Description

We believe that an investment in Sonos (SONO) is likely to deliver strong (50 - 100%), potentially uncorrelated returns over the next several years as the company addresses several self-inflicted wounds. While not a classic “value investment” in the sense that Sonos is not obviously cheap relative to near-term earnings (at least, not after treating stock comp as a cash expense), we believe there are multiple reasons for a longer-term investor to initiate a position at these prices, and that the situation is somewhat analogous to investing in Chipotle during its E. coli incident - an investment that would have paid off brilliantly over the long term.  While we are not suggesting that Sonos is a business of the same quality, nor are we suggesting it will achieve such stratospheric returns, we believe that it’s an interesting opportunity to buy when there is blood in the streets.

Sonos was written up twice in 2022, from a bullish angle by DogsAreLife and from a bearish angle by oldyeller.  We recommend reading those writeups; we won’t rehash them in depth and the rest of this writeup will assume that you have read those writeups (or at least have some pre-existing understanding of the business), but will summarize and address key points that remain relevant.  

Business Model Overview - From Our Perspective

As DogsAreLife explains in more detail, Sonos invented multi-room audio and remains the dominant player in this space (which we will get into).  Sonos speakers seamlessly and wirelessly integrate, enabling use cases such as easy surround sound in large spaces, or the ability to continue listening to the same music or podcast as you move between areas of your house.  

Similar to how John Deere employs more software engineers than mechanical engineers, Sonos is the story of eating the world.  Sonos hardware is not particularly special (although it may be now, with its acquisition of Mayht - more on this later), and users readily acknowledge that speakers of similar or better audio quality can be purchased at similar or lower prices.  

Where Sonos shines is convenience - from frustration-free unboxing to easy-breezy setup.  Speakers can be controlled through the app or via voice assistants, and they just work in an easy and intuitive way.  No ugly cables or hardwiring through your house, no complicated equipment or remotes.  Sonos passes the grandparent test; my elderly (and not-too-tech-savvy) parents can work it with ease.  Replicating the Sonos experience would be very difficult without concerted effort (and patent infringement).

What this means is that Sonos does have an ecosystem; if you have one or two Sonos speakers, you are likely to stay within the ecosystem for speakers 3, 4, or 5 for many reasons.  Sonos speakers can be paired together to create stereo pairs, or separated to cover more rooms, which can operate on their own or in groups at the touch of a button (or a voice command).  This is different from (for example) purchasing an TV - if I have a Sony TV in one room, I might purchase an LG for another room.  Sonos is, then, somewhat like Apple (I make this analogy as a dedicated Android guy).   

This is where we diverge from the purely bullish view.  We are long-only but when we had analyzed Sonos in 2022, we ended up leaning more towards oldyeller’s view and thus stuck it on our watchlist (enjoying the products) but didn’t consider taking a position.  The idea that Sonos is a recurring-revenue business - one the company desperately tries to promote - is, in our view, laughable.  While the ecosystem does make people more likely to be loyal to the brand, these are discretionary hardware purchases.  

While some people with questionable judgment, such as myself, will be real enthusiasts (I am about to hit what I believe is the limit for the maximum number of Sonos devices on a single network - 32), there is an upper limit to the number of speakers most people need in their home, particularly since Sonos operates in the middle ground between generic, low-quality devices (such as Amazon’s Echo devices, even the higher-priced ones that are supposed to compete with Sonos) and true audiophile systems (which offer higher sound quality with the tradeoff of either convenience of price.)  

Indeed, for certain of the company’s products, the purchase of one negates the need for future purchases (at least for a while.)  My wife and I both have Sonos Ace headphones and now have no need for another pair; similarly, if you have an Arc soundbar, you’re not going to buy a second one unless you purchase a new TV.

So, oldyeller correctly identified that Sonos - like many consumer businesses, e.g. Traeger and others - had seen a massive pull-forward in demand as people were stuck at home during COVID, unable to have experiences outside the home or spend money on travel and dining - so, naturally, they bought things to make their home nicer (like cool sound systems).  This led to a classic “bullwhip effect” leaving an air pocket in demand into a softening consumer environment.  Oldyeller cited a former executive stating that Sonos didn’t become a better business during the pandemic, and we think this is true, although we also believe that just as the company was in a bit of a bubble before, it’s in a bit of a trough now; i.e., it is also not today a worse business than it ever was.  Just a less popular one.

The App-ocalypse

Before discussing the company’s economics and future, we have to talk about something that might go down in history as one of the worst business decisions of all time, on par with New Coke.  I’m not sure what VIC’s policy on language is, but I think the only apt description for the company’s app update in May starts with “cluster” and rhymes with “duck.”  It was a total, unmitigated disaster.

