By Brian Nelson, CFA
Sonos Solves a Critical Home Audio Problem
Last week, I had some time to kill, so I did my usual channel checks at the neighborhood Best Buy (BBY), and I must say, I was impressed with the floor space afforded to home audio equipment maker Sonos (SONO). It was really quite something. As I am not the most tech-savvy individual, I asked a Best Buy employee to explain all of what I was looking at, and I came away impressed. I ended up buying two of the Sonos Ones, and I was on my way back home in a hurry to try them out. I was told they both came with Amazon's (AMZN) Alexa, and I couldn't wait to tell them to play my Frank Sinatra playlist.
Well, they certainly didn't disappoint. After downloading the app and doing some pretty cool configuration stuff, both were plugged into the wall and ready to go. After inquiring about the weather and seeing if she had heard about my new book Value Trap: Theory of Universal Valuation, which is on Amazon (she hadn't, which was quite the blow to the ego, but that's okay), I was listening to Frank Sinatra. It was super cool. The next morning, my seven-year-old son was up early talking to Alexa and he managed to get her to play the soundtrack of PJ Masks and the Star Wars theme song. Needless to say, our household was bombarded with some awesome technology of Amazon and Sonos all at once. We were super impressed. I love them so far and I hope to add more to the home audio system.
Sonos, as it relates to my situation, solved a very unique problem. You see - I've had these Bose and Harmon Kardon speakers that I can hook up with my Bluetooth, but the problem that I encountered at my annual Christmas party was that I wasn't able to play both speakers through Bluetooth at the same time. Well, on the two Sonos Ones, I was, and the sound was awesome as it echoed throughout the house. I must say, thus far, Sonos seems to have hit the ball out of the park. That said, I tend to view myself as a late adopter, and the floor space afforded to Sonos at Best Buy speaks to that.
Image Source: Sonos' S-1 (SEC)
But Is the Company's Trajectory Sustainable?
When it comes to stock analyst coverage, Sonos is a relatively undiscovered company. The company went public in 2018 and its mission is "to fill every home with music," inevitably leading to the creation of the wireless multi-room home audio system. It's hard not to like Sonos' market opportunity, but the home sound system market for consumers is one that is overflowing with competitive participants (and barriers to entry aren't that high). There are also various ways to deliver entertainment (i.e. streaming) that could impact demand for its products. From what I can tell (as an average consumer), however, Sonos has a fantastic product suite, and I think customers continue to enjoy its products. Here's more information on where Sonos operates in the home entertainment market. From its S-1:
(Sonos) debuted the world's first wireless multi-room home sound system in 2005, and has since been a leading innovator in wireless home audio. Today, (its) products include wireless speakers, home theater speakers and components to address consumers' evolving home audio needs. (Sonos) launched (its) first voice-enabled wireless speaker, Sonos One, in October 2017, and (its) first voice-enabled home theater speaker, Sonos Beam, in July 2018. In addition to new product launches, (Sonos) frequently introduces new features through software upgrades, providing (its) customers with enhanced functionality and improved sound in the home. (Sonos is) committed to continuous technological innovation, as evidenced by (its) growing global patent portfolio of over 630 issued patents and 570 applications. (Sonos) believe (its) patents comprise the foundational intellectual property for wireless multi-room audio technology.
The problem that I see, however, is that Sonos' business is not as recurring as the long-term investor might prefer, given that most sales are driven by products, themselves (i.e. speakers, components, etc.). Though its software may be a differentiated product and existing customers continue to add new products to their Sonos home sound system (existing households account for ~40% of new product registrations), the company will have to continue to innovate to keep revenue moving in the right direction over the long haul, in my opinion. I know I'm going to want better "stuff" in the coming years. Technology, especially in the music and home entertainment business, changes fast, and those on top of the market today may not be on the top of the market 10 or 20 years from now. Picking long-term winners in emerging-growth equities with nascent products, particularly in technology, is hit or miss at times (actually, most of the time).
Image Source: Sonos S-1 (SEC)
Sonos' revenue has advanced at a decent clip in recent years, but another one of our concerns is that the company's revenue model will be lumpy and revenue from existing customers may not offset the ebbs and flows of a new-product-driven operation. For example, in its first quarter as a public company (its third-quarter fiscal 2018 results, released September 2018), revenue dropped nearly 7% on a year-over-year basis, while its gross margin dropped 2.3 percentage points from the year-ago period. In its second quarter as a public company (its fourth-quarter fiscal 2018), however, revenue leapt 27% on a year-over-year basis, while EBITDA came in at $20 million, representing tremendous growth from the prior-year period.
Sonos' long-term target for revenue growth is 10%+ per annum, while adjusted EBITDA growth is guided for 20%. For fiscal 2019 (ends September 2019), Sonos is looking for 10-12% sales expansion and adjusted EBITDA in the range of $83-88 million. At the end of fiscal 2018 (ends September 2018), cash and cash equivalents stood at $220 million, while short- and long-term debt totaled ~$40 million, good for a $180 million net cash position. Free cash flow has been lumpy in the past, too, with the company generating roughly $30 million in fiscal 2017, only to fall to negative territory in the most recently completed fiscal year.
Image Source: Sonos S-1 (SEC)
If we give Sonos an optimistic 8x multiple on 2019 EBITDA of ~$88 million, the high end of the range for fiscal 2019, and add its net cash position of $180 million, a reasonable fair value would fall in the range of $800 million to $1 billion. With shares outstanding at the end of 2018 of 84 million, we'd value the company at about $12 per share. Goldman has an $18 price target, however.
Though our fair value estimate suggests modest upside following the sell-off related to the news that its CFO will retire later this year (its shares are trading at ~$10 each), we don't view Sonos as a long-term investment, even if we love its product offerings and the company posts a fantastic fiscal 2019, which is not guaranteed. Bang & Olufsen (OTC:BGOUY), Bose, Samsung (OTC:SSNLF) (Harman Kardon and JBL), Sony (NYSE:SNE), and Sound United are but a few of its many rivals. From where we stand, Sonos lacks a moat and that means pricing pressure and long-term product obsolescence risk.
Right now, I am a super happy customer with the Sonos Ones (and so is my household), but that doesn't mean I'm in a hurry to be excited about the stock. There's a lot more to stock analysis than just liking a company's product. We're going to stay on the sidelines with this one. Technology changes too fast, and we just don't see an economic moat to protect the company's business long term.
Part of this article has been reformatted from Valuentum's website.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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.