2023-08-10 12:49:19 ET
Summary
- Although there were some improvements in Q3, I believe Sonos will continue to find it difficult to cope with macroeconomic challenges in the next few quarters.
- As I believe the company’s current valuation accurately reflects the challenges the business is facing, valuation is not a main factor in my bullish stance today.
- My bullish stance on Sonos stems from the large addressable market opportunity and the superior quality of Sonos products, which are both quantifiable as I reveal in this analysis.
Sonos, Inc. ( SONO ) stock jumped more than 7% in after-hours trading yesterday after the company reported better-than-expected revenue and earnings for the third quarter of Fiscal 2023. Given that I am sitting on losses from my investment in Sonos – not that it actually matters to me in the short run – I welcomed yesterday’s seemingly strong earnings report, but at the same time, I would have preferred a more pronounced improvement in the inventory levels. After digesting third-quarter earnings, I am not convinced of a notable recovery in Sonos’ financial performance in the next couple of quarters, but as a long-term-oriented investor, I have decided to remain long because of two major reasons.
Q3 Earnings Report; Nothing Too Exciting
For the third quarter, Sonos reported revenue of $373.4 million, a 23% sequential improvement. Although this double-digit revenue growth looks good on paper, products sold declined by 11%, highlighting the challenging demand environment the company is facing today. Compared to the third quarter of the previous fiscal year, revenue grew just 0.4%. The company raised the prices of many of its popular products and there was a favorable shift in the product mix toward high-value items, which helped offset the impact of the notable decline in products sold.
The company reported adjusted EBITDA of $34.3 million for Q3, a notable decline from $42.1 million in Q3 2022. Rather concerning was the decline in adjusted EBITDA margin from 11.3% to 9.2%. Even on the back of cost savings resulting from a 7% reduction in the headcount, a 50% reduction in leased office space in Boston, and a $700,000 FX tailwind, margins took a hit, highlighting the need for more operating efficiencies and scale to drive profitability higher.
Exhibit 1: Q3 financial performance highlights
Earnings presentation
The full impact of cost reduction initiatives will not be felt until after a few quarters, and I believe it is reasonable to expect some operating leverage in the next fiscal year if demand trends move in the right direction.
Revenue in the Americas segment grew 8% YoY, supported by resilient consumer demand amid inflationary pressures. However, both EMEA and APAC regions reported YoY revenue declines of 28% and 4%, respectively, highlighting the challenging business conditions in these fast-growing regions. My investment thesis for Sonos is centered around expectations for higher adoption of premium home entertainment solutions – including audio products – on a global scale, especially in emerging markets where there are signs of a strong middle-income society. The lackluster Q3 performance of Sonos in the APAC region underscores the weakening strength of consumers in this region. With consumer discretionary spending taking a hit in most global regions, I do not expect my expectations for higher spending on premium audio products to materialize in the next few quarters.
Total inventories declined by 9% compared to the previous quarter, which is an encouraging sign given that Sonos has been grappling with inventory management problems in the recent past amid lower-than-expected demand growth. Granular details on the inventory balance reveal that finished goods have trended in the right direction, while the components balance grew 12% QoQ, primarily because of the challenging demand environment. I was expecting a pronounced improvement in the inventory levels given that Sonos has taken strategic steps to reduce inventory, but macroeconomic challenges are keeping the company’s progress at bay.
Exhibit 2: Inventory trends
Overall, the third-quarter earnings report of Sonos highlights the many challenges the company is facing today. While most of these challenges stem from unfavorable macroeconomic developments, the company’s inventory management strategy will need to be closely monitored, as the last thing shareholders want to see is the company losing market share in the next growth phase because of a failure to cater to consumer demand.
Two Reasons To Remain Long
Sonos is not cheaply valued, but I expect the company to enjoy premium valuation multiples over an extended period, given that the company has a long runway to grow. Because I believe the company’s current valuation accurately reflects the challenges the business is facing, valuation is not a main factor in my bullish stance today.
Superior product quality is the first reason why I remain long. Competitive advantages can stem from different factors, and product quality certainly is a moat source, in my opinion. When you look at the customers of Sonos, the company is targeting higher-income households, as its products are priced at a premium to many of the home audio products available in the market. This customer cohort expects premium quality, and Sonos has been able to meet or exceed their expectations consistently in the last few years despite increasing competition. Recently, I came across an interesting post on Sonos Community published eight years ago predicting the death of Sonos due to rising competition. But here we are, with Sonos still enjoying a comfortable lead over many of its peers in key markets, primarily because of the premium quality products it launches every year.
Exhibit 3: A Sonos Community post that predicted the end of the company 8 years ago
A key differentiator of Sonos is its open platform approach which enables users to connect with a wide variety of content partners, home automation products, and voice assistants. This open platform approach has been a key pillar of the company’s success, as Sonos has been able to welcome consumers from different ecosystems with this strategy.
Exhibit 4: The open platform approach enhances options for users
A closer look at the purchasing patterns of existing Sonos customers leaves me with no doubt that Sonos customers – including yours truly – are truly impressed by the quality of the company’s audio products. At the end of 2022, 60% of Sonos households used multiple products, and existing customers accounted for 44% of new product registrations in 2022.
Exhibit 5: Existing Sonos households are driving growth
Investor presentation
In addition to confirming the superior customer satisfaction associated with Sonos products, purchasing habits of existing customers reveals an opportunity for the company to grow the lifetime value of its customers by continuing to launch innovative, high-quality products over time.
Although I do not want to assign Sonos a strong economic moat yet, I believe the quality of the company’s products will help Sonos enjoy durable competitive advantages in the long term.
The large addressable market opportunity is the second reason why I want to remain long today, despite the company suffering from short-term headwinds. According to the company, the premium global home audio market is valued at $22 billion today, and Sonos controls less than 10% of this market. The company, in its presentations, has used a 2% market penetration rate based on its belief that Sonos will be able to capture a share of the much larger global home audio market, but I believe investors need to focus on the prospects for the premium home audio market where Sonos is already a leading player.
An evaluation of content consumption patterns reveals that video, audio, and gaming activities account for the bulk of tech and media activity of the global population today. Recent data shows that the pandemic-induced increase in online content consumption has persisted even in the post-pandemic era. In a survey, DoubleVerify found that this increase in online content consumption is spread across almost all regions.
Exhibit 6: Percent of survey respondents that spend more time-consuming online content
The surging demand for online content consumption coincides with the growth of OTT video streaming as well, in addition to growth in many content formats such as podcasts and music streaming. Using this data and the increasing prevalence of remote working, we can assume that at-home content consumption is continuing to increase. This, in return, will boost the demand for home audio products, including premium products.
Next, emerging economies are expected to catch up – at least partially – with the income levels of the developed world in the coming decades. Emerging markets, therefore, will be a growth driver for the premium home audio market in the coming years. Sonos is strategically expanding into many emerging markets including India, several South Asian nations, and the Middle East, which should open new doors for the company to grow.
Based on these reasons, I believe Sonos enjoys a large addressable market opportunity.
In summary, I remain long SONO stock because of the premium quality of Sonos audio products, which should help the company enjoy competitive advantages and the large addressable market opportunity.
Takeaway
I am neutral on Sonos’ third-quarter earnings. Although there were some improvements, I believe the company will continue to find it difficult to cope with macroeconomic challenges in the next few quarters. Looking at the long term, I believe Sonos is a company that has the potential to earn economic profits far exceeding its cost of capital, given my belief the company will scale profitably.
For further details see:
Sonos Stock: 2 Reasons Why I Remain Long