News Column

PARAMETRIC SOUND CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 13, 2014

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 and with our audited consolidated financial statements and the related notes included in our Prospectus Supplement filed with the Securities Exchange Commission on April 24, 2014. This discussion and analysis contains forward-looking statements that are based on the beliefs, as well as assumptions made by, and information currently available to, its management. Actual results could differ materially from those discussed in or implied by forward-looking statements for various reasons. Business Overview Parametric Sound Corporation (the "Company") is an audio technology company that markets innovative products under the Turtle Beach and HyperSound brands. The Company designs and markets premium audio peripherals for video game consoles, personal computers and mobile devices under the Turtle Beach brand (TurtleBeach.com), including officially-licensed headsets for the next-generation Xbox One and PlayStation 4 consoles. Under the HyperSound brand (HyperSound.com), the Company markets pioneering directed audio solutions that beam sound to a specific listening area without the ambient noise of traditional speakers. HyperSound has applications in digital signage and kiosks, consumer electronics and health care. The Company's mission is to utilize innovative technology to create exceptional audio experiences across a wide range of consumer and commercial applications. On January 15, 2014, Parametric Sound Corporation completed a merger (the "Merger") with VTB Holdings, Inc. ("VTBH"), which operates the Turtle Beach business. The Merger resulted in a company with a new investment profile and unaudited pro forma combined net revenue of $179 million for the year ended December 31, 2013. The Company's stock is traded on NASDAQ under the symbol HEAR (formerly PAMT) and the Company anticipates changing its legal name from Parametric Sound Corporation to Turtle Beach Corporation in May of 2014. Audio technology and digital signal processing are core competencies of the combined companies, and we intend to leverage these competencies to continue to expand both our headset and HyperSound product portfolios. We consider continued innovation and state-of-the-art product development key factors to our future success. The Merger combined the unique intellectual property and HyperSound product platform of Parametric Sound Corporation with the commercialization skills and resources of Turtle Beach, including proven product design, product development, supply chain management, sales and marketing. We believe that the strength of the Turtle Beach headset business provides a strong foundation that will enable us to invest in the advancement and commercialization of HyperSound. Headset Business Overview Turtle Beach is a leading designer, developer and marketer of premium audio peripherals for video game console, handheld console, personal computer and mobile platforms. Turtle Beach launched its first gaming headset in 2005, and played a significant role in developing the market for advanced gaming headsets. Today's consumers know Turtle Beach for advanced gaming headsets, which allow video game players to experience high-quality, immersive surround sound and to communicate with others while playing video games. Turtle Beach is the only gaming headset company that is officially licensed by all three major gaming consoles platforms - Microsoft Xbox, Sony PlayStation and Nintendo Wii. In addition, Turtle Beach has licensing agreements with major software and entertainment brands, including Activision, Blizzard, Disney and Marvel to create co-branded headsets with popular franchises, such as Call of Duty® and Star Wars. Turtle Beach believes that its licensing agreements with leading console and software companies provide a competitive advantage and build brand awareness. Turtle Beach branded headsets are now distributed in 44 countries across North America, South America, Europe, the Middle East, Africa, Australia, and Asia. The headsets are sold at more than 27,000 storefronts, including major retailers such as Amazon, Apple, Best Buy, GameStop, HMV, Target and Walmart. We believe that the primary growth drivers for our console gaming headset business are: • Cumulative sales of 163 million consoles, in the aggregate, of Xbox 360, Xbox One, PlayStation 3, and PlayStation 4 consoles as of year-end 2013, as estimated in the March 2014 DFC Intelligence: Worldwide Console Forecast; • Projected sales of next-generation Xbox One and PlayStation 4 consoles, which are forecasted to reach 149 million cumulative units by 2018, as estimated in the March 2014 DFC Intelligence: Worldwide Console Forecast; 24 -------------------------------------------------------------------------------- • The increase in multiplayer online gaming, whether console-, mobile-, or PC-based, in which a gaming headset provides the additional benefit of being a communication device; • The launch of new console video game titles, which we believe increases foot traffic into retail stores and lifts console gaming headset sales; and • The installed base of more than 7 million Turtle Beach headsets, which we expect to drive upgrades and replacements. Business Trends The gaming industry experienced a cyclical event in 2013 as Microsoft and Sony each introduced new consoles for the first time in eight years. Turtle Beach's gaming headset business was materially impacted in 2013 by the beginning of this multi-year transition from sixth generation consoles to seventh generation consoles. After Sony announced the PlayStation 4 in February 2013 and Microsoft announced the Xbox One in May 2013, consumers began delaying gaming purchases in advance of the introduction of the new consoles, negatively impacting global sales of console hardware and software. Turtle Beach focused in 2013 on investment and consolidation with the goal of positioning itself for renewed growth in 2014. Turtle Beach increased spending and investment in personnel and infrastructure to enter or strengthen its position in new geographic regions and expand the product line into areas outside of console gaming headsets. In October 2013, Turtle Beach launched a new line of wireless media headsets as part of its strategy to broaden its base of users from console gaming headsets to headsets for music, movies, and mobile gaming. In addition, Turtle Beach signed a licensing agreement with Microsoft to create audio solutions for the Xbox One. The consumer response to Xbox