Sonos: Trade Sale Possibilities, Otherwise A Short

Summary

• As predicted in my article, “Sonos: Long The Products - Short The Shares”, published ahead of the Sonos Q1-2019 earnings release, results for revenue and EPS surprised to the upside.
• Also, as predicted, the results confirmed Sonos is suffering from a continuing decline in gross margins that is proving intractable. Cutting sales and marketing expense is not a solution.
• Based on share volume since the end of Sonos’ 180 day IPO lock-up on January 28, many of Sonos’ pre-IPO investors, not subject Rule 144 restrictions, will have now exited.
• That leaves an overhang of ~51 million shares held by 5% investors, over half the float, free to sell following the earnings release, and undoubtedly looking for an early exit.
• This idea was discussed in more depth with members of my private investing community, Analysts' Corner. Start your free trial today »

Sonos’ Short Thesis

The two factors discussed in my article, “Sonos: Long The Products – Short The Shares”, are still in play, following the events of the past week, culminating in the company’s first quarter earnings release, after market close on Wednesday February 6. A third factor, involving a caveat, also needs to be taken into consideration.

• Factor 1 - the need, for private and institutional venture capitalists, to exit their investments in Sonos at the best possible price.
• Factor 2 - the fundamentals of Sonos’ business do not support the current share price level, now or in the future.
• Factor 3 - In my previous article, I noted the possibility of a secondary offering to facilitate exit of the 5% shareholders, holding ~51 million shares. An alternative possibility is a trade sale. I do think that poses some difficulties. But, a trade sale would destroy the short thesis.

Sonos Short Thesis Factor 1 – Sell High, Cover Low, Expect Share Price Support To Wane

The elevated share price over the past fortnight, has undoubtedly enabled many of the Sonos early stage, pre-IPO investors to achieve an exit. The share price achieved by these investors would be in the ~$11 to $13+ range. This would likely be disappointing for these investors, as the IPO price was $15, and in the period immediately after IPO, share price rose above $22. TABLE 2 further below, shows details of the pre-IPO investors, holding ~31 million shares, and not subject to Rule 144 restrictions. These shareholders were free to trade their 31 million shares, from and including January 29, the first day after the end of the IPO lock-up period. Volume of shares for the 11 trading days, January 29 to February 13, was a little over 40 million per TABLE 1 below.

TABLE 1

As per my previous article, it would appear positive analyst recommendations together with market maker activity is the likely reason for the average share price increasing post IPO lock-up, despite share volume increasing 6.6 times compared to the comparable period pre lock-up expiry. The holders of the 31 million shares per TABLE 2 below, who were not subject Rule 144 restrictions, were private equity investors in Sonos ahead of its IPO. Most, if not all of these investors have now likely exited their positions.

TABLE 2

The share price looks like it is still following the pattern described in my previous article referred to above. If that pattern continues, there remains an opportunity to short at these elevated prices, before the share price “falls off a cliff”. I gave reasons in my previous article, why the share price could go down to the $5-8 range by 2020. There is a caveat to that, depending on what steps the 5% shareholders, holding ~51 million shares per TABLE 2 above, might do to achieve an exit. This is discussed in more detail below.

Factor 2 - the fundamentals of Sonos’ business do not support the current share price level, now or in the future.

As mentioned above, Sonos is in a catch-22 situation - it either advertises heavily to grow sales, with additional cost of advertising eating up margins, or limits advertising with resulting diminished margins. This is illustrated in TABLE 3 below.

TABLE 3

It can be seen in only one of the four cases above is the percentage margin on incremental sales greater than the full period margin percentage. For Q1-2019 the gross margin on incremental sales is negative. There is lower gross margin despite 5.8% higher sales revenue. However, Q1-2019 gross margin, net of sales and marketing expense, is up $26.14 million on the comparable figure for Q1-2018, due to a $26.87 million reduction in sales and marketing expense in Q1-2019. That is fine, but continuing to cut sales and marketing expense to offset ongoing margin reductions is unlikely to be a viable option going forward. Another concern is the 17.4% decline in wireless speakers sales in Q1-2019 compared to Q1-2018. This decrease is likely due to a boost in sales in Q1-2018 from introduction of the Sonos One speaker in October 2017. But, if increases in sales, from introduction of new products, fall away so soon as one year later, Sonos has a problem with lives of new products. No doubt, the 41.8% increase in home theater speakers sales in Q1-2019 is due to introduction of the Sonos Beam in July 2018. Sonos management provide some insights into the company's reliance on continuing innovation in these excerpts from its August 1, 2018 prospectus:

