2023-07-19 18:33:30 ET
Summary
- Sonos, known for its high-quality audio products, is facing challenges due to a significant increase in inventory over the last two years, raising concerns about weakening demand and potential impact on margins.
- Despite these challenges, Sonos is making efforts to streamline operations, including a 7% workforce cut and a potential reduction in real estate footprint, which could increase margins and make the stock an attractive investment.
- Sonos recently won a patent infringement lawsuit against Google, validating their intellectual property and highlighting their innovative capabilities.
- And the company's stock appears undervalued by around 50%.
The thesis: high-quality asset with some challenges
Sonos ( SONO ) develops and sells audio products, from wireless speakers to home theatre speakers, and a lot of accessories. They are known for the high quality of their products, and as we already explained in one of our previous articles :
Rather than going cheap and competing with foreign companies that can half every price, they have decided to focus on reliability and real quality of sound. This is why more than 12 million households decided to buy about 37 million Sonos devices, with 60% of customers buying more than 1 device (strong retention rate)
In that article from February 2022, we discussed also the lawsuit that Sonos filed against Google at the ITC, and the importance of such action to validate the company's patents. We also had recent developments on this side which we are discussing below.
Today, we still believe that Sonos is a high-quality asset that however is facing some challenges. The company experienced a strong increase in inventory in the last 2 years that is well above the historical average. This contributed to the concerns that demand started weakening consistently, and that margins can suffer. Inventory obsolescence risk is also real, and a big write-off will definitely not look in this period of depressed valuations. On the other hand, we noticed a much-appreciated effort to make operations leaner with a cut of 7% of the workforce and a possible cut in the real estate footprint as well.
We think that if Sonos is able to increase margins by cutting costs while waiting for demand to pick up and inventories to go down, the stock is at an attractive valuation. The market is probably underestimating the chances of these improvements taking place in the foreseeable future, and thus we believe that the stock is a BUY.
Past results and the new plan going forward
As already mentioned, since 2020 SONO accumulated inventory for as much as $450 million as of December 2022. While it now came down to $350 million during the first quarter, the number of products still in the shells compared to the pre-2021 period is still very high. This is likely demand-driven, and will likely impact the gross margins as the company empties the warehouses by lowering the prices.
Inventory (Seeking Alpha)
Another interesting development that the market probably did not like much, is the expansion of owned real estate assets - mostly offices and operating facilities.
RE Assets (Seeking Alpha)
This of course translates into two main things: (1) Capex, both for growth and maintenance; and (2) higher operating costs. Luckily the company recently pulled back on this strategy and announced a reduction of the owned square footage along with a cut in the workforce. The SG&A margin stands now above 40% and needs to be cut substantially in order to reach a positing operating income and increase cash flows. As the company will start restructuring, I expect they will incur in $11 to $14 million in extraordinary expenses. This will however benefit the company in the long run. Here's a detailed analysis of our own forecasts on margins and Opex going forward.
The reason why we do not believe in much margin improvement after 2024 is that the company needs to spend quite a consistent amount in R&D. Indeed, to keep the quality of their products superior to competitors and to continue to innovate I think they need to keep that spending at around 10-15% of revenues with little margin of cut. This of course weighs on the overall SG&A margin which is expected however to decline to 32% from the current 40% in the next 5 years.
Sonos v. Google: the ultimate validation of the Intellectual Property
As we already discussed in a previous article, Sonos was challenging Google for patent infringement. The company brought a lawsuit after claiming that Google was a "serial infringer of our patent portfolio". The litigation was filed in several districts (i.e., "normal" courts), and also in front of the International Trade Commission ((ITC)).
Among the powers of the ITC, we find that they can put in place an injunction that prohibits the infringing companies to import the infringed products in the US. And this is exactly what happened last year with this ruling .
After a long series of rulings and motions across different venues, the two companies eventually went to trial in May 2023, and Sonos won. The judge awarded SONO around $30 million for infringement of their patents. This comes however after the number of claims was restricted and the damages figure asked by Sonos was lowered from $3 billion to $90 million.
This represents a good victory for the company, not primarily from a financial perspective (although a 10% bump in cash is a good score), but definitely for validation of their own IP. This highlights SONO products and their ability to innovate the industry where they are inserted as leaders, able to compete and win against a giant like Google.
Risks and the downside case for Sonos
We also would like to highlight some significant downside risks that SONO may be exposed to. As already mentioned, the accumulation of inventory at levels above $400 million is quite risky and was driven by weaker and slower demand for their products. While in the short run I don't think this is posing any existential threat to the company - given its cash position and light capital structure - there is one problem for the long term. This is related to competition and the ability of Sonos to remain one of the top players in this niche.
If Google or Amazon or any other big competitor were to come up with a far better solution, we may face the possibility that the brand value won't be enough and competition from a better product will destroy Sonos. This however is true for most tech (if not all) companies, and we assign a very low chance of happening.
Valuation: looking into future cash flows to assess its fair value
To give a perspective on fair value, we are using a standard DCF model. We will forecast margins, revenue growth, and capex to derive FCF and discount it to get a fair value per share. Here's what the assumptions look like:
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Revenue will grow at around 10% per year throughout 2026, reflecting a return of strong demand after 2023. Then growth will decline to 8% to the end of the model.
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EBITDA margin improving from last year's 8% to 10% and then 12% reflecting gradual improvement coming from reduced SG&A margin as discussed previously.
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Capex is estimated to be divided in maintenance and growth capex, with overall spending around 3% or revenues after 2024, reflecting continued re-investments to support growth.
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Discount rate set at 10% and perpetual growth rate at 1.5% to compute terminal value.
Forecasted Financials (Author's estimates)
And this is what forecasted revenue and EBITDA look like. And the final results point out an implied undervaluation of around 50% for a fair value per share of $26.
Conclusion
Sonos is a high-quality asset with a strong MOAT derived from the quality of its products. The company has however encountered challenges in the last year with lower organic demand and accumulating inventories. We believe that SONO will be able to cut costs while capturing any incoming demand better than competitors, and the stock appears undervalued by around 50%. We assign a BUY rating with a target price of $26.
For further details see:
Sonos: A Great Value Play If Some Key Issues Are Resolved Quickly