One and PlayStation 4 has been overwhelmingly positive, creating a growing installed base of users and a market for next generation headsets. We believe we are well positioned to benefit from the anticipated growth in the segment as consumers purchase new consoles over the next three years and beyond. DFC Intelligence estimates Xbox One cumulative sales will increase approximately 23 times from a base of 2.8 million in 2013 to 63 million in 2018, and estimates PlayStation 4 cumulative sales will increase approximately 21 times from a base of 4.2 million to 86 million over the same period. In addition, industry analysts expect Microsoft and Sony to continue to support their current generation consoles over the next few years and, as a result, we anticipate that there will continue to be a significant market through 2014 for our headsets that are compatible with Xbox 360 and PlayStation 3. Seasonality Our gaming headset business is seasonal with a significant portion of sales and profits typically occurring around the holiday period. Historically, more than 50% of Turtle Beach's revenues are generated during the period from September through December as new headsets are introduced and consumers engage in holiday shopping. PlayStation 4 console launch In preparation for the launch of the PlayStation 4 in November 2013, we introduced two headsets designed for the new console, the P4C and PX4. In addition, we aggressively marketed many current generation headsets in our portfolio that were also compatible with the new console. As a result, sales of PlayStation 4 compatible headsets played a large role in Turtle Beach's improved performance at the end of 2013, which carried over to the first quarter of 2014. Xbox One console launch At this time, Turtle Beach remains one of only two announced audio companies currently licensed and approved by Microsoft to develop and sell Xbox One compatible audio products. In order for headsets to receive integrated voice and chat audio from the Xbox One, a Microsoft proprietary hardware adapter is required. Due to the inclusion of this proprietary adapter, older headsets lacking a license from Microsoft, including older Turtle Beach headsets, are not compatible with the Xbox One without the separately purchased adapter. In October 2013, Microsoft informed Turtle Beach that the adapter and software created by Microsoft and required to enable full headset functionality on the Xbox One would not be implemented until the first quarter of 2014. As a result, Turtle Beach deferred the launch of its XO Four and XO Seven headsets until the first quarter of 2014. 25 -------------------------------------------------------------------------------- Turtle Beach launched the first-ever Xbox One compatible headsets on March 6, 2014. Consumer reaction to the new headsets -- the XO FOUR, XO SEVEN and Titanfall Atlas -- has been positive, which helped Turtle Beach achieve a 74% dollar share of Xbox One headsets in the first quarter of 2014 according to sales tracking data from the NPD Group, Inc. Investments in People and Infrastructure Turtle Beach's net revenues have more than doubled from 2010 to 2012 and it has continued to invest in building internal capabilities, including the hiring of new executives, significantly expanding the number of internal product development, product management, and operational personnel, and increasing marketing expenditures and investment in retail selling displays. In addition, Turtle Beach acquired a United Kingdom based distributor, Lygo International Limited (now Turtle Beach Europe Ltd) in October 2012, which added sales and marketing staff and expenses as well as warehouse and distribution facilities. We intend to continue to invest in internal capabilities to support longer term growth. Geographic Expansion Turtle Beach has a strong market position in North America, United Kingdom, and Australia. Turtle Beach is also one of the top gaming headset providers in the rest of Europe but believes there is further opportunity for growth. Asia, in particular China, and Latin America are viewed by the Company as additional long-term growth opportunities. The Company intends to continue investing in a stronger presence and growth in these regions. Total points of distribution is a standard retail trade term used to summarize distribution breadth by multiplying the number of retail outlets selling a product by the number of those products in each location. It takes into account how widely products are available and how many items are available. Points of distribution for Turtle Beach headsets nearly tripled overall from 2011 to 2013, increasing from approximately 128,000 to approximately 370,000. The international growth rate over the three-year period was 490%, with points of distribution increasing from approximately 27,000 to 159,000. Product Portfolio Turtle Beach offers a variety of headsets at retail price points ranging from $30 to $300 and has offerings across all major gaming platforms. As gaming consoles have evolved from dedicated video game platforms to home entertainment hubs, and mobile devices have become platforms for entertainment, we have continued to evolve our Turtle Beach headsets to reflect how content is consumed. For example, in October 2013, we introduced media headsets, the iSeries, that can bring sophisticated audio processing technology to consumers watching movies or listening to music, as well as playing video games. These new headsets are available at Apple retail stores, with expanded distribution anticipated later in 2014. While the stereo headphone category is large and very competitive, Turtle Beach management believes that the availability of the iSeries in Apple stores and the underlying technology innovation in the products will be an important catalyst for expanding its consumer base. This initiative represents an investment of over $3 million in product development and marketing in 2013. HyperSound Business Overview Technology Target Markets Several innovations have made HyperSound a distinctly different technology from previous utltrasonic audio solutions. These patent-protected innovations provide a competitive advantage over other solutions in the marketplace. Digital signal processing has significantly improved audio quality and frequency response, electronics advancements have enabled the use of low voltage cables and lowered overall power consumption, and innovations in emitter panel design have improved the ratio of audio volume to panel size, allowing for the production of much smaller panels. Combined, these improvements open the door to the use of HyperSound in a host of commercial and consumer applications that was closed to past ultrasonic sound technologies. We are currently focusing our product development efforts for HyperSound-based products in the following three areas: commercial, health care and consumer applications. We are also pursuing licensing opportunities in addition to the products we are commercializing. 