B Preferred stock remain outstanding. The redemption value of the Series B Preferred Stock was $19.4 million as of the transaction date, and $18.9 million as of December 31, 2017.

The Company assessed the relative fair values of the Series B Preferred Stock retired pursuant to the Exchange Agreement and Settlement Agreement to determine the amount of the total transaction consideration transferred that was allocable to each component.  The Company determined the fair value of the Series B Preferred Stock to be greater than the total consideration transferred.  In addition, the Company was not able to reliably estimate the fair value of the litigation settlement. Based on these fair value assessments, the Company utilized the residual approach and first allocated proceeds to the Series B Preferred Stock, which resulted in no amount of the consideration being allocated to the litigation settlement.  Accordingly, the entire transaction was accounted for as an equity transaction with the difference between the carrying value of the Series B Preferred Stock and the fair value of the consideration transferred included in stockholders equity. The warrants issued in connection

25

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

with the retirement of the Series B Preferred Stock are accounted for as a financial instrument obligation. See Note 1, “Background and Basis of Presentation,” for further details.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our operations should be read together with our unaudited condensed consolidated financial statements and the related notes included in Part I of this Quarterly Report on Form 10-Q/A and with our audited consolidated financial statements and the related notes included in our Annual Report on Form 10-K filed with the Securities Exchange Commission on March 7, 2018 (the "Annual Report.")
This Report on Form 10-Q/A contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this Report are indicated by words such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “estimates,” “projects,” “strategies” and similar expressions. Caution should be taken not to place undue reliance on any such forward-looking statements because they involve risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such statements. Forward-looking statements are based on the beliefs, as well as assumptions made by, and information currently available to, the Company's management and are made only as of the date hereof. The Company undertakes no obligation to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. In addition, forward-looking statements are subject to certain risks and uncertainties, including those described elsewhere in this Quarterly Report on Form 10-Q/A that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections.

Business Overview
Turtle Beach Corporation (herein referred to as the “Company,” “we,” “us,” or “our”), headquartered in San Diego, California, and incorporated in the state of Nevada in 2010, is a premier audio technology company with expertise and experience in developing, commercializing and marketing innovative products across a range of large addressable markets operating under two reportable segments, Turtle Beach® (“Headset”) and HyperSound®.
Turtle Beach is a worldwide leading provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers, tablets and mobile devices.
HyperSound technology is an innovative patent-protected sound technology that delivers immersive, directional audio with applications in digital signage and kiosks, consumer electronics and hearing healthcare.
Business Trends
Gaming Headset Market

Gaming headsets are part of a global, growing gaming market sized at over $100 billion. Global gaming now exceeds both global cinema and global music market sizes with over 2.1 billion active gamers worldwide. Gaming peripherals are a $2 billion business globally with over 75%, more than $800 million, of that market in the Americas and Europe where the Company’s business is focused. Gaming headsets are nearly half of that, at over $1 billion in global market size.

eSports is a global phenomenon where professional gamers train, compete, win prize money and attract fans similar to other professional sports. There are over 140 million eSports enthusiasts globally and growing quickly. Gaming headsets are a must-have piece of equipment for competitive gaming.

Xbox and PlayStation® consoles are the dominant gaming platforms in North America and Europe. Many gamers play online where gaming headsets - which include a microphone and allow players to communicate with one another in real time - provide the ability to jump in and engage in the industry’s most popular games and franchises. Gaming headsets also create a more immersive and rich gaming experience. In addition to consoles, personal computers are a key platform for gaming and utilize similar style headsets with the requisite benefits. Gaming on mobile/tablet devices represents about a third of the global gaming market and headsets can be used for mobile gaming, but Xbox, PlayStation®, and PC gaming are by far the largest drivers of gaming headset use. Nintendo Switch™ has emerged as a popular gaming platform, although much less of a driver of gaming headset sales.


26



Historically, Microsoft and Sony go through cycles where their respective console platform is changed and/or updated to a significant new version. In holiday 2013, Microsoft launched Xbox One to replace Xbox 360, while Sony launched Playstation®4 to replace Playstation®3. Those console transitions created a major disruption for gaming headsets and other accessories because the fundamental connectivity to the new platforms changed. From 2013 to 2015, that disruption negatively impacted the gaming accessory market as the old generation headset business rapidly declined and new headsets had to be developed for the new consoles. In 2016 and 2017, respectively, both Microsoft and Sony launched “Pro” versions of their latest console platforms which didn’t create similar disruption for the gaming headset business, and the Company believes this is a positive indication that any potential future console changes will not be as disruptive.

