Sonos: Weak Financial Performance Ahead (NASDAQ:SONO)

Company description

Sonos, Inc (NASDAQ:SONO) is a company that designs, develops, manufactures, and sells wireless audio products globally. Its products include wireless speakers, home theater speakers, components, and accessories. The company distributes through retailers, as well as their e-commerce store.

Share price

Sonos’ share price has had an eventful few years, gaining significantly due to post-pandemic demand driving impressive revenue gains. As things have softened, the share price has quickly rerated.

Financial analysis

Presented above is Sonos’ financial performance since 2015, summarized as continued development.

Revenue has grown at a CAGR of 10%, driven largely by FY21. This being said, Sonos has shown a consistent ability to achieve 5%+ growth. FY21 was an unusual year, with consumers leading a spending splurge, driven by pandemic-related financial support and the end of the lockdowns. What is more important for us is the sustainability of revenue growth. One of the reasons Sonos has been able to achieve its current growth rate is due to the company’s current market positioning. Sonos has married the two key areas of development in the speaker market, that is technology and quality. The primary spenders in the industry are the younger generation, who are increasingly incorporating tech into their lives. Many of the large tech players such as AAPL and AMZN have launched speakers in recent years, focused on technological integration rather than sound and build quality. On the other end of the spectrum, legacy businesses have focused on sound, targeting audiophiles as they lose market share in the wider consumer industry. Sonos on the other hand has focused on both, building a quality tech platform while selling the premium image. This has given Sonos a leading image in the industry.

Another revenue driver is customer satisfaction. As simple as that sounds, Sonos is producing great products. The interesting dynamic with the speaker industry is that in most cases, consumers can benefit from having multiple products. For example, a (wealthy) household could have 3 Sonos All-In-One speakers (Living room, Kitchen, Bedroom), as well as, a home theater system. This combination would cost several thousand dollars but allows consumers to keep their system within one ecosystem. The graph below illustrates the growth in the install base, with the increase being driven predominantly by “Existing Households”.

Further, if we look at reviews for many of Sonos’ products (RTings is a highly regarded review site), the consensus is that the brand produces fantastic products for their price.

Furthermore, Sonos has consistently launched new products, allowing the business to diversify its revenue stream while increasing its reach within the wider speaker industry. Although these are not revolutionary products, they represent continued technological development alongside increasing reach, which in the long term will be beneficial.

For these reasons, we consider Sonos’ revenue to be of high quality, driven by commercial improvement on Sonos in the marketplace. As of Q1-23, the company is a market leader according to NPD, reiterating its positioning as a premium offering that justifies its price point.

Gross profits had been trending up, improving from 45% in FY15 to 47% in FY21. This is a reflection of Sonos’ impressive pricing power, with the business able to command a higher price than many in the industry. Further, the company has been increasing its direct-to-consumer and installer solutions, which are higher-margin distribution segments, due to the lack of a middleman. This being said, margins have slipped in the LTM period, driven by greater discounting and a reduction in DTC. This is due to slowing economic conditions, with Sonos needing to be more price competitive to maintain sales.

Sonos’ EBITDA has been consistently improving but not necessarily at the rate one would expect. This is due to very high R&D spending, with a 13% CAGR in 8 years. An attractive operational profile would be c.30% of revenue, with Sonos currently at far higher at 40% (25% S&A, 15% R&D). Our view is that this is not a concern currently, as the company is still creating more products, which we believe is needed to continue healthy growth. As the following illustrates, the R&D developments are translating into patents.

These factors have contributed to great growth but a fairly unattractive profitability profile, with EBITDA only reaching double digits once, and FCF being negative. With this in mind, EBITDA margins may remain “artificially” low while the company invests in R&D. If R&D spending was to hypothetically fall to c.8% of revenue, its EBITDA margin would increase to 12%, which is still not amazing.

Moving onto the balance sheet, the company’s poor profitability is reflected in its ROE, which is a sorry 3%.

Inventory turnover has increased almost 1x, which is unusual compared to many in the industry who have found themselves accumulating inventory due to slowing demand. This suggests good operational controls over stock and reduces the risk of deep discounts in the coming year.

Further, the company is well capitalized, with a net debt balance of (398)k. This will allow the business to be more flexible with investing in future growth, while not having to be concerned with growth slowing.

