Sonos: We Are Buying Into Weakness

Introduction

Sonos, Inc. (NASDAQ:SONO), sent shockwaves through the market when it reported its earnings on May 10, causing its stock to plummet by almost 30% within just five days. Currently trading near levels last seen in 2020, this drastic drop has raised eyebrows and divided opinions among analysts. While Seeking Alpha analysts lean towards a sell rating, Wall Street sees it as a buying opportunity. Intrigued by this divergence, we delve into a comprehensive review of the company's fundamentals and offer our insights on the potential future trajectory of the stock.

Key Takeaway from Q2 2023 earnings

Sonos recently issued a warning about declining demand in the home theater category, citing macroeconomic factors and increased competition as contributing factors. In Q2 2023, the company experienced a significant 23% drop in revenues, resulting in decreased margins and a downward adjustment of its 2023 guidance. Sonos acknowledged that part of the reason for this decline was retailers reducing replenishment orders due to excessive inventory. However, the management remains optimistic that margins will improve in the second half of the year, and they anticipate a narrower decline of around -5% in revenues on a constant currency basis. These disappointing Q2 results have undermined investor confidence in Sonos' game-changing Era 100 and 300 products:

Sonos CEO Patrick Spence commented, "This quarter we made outstanding progress in delivering on our product roadmap with the launch of two new game-changing products, the Era 100 and 300, both the best of their kind. And we entered a new product category with our SaaS-based Sonos Pro offering."

Fundamentals

Loyal customer base

However, over the past five quarters, Sonos-Americas has consistently outperformed the overall U.S. electronics and appliance store industry, with the exception of Q1 2023. While Q1 2023 may have presented some hurdles, Sonos-Americas' track record highlights its resilience.

One of Sonos' notable strengths lies in its seamless connectivity across devices and support for various streaming services. Analyzing the data reveals robust customer loyalty, evident in the increasing number of Sonos products per household. This indicates that Sonos' connectivity features have a market with untapped potential, suggesting further room for growth and expansion.

Sonos offers a price range spanning from $99 to $899, positioning itself between more affordable options like the $19 Google Home or Alexa and the most expensive, high-end alternatives. The company targets affluent customers with an average annual income above $75,000. This approach seems justified considering the average number of Sonos products per household is 4.3. It's unusual for a small household to own that many devices, indicating that Sonos has a strong consumer buying capability and a loyal customer base. These statistics suggest that Sonos has successfully attracted customers with purchasing power and fostered customer loyalty.

Is the company innovating enough or just wasting money?

Sonos has gained a reputation for its continuous introduction of new and innovative products, evident in its high investment of 12% of revenue in R&D. This R&D expenditure is notably higher than that of many other consumer product companies. For comparison, in FY 2020, Apple allocated approximately 8.2% of its revenue towards R&D.

While Apple may not be perceived as actively innovating its iPhone in terms of functionality, the level of R&D spending provides investors with insight into the company's commitment to research and development.

The CEO of Sonos emphasized that the launch of Era 100 and 300 marked a significant turning point for the company. In the past, Sonos was frequently compared to Bose, a leading consumer audio equipment company. Sonos received praise for its connectivity and support for various streaming services, while Bose was lauded for sound quality. However, the Era 100 and 300 have garnered endorsements not only for their quality but also for their spatial audio performance. Traditionally, consumers had to set up multiple speakers to achieve spatial audio, whereas Sonos' Era speakers require just one. This indicates that Sonos' R&D efforts have supported its innovative advancements.

However, the innovative nature of Sonos' products can be a double-edged sword. On the one hand, the company employs a strategy that encourages consumers to purchase its latest models by discontinuing support for older models in the future. This approach has proven effective for companies with a loyal fan base, as Apple demonstrated in its early days.

However, this strategy also introduces risks, particularly in the face of deteriorating macroeconomic conditions and shifting consumer behaviors. In 2022, the consumer electronics market experienced a slower pace of growth due to various factors, including a shift in consumer spending towards travel and the impact of inflationary pressures. Sonos, heavily reliant on distribution channels, faced a slowdown in sales growth. The company's direct-to-consumer sales accounted for only 22% of its total sales, and the wholesale channel based its orders partly on DTC performance. Although Sonos witnessed significant DTC sales growth from 2019 to 2021, the 5% decline in DTC sales in 2022 influenced the purchasing decisions of the wholesale channel in 2023. This context, in our opinion, clarifies Sonos' unexpected revenue decline in Q2 2022.

Network effect

The company's statistics, based on the overall number of households that own Sono's products, indicated an 8% penetration rate among wealthy households. However, if we adopt a more conservative approach that considers only households owning multiple devices, the penetration rate is 4.9%. This rate is often seen as the 5% threshold for network effects to emerge. At this level, the network gains momentum and experiences positive network effects, leading to increased value for each user as the network expands through more user participation. This signifies the potential for further growth and benefits as more users join the network.

Valuation

Sonos' stock is currently trading at a forward P/S ratio of 1.2x, which is relatively low compared to its historical range.

In comparison to electronic companies like VIZIO Holding Corp. (VZIO) and GoPro (GPRO), Sonos' stock trades at a premium, reflecting its strong pricing power demonstrated by significantly higher gross margins. These gross margins are comparable to those of Apple Inc. (AAPL), indicating Sonos' strong pricing power, especially considering that Apple has higher margins on its services. However, Sonos' stock is trading at a much lower P/S ratio than Apple's 7.1x.

Risks

Competition poses a significant risk to Sonos, as the company heavily relies on its new product offerings. Sonos' decision to partner exclusively with Apple Music could have both advantages and disadvantages. On one hand, it provides a unique selling point, but on the other hand, it exposes Sonos to competition from Apple itself, which has a stronger product line and a larger customer base.

Furthermore, the emergence of AI technology, with substantial investments from companies like Google and Amazon, could disrupt the traditional audio equipment industry. If these companies successfully launch AI assistants for home speakers, it has the potential to reshape market dynamics and pose further challenges for Sonos.

Catalysts

There are two key areas driving the upside potential for Sonos stock. First, the stock can be repriced through multiple expansions as a result of improved margins. Despite the presence of numerous competitors, Sonos has successfully increased product ownership among consumers, indicating strong customer loyalty. This has the potential to lead to steady margin growth in the long term.

Second, Sonos has focused on providing connectivity across streaming services, which aligns well with the global expansion of streaming service companies. Sonos has generated 33% and 7.5% of its revenues from EMEA and APAC, respectively, while streaming service providers, such as Spotify and Pandora have significant global user bases. This suggests a promising opportunity for Sonos to expand internationally alongside the growth of streaming service providers.

Summary

Our investment philosophy favors consumer products with a loyal customer base, and Sonos aligns with this strategy. The company's lack of debt, combined with a 5% penetration rate among its loyal consumers, presents a good risk-reward investment opportunity. Sonos operates under a traditional business model and currently trades at a valuation multiple that is at its lowest point in the past five years. While competition risks exist, there are no imminent threats to the market space, reducing the overall perception of risk. Additionally, Sonos has the potential to improve margins and experience accelerated revenue growth in the second half, making the timing and price level of investment attractive. We rate the stock as "Buy".