Description

Executive Summary

I believe Sonos (SONO or the “Company”), the dominant multi-room audio hardware/software solution is an attractive long-term investment, with a strong growth profile and free cash flow generation over the next several years and optionality from incremental license deals through successfully defending its vast patent portfolio.  Additionally, the Company has strong downside protection through its net cash balance sheet which is currently being used to execute a share repurchase program, large installed base of homes and devices, strong brand name and pipeline of new products.  At the crux of my investment thesis, I believe that Sonos is much more akin to a software business / ecosystem than a single-purchase hardware company and that can be justified by many of purchasing statistics given by the company.  As more customers buy incremental products to grow their home audio networks (and potentially connections to auto and commercial uses), the Company should benefit from increased LTV and reduced CAC given the growing brand presence and growth in the direct to consumer distribution model.  From a macro perspective, the continued growth in consumption of streaming at home and ability for consumers to be more mobile including working from home both can drive incremental demand for many years.  Given its current valuation and growth trajectory, I believe SONO can compound in the high 20%s to 30% over time given reasonable revenue growth and operating leverage through both mix-shift and leverage of G&A.  Additionally, with recent successful patent challenges, there is a blue-sky scenario leading to a significant and growing high-margin royalty revenue stream in the next several years.

Why does This Opportunity Exist?

·       Sonos is a technology company, though it actually generates GAAP profits and free cash flow.  What that means is that the stock has been going down for months, despite a steady stream of generally good news and performance.  Basically, SONO isn’t immune to market trends, but over time healthy businesses that compound value will get to the right price.

·       Sonos is viewed more like a hardware company such as GoPro or FitBit, and as a result has an overly punitive valuation for a business with strong and growing EBITDA and limited capex.  In reality, Sonos has strong repeat purchasing behavior and is slowly growing a network of homes and devices that allow consumers to take their audio experiences everywhere.  I do not believe Sonos is a pure software company either, but you don’t need to believe that to have strong returns owning Sonos stock.  

·       I believe Sonos suffers a bit from investor fatigue.  The Company has basically beaten and raised every one of the last four quarters and has won some significant rulings protecting its IP, but the stock has languished for about a year.  There is probably some “when will this work if not now?”

·       There is some fear that the post COVID world could be bad for SONO, as it may have benefited from a surge in purchases as people were forced to stay at home.  I believe these purchases have just planted seeds for more purchases in the future and have expanded Sonos’ network and brand.  Additionally, although COVID caution/lockdowns may (hopefully) end at some point, increased streaming at home and demands for improved home audio solutions are only increasing.

Capitalization

Business Description

Sonos is a leading provider of wireless audio solutions and the inventor of multi-room wireless audio products.  The Company sells a variety of products, most notably wireless speakers that can stream myriad services and can be played as a group or independently easily through its software.  Although the Company sells hardware products, including home theater components and even services, Sonos prides itself on its unique software which makes its various components work easily together and allows for listening both at home and on the go.  The Company invests nearly 2/3 of its investment dollars into software and believes that it monetizes its software through hardware, giving it a long-term competitive advantage as its network of users and penetrated households grows.  Currently Sonos has a 92% market share of wireless speakers, though it is a much smaller portion of the roughly $18bn TAM for premium audio products.  Sonos’ market opportunity continues to grow, driven primarily by three factors:

·       This is the so-called “golden age of audio” with the volume of music, audio book and podcast streaming growing at incredible levels.  

·       Premium video content continues to be sold directly to the home.  Disney and HBO continue to release premium content directly to consumers, fueling demand for premium home audio products to more accurately capture a theatre-like experience at home.

·       An increased number of consumers that have the flexibility to work anywhere.  This has allowed for more time enjoying home entertainment, as well as the need for flexible solutions such as Sonos that can be used at multiple locations.

In addition to wireless speakers, the Company manufactures a number of products that enable traditional home theatre systems to connect to the Sonos platform.  It is expected that the Company will continue to roll out new products and services (stated goal of two per year) that may expand into larger, untapped markets.  As an example, Sonos recently entered into a partnership with Audi, providing Sonos solutions in select Audio vehicles in 2022.  As discussed later, one of the stronger elements of Sonos’ business model is the flywheel effect of its network.  The Company has very strong repeat purchase behavior and continues to grow total households that have Sonos equipment.  Users with the Sonos app can also access systems in other households or potentially even commercial locations.  As brand awareness grows, it is also benefitting from more direct-to-consumer sales which helps to grow its operating margins.  Over the long-term, Sonos expects to continue to grow its network of connected devices and continues to invest in software, with the goal of being the de-facto solution for premium audio both at home and on the go – as Sonos puts it, to be the “world’s leading sound experience company.” 

