Sonos: Still Not Liking The Sound Of This

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About: Sonos, Inc. (SONO)
by: The Value Investor
Summary

Sonos has started 2019 on a solid note, but at the same time warns for a soft Q2.

Inventory channel buildups are dangerous, as the company maintains the full year guidance nonetheless.

I see the appeal of low sales multiples, yet recognise that Sonos still has more to prove before justifying a small position.

Sonos (SONO) is a name which I have covered with great interest following its IPO. At first I was not too compelled with what I saw, but in November, I was turning more constructive on the shares, although did not find enough compelling reasons to own the shares just yet.

In November, I was compelled to the situation unfolding, that of great pressure on the shares since they went public, while the company continued to grow and was rapidly approaching break-even levels. This situation made me more upbeat at the time. While a strong start to 2019 looks compelling, reality is that Q2 will likely be very soft, although the company is maintaining the full year guidance. As such I am compelled to low (sales) valuation multiples, yet fail to see the trigger to buy the shares.

Re-Evaluation Of The Thesis

In the IPO, Sonos sold shares at $15 per share, far below the preliminary pricing midpoint of $18 per share. I was surprised to see shares run higher to $20 in the first weeks of trading, although I did note that a limited free float could result in a melt-up following the IPO, as we have seen with many other offerings in recent years.

This circumstance and the potential of Sonos being a "boom-bust" story like GoPro (NASDAQ:GPRO) or Fitbit (NYSE:FIT), made me very cautious, although the products of Sonos are truly very popular of course as the company has been around for a much longer period of time, and in fact, it is 17 years old already.

Calling out Sonos as a trend which might not last might not be shortsighted. After all, the multi-room audio solutions with great design and navigation functions are adopted by millions of users across the globe.

Valuation Talks

At the offer price of $15, with 98 million shares outstanding, Sonos was awarded a $1.47 billion equity valuation at that price, including a net cash position of $150 million. This $1.3 billion valuation for the operating assets looked very modest as sales approached the billion mark in 2017. There were two issues with that low multiple and that is that despite the popularity of the product, sales growth was not spectacular in 2017, with sales up around 10%. The bigger worry is that of an operating loss of $16 million reported in 2017, despite the popularity of the product and the premium pricing associated with it.

2018 looked to start on a strong note with first quarter sales (representing the holiday season given the different fiscal year of the company) growing by 25% to $469 million. The issue is that second quarter sales were up just 2%, while third quarter sales fell by 7% amidst pressure on pricing as losses started to increase again.

That was the situation around the time of the IPO, as the fourth quarter results (as released in November) showed fourth quarter sales increasing by 27% to $273 million, causing shares to spike from $12 to $17, although momentum was short lived. The reason for that is that the strong Q4 was driven by the "Beam," yet the popularity is apparently not seen lasting in 2019.

While fourth quarter sales growth was strong, the problem might have been in the outlook as Sonos expected 2019 sales to increase between 10 and 12% to $1.250-$1.275 billion, with adjusted EBITDA seen around $83-$88 million. Despite being in business for 17 years and posting over a billion in sales, this is not enough for Sonos to really start reporting profits.

About The Quarter

The first quarter of the fiscal year for Sonos is crucial, as first quarter sales for 2019 rose by 6% to $496 million. Comforting is that adjusted EBITDA did rise by 34% to $87 million, as the first quarter EBITDA number equals the expected profitability seen for the full year. The revenue composition shows a clear decline in sales of wireless speakers as home theatre speakers showed remarkable growth thanks to Beam.

The results contained a warning and that is slower sales velocity towards the end of the first quarter, creating higher inventory levels than the company would like to see heading into Q2. While the company does expect softness in Q2, the company is sticking to its 2019 full year outlook following the stronger first quarter and expectation of a deal with Ikea starting to contribute from Q3.

This guidance indeed confirms no real profits to be seen in 2019 as first quarter depreciation expenses came in at $10 million while stock-based compensation runs at $9 million a quarter. Annualised, these expenses come in at $76 million as some other charges result in real zero profits, for the year.

The lack of profitability being in sight makes that shares have fallen below the $11 mark, as a fully diluted share count of 112 million shares makes for a $1.23 billion equity valuation, and slightly less than a billion valuation for the operating assets of the company as the company holds $267 million in net cash. This suggests that operating assets trade at less than 0.8 times sales based on the operating assets of the business.

Continue To Be Constructive, Still Not Pulling The trigger

Having become more constructive, yet holding a neutral stance on the shares at $12 in November, I am reiterating that conclusion at $10.70 currently as the company is maintaining the 2019 guidance but some risks appear to be forming on the horizon (with regards to the second quarter of this year, as channel inventory buildups are typically dangerous things). Another concern potentially in relation to that is the departure of the CFO, which never is a comforting sign, but certainly not as this is not a well-oiled machine (just yet).

Debates about the popularity of the brand and its products, and cheap (optic) sales multiples are quite active. While some claim that this might be a great takeover candidate given the modest valuation and great brand awareness, big technology names have more often than not, not acquired these "natural" acquisition targets. Interestingly enough, Sonos believes that premium products and adoption of voice as technology, ironically by the company's biggest competitors, actually provide a tailwind for Sonos as consumers adopt voice and sound.

Hence, I continue to hold off buying the shares for now, looking for more clues about real margin gains after what will become a very difficult second quarter.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.