26 -------------------------------------------------------------------------------- Commercial Applications Among potential commercial applications, we are currently marketing our HyperSound technology to retailers and audio-visual integrators for use in settings where directed audio and sound zones are beneficial, such as digital signage and interactive retail displays. Digital signage is a growing form of direct advertising, capturing an increasing share of advertising spending. Restaurants, banking, retail outlets, museums and other outlets and organizations employ commercial displays to communicate with patrons, many of which currently have no audio. Interactive retail displays and related computer terminals such as ATMs, power applications for communication, commerce, entertainment and education. Electronic gaming and casino slot machines are also becoming increasingly sophisticated computerized entertainment devices. We believe the ability to focus sound on the user in front of such displays or devices, while limiting or removing sound disruption outside the listening area, offers utility unavailable with traditional speakers. HyperSound creates discrete in-store promotional audio zones that offer a personal experience to an individual while preventing noise pollution that could be heard by surrounding customers. Health Care We believe our research studies, including preference testing and clinical trials, demonstrate that HyperSound technology offers improved comprehension of audio for persons with varying types of hearing impairments by delivering higher volume and clarity of audio to hearing impaired listeners when compared to a conventional acoustic speaker. In February 2014, we received clearance from the U.S. Food and Drug Administration, or FDA, for the marketing of the HyperSound audio system as a hearing improvement device. We are focused on bringing a product to market that will have a positive impact on the quality of life for people with certain hearing disabilities. With over 48 million people in the United States experiencing hearing impairments, we believe hearing health represents a strong opportunity for us, and that our technology will fill a need in the market. Consumer Applications Our HyperSound technology has the potential to be developed into consumer products for various applications, including computers, video game consoles, televisions, home theater and home audio. With the advent of flat panel displays for use in televisions and mobile devices, manufacturers have been focused on creating thinner products often at the expense of sound quality. We believe this has created an opportunity to develop integrated and companion HyperSound products that improve the audio experience by providing immersive 3D sound. We believe that our ability to create a 3D sound image from two thin emitters, compared to a five- or seven-speaker surround sound set-up using conventional speakers will deliver a compelling and enhanced audio experience for consumers. Basis of Presentation Merger Agreement On January 15, 2014, VTB Holdings, Inc. ("VTBH") and Parametric Sound completed the merger of Paris Acquisition Corporation ("Merger Sub") with and into VTBH in accordance with the terms and conditions of the Merger Agreement, dated August 5, 2013 (the "Merger Agreement"), by and among Parametric Sound, VTBH and Merger Sub (the "Merger"). As a result of the Merger, VTBH, the surviving entity in the Merger, became a wholly-owned subsidiary of Parametric Sound. For accounting purposes, the Merger was treated as a "reverse acquisition" and VTBH was considered the accounting acquirer. Parametric Sound Corporation is operating under the Turtle Beach management team, and its Board of Directors consists of two former Parametric Sound directors and five directors selected by Turtle Beach. Accordingly, Turtle Beach's historical results of operations will replace Parametric Sound's historical results of operations for all periods prior to the Merger, and for all periods following the Merger, the results of operations of both companies will be included in Parametric Sound's financial statements. Prior to the Merger, Parametric Sound had a September 30 fiscal year end, which was subsequently changed to a December 31 calendar year end after the Merger. In connection with the Merger, Parametric Sound Corporation issued to the former holders of VTBH common stock and Series A Preferred Stock an aggregate of 30,227,100 shares of Parametric Sound common stock, par value $0.001 per share ("Parametric Sound Common Stock"). The number of shares of Parametric Sound Common Stock issued was computed in accordance with a formula specified in the Merger Agreement using an exchange ratio of 0.35997 shares of Parametric Sound Common Stock for every one share of VTBH common stock or Series A Preferred Stock. In addition, in accordance with the terms of the Merger Agreement, all outstanding options to purchase shares of VTBH common stock were converted into options to purchase shares of Parametric Sound Common Stock that were assumed by Parametric Sound Corporation. These newly issued shares of Parametric Sound Common Stock, together with the converted options, represented approximately 80% 27 -------------------------------------------------------------------------------- of the total issued and outstanding shares of Parametric Sound Common Stock, on a fully-diluted basis, as of the closing date of the Merger. Revenue Prior to the Merger, the Company's historical revenues were primarily derived from the sale of gaming headsets and accessories, including replacement parts for gaming headsets and audio cables. During 2014, revenues will also include the sale of HyperSound products for commercial, health care and consumer applications. During 2013, the majority of the Company's revenues were derived from sales of headsets designed primarily for use with the Xbox and PlayStation consoles. The majority of the Company's products are distributed domestically to specialty retailers of consumer electronics, superstores, online retailers and wholesalers, and internationally through TB Europe and to wholesalers. Products are also sold