Part of the company’s strategy over time has (naturally) been to expand into adjacent categories (soundbars, for example, as well as battery-powered speakers that can be plugged in at home but taken to the park, the lake, or the tailgate as well).  The company has long toyed around with moving into other areas where people listen to music or podcasts, such as vehicles.  But the obvious – and massive – product category they never played in has been headphones.  Apple Airpods alone sell something like $15 billion per year in revenue, or roughly 10 times the company’s current annual revenue.  Sonos released the long-anticipated headphones – named Ace – this June.

To enable this, the company needed to make some meaningful changes to its app.  Meanwhile, as with many companies that have been around for a while and built ground-up technology, the company’s technology stack needed a refresh for the modern era.  Sonos also – as oldyeller astutely pointed out – has a uniquely challenging responsibility.  It sells hardware up front, but then has the responsibility of supporting that hardware over its lifetime.  Given the build quality, many (arguably most) Sonos products that haven’t been mistreated last a long time, and there are many, many threads of people who purchased products 10-15 years ago which are still going strong and working like new – a rarity in consumer electronics.  (The company actually has a special room that tests speakers with harsh “life test noises” to simulate 10 years of continual playback, among other tests such as extreme temperatures, static electricity, and so on.)  In 2018, Sonos claimed that 93% of the players it had sold were still in use.

This durability also creates backwards-compatibility issues.  While Sonos provides upgrade credits and discounts to encourage people to purchase new gear, many people (naturally) expect products they paid for, that have worked seamlessly for a long time, to continue working.  This means that in the process of upgrading, Sonos still has to be able to support old products, the same way that Microsoft was still supporting early-2000s Windows XP until 2014.

To make a long story short, Sonos bit off more than it could chew.  In an effort to rush the Ace headphones to market, it didn’t perform enough quality testing – both internal and external observers have made analogies to Boeing’s many issues with the MAX.  The Ace headphones themselves are mostly fine (although a number of important features are missing), but in the process of trying to update the app to accommodate the headphones, as well as update the core architecture, they broke pretty much everything else. 

They (incredibly and very stupidly) decided to release a version of the app that lacked extremely basic features like setting alarms and managing playlists.  Of course, this would only be an issue if the speakers worked at all – which they often didn’t.  People whose systems had been working seamlessly for a decade woke up one day to find that their speakers didn’t connect at all, dropped in and out, decided to change their own volume to inaudible or ear-splitting levels, or had a host of other issues.  For a company whose brand was built on everything being easy and seamless, it was a rude awakening.  Compounding things, the company’s initial responses often appear to have been defensive in nature. 

It was a disaster for which there are potentially no superlatives that are hyperbolic.  The company has received a firestorm of bad press and furious Reddit posts in the (quite active) r/sonos subreddit.  They very quickly saw the light and have delayed new product launches until the app is fixed.

This is where I should note that prior to the app disaster, I had about six or seven Sonos speakers (with another few I’d purchased that were still in the return period) and I wasn’t a shareholder… so my views here are hopefully not simply the result of commitment bias.  It was only after the app disaster that I decided to go all-in on Sonos (as a consumer) and make it a small position (as a fund manager.)    

The TINA Trade

Why are we choosing to make an investment when everyone hates the company?  Because the company is well on the way to having the app fixed, and because – to borrow a popular Fed-watching phrase – there is no alternative.  We’ve heard this (secondhand) through channel checks with installers, as well as through online forums such as Reddit.  There are many threads from frustrated users asking “what else can I use?” and the answer is basically “nothing replicates the Sonos experience.”  As one Redditor succinctly observed:

Unfortunately, there are no other alternatives that compare in terms of price, performance, ecosystem, and build quality.

All the other alternatives that everyone posts are either more expensive, require additional components, lack home theatre capabilities, or have less convenient wifi usage.

He or she was not alone; this has been posted many times.  Put another way, money talks and something else walks.  Despite the seemingly universal hatred from angry users, we have found that eBay listings for even legacy, dated products - or products that aren’t working and sold only for parts – see strong bids from multiple bidders.  (You can verify this yourself… go buy yourself a fun toy in the process!)  For every post from someone threatening to leave the Sonos ecosystem, there’s someone saying “if you want to sell, let me know.”   

Just as with anything else, a small number of aggrieved parties are making a lot of noise, but a lot of people’s Sonos systems (including mine) are working… mostly fine.  Are they perfect, no, are there still occasional issues, yeah sure.  But am I getting a lot of use and joy out of them - yes - I am enjoying lovely surround sound music (Five + sub mini, stereo pair of Era 100s + sub) in my living room right now, which I can control with my voice while working on this writeup.  Would I be able to do that as easily with anything but Sonos - no.  So, thousands of dollars in, do I regret any of my purchases - not one tiny single little bit.  

