Sonos: Lost The Battle Before It Started

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About: Sonos, Inc. (SONO), Includes: AAPL, AMZN, GOOGL
by: Nascent Trader
Summary

The company's only economic moat is protected by patents that are expiring in 2026.

Sonos failed to catch up with the voice-recognition trend; the company's relevance is at other companies' discretion.

$1bn market cap makes it an expensive acquisition target.

Source: Sonos

Recommendation

We recommend selling Sonos (SONO) as it is fairly valued now according to our DCF model (suggesting $9.74). We do, however, have a bearish view of the company in the long term for three reasons. For value investors, the company lacks a sustainable moat that would give SONO a long-term competitive advantage. Secondly, whilst the multi-room synchronisation technology helped kickstart the company, the management failed to develop proprietary VPA technology that is essential to the smart speakers. Lastly, the market generally sees Sonos as a good acquisition target and hopes it will be bought out at a premium; however, giants like Amazon (AMZN), Apple (AAPL) and Google (GOOGL) do not have compelling reasons to burn the cash to buy something that would be available in a few years (we are talking about the patent expiration).

Investment Theses

Unsustainable economic moat

The company spearheaded the integration of mesh network used in the military with speakers. The multi-room experience is the selling point that has been sustaining the company since its inception. Nevertheless, the company identifies itself as a smart speaker maker who competes with Amazon, Google and Apple. Sonos has correctly identified the potential market and trend in the smart speaker segment but the smart part, or the soul, of Sonos speakers, is from other companies, viz., Alexa from Amazon and Google Assistant from Google. Source: Futuresource Consulting, JP Morgan estimates

We can see that there is a sizable addressable market for smart speakers but it is safe to say that this market would be primarily dominated by Amazon and Google, given their market shares last year (see pie chart). It might be easier for Apple to catch up than Sonos because of Apple's existing customer base and the in-house VPA, Siri.

Source: Voicebot.ai

Sonos has a strong patent portfolio that does not only give it the protection, but also the leverage to bargain with the giants.

Bulls might argue that the ability to integrate multi-voice assistants is a competitive advantage. While it is true that Sonos is the first-ever company that is able to allow users to use both Alexa and Google Assistant, this advantage merely comes from Sonos' patent portfolio. Google agreed to let Sonos use its VPA because it infringed Sonos' patent, so "Instead of suing Google, or negotiating a licensing agreement, Sonos proposed a partnership with Google allowing integration of Google Assistant into the Sonos speaker, said a person close to the situation.”

Playing patent hardball is not a sustainable approach to establish competitive advantages. Nor is the reliance on other companies' VPAs. For example, although Sonos speakers have multi VPAs, compatibility is an issue. Users may use Alexa for one Sonos speaker and Google Assitant for another but cannot use both on one speaker. Further, the user experience suffers since Google Assistant is not designed for Sonos' six-array MEMS mics (see image).

Sonos One microphone arrays for far-field voice recognition. Source: Ben Einstein's disassembly

Google's Home Hub has two mic arrays. Source: Fubon Research (a sell-side report)

People are basically buying metals and plastics from SONO as the soul of the speakers, the VPA, is from Amazon and Google. Amazon and Google can terminate the partnership at any time at their discretion. The only proprietary advantage that SONO has is its multi-room synchronization technology. This moat is temporary because it’s only protected by SONO’s strong patent portfolio. However, the core of the patent portfolio, the protection for multi-room synchronization (US9164531B2) is expiring in 2026. And this technology is not very hard to duplicate. Basically, there's an internal clock in each speaker. The master device assigns a timestamp for the playback to other "slave" speakers so they can play the music with no time difference (aka lagging). We would be surprised if tech giants like Amazon cannot accomplish the same, if not better, method.

Source: Google Patents

Lost the battle before it started

The company’s core technology lies on the multi-room synchronization, which was relevant a few years earlier. However, the future potential lies in smart speakers, which was not the company’s focus. It had failed to invest in voice-recognition technologies when Amazon and Google were starting up. The previous CEO stepped down for this very fact, who commented “I fell into that trap where I’ve been watching voice recognition for years... I tried Echo in the beginning and wrote it off. I had too many distractions at that time. I wasn’t playing at the level I should have been playing at in all frankness.”

At this point, the company has a strong cash position (~$280m), which implies potential future buyouts, according to Patrick Spence (the CEO) during the 1Q19 earnings call. However, we expect the company to buy peripheral technologies to expand the speakers portfolio to portables and autos, instead of some voice-recognition companies because that would not be an economical decision as 1) investors would suffer from a short-term loss due to the outlay and 2) it takes time and a sizable customer base that SONO does not have to train the AI.