directly to consumers through the Company's website. International sales are generally shipped directly from the Company's suppliers in China to international wholesalers. We recognize revenue when all of the following criteria are met: (1) persuasive evidence exists of an arrangement with the customer reflecting the terms and conditions under which the services will be provided; (2) services have been provided or delivery has occurred; (3) the fee is fixed or determinable; and (4) collection is reasonably assured. Collectability is assessed based on a number of factors, including the creditworthiness of a customer and transaction history. Net revenues are influenced by numerous factors such as product volume and mix, pricing, geographic mix, foreign currency exchange rates, the mix between sales to resellers and end users and adjustments for sales returns, price protection programs and co-op programs. Cost of Revenue and Gross Profit The Company's cost of revenue primarily consists of manufacturing costs associated with its headsets and subsequent to the merger, manufacturing costs associated with production of HyperSound products. Cost of revenue also includes costs for product royalties, warranty expense, logistics and facilities costs, freight and personnel costs (including stock compensation expenses). Gross profit percentage is influenced by numerous factors such as product volume and mix, pricing, geographic mix, the mix between sales to resellers and end-users, third-party costs (including both raw material and manufacturing costs), warranty costs and charges related to returns and customer promotional programs. Operating Expenses The Company's significant operating expenses are selling and marketing, research and development, and general and administration. The components of sales and marketing expenses include trade shows and events, promotions, salaries and benefits, direct media advertising, in-store advertising and interactive retail displays. Personnel expenses are the largest category of expense and include salaries, benefits, bonuses, sales commissions and stock-based compensation expense. Selling and Marketing Expenses. Selling and marketing expenses are the Company's largest functional category of total operating expense. These expenses primarily consist of media and advertising, which include online search engine optimization, investment in retail sales displays and tradeshows. Expenses also include salaries and benefits related to the Company's worldwide direct sales force, sales commissions, travel and entertainment costs, sales support, sales development and outside sales consultants. The Company plans to continue to invest in sales and marketing efforts, including a plan to increase the number of sales personnel worldwide in order to expand reach in international markets as well as to expand the HyperSound businesses. In addition, the Company intends to continue to grow its marketing and promotional expenditures to build brand awareness for both Turtle Beach and HyperSound brands. Research and Development Expenses. Research development expenses are costs related to the development and enhancement of the Company's Headset and HyperSound related products. These expenses consist of salaries and benefits, information technology, consulting, engineering samples and prototypes and allocation of facility-related costs. The Company expects its development costs to increase in absolute dollars as it continues to expand product offerings and its global reach. General and Administrative Expenses. General and administrative expenses consist primarily of salaries and benefits, professional fees and depreciation. General and administrative personnel costs include the Company's executive, finance, human resources, information technology and external legal functions. Professional fees consist primarily of accounting, tax, legal, recruiting and other consulting costs, including costs associated with being a public company. 28 -------------------------------------------------------------------------------- Business Transaction Costs. Business transaction costs consist primarily of legal, accounting and investment banker fees associated with the Merger transactions. Costs include legal costs related to due diligence, contract reviews and preparation of SEC documents, accounting and public company readiness costs related to the increased requirements for operating as a public company, accounting firms review and audit of transaction related SEC filings, and fees paid to investment bankers including fairness opinions and success bonuses upon close of the Merger. Other Expense, net Other Expense, net, is comprised of the following items: Interest expense consists primarily of cash interest expense on the Company's revolving credit facility, term loan, non-cash interest on subordinated notes and Series B preferred Stock and amortization of financing costs. Other expense consists primarily of foreign currency exchange gains and losses. The Company's foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. The Company expects its foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Other expenses also include derivatives to partially offset exposure to foreign currency exchange risk. Provision for Income Taxes The provision for income taxes consists of federal and state income taxes in the United States, income taxes in certain foreign jurisdictions and deferred income taxes reflecting the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and includes uncertain tax positions. Earnings from the Company's non-U.S. activities are subject to local country income taxes and may be subject to U.S. income taxes. Results of Operations The following table sets forth the Company's statement of operations for the periods presented: Quarter Ended Quarter Ended March 31, 2014 March 31, 2013 (in thousands) Net Revenue $ 38,288$ 29,533 Cost of Revenue 26,012 20,908 Gross Profit 12,276 8,625 Operating expenses: Selling and marketing 7,000 5,706 Research and development 1,998 887 General and administrative 3,573 2,370 Business transaction costs 4,228 - Total operating expenses 16,799 8,963 Operating loss (4,523 ) (338 ) Other (income) expense, net: Interest expense 4,240 1,314 Other (income) expense, net (25 ) 389 Total other expense, net 4,215 1,703



Loss before (benefit) provision for income taxes (8,738 ) (2,041 ) (Benefit) provision for income taxes

(5,832 ) 263 Net loss $ (2,906 )$ (2,304 ) 29