The business analogy is Chipotle.  While the company’s results (and of course stock) took a big hit during the 2015 E. coli outbreak, there is no alternative, and the product is still good.  Even though the concept of a burrito /bowl assembly line seems relatively simple, there is no other company at scale (save perhaps Cava, at a totally different price point) that even comes close to replicating it.  There is simply nowhere else that for the same price and convenience (including a mobile app that remembers your exact order), you can get a high-quality, tasty, healthy, freshly prepared meal customized exactly to your tastes.  To hear it back then, nobody was ever going to eat at Chipotle ever again… even after a recent pullback, the stock is up 800% off the lows post the E. coli incident, and was up as much as 1,000% at one point earlier this year. 

Sonos is not Chipotle, but the point is that memories are short.  If you can make people sick and they still eat there, I think you can make their speakers not play music for a while and they’ll forgive you too.  There is a large population of people (you can find some of them on Reddit, not all of them can be paid shills!) who still, believe it or not, enjoy their systems and even want to purchase new products like the Arc Ultra.  Sonos revenues have not dropped to zero.  This is not a broken business.  Sonos has a great balance sheet with nearly $300 million of cash and marketable securities, with no debt. 

While the company is not operating at what we view at an acceptable level of profitability, it is still looking at generating over $100 million in adjusted EBITDA, so it is solidly cash flow positive and there is no credit risk here – purely financially speaking, they have all the runway they need to get back on track.  

We’ll get into the specific economics in a minute, but from a high level business-case perspective, if the product is still irreplaceable, the company still has a long growth runway, and the economics of the business have not been fundamentally broken, then brighter days lie ahead.  Near-term results will be challenged, as the company will be forced to spend extra money fixing its mistakes and (likely) soothing existing customers – and attracting new ones – with more discounts than it typically offers, but this is not likely to be a structural issue once the app is back to humming along (which it mostly already is).

Valuation & Fixing The PnL

We mentioned that Sonos isn’t exactly cheap on near-term earnings.  The company, today, has an enterprise value of roughly $1.2 billion compared to revenues of $1.5 billion.  While they are guiding to over $100 million in Adjusted EBITDA, they - like many technology companies - have generous stock-based compensation, which has clocked in at $65 million year-to-date.  (If I had a nickel for every time a company claimed stock comp was not a real cost but then turned around and said they were buying back shares - with cash - to “offset dilution” - but I digress…)  Anyway, this is a real expense and as such, while the company is cash flow positive and not in any credit risk, it is not currently meaningfully economically profitable (in our view).        

At the same time, Sonos generated $278 and $226 million in Adj EBITDA on revenue figures in the $1.7 - $1.75 billion range a few fiscal years ago; while those results are not sustainable, they do demonstrate the impact of operating leverage.  Near-term top and bottom-line results are being fairly obviously weighed down by a number of discrete, identifiable factors that are not likely to be permanent:

1. Lack of new product launches - the new high-end Arc Ultra soundbar (we’ll talk about this in a second) and the Sub 4 are widely reported to be ready to go, but the company has delayed new product launches while getting the app fixed.
   
   

2. The previously mentioned digestion/bullwhip effect from COVID.
   
   

3. Consumers not purchasing (or even returning) speakers due to the ongoing press and app issues.
   
   

4. Costs spent on addressing the app issue.
   
   

5. Costs spent on customer service or promotions.
   
   

So while we’re not going to slap a multiple on 2021 earnings, we also don’t think that valuing the company off near-term earnings is fair either.  Still, it’s worth noting that this was an $18 - $20 stock (vs $12 today) earlier this year before the app disaster.  

In terms of management quality, while some colossal mistakes were obviously made and it would not be a surprise (to us) if CEO Patrick Spence is ultimately fired for the app-ocalypse, the rest of the management team is solid.  The new CFO, Saori Casey, was the VP of finance at Apple for 13 years and brings a much stronger focus on efficiency (of both operating expenses and capital) and capital allocation, which we think will help Sonos mature and “grow up” on the financial side, which they desperately need.  Meanwhile, the person in charge of fixing the app is Nick Millington, the original architect of the Sonos system (great interview here that is worth reading on the background of the company and the technical challenges it has surmounted).    

We think that over time, the company can return to solid revenue growth and double-digit real EBITDA margins (net of stock comp), which would suggest a value substantially in excess of 1x revenue (perhaps closer to 2x).  We think the products, technology, and brand are all worth a lot more than the current market value, and Sonos would make a bite-size acquisition.  While a major tech company such as Google, Apple, Facebook, or Amazon is probably off the table due to antitrust (see Amazon and iRobot), any number of private equity companies or other consumer technology companies should probably be taking a hard look at Sonos at this valuation. 