In addition to console sales, the Xbox, PlayStation®, and PC gaming markets are driven by major games that encourage players to buy equipment and accessories. On Xbox and PlayStation®, tentpole games like Call of Duty®, Destiny, Battlefront, Grand Theft Auto and more recently Fortnite and PlayerUnknown's Battlegrounds are examples of major franchises that feature online multiplayer modes, which management believes drive gaming headset sales. Many of these established franchises launch new titles annually leading into the holidays, which furthers the popularity of gaming headsets as gift items. As a result, the gaming headset business is highly seasonal, often with 45%-55% of the business occurring in the fourth quarter. The gaming headset business can also expand or contract based on the success of these major game launches.

During 2017, PlayerUnkown’s Battlegrounds introduced a new style of multiplayer game known as “battle royale,” where players compete in a large, but shrinking map until a single winner remains. Players can play on teams, and audio cues are very helpful to surviving, making headsets a key accessory for this type of game. Epic Games introduced Fortnite, which includes a similar format, in late 2017, but with a more kid-friendly feel. Both games have soared in popularity over the past several months with large and growing audiences of both players and spectators via content sharing platforms like Twitch, YouTube, Xbox’s Mixer, and PlayStation® Now.

Our gaming headsets are sold through major retailers such as Argos, Best Buy, GameStop, Target and Walmart as well as online retailers such as Amazon and NewEgg. Brick and mortar retailers often have “kiosks” which enable shoppers to “try before they buy,” offering consumers the opportunity to experience each headset’s specific fit, feel and overall audio quality.

Key Performance Indicators and Non-GAAP Measures

Management routinely reviews key performance indicators including revenue, operating income and margins, and earnings per share, among others. In addition, we believe certain other measures provide useful information to management and investors about us and our financial condition and results of operations for the following reasons: (i) they are measures used by our board of directors and management team to evaluate our operating performance; (ii) they are measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made are often viewed as either non-recurring or not reflective of ongoing financial performance or have no cash impact on operations; and (iv) they are used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by adjusting for potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense). These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (“GAAP”) and, given the limitations of these metrics as analytical tools, should not be considered a substitute for gross profit, gross margins, net income (loss) or other consolidated income statement data as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:

Adjusted EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash) and certain special items that we believe are not representative of core operations.
Cash Margin is defined as gross margin excluding depreciation and amortization, and stock-based compensation.

27



Adjusted EBITDA (and a reconciliation to Net income (loss), the nearest GAAP financial measure) for the three and nine months ended September 30, 2018 and 2017, are as follows:
 
Three Months Ended
 
Nine Months Ended
 
September 30,

September 30,
 
2018

2017

2018

2017
 
(in thousands)
Net income (loss)
$
14,932

 
$
(492
)
 
$
14,576

 
$
(17,479
)
Interest expense
1,093

 
2,042

 
4,356

 
5,717

Depreciation and amortization
814

 
876

 
3,174

 
3,259

Stock-based compensation
587

 
370

 
1,409

 
1,187

Income tax expense
398

 
578

 
762

 
1,098

Unrealized loss (gain) on financial instrument obligation
(209
)
 

 
8,410

 

Restructuring charges

 
241

 

 
509

Business model transition charge

 
(312
)
 

 
41

Adjusted EBITDA
$
17,615

 
$
3,303

 
$
32,687

 
$
(5,668
)
Comparison of the Three Months Ended September 30, 2018 to the Three Months Ended September 30, 2017

Net income for the three months ended September 30, 2018 was $14.9 million, including a $0.2 million unrealized gain on a financial instrument obligation, compared to a net loss of $0.5 million in the prior year period, all of which was attributable to the Headset business.

For the three months ended September 30, 2018, Adjusted EBITDA on a consolidated basis was $17.6 million compared to $3.3 million in the prior year period, including investments of $0.2 million in the HyperSound business during the three months ended September 30, 2017. Net income and Adjusted EBITDA increased on higher revenues and fixed cost leveraging margin improvement as a result of strong consumer demand driven by the continued popularity of the “battle royale” style games Fortnite and PlayerUnknown’s Battlegrounds.