-------------------------------------------------------------------------------- Results for the quarter ended March 31, 2013 include the accounts of VTBH only, since VTBH is considered the accounting acquirer in the January 15, 2014 Merger transaction. Results for the quarter ended March 31, 2014 include VTBH and the results of Parametric subsequent to the date of acquisition. Quarter Ended March 31, 2014 Compared to Quarter Ended March 31, 2013 Net Revenue Net revenue for the quarter ended March 31, 2014 totaled $38.3 million, or $8.8 million (30%) higher than a year ago. The increase was primarily driven by Xbox One headset revenue. Microsoft delayed gaming headset audio when the Xbox One console was rolled out (November 2013) until March 2014. In late February 2014, the Company began shipping Xbox One headsets on a global basis to position for the release of gaming headset audio on March 11, 2014. The Company is one of two third parties licensed to manufacture and sell headsets for Xbox One today. The Microsoft delay resulted in a deferral of headset sales from the 2013 holiday season into the first half of 2014. In addition, the Titanfall game for Xbox One was released in March, and the Company sells a licensed headset for this multi-player game. The new Playstation and Xbox consoles released in November 2013 have sold over 12 million units total as of April 2014, exceeding industry estimates. Cost of Revenue Cost of revenue for the quarter ended March 31, 2014 totaled $26.0 million, or 67.9% of net revenue as compared to 70.8% of net revenue a year ago. The lower cost of revenue on a percent-of-net revenue basis was driven by lower product costs and royalties, driven by product and customer mix, and offset by higher freight-in and warehouse costs associated with positioning Xbox One headsets in retailers in time for Microsoft headset audio release in March. Selling and Marketing Selling and marketing expenses for the quarter ended March 31, 2014 totaled $7.0 million, representing an increase of $1.3 million, or 23%, compared to $5.7 million for the quarter ended March 31, 2013. This increase was primarily due to a $0.5 million increase in depreciation expenses primarily related to the expansion of interactive retail display kiosks into two large retailers in the fourth quarter of 2013, $0.5 million increase in salary and benefit expenses, $0.4 million of marketing costs for the HyperSound business and a $0.2 million increase in international marketing costs. These increased expenses were partially offset by, a $0.3 million decrease in advertising expenses. Research and Development Research and development expenses for the quarter ended March 31, 2014 total $2.0 million, representing an increase of $1.1 million, or 122%, compared to $0.9 million for the quarter ended March 31, 2013. This increase was primarily due to $0.5 million in costs in HyperSound business, and $0.3 million of expenses related to staff additions made during 2013. General and Administrative General and administrative expenses for the quarter ended March 31, 2014 totaled $3.6 million, representing an increase of $1.2 million, compared to $2.4 million for the quarter ended March 31, 2013. The increase was primarily due to a $0.5 million related to additional finance and accounting headcount to support being a public company, $0.4 million in accounting and consulting temporary staffing costs, added to assist with the bank refinancing and equity offering and $0.3 million in expenses related to the HyperSound business. Business Transaction Business transaction expenses for the quarter ended March 31, 2014 increased $4.2 million compared to the quarter ended March 31, 2013. The increase was primarily due to investment banker success fees of $2.7 million payable upon the close of the Merger as well as associated legal and accounting fees. Interest Expense, net Interest expense, net, increased by $2.9 million for the quarter ended March 31, 2014, as compared to March 31, 2013, primarily due to the increased amortization costs as a result of the write-off of $2.2 million of unamortized debt issuance costs related to the payoff of Turtle Beach's previous credit facility on March 31, 2014. The remaining increase during the quarter 30 -------------------------------------------------------------------------------- ended March 31, 2014 was due to the the addition of the subordinated notes and higher interest rates on the revolver and term loan balance outstanding under the old credit facility that was retired on March 31, 2014. Income Taxes Income tax benefit was $5.8 million for the quarter ended March 31, 2014, which represented a decrease of $6.1 million from the income tax expense of $0.3 million for the quarter ended March 31, 2013. The effective tax rate in 2013 was a provision of approximately 70%. The difference between the effective tax rate and the statutory tax rates is primarily related to differences in book and tax treatment of stock based compensation, transaction costs, interest on the Series B Preferred Stock and other non-deductible expenses. Adjusted EBITDA Adjusted EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash), non-cash amortization of payments to founders and certain business transaction expenses. Management believes Adjusted EBITDA is a useful measure to help evaluate its business, analyze trends, measure performance, prepare financial projections and make strategic decisions. Management adjusts net income (loss) for business transaction costs from its calculations of Adjusted EBITDA because it believes that such items are not representative of core operations. For the quarter ended March 31, 2014, business transaction costs consisted of acquisition-related costs in the amount of $4.2 million related to the Merger. We believe Adjusted EBITDA provides useful information to investors about us and our financial condition and results of operations for the following reasons: (i) it is one of the measures used by our board of directors and management team to evaluate our operating performance; (ii) it is one of the measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made in our calculation of Adjusted EBITDA (business transaction costs, payments to our founders, and stock-based compensation) are often viewed as either non-recurring or not reflective of ongoing financial performance or have no cash impact on operations; and (iv) it is used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by backing out 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 expense). The term Adjusted EBITDA is not defined under U.S. generally accepted accounting principles ("U.S. GAAP") and is not a measure of operating income, operating performance or liquidity presented in accordance with U.S. GAAP. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation, or as a substitute for net income (loss) or other consolidated income statement data prepared in accordance with U.S. GAAP. We compensate for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only as a supplemental measure. Some of these limitations include, but are not limited to: • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not reflect interest expense, or the cash requirements necessary to service interest or principal payments, on our debt; • Adjusted EBITDA does not reflect income taxes or the cash requirements for any tax payments; and • Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. 31 -------------------------------------------------------------------------------- Adjusted EBITDA (and a reconciliation to net income (loss), the nearest GAAP financial measure) for the quarters ended March 31, 2014 and 2013 are as follows: Quarter Ended Quarter Ended March 31, 2014 March 31, 2013 (in thousands) Net loss $ (2,906 )$ (2,304 ) Interest expense, net 4,240 1,314 Depreciation and amortization 2,051 1,167 Stock-based compensation 1,049 708 (Benefit) provision for income taxes (5,832 ) 263 Business transaction costs 4,228 - Payments to founders - 527 Adjusted EBITDA $ 2,830$ 1,675 Adjusted EBITDA increased for the quarter ended March 31, 2014 as compared to the quarter ended March 31, 2013 primarily due to increased revenues related to headsets for the Xbox One console. Liquidity and Capital Resources The Company has funded its operations and acquisitions in recent periods primarily with its operating cash flows, proceeds from debt financings and invoice factoring. The table below presents a summary of our cash flows for the quarters ended March 31, 2014 and 2013: Quarter Ended Quarter Ended March 31, 2014 March 31, 2013 (in thousands) Cash and Cash equivalents at beginning of year $ 6,509 $



5,219

Net cash provided by operating activities 8,902



24,951

Net cash provided by (used in) investing activities 3,625 (254 ) Net cash (used in) financing activities (13,612 ) (27,750 ) Effect of foreign exchange on cash 128 - Cash and Cash equivalents at end of year $ 5,552 $



2,166

Net cash provided by operating activities Net cash provided by operating activities was $8.9 million during the first quarter of 2014 compared to $25.0 million during the first quarter of 2013. For the quarter ended March 31, 2014 the cash provided by operating activities consisted primarily of decreases in accounts receivable, inventory and accounts payable of $18.6 million, $8.4 million and $15.8 million, respectively. For the quarter ended March 31, 2013 the cash provided by operating activities consisted primarily of decreases in accounts receivable, inventory, accounts payable and income taxes payable of $45.1 million, $1.9 million, $16.5 million and $8.1 million, respectively. Net cash provided by (used in) investing activities Net cash provided by investing activities was $3.6 million during the first quarter of 2014 compared to $0.3 million net cash used during the first quarter of 2013. The net cash provided in the quarter ended March 31, 2014 was principally due to $4.0 million of cash acquired in the merger partially offset by capital expenditures during the period. The net cash used in the quarter ended March 31, 2013 was due to capital expenditures. 32 -------------------------------------------------------------------------------- Net cash used in financing activities Net cash used by financing activities was $13.6 million during the first quarter of 2014 compared to $27.8 million during the first quarter of 2013. The net cash used in the quarter ended March 31, 2014 is primarily due to the draw down on the new revolving line of credit of $34.4 million, net payments to close out the legacy term loan and revolving line of credit of $54.2 million as well as the issuance of $7.0 million of additional subordinated debt. The net cash used in the quarter ended March 31, 2013 is due to net repayments of the revolving line of credit and term loan. Management assessment of liquidity Management believes that its current cash and cash equivalents, proceeds received from the April 2014 equity offering, and the amounts available under its asset-based credit facility and its cash flows derived from operations will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. The Company may explore additional financing sources to fund expansion, to respond to competitive pressures, to acquire or to invest in complementary products, businesses or technologies, or to lower its cost of capital, which could include equity and debt financings. The Company cannot guarantee that any additional financing will be available on acceptable terms, if at all. If the Company raises additional funds through the issuance of equity or convertible debt, the Company's existing stockholders could suffer significant dilution, and if it raises additional funds through the issuance of debt securities or other borrowings, these securities or borrowings would have rights senior to common stock and could contain covenants that could restrict operations. Debt Obligation On March 31, 2014, Parametric and certain of its subsidiaries entered into a new asset based revolving credit agreement ("Loan Agreement"). The Loan Agreement was entered into by and among Parametric, VTB (together with Parametric "US Borrowers"), TB Europe Limited (the "UK Borrower", and together with the US Borrowers, the "Borrowers"), PSC Licensing Corp. ("PSC"), and VTBH (together with PSC, the "US Guarantors", and together with the US Borrowers, the "UK Guarantors"); and Bank of America, N.A., as Agent, Sole Lead Arranger and Sole Bookrunner ("Bank of America"). The proceeds of this borrowing were used to repay the existing revolving credit facility in the U.S. and the invoice factoring arrangement in the UK. The Loan Agreement is a $60,000,000 credit facility with designated sub-facility limits of $50,000,000 for the US Borrowers and $10,000,000 for the UK Borrower. Actual credit availability under the Loan Agreement will fluctuate because it is subject to a borrowing base limitation that is calculated based on a percentage of eligible trade accounts receivable and inventories, the balances of which fluctuate, and is subject to discretionary reserves and revaluation adjustments. The Borrowers may utilize the Loan Agreement for borrowings as well as for the issuance of bank guarantees, letters of credit and other general corporate purposes as defined by the Loan Agreement. The