The Future

As with most new positions, we are not jumping in all at once, and part of why we’re posting it on VIC (rather than another idea) is to solicit discussion and input from those who may see things differently.  We’d like to see Sonos continue to make progress stabilizing the app, and generating stronger profitability.

At the same time, there are things that we think are being overshadowed.  Extending the company’s brand into the large headphones market makes a lot of sense to us, and it’s hard to judge anything by Sonos Ace given everything else going on.

There are other really interesting things, too.  For example, I said earlier that Sonos is nothing special as far as hardware goes.  That has historically been true, but may be about to change in a big way.  In 2022, Sonos acquired startup Mayht for $100 million in cash.  Mayht developed an interesting new speaker technology.  This interview explains:

“We can finally show our technology in different kinds of applications — from soundbars to small subwoofers to small voice-assistant speakers. We believe the latter, in particular, will really disrupt the market. If say, an Echo Dot can have the same sound as the Sonos One, or a soundbar. Or if a speaker without a subwoofer can have the same sound as something that does have one. It makes a big change in the market. We are finally able to show those things to the public.”

The company claims it has invented a new generation of speaker drivers. Whereas a typical speaker driver has a membrane, it can make limited movement, because the whole motor structure is behind the membrane. Mayht’s innovation is to put the motor structures at the sides of the membrane. That means more movement, and more displacement. You see a similar thing in automobile engines: A “bigger” engine can work in one of two ways — either you make each cylinder bigger, which means that more gas and air mixture can explode and create power. Or you make the stroke longer. Mayht is applying the same idea to speakers here. Speakers need to be smaller in a lot of different applications — the company suggests smart home speakers like the Google Mini and Alexa’s speakers, but also in vehicle tech, where space is at a premium. The company also claims that its speaker tech reduces rattle. 

“It’s exactly the same story for all the manufacturers — Bang & Olufsen, Bose, Sony. Every company uses the same technology and the same drivers because they essentially come from the same factories. There are three or four major manufacturers and all those different speaker brands take their drivers from those manufacturers. It’s not strange that there is no innovation in that field,” laments Scheek. “Because the manufacturers themselves don’t really develop drivers, they are not pushed to make higher-quality tech. They may move the needle by 1 or 2% but not to change the complete architecture of the driver. Doing so would mean changing their whole manufacturing setup, which is just a huge risk for those companies.”

“The speaker companies are not rewarded to really, truly innovate. From a cost perspective, they have to perform for the best quality with the lowest level of cost. And so there’s no incentive for speaker manufacturers to really think out of the box to bring out something really new and innovative,” explains Max van den Berg, Mayht’s chief commercial officer. “To put this into perspective, we’ve spoken to around 45 speaker companies globally since the start of this company. None of them have seen anything like this before — this is truly disruptive innovation.” 

Yes, a lot of this is breathless techie-speak, but as best we can tell, the Mayht technology is real and nobody seems to dispute that.  The question is whether it is cost-effective and can enable Sonos to actually produce unique hardware to match with its historically exceptional software, either in existing product categories or potentially in new areas (such as vehicles).  

So far, Sonos has not introduced any products with Mayht technology, for a variety of reasons including cost.  They are about to release their first - the Arc Ultra soundbar (previously codenamed Lasso) - which by all accounts, will feature Mayht drivers.  It seems fairly obvious to me that nobody in the investment community really cares about Mayht right now (I mean, why would you), but I think that there is an embedded call option here that is very intriguing.  I have no more knowledge about their product roadmap than anyone else does, but I have to imagine that Arc Ultra is not alone and that some other future products will also contain Mayht technology.

Conclusion

An investment in Sonos is not for everyone, and it may not even be for us (it’s a 2% starter position.)  But we think that there’s a lot of interesting angles here, and it really boils down to:

1. Do you believe they will fix their app.  (We believe the answer is that they mostly already have.)
   
   

2. Do you believe the brand will be permanently damaged.  (We believe the answer is no - certainly there are some consumers who will never buy Sonos again, but that is true for every company everywhere for some reason.)
   
   

3. Do you believe that they will improve their cost structure and get the company back to some reasonable level of profitability.  (We believe the answer is yes, although this is where we are most uncertain, particularly because of their hideous level of stock-based compensation.)

Sonos is a fundamentally good and fairly unique asset and ultimately, a price of <1x EV/revenues makes no sense.  The company is not burning cash and worse businesses have been acquired at much higher multiples.  We think that this has the potential to be a relatively quick and nice win as they fix their app and market attention turns to their next breakout product launch (whether that’s the Arc Ultra or not) and - eventually - improving economics.  Certainly, a lot could go wrong too, but another bump in the road could provide an even better entry point that will be viewed, with hindsight, as patently silly.  We think this one is at least worth watching over the next several quarters.   

Catalyst

Fixing the app