Comparison of the Nine Months Ended September 30, 2018 to the Nine Months Ended September 30, 2017

Net income for the nine months ended September 30, 2018 was $14.6 million, including a $8.4 million unrealized loss on a financial instrument obligation, compared to a net loss of $17.5 million in the prior year period, including $23.1 million of net income and $16.1 million of net loss attributable to the Headset business, respectively.

For the nine months ended September 30, 2018, Adjusted EBITDA on a consolidated basis was $32.7 million compared to $(5.7) million in the prior year period, including investments of $1.1 million in the HyperSound business, during the nine months ended September 30, 2017. Net income and Adjusted EBITDA increased on higher revenues and fixed cost leveraging margin improvement as a result of strong consumer demand related to new “battle royale” style game launches Fortnite and PlayerUnknown’s Battlegrounds.


28



Results of Operations
The following table sets forth the Company’s statements of operations for the periods presented:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Net revenue
$
74,427

 
$
35,975

 
$
176,118

 
$
69,439

Cost of revenue
43,925

 
23,437

 
110,310

 
48,384

Gross profit
30,502

 
12,538

 
65,808

 
21,055

Operating expenses
13,980

 
10,662

 
37,231

 
32,236

Operating income (loss)
16,522

 
1,876

 
28,577

 
(11,181
)
Interest expense
1,093

 
2,042

 
4,356

 
5,717

Other non-operating expense (income), net
99

 
(252
)
 
8,883

 
(517
)
Income (loss) before income tax
15,330

 
86

 
15,338

 
(16,381
)
Income tax expense
398

 
578

 
762

 
1,098

Net income (loss)
$
14,932

 
$
(492
)
 
$
14,576

 
$
(17,479
)

Net Revenue and Gross Profit
The following table summarizes net revenue and gross profit for the periods presented:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018

2017
 
 (in thousands)
Net Revenue
$
74,427

 
$
35,975

 
$
176,118

 
$
69,439

Gross Profit
$
30,502

 
$
12,538

 
$
65,808

 
$
21,055

Gross Margin
41.0
%
 
34.9
%
 
37.4
%
 
30.3
%
Cash Margin (1)
41.3
%
 
35.4
%
 
37.8
%
 
30.9
%
(1) Excludes non-cash charges

Comparison of the Three Months Ended September 30, 2018 to the Three Months Ended September 30, 2017

The strong increase in demand for gaming headsets that occurred with the rise of the “battle royale” style games has continued as net revenues for the three months ended September 30, 2018 were $74.4 million, a $38.5 million increase and more than double the net revenues of $36.0 million in the comparable prior year period. The market has expanded further across all channels and Turtle Beach products continued to be the top-selling console headsets, including the industry leading Recon 50X and Stealth 600.

For the three months ended September 30, 2018, gross profit as a percentage of net revenue increased to 41.0% from 34.9% in the comparable prior year period. Headset margins were positively impacted by product and customer mix combined with higher volume driven fixed-cost leveraging.

Comparison of the Nine Months Ended September 30, 2018 to the Nine Months Ended September 30, 2017

Net revenues for the nine months ended September 30, 2018 were $176.1 million, a $106.7 million increase and more than double the net revenues of $69.4 million in the comparable prior year period. Management believes this increase was driven by higher volumes across all channels as the releases of Fortnite and PlayerUnknown’s Battlegrounds generated sales of gaming headsets in the $100 and below price point, which includes our Ear Force Recon 50 Series, Stealth 600 Series and Recon Chat headsets, from new gamers and upgrade purchases from existing players.

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For the nine months ended September 30, 2018, gross profit as a percentage of net revenue increased to 37.4% from 30.3% in the comparable prior year period. Headset margins were positively impacted by higher volume which drove fixed-cost leveraging and a less promotional environment as compared to the prior year period in which channel inventories were much higher than normal following weaker than expected 2016 performance of the major holiday game releases. These improvements were partially offset by incremental air freight ($3.1 million) incurred to keep pace with increased consumer demand.

Operating Expenses
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Selling and marketing
$
8,517

 
$
5,586

 
$
21,264

 
$
15,564

Research and development
1,400

 
1,336

 
4,056

 
4,423

General and administrative
4,063

 
3,499

 
11,911

 
11,740

Restructuring charges

 
241

 

 
509

Total operating expenses
$
13,980

 
$
10,662

 
$
37,231

 
$
32,236