Loan Agreement matures in 5 years. Borrowings will bear interest at a rate that varies depending on the type of loan and the Borrower. The interest rate will be calculated using a base rate plus a margin. Depending on the type of loan, the base rate will either be a rate published by Bank of America or the London interbank offered rate ("LIBOR"). The margin will range from 1.00% to 1.50% for U.S. base rate loans and from 2.00% to 2.50% for U.S. LIBOR loans and U.K. loans. The Loan Agreement also provides for an unused line fee, letter of credit fees, and agent fees. If certain availability thresholds are not met, the Loan Agreement requires the Company and its restricted subsidiaries to maintain on a consolidated basis a fixed charge coverage ratio (defined as the ratio, determined on a consolidated basis for the Company and its subsidiaries for the most recent four Fiscal Quarters, of (a) EBITDA minus capital expenditures (except those financed with Borrowed Money other than Revolver Loans) and cash taxes paid (b) Fixed Charges (the sum of cash interest expense plus scheduled principal payments on made on Borrowed Money, Distributions made in cash, and the Permitted Earnout Payment) (as such capitalized terms are defined in the Loan Agreement). 33 -------------------------------------------------------------------------------- The Loan Agreement also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our 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. At March 31, 2014, the Company was in compliance with all financial covenants under the Loan Agreement. Loan and Security Agreement Term Loan In October 2010, Turtle Beach entered into a loan and security agreement (the "Loan and Security Agreement") with various financial institutions. The Loan and Security Agreement provided for term loans aggregating to $28.0 million. Turtle Beach's obligations under this credit facility were secured by a first priority lien against substantially all of Turtle Beach's assets. The term loans bore interest at the greater of (i) the minimum interest rate of 5.50% or (ii) LIBOR plus 4.0% per annum. Interest was due monthly. In August 2012, the Loan and Security Agreement was amended and restated to increase the principal amount on the term loans to $45.0 million and to amend the maturity date to August 22, 2015. Turtle Beach drew down $45 million of the term loan in connection with the amendment, of which $22.1 million went to pay off the outstanding balance. The term loans bore interest at Turtle Beach's option at (i) the Adjusted Base Rate plus the applicable margin ranging from 2.50% to 3.25% as determined by Turtle Beach's total leverage ratio, or (ii) LIBOR, plus the applicable margin ranging from 3.50% to 4.25%. The Applicable Base Rate is equal to the highest of (a) the Prime Rate as determined by the syndication agent, (b) Federal Funds Rate plus 0.5% and (c) the LIBOR rate plus 1%. On January 15, 2014, we repaid $7.0 million of the term loan with proceeds from a $7.0 million subordinated note, and on February 28, 2014 we repaid the remaining $7.5 million principal balance with funds from operations, as required by amendments to the Loan and Security Agreement entered into during the first quarter of 2014. See "2014 Amendments" below. Revolving Line of Credit In August 2011, the Loan and Security Agreement was amended and restated with various financial institutions to include a $15.0 million revolving line of credit. In August 2012, the Loan and Security Agreement was amended and restated to increase the borrowing capacity on the revolving line of credit to $55.0 million. As part of the amendment, the outstanding balance of $10.0 million was paid off. During the year ended December 31, 2012, subsequent to the amendment, Turtle Beach drew down $38.0 million on the revolving line of credit. The maturity date on the revolving line of credit was amended to August 22, 2015. The revolving line of credit was subject to limitations based on specific percentages of eligible accounts receivables and inventory and bore interest at Turtle Beach's option at (i) the Adjusted Base Rate plus the applicable margin ranging from 2.50% to 3.25% as determined by its total leverage ratio, or (ii) LIBOR, plus the applicable margin ranging from 3.50% to 4.25%. The Applicable Base Rate is equal to the highest of (a) the Prime Rate as determined by the syndication agent, (b) Federal Funds Rate plus 0.5% and (c) the LIBOR rate plus 1%. 2013 Amendments to Term Loan and Subordinated Notes Turtle Beach entered into amendments to the Loan and Security Agreement in July 2013 and August 2013 (the "2013 Amendments"). The 2013 Amendments waived certain defaults of the fixed charge coverage ratio by Turtle Beach, and also provided for a new minimum EBITDA financial covenant, modifications of the fixed charge coverage ratio and maximum total leverage ratio for periods ending on or after September 28, 2013, and a modification of annual clean-down requirements with which Turtle Beach would need to comply in order to provide for an increase in the eligible amount outstanding under the facility. In addition, the 2013 Amendments amended the interest rate on the outstanding term loans under the Loan and Security Agreement and required Turtle Beach to issue $10.0 million of subordinated notes to reduce the outstanding borrowings on the term loan. In August 2013, Turtle Beach issued $10.0 million of subordinated notes to certain affiliated investors, including SG VTB Holdings, LLC, Turtle Beach's chief executive officer and a director of Turtle Beach. On January 15, 2014 we issued an additional $7.0 million of subordinated notes on similar terms and used the proceeds to pay off an equivalent amount of term loan debt under the loan and Security Agreement. 