Financial Snapshot

Investment Case

The investment case for Sonos is relatively straight-forward.  Essentially, Sonos is benefitting from a number of positive market trends, has a dominant market share in its growing category, and has a business model with a demonstrated history of attracting follow-up purchases as consumers build their personal Sonos networks.  Over time, more connected devices and homes with Sonos should only increase its competitive moat, and the Company should be able to layer on additional products and services to capture a larger portion of the audio streaming/listening pie.  In addition, Sonos has a strong patent portfolio that it may be able to monetize for royalties, or worst case, that will prevent competitors from having features that are becoming synonymous with multi-room audio solutions.  The Sonos investment case is as follows:

·       This is a connected product and software company.  The biggest misconception, in my opinion, is that Sonos is not simply a hardware company.  Does it sell devices?  Yes, of course.  But those devices are hardly impactful without its software and it is the software the drives a number of business characteristics that make Sonos much more software-like and thus, more valuable as a business.  First, to state the obvious, adding incremental wireless speakers over time that connect to the system is only really possible through software.  Additionally, the Company is able to provide real-time updates to its app and product features through software updates (i.e., relatively low cost to improve and upgrade products).  The business has a relatively low capital expenditure burden and doesn’t require significant capital to grow.  Sonos also has multi-room audio capabilities because of its software, which is a key reason why existing customers continue to add more devices.  This dynamic is probably best seen in some of the data the Company has disclosed over time, demonstrating the company’s growing brand awareness, repeat purchase behavior and products per household, all of which signify a loyal and sticky customer base more akin to a recurring software business than a single-purchase device company.  I think of these repeat purchases as almost an incremental subscription, in much the same way iPhone upgrades and purchases are really just the manifestation of being locked into the iOS platform.  The data is summarized below:

As the brand becomes stronger and more users become connected to the Sonos platform, both CAC and LTV have moved in the Company’s favor (from March 2021 Investor Day):

In short, although Sonos is not a pure software business, it is far better than a single-purchase hardware company and its growing network should be a powerful barrier to any significant new competition.  The financial metrics the Company is already showing suggest a more compelling business than a commodity consumer electronics company (think GoPro or FitBit) and should drive reliable, growing free cash flow over time.

·       Still a small percentage of the total TAM for premium audio.  Although Sonos is currently the dominant provider for wireless speakers, it is still just a fraction of the premium audio market today.  

This dynamic is a very favorable one given that Sonos continues to penetrate new households and continues to see customers buy more products to enhance existing systems.  Sonos has already laid the groundwork for its future growth and has a lot of room to go given the current low penetration as well as the inevitable replacement cycle for existing products.  I believe Sonos can achieve its stated goals with the current product set, but the Company has a significant opportunity with new products and services that can drive revenue well beyond current targets.  Sonos expects to release two new products per year, which historically has been a combination of new speakers, components, or more recently services.  As an example, Sonos introduced Sonos Radio, a subscription service with an aspirational goal of 500k subscribers over time.  More recently, Sonos entered the auto audio market through a partnership with Audi.  I do not know exactly where this is going, though they spend a good amount of dollars on R&D and I have heard rumblings about Sonos headphones and other mobile products.  I believe part of the product roadmap is introducing enough products to allow for a seamless audio experience at home and on the go.  Basically, take your listening with you wherever you are and allow seamless switching between devices.  Or, imagine being in a car where passengers can all listen to their own audio streams through Sonos headphones and where the driver can even communicate with rear passengers through Sonos headphones.  Could they be in more commercial spaces or have more partnerships with hotels for in-wall speakers or even standalone speakers in rooms?  Possibly.  This is just food for thought.  All I know is that as more people become attached to Sonos products, there are a lot of possibilities and product extensions for the Company to capitalize on.  And then, if all your friend’s houses, commercial spaces and autos all start to use the Sonos platform, why would a new customer not strongly consider Sonos?

·       Improving margin profile due to generally fixed overhead and a mix towards DTC channel.  Sonos continues to post profitable quarters, with surprising upside to profitability even in the face of supply shortages and tariffs on imported products.  One underappreciated point is how quickly both adjusted EBITDA and free cash flow are growing relative to revenue.  The company has a reasonably fixed overhead structure and high product margins.  Additionally, as brand awareness has grown, the Company has been able to generate more sales through its higher margin DTC channel.  As previously shown, with so many new households entering the Sonos network in the past few years, incremental growth seems likely without a significant investment in advertising or promotional discounts. 

·       Solid management team.  The management team at Sonos has generally done the things you would want.  They have taken on the gorilla in defending their IP against Google (successfully…more on that below) which could drive significant royalty revenue, have driven profitable growth, innovated with entry into Bluetooth speakers and the automotive market, secured strategic partnerships with Ikea, Sonance and others, and have entered services with Sonos Radio.  On the financial side, they have a stock repurchase plan in place and initiated a restructuring of corporate costs during 2020 to enhance profitability.  The CEO has scars from RIM, which probably means the Company won’t ever get too comfortable – a positive for investors.