Partnership with IKEA is a good idea to add more price points and innovative products. But these products are only creative in design, the core technology has not changed, viz., still relies on Alexa/Google Assistant. It might add more revenue to the firm but if the market sees it as a profitable method by integrating speakers with furniture, giants like Amazon would catch up quickly due to their customer base and strong bargaining powers.

It is worth noting that we have seen some dynamic change in the company's revenue make-up (see chart). The wireless category has declined QoQ while the home theatre segment has increased QoQ. By speaking with the company, we get a reasonable explanation behind the change: "the success of our Beam product is positively impacting FY19 home theater performance. In the wireless category, our removal of the PLAY:3 product has created a headwind to growth on a year-over-year basis."

Source: company filings, SnowPeak Securities

The management has failed to catch up with the VPA trend. Now, the management decides to roll out more products in the year ahead. However, the firm sacrifices the quality of the devices. For the flagship product Sonos One, the second generation seems like a rushed-out product with no innovation other than some minor hardware updates that do not make any material improvement to the user experience.

Seasonality of Sonos quarterly revenues. Source: company filings, Bloomberg

The timing of the Gen 2 release can be interpreted as an attempt to inflate the revenue to defy the seasonality of its revenue trend (see chart). But due to a lack of features, we do not expect the release of Gen 2 to have any material impact on the top line. Note that the CEO of the company has extensive marketing experience from his tenure at Blackberry and as a CMO at Sonos. Spence puts emphasis on holiday promotions, which fits his speciality. However, that gives us the seasonality we are seeing. The company has been spending twice as much S&M as R&D. Winning through marketing is not sustainable.

We also see some operation expense-related inefficiencies due to the company's sales channel through third-party retailers. The company is shifting its sales strategy toward direct-to-customer channels and e-commerce. The revenue driver for Sonos relies on products sold and the release of new products. The revenue mainly comes from new customers and existing customers buying more products. So there is only one revenue stream revolving around the goods. Further, the existing customers of new product registrations only account for 38% of new products sold. It would be hard for Sonos to gain customer loyalty without offering special service and ecosystem that Amazon, Google and Apple have.

As mentioned in the 1Q earnings call, there were some slow-down in the sell-through velocity, implying a higher than expected inventory level. That indicates the inefficient management and a lack of understanding of the market demand. It takes about 69 days on average to turn over the inventory, which is in line with the time it takes for the company to pay its suppliers.

The bottom line is, Sonos is, after all, a hardware company facing fierce competition and high barrier into the VPA field.

Unlikely an acquisition target

The market thinks that Sonos can be a good acquisition target for the giants. However, valuing at $1.02bn, Sonos is expensive for what it offers.

Think about the synergy that can be added toward the merger. Apple would have to pay the who team at a premium to get the technical know-how that they could get easily if Apple decides to slate resources to the HomePod development. Further, Sonos does not have an attractive profit margin and customer base, which does not add align with Apple's investment philosophy. Sonos' ~4% market share would not help Apple much in competing with Amazon. So, we can eliminate Apple from the potential acquirer list.

Would Amazon buy Sonos? Perhaps not due to the aforementioned reasons. Would Google do it? Very unlikely because Sonos devices are not even compatible with Google Assistant.

A likely synergy would be the reduction in the cost as Sonos uses the same group of suppliers as other giants do.

Source: Jefferies, Bloomberg, SnowPeak Securities

Catalysts

Upcoming catalysts that would push the stock price to our lower-end target price include the FY2Q earnings release, new product release from competitors that incorporate multi-room synchronisation without infringing Sonos' patents, and, most importantly, the expiration of Sonos' core patents.

The management does not have guidance for 2Q performance but the consensus agrees on $229.74m for revenue, factoring the Gen 2 release and IKEA partnership. Any miss on the revenue would help push the stock lower.

Risks

The company has just IPOed and it is still growing. Potential risks against our short position would be new products that are disruptive with new technologies.

Better-than-expected earnings would also work against us.

Lastly, if the company gets acquired by another company, we can expect a 10-25% premium added on the stock price.

Valuation

Assuming a 10% growth rate for revenue, 9.21% for WACC, and 2% terminal growth rate, we get $9.74 as a target price. Of course, we have to consider the up and downsides. So, a range of 7.52-12.68 is what we expecting here.

Source: SnowPeak Securities

Last words

The company has a simple business model, so there is a little room for us to find the mispricing in this stock. At this point, the company is fairly valued, investors should consider selling their holdings. However, we are not optimistic about the firm's long term development as it would be irrelevant in the smart speaker market in the future due to a lack of proprietary VPA. It would be interesting to see where the company stands when its patents expire. As of yet, we do not see any sustainable moat for Sonos.

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.