Sonos Stock: One Of The Largest Longs At My Last Shop (NASDAQ:SONO)

The following segment was excerpted from this fund letter.

Sonos, Inc. (NASDAQ:SONO)

Sonos began as one of the largest longs at my last shop. We entered the position in September 2020 and exited the majority of the position in Q4 2021.

The high-level long thesis at the time was that Sonos’ lumpy growth, low margins, and one time nature of its purchases, coupled with loss-leader big tech competition, was incorrect. Instead, the company’s focus on premium home theater (where it faced no big tech competition) and seamless and easy connection of its devices afforded the company a long runway to grow its installed base in high-income US households and cross sell complimentary audio products at much higher incremental EBITDA margins. In addition, new product refreshes with higher ASPs and a focus on the home would be a tailwind during COVID as consumers looked to trade up their home audio experience. In addition, short term supply chain issues affecting margins and ability to deliver product weighed on sentiment as short interest was 8% at the time and sell side ratings were unfavorable.

The LT Return Framing was simple:

• Base20 Component
  • The top line growth calculus for a 20% IRR at a 16x FCF exit multiple, was simple at 1.8mn new households per year (reaching 15% of all US households in FY25 from 9% in FY20) and $70 of spend annually per existing household; GMs would increase LT as trade war and supply chain issues abated; and, EBITDA/FCF margins could reach the low teens on G&A leverage and an increasing base of existing household sales leading to Sales & Marketing leverage
    • Sonos’ hardware business revenue growth visibility and durability was underappreciated with ~ 40% of product registrations every year coming from existing households
    • COVID tailwinds around focus on the home would lead to higher product expansion in the out years

• Plus Component
  • Sonos’ Patents
    • The company’s legal fight against Google (GOOG, GOOGL) was its first foray into monetizing its IP and could produce DLB-like royalty revenue, margins, and multiple on this business line which was significant given ~80mn big tech speakers sold annually

Transitioning to Sandbrook, I took a 3% short position in the company a little over $18/share during 1Q given a negative view on the Q2 and FY revenue and EBITDA guides. Specifically, street was mismodeling the unit comps in Q2 and on a FY basis, idiosyncratic headwinds concerning margins (unusual discounting, high inventory levels, and OpEx deleverage), and there were obvious ASP headwinds. Furthermore, the company’s CFO departed for a private company right before the company’s large holiday quarter. The new CFO is also the company’s Chief Legal Officer.

The high-level numbers to the thesis were:

• A 2Q guidance miss (revenue $300-$305mn vs. street at $377; EBITDA -$23mn vs. street +$27mn) and guide down for the FY (revenue $1.64bn vs. $1.75bn; EBITDA $84mn vs. street $160mn) would send the stock into the low teens as investors questioned how big the pandemic pull forward was, the duration of the gulley, and whether the company’s new product launches were big enough to drive LT growth therefore reigniting pre-COVID bear narratives and a corresponding multiple
• Traditionally, the company only discounts its entry-level One speaker during the holiday shopping season. However, during C4Q22, the company discounted their high-end home theatre soundbars, subwoofers, and speakers 20%. I believed this would put GMs in the high 30s vs. street at 45% (actuals were 42.4% driven by said promotional activity).

I arrived at my estimates for Q2 and the FY through a bottom up build of the various segments. Sonos provides units sold per quarter as well as revenue for its Speaker, System, and Partner & Other business lines. When backing out ASPs for Sonos’ System products (where ASPs and mix is relatively constant given this is mostly professional installer demand) and Partner & Other lines, you can get a rough estimate of Sonos’ Speaker Units and ASPs. Given y/y, 2yr, and pre-COVID stacked unit sales for the Speaker line, I estimate fiscal Q2 speaker units come in at ~735k units vs. my rough math of ~600k in FY18 and FY19, 450k in the COVID quarter (March 2020 ending), 750k in FY21, and 1.05mn in FY22. I believed the company was backfilling the channel throughout FY21 and 1H FY22 which created difficult unit comps specifically in 2QFY23. In addition, Sonos was lapping price increases this fiscal Q1, which provided no tailwind to ASPs or margins. Speaker ASPs also faced a headwind from mix of newer product introductions such as the Roam, Ray, and Sub Mini which are offered at a lower price than Sonos’ flagship products (the company’s premium AMP @ $699 and Arc @ $899 were a higher share of mix during ‘20-’21). I saw a similar unit and revenue story playing out in the Systems segment. Units of 80k in 2QFY23 will be ahead of the ~70k pre COVID but below the 90-110k level during the following 3 years.

The biggest risk was a 1Q beat which I had in my model (also, since the company was just starting its federal Google trial in May, there was little ST convexity risk to an IP announcement). The alt data on Sonos called for a 1Q beat but it is noisy given the company’s higher mix of channel sales where sell through is captured by Google Analytics accounts of distributors and BBY where share of spend is captured by email receipt data which is not indicative of Sonos sell-in. My numbers for Q1 revenue were ahead of street ($625-$635mn vs. actual $678mn vs. street at $578mn) reflecting easy 1yr and 2yr comps in the Speakers segment. The revenue beat vs. my numbers was a $30mn beat in System revenue (these are components popular with installers that allow a customer to connect other speakers into the Sonos app/system).

The stock performed well on this 1Q revenue and EBITDA beat accompanied by unrevised FY guidance. Other positive highlights included a strong sell down of inventory, strong performance of bundled sets, stable OpEx growth going forward, no air freight costs, and a new category entry this year. While no formal 2Q guidance was provided, the new CFO gave rough guidance for 2Q revenue down 50-60% q/q on more normalized seasonality. As of mid-April, the Street is currently at $297mn in revenue for 2Q. I felt comfortable holding the short as I continued to believe that FY estimates on revenue and EBITDA remained too high and consumer discretionary broadly remained a good place to have negative net exposure.