...we recently introduced our first voice-enabled speaker, Sonos One, in October 2017, and our first voice-enabled home theater speaker, Sonos Beam, in July 2018. ...Historically, we have experienced stronger revenue growth when we have introduced major new products. For example, in calendar year 2013, we introduced both our PLAYBAR and PLAY:1, which led to 75.3% revenue growth for fiscal 2014 compared to the prior fiscal year. In the three years following fiscal 2014, we introduced two products, the second-generation PLAY:5 and PLAYBASE. Due in part to this lower number of product introductions, we had lower revenue growth in those years. However, we were still able to grow our revenue at a compound annual growth rate of 8.5% from fiscal 2015 through fiscal 2017, due to sustained interest in our products, follow-on purchases by our existing customers and an expanded market opportunity.

Source: Sonos Prospectus

Click to enlarge

TABLE 3 above, shows yearly revenue growth increased from 6.8% for 2016 to 14.6% for 2018. Despite this, yearly percentage growth in gross margin, net of sales and marketing expense, has decreased from 32.5% for 2016 to 17.5% for 2018. Given the inextricable link between sales and marketing expense and gross margin, percentage growth in gross margin, net of sales and marketing expense, is a far more relevant KPI than gross margin percentage. The improvement in this KPI in Q1-2019 to 24.6% should give little comfort. It was achieved by a large cut in selling and marketing costs, compared to the comparative prior period. That is possibly not repeatable in future periods. To do this on an ongoing basis would result in sales and marketing expense being wholly eliminated.

Sonos FY-2019 And FY-2020 Projections, Based On Company EBITDA Guidance

Sonos confirmed previous guidance in their letter to shareholders dated February 6, 2019, per Figure 1, below.

Figure 1

Projections below conform to the high range of EBITDA outlook provided by Sonos.

TABLE 4

Based on Sonos outlook for EBITDA I calculate a close to break-even result for FY-2019, and ~$0.13 EPS for 2020. Based on the closing share price of $11.22 at February 12, a $0.13 EPS in 2020 would represent a 2 year forward P/E of ~86. Amazon (AMZN) has a 1 year forward P/E of 61.88, and Apple (AAPL) a 1 year forward P/E of 15. Applying those multiples to Sonos projected FY-2020 EPS would give a valuation range between $2 and $8 per share.

Sonos Short Thesis Factor 3 - The Caveat

Sonos 5% stockholders, and company employees and officers, subject rule 144, hold 52 million shares, plus 2.5 million exerciseable options. In addition to this, as per detail in my previous article, general staff of Sonos hold around 28 million in-the-money and exerciseable options. That is a lot of additional Sonos shares to sell in the public market. In my previous article, I posited the 5% shareholders might achieve an exit through a secondary offering of Sonos shares. That would not take away from the short thesis, just extend the time frame before the share price might fall off the proverbial cliff. Another alternative would be through a trade sale. A trade sale, near to, or above the current share market price, would completely destroy the short thesis, as it would offer no opportunity to cover at a low price. On that basis, it is worth exploring the pros and cons, to judge the likelihood of a trade sale for Sonos.

Sonos: Secondary Offering Possibility

Details of shareholdings of 5% stockholders and senior executives and directors appear in TABLE 2 above. In my previous article, I posited an exit for some, or all, of their shareholdings might be best achieved by selling in a secondary offering by the company. I believe that is still a possibility, but it likely would not achieve the share price levels desired. There has already been the experience of being unable to get the IPO priced in accordance with expectations ~$20, which was eventually reduced to $15 per share. First quarter earnings release has come and gone, the best quarter of the year, and the share price has gone down. The company has warned of issues impacting Q2 revenues, so the climate does not seem right for a further offering of shares. The company would only need to issue a small number of shares for shareholders to sell shares alongside the company new issue. But the company does not appear to have any good reason for issuing a prospectus, as it should have adequate remaining cash reserves from the IPO. In the absence of a suitable basis for a secondary offering, a trade sale might offer a viable alternative. But watch what the share price does over the days ahead, as it appears to be firming up again. There is also the possibility Sonos could use some of its $307 million cash reserves to repurchase shares to support the share price, and facilitate existing shareholder exits. It may have already started on this path.