34 -------------------------------------------------------------------------------- 2014 Amendments On January 15, 2014, in connection with the consummation of the Merger, Parametric became an obligor and guarantor under the Loan and Security Agreement, and the Company entered into an amendment to the Loan and Security Agreement to (i) allow the Company to incur an additional $7.0 million of subordinated indebtedness, (ii) provide for the repayment of the term loan portion of the facility by February 28, 2014, (iii) change the maturity of the revolving line of credit portion of the facility to September 27, 2014, (iv) reduce the commitments under the revolving line of credit to $35.0 million after March 1, 2014, (v) increase the margin pursuant to which interest on outstanding amounts under the Loan and Security Agreement was calculated by 0.75%, and (vi) modify the financial covenants contained in the Loan and Security Agreement. On March 13, 2014, the Company entered into an amendment to the Loan and Security Agreement to (i) increase the maximum principal amount of the lenders' revolving loan commitment between February 28, 2014 and April 15, 2014 from $35 million to approximately $39 million, (ii) provide that the borrowers, on or prior to April 15, 2014, would reduce the aggregate dollar amount of revolving loans outstanding under the Loan and Security Agreement to the lesser of $35 million or the Company's borrowing base (calculated in accordance with the terms of the Loan and Security Agreement) as of such date, (iii) waive the Company's obligation to deliver certain certificates regarding its liquidity and borrowing base for the fiscal month ended February 28, 2014, and to specify the delivery date of such certificates during March 2014 and April 2014, (iv) eliminate a requirement that the borrowers reduce the aggregate dollar amount of revolving loans and swing loans outstanding under the Loan and Security Agreement to an amount no greater than $25 million for a thirty consecutive day period during the first fiscal quarter of each fiscal year, and (v) eliminate the lenders' obligation to make additional revolving loan commitments after February 28, 2014. Invoice Factoring Prior to March 31, 2014, Parametric's UK Subsidiary ("TB Europe") had an accounts receivable factoring arrangement with a third-party financial institution in order to accelerate its cash collections from product sales. This arrangement involved the transfer of ownership of eligible trade accounts receivable up to a maximum of £5.0 million at any time, without recourse, to the third-party financial institution in exchange for cash. As of December 31, 2013, TB Europe sold trade accounts receivable of approximately $5.7 million to the third-party financial institution, which was netted against accounts receivable on the Company's balance sheet. . The invoice factoring arrangement was terminated on March 31, 2014, and related borrowings were fully paid with proceeds from the Loan Agreement described above. Series A convertible stock In conjunction with the Merger, $24.4 million principal amount of the Series A convertible stock was converted into shares of our post-Merger common stock pursuant to an exchange ratio as specified in the Merger Agreement. Series B redeemable preferred stock In September 2010, Turtle Beach issued 1,000,000 shares of its Series B Preferred Stock with a fair value of $12.4 million. Turtle Beach is required to redeem the Series B Preferred Stock on the earlier to occur 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. The redemption value was $14.0 million and $13.7 million as of March 31, 2014 and December 31, 2013, respectively. Critical Accounting Policies and Recent Accounting Pronouncements The Company's consolidated financial statements are prepared in accordance with U.S. GAAP and include its accounts and the accounts of its wholly-owned subsidiaries. The preparation of these consolidated financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the applicable periods. The Company's management bases its estimates, assumptions and judgments on historical experience and on various other factors that it believes to be reasonable under the circumstances. 35 -------------------------------------------------------------------------------- Different assumptions and judgments would change the estimates used in the preparation of the Company's consolidated financial statements, which, in turn, could change the results from those reported. The Company's management evaluates its estimates, assumptions and judgments on an ongoing basis. Refer to Note 2 - Summary of Significant Accounting Policies in our Prospectus Supplement filed with the SEC on April 24, 2014. Off-Balance Sheet Arrangements Off balance sheet arrangements are transactions, agreements, or other contractual arrangements with an unconsolidated entity for which the Company has an obligation to the entity that is not recorded in the consolidated financial statements. The Company does not have any significant off-balance sheet arrangements. Contractual Obligations The Company's principal commitments primarily consist of obligations for minimum payment commitments to leases for office space, Turtle Beach's term loan and revolving line of credit. As of March 31, 2014, the future non-cancelable minimum payments under these commitments were as follows: Payments Due by Period (in thousands) Less Than One More Than Five Total Year 1 - 3 Years 3 - 5 Years Years Contractual Obligations: (1) Operating lease obligations (2) $ 3,566$ 886$ 1,259$ 1,098 323 Series B redeemable preferred stock (3) 51,928 - - - 51,928 Principal payments on long term debt (4) 34,490 34,490 - - - Due to shareholders 3,125 3,125 - - - Subordinated notes (5) 17,737 17,737 - - - Total $ 110,846$ 56,238$ 1,259$ 1,098$ 52,251 (1) Contractual obligations exclude tax liabilities of $1.5 million related to uncertain tax positions because Turtle Beach is unable to make a reasonably reliable estimate of the timing of settlement, if any, of these future payments. (2) Operating lease agreements represent the Company's obligations to make payments under non-cancelable lease agreements for its facilities. (3) In September 2010, Turtle Beach issued shares of its Series B Preferred Stock. If the Series B Preferred Stock is still outstanding as of October 2030, the Company will be required to redeem the shares for an aggregate of $51.9 million, which is comprised of the aggregate purchase price of $12.4 million plus cumulative preferred dividends of 8.0% per annum, or $39.5 million in the aggregate. (4) On March 31, 2014 the Company entered into a new Loan Agreement. See Footnote 8 - Long-Term Debt to the Condensed Consolidated Financial Statements included in this Form 10-Q. (5) On August 30, 2013, Turtle Beach issued $10.0 million of subordinated notes to certain affiliated investors, including SG VTB Holdings, LLC, our Chairman of the Board and our Chief Executive Officer, the proceeds of which were applied against the outstanding balance of the term loan. On January 15, 2014, Turtle Beach issued $7.0 million of additional subordinated notes to SG VTB Holdings, LLC the proceeds of which were also applied against the outstanding balance of the term loan. Accrued interest on the subordinated notes was $0.7 million at March 31, 2014. 36



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