SoundHound AI: Rich Valuation, Poor Prospects

Overview

Audio processing and speech recognition technology company SoundHound AI (NASDAQ:SOUN) posted a close-to-consensus Q1 2023 quarter, marginally missing across both top and bottom lines. The stock was sold off in response to the earnings report, indicating ongoing negative sentiment around its recent results.

This is also a stock that appears to have benefited from ongoing AI hype in this recent cycle, having appreciated 98.47% YTD, well in excess of the NASDAQ Composite.

This article will review SoundHound’s performance and valuation while including the fresh information that we have from the latest earnings report.

Fundamentals

SoundHound continued to grow revenues briskly y/y. While notably a cyclical business, the firm has maintained a high double-digit growth rate when looking at numbers year-over-year. The latest quarter’s revenue growth figure of 56.34% and 87.96% for gross profit were quite good, albeit indicating a drop-off from the blistering growth rates that it has seen in the last 2 quarters. I will note that the absolute numbers here are quite small.

The firm continued to generate an operating loss in its latest quarter.

This represented an accelerating y/y operating loss and an overall operating margin of -319.86%. The company’s cost structure and well above its current revenue growth levels. SG&A expenses also ticked up q/q, indicating that management has its foot on the gas in terms of growing revenues.

Indeed, net income continued to decline, albeit at a slower rate. The company lost $26.4M on a net basis last quarter – a disconcerting -394% net margin.

On the cash side, the picture doesn’t look much better. Cash from operations stayed negative and further declined 3.48% y/y.

Overall, this looks like the company is spending more on growth than it is bringing it. The unit economics here are quite poor and have actually deteriorated y/y in its most recent quarter.

As to financing, the company recently acquired a $125M loan facility (due 2027) in order to improve its credit profile and balance sheet. Also worth noting is that the firm issued $30.8M worth of common stock last quarter and increased its common shares outstanding by 7.25% q/q, a material dilution. At a total cash from financing figure of $51.6M last quarter, it appears that the company drew down $20.8 from its new credit facility in addition to the equity financing.

This has provided the company with $46.3M of total cash in its most recent period. Immediately we should note that this company would have ran out of cash had it not been for the last-minute equity and debt issuance. That’s a significant red flag.

Considering SoundHound’s latest quarter’s operating cash loss of $14.5M, this represents cash-on-hand for only 3.2 quarters. If the firm is to draw down the remaining $100M of its loan facility, this would be extended by another 6.9 quarters at the current run rate. While the interest rate on the new loan facility was not made clear by the company, I think this picture is concerning. Unless the company can rapidly change its cash flow profile, it will have to make further use of this loan facility and put cash pressure on what is already a business operating well into the red. This could kick off a vicious cycle.

Overall, I do not like what I see with these financials. The company is spending far more than $1 for every $1 of marginal revenue growth. This, combined with the relatively dire cash situation, does not bode well. Additionally, we should note that SoundHound has an Altman z score of -8.8. This could be considered ‘abysmal’ and a strong indicator that the company could very well go bankrupt.

Additionally, we should note that short interest now stands at 11.75% of the float and has been ticking up, with a 7.54% average shares shorted/float over the last 30 days.

Business, Risks, and Valuation

While SoundHound could very well have a large total addressable market for its audio processing software, it is lacking the most important aspect of any business competing in AI: scale.

Consider a company like Amazon, which has a very mature voice-recognition capability due to its long-standing Alexa business. Amazon could readily step in and eat SoundHound’s lunch in its target market. Given how much larger Amazon is, and how much more data it has, the product would quite likely be better off the bat. Given the very close relationship between data quantity and AI system quality this is a sensible conclusion to draw.

As such, SoundHound has no real moat for the long-term. If the company is to survive the short-term, this is a significant downside risk for the company long-term that isn’t going away.

Along with all of this, SoundHound is trading at a rich valuation. It has a 442.7% price/sales premium to the IT sector on a TTM basis and a 378.51% price/sales premium to the IT sector on a forward basis.

Given the way that the business is going, I see there being no justification for this valuation. This company is nowhere near profitability while it is spending $3.94 for every $1 of revenue it is bringing in. This, combined with its poor structural positioning versus the AI goliaths, points to a lack of rationale for this valuation across both the short and the long term.

Conclusion

Across the board, it is clear that this is not a good stock. I believe that this company benefited from having ‘AI’ in its name but doesn’t have the business, or frankly the business prospects, to deserve its valuation.

As with the investors already selling this short, I would consider this to be a decent target for selling short. The very significant risks around doing so involve the fact that this company's share are cheap on an absolute basis and that this is volatile relative to the market, with a 24-month beta of 1.82. This could create price swings with large percentage moves upwards and result in significant margin interest obligations for investors selling short. Overall, I do not recommend shorting in this particular instance. Nonetheless, SoundHound overall is a sell.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.