Overall, we are lukewarm about Sonos’ financial performance. Profitability is quite unattractive but is a reflection of a growing business. Revenue on the other hand is attractive, being driven by recurring customers and successful product development. This leads to the question of whether the current growth is attractive enough to offset the current profitability. Our view would be no, given that growth is seemingly slowing.

Outlook

Presented above is Wall Street’s consensus view on the coming 5 years.

Revenue is expected to grow at a rate of 6%, with an initial slowdown in FY23. The slowdown looks conservative given Sonos is potentially overly exposed to an economic slowdown. The medium-term growth rate looks more reasonable, with analysts likely taking a similar view on revenue that we do. Sonos has only penetrated 2% of the global audio market, leaving significant scope to expand both geographically and by product.

Further, Sonos will likely continue with its success in generating recurring sales. Based on the assumption that trends continue as they are, Sonos calculate an incremental revenue opportunity of $5BN, which is over double the LTM revenue.

Margins are where the interesting margins are. Analysts are forecasting an initial jump in EBITDA margin, followed by an incremental improvement over the 5 years. With revenue slowing, it looks to be a good time for Sonos to transition its profitability model toward EBITDA rather than growth. As we assessed earlier, an 8% R&D spend as a % of revenue looks reasonable as it generates an EBITDA margin of 14%, which looks to be what analysts see occurring in FY27.

Economic headwinds

We are currently experiencing heightened inflation across the West, which is contributing to slowing discretionary spending. The reason for this is that it is reducing consumers’ financial strength, as a greater proportion of income is committed to living expenses. Interest rates are compounding the impact of this, with borrowing costs rising noticeably. This is an issue for Sonos as its products are not a required spend for consumers, meaning it is easily foregone or deferred. Further, as a premium offering, the company is more greatly exposed, due to a higher elasticity.

In the most recent quarter, Sonos has seen Revenue increase by 1.2% Y/Y on a constant-currency basis. Although it is positive that revenue continues to grow, GPM has declined Y/Y to 42.4%, suggesting this revenue growth is low-quality, driven by discounting activities. Whether growth continues in the coming quarters is uncertain but it is likely GP will fall.

Looking ahead, our view would be that demand for discretionary products will continue to soften, as inflation continues its slow decline. As we have stated, our view is that revenue will decline at a greater amount than analysts are forecasting, with a bounce back likely in FY24.

Peer comparison

To assess Sonos’ relative performance, we have utilized Seeking Alpha’s rating system, which compares Sonos to a peer of Consumer electronics businesses.

From a profitability perspective, Sonos scores better than we expected. Its GPM rating is a B, which supports our view that the company can command a premium price for its products. From this point, the ratings are lower, with a D+ for EBITDA and C for net income. At these levels, our view is that Sonos looks relatively attractive, on the assumption that growth outperforms the market.

Unfortunately, Sonos’ growth is not great currently. This is primarily due to the slowdown we are currently experiencing and means the company’s past performance is hidden somewhat. The company will likely kick on growth-wise over 5 years, however, the next 12-24 months could be tough. Importantly, this suggests that Sonos is overly exposed to cyclical changes.

Valuation

Sonos’ valuation does not align with its current performance, with the business trading at a steep premium to its peers. Given the marginal profitability, it may be more appropriate to consider sales, where Sonos is still slightly more expensive. Investors are likely pricing in margin expansion and a return to growth, which we do see occurring. However, this is not likely to occur in the coming 12 months and so the stock will likely be dead money, potentially seeing its share price trending down.

Final thoughts

Sonos has done well to develop its brand in a highly competitive market, growing market share healthily and keeping customers happy. Those it has enticed are buying more products over time, remaining within the Sonos ecosystem. Further, R&D spending will allow the company to continue to develop its product offering. From a commercial perspective, we see long-term value with this business. Financially, growth has been attractive, with the brand positioned fantastically in the market. This said the profitability is not at the level required, especially when considered in conjunction with growth.

Our view is that investors should avoid Sonos in the coming 12-18 months, with only downside risk with slowing demand ahead and no valuation upside. We do see long-term value once margins improve and growth returns and so this stock should certainly be revisited once economic conditions change.