A Word on IP Disputes

I do not claim to be an expert on Sonos’ patent litigation strategy, nor do I think you need a successful outcome there for this stock to perform very well.  With that said, Sonos has an extensive patent portfolio including many patents related to multi-room audio, individual speaker volume control, seamless setup and integration of multiple speakers, and a variety of other things that make multi-room audio solutions the good products they are.  Sonos has already entered into royalty agreements with a few providers that were infringing on Sonos patents (Legrand, Denon), but sued Google in early 2020 asserting that Google infringed on five critical patents related to multi-room audio and Google’s home speakers.  To make a long story short, this past Thursday the ITC upheld Sonos’ view that Google infringes on the five patents, preventing Google from importing these products.  Google has already worked on a product redesign that the ITC has approved, but it does require users to have an inconvenient experience and actually prevents some features such as controlling speaker volume using your phone’s volume button.  This sounds trivial, but the initial comments on the Google Community pages are pretty negative, with people asking for refunds and suggesting that the entire benefit of buying the Google products is gone.  So, while it may not yield an immediate import ban, it seems as though this is a competitive benefit for Sonos.  How does this end?  There is another case in California that will be tried in mid 2023, but the hope is that Google and Sonos could reach some kind of royalty agreement where Google pays a royalty on devices sold.  I would think the ITC ruling in Sonos’ favor helps that eventual outcome, but it still seems like Google intends to fight this tooth and nail until they have no choice but to stop selling the products, sell the products without these critical features, or finally just agree to a royalty.  The Company has also won a ruling in Germany against Google which bans certain Google products from being sold. Sonos has foundational patents for this technology and it seems clear they intend to continue to pursue companies that infringe and seek royalty arrangements.  I’m not factoring this in, but with the recent ITC ruling, it certainly seems like there is some real royalty value that is not being valued in the stock.  For what it is worth…after initially opening up 4% on Friday, the stock ended basically flat.  Fatigue right?  The stock responded positively to the initial ruling in August 2021 as well before fading.  I’m not totally sure what to make of it, but if they continue to be successful, I’d imagine there are millions of Google devices out there that will need to pay some kind of fee and I think that fee is 100% margin.  There is a chance Sonos’ margins increase significantly as royalty revenue grows from low single digits % of the total today to more of the pie in the future.

Valuation

As already highlighted, Sonos is a growing, free cash flow generating hardware/software business with a loyal customer base and a long run-way for growth.  It has a strong patent portfolio that can yield additional upside and strong returns on invested capital.  Although revenue is expected to grow in the low to mid-teens over the coming years, EBITDA and free cash flow should grow significantly higher.  Below are Sonos’ published financial targets for the period ended 9/30/24, as well as the “transcript estimate”.  That estimate is when Sonos said they still expect a 13% revenue CAGR off of 2021, despite being way ahead of schedule on the plan given in early 2021.  The Company has a history of being conservative and has pretty much beaten and raised every quarter over the past year and half.  Margins are already above the low end of the 3-year forward projection, and if anything things are even better than they could have imagined on DTC which adds to margin.  Below is a depiction of medium-term projections for Sonos.

The transcript estimate is more relevant at this point given how far ahead of schedule Sonos is on their long-term plan.  I’ve used a bit of a swag for free cash flow generation and have not assumed any new shares issued (but have also not assumed any buyback).  So can Sonos trade at a mid to high teens multiple on adjusted EBITDA on a trailing basis?  I think a growing, asset-light business with a leading market share should, and it probably will.  This is a business that it dominant in its sector and has strong operating leverage on continued growth.  On an EBITDA-CapEx basis it looks even better, but I think the point is that you don’t need to believe much to get very strong returns here without a lot of downside risk.  They are already above the midpoint on margins and I think the trend will be that they exceed 18%.  This is roughly a 30% IRR with continued execution and a very modest re-rating which I think would be justified given continued growth in free cash flow and revenue.  That gets you to roughly $60/share in the next few years.  Overall, this is a compelling investment with strong downside protection and a moat that is strengthening over time with upside potential that is far greater in the event of a blockbuster royalty deal.

Risks

·       Supply chain disruptions that lead to temporarily slower sales and/or lower margins.  This is factored into the 2022 forecast.

·       I don’t have the data, so on a quarterly basis, there might be investors with an advantage and insight into beats or misses based on point of sale data

·       The market is actually smaller than we think and/or is more saturated than we think.  There is no sign of this so far as devices per household and households are both increasing

Catalyst

·       Continued FCF generation

·       Continued quarterly beats/raises

·       Positive resolution of IP disputes, particularly with Google, and royalty deals

·       Potential target in an acquisition down the road