Sonos : Trade Sale Possibilities

This PWC blog discusses exit strategies for private equity firms, like KKR and the other 5% stockholders in Sonos,

Holding period – In an IPO, the PE firm must retain a significant stake in the company, which would prolong the holding period for an investment. With that in mind, if the end of the planned holding period is approaching or has passed, or an exit must be assured to meet fund return targets, a trade sale can be used as a backup option to potentially expedite the exit process and receive the full proceeds from a sale. The median holding period has increased steadily since the economic crisis in 2008, reaching just over five years in 2016—significantly higher than pre-crisis holding periods of 3-4 years.² In this environment, proactively searching for a buyer could improve the internal rate of return (IRR) for PE firms.

From its web-site we can determine KKR has held its investment in Sonos since 2012, a period of 6-7 years, far beyond the industry median of 5 years.

The Street published an article, mentioning Sonos as a potential acquisition target for Apple, in May, 2017, "Here Are Some Companies Apple Might Acquire With its Huge $250 Billion Cash Stockpile." From the same article, "Facebook said that it acquired virtual reality headset developer Oculus for $2 billion in 2014."

A Non-exhaustive List Of Possible Contenders To Acquire Sonos -

Apple (AAPL), Amazon (AMZN), Google (GOOG), Cisco (CSCO), Ikea (private)

Buying Sonos - Pros And Cons

• Gain a competitive edge in the multi-room voice controlled wireless music and video system market, due to Sonos technical superiority. This is a two edged sword. A distinct advantage for Sonos, is its speakers and other products are presently compatible with products of many of these potential acquirers, including remote voice control, using Amazon and Google products. An acquirer might see a significant part of the present market disappear, if third party support is withdrawn.
• Better exploitation of the products through superior sales and marketing. Sonos products are already sold through Amazon. Apple has shown an ability to maintain and improve both margins and volume, selling high end products. It is likely to be more successful in this regard than Sonos, who have had to either sacrifice margin, or engage in costly advertising to grow sales, at the expense of profit growth (as discussed further below). Ikea might be able to grow revenues, but do not appear to be a good fit for maximizing margins. I do not see Ikea continuing to sell through Amazon, and I do not see Amazon selling Ikea products, though there is nothing to prevent that.
• Cheaper than developing own competing product. Sonos market cap is presently $1.1 billion and it could be assumed a trade sale would be above that figure. Even if not cheaper than developing own competing product, this could be an attractive option for an entity committed to entering the voice controlled wireless music and video business. The attractiveness stems from: removing a source of competition; a knowledgeable R&D team; numerous patents and products under development, an immediate product/s with established market share; and 8 million, by all reports, satisfied customers, many of whom are return buyers - 8 million customers who may be sold existing products of the takeover entity.
• Availability of more effective, and much lower cost marketing and distribution channels, than Sonos currently has. As explained below, Sonos is in a catch-22 situation - it either advertises heavily to grow sales, with additional cost of advertising eating up margins, or limits advertising with resulting diminished margins.
• The buying entity believes, in addition to the above potential advantages, Sonos activities can be absorbed within its own structure, with synergistic cost savings.
• Following the IPO, Sonos had minimal debt, net working capital $281 million positive, including a cash balance of $307 million at December 28, 2018.

Value Is In The Eyes Of The Beholder

This PWC blog explains how a business may hold more value for one buyer than for other buyers-

Corporate acquirers will have their own, often quite precise, criteria for acquisitions, and it can be hard to second-guess what these are. There are so many variables, not least their current product and geographical mix, and the potential for very specific synergies. A target that ticks all the boxes may well merit a much higher price than another financial investor would pay.

TABLE 5 below shows a projection of results for Sonos that might be made by a buyer with strong conviction on their ability to grow revenues at higher margins, while cutting costs through anticipated synergies.

TABLE 5

A buyer able to maintain revenue growth without sacrificing margins, and synergistically cut costs without impacting revenue growth, could achieve a huge improvement in the Sonos adjusted EBITDA result. Based on the assumption changes reflected in TABLE 5 above, FY-2019 adjusted EBITDA increases from $88 million per TABLE 4 to $159 million. Similarly, FY-2020 adjusted EBITDA increases from $105 million per TABLE 4 to $297 million per TABLE 5.

Conclusions On Sonos Future Directions

KKR and other 5% shareholders might be able to engineer an exit for their ~52 million shares, through private placement or secondary IPO. If this is the path followed, I believe Sonos will struggle to grow profits, as discussed under Factor 2 above, and remaining shareholders will likely see the share price decline over time. Alternatively, KKR and other 5% shareholders might be able to engineer an exit for their ~52 million shares, through a trade sale of Sonos. In that case, all shareholders would benefit, and the concern of a long term decline in the share price would be eliminated.

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.