Sonos Faces An Uphill Climb; Selling Out Of My Position (NASDAQ:SONO)

In this year’s early rebound, we have to be careful to avoid thinking that a rising tide will lift all boats. Amid the rising market, it’s easy to forget that macro conditions are still quite tight, and some companies are going to feel the burn more than others.

Sonos (NASDAQ:SONO), in particular, is a stock I’ve deselected out of my portfolio. The home audio vendor has had a rough 2022, and I think macro pressures will disproportionately weigh on this stock in 2023. Having already rebounded 20% year to date, I think Sonos has reached its near-term ceiling.

Though previously bullish on this stock, I have now switched my thinking to sell.

Sonos recently released a fairly disappointing fiscal first-quarter earnings print that highlights my concerns on the business going forward. The main one to be wary of: Sonos, in my view, is a highly discretionary purchase and one that sits toward the higher-end of consumer purchases. The pandemic era benefited from many people moving out of cities and into new homes and apartments in the suburbs – so all home goods-type companies saw a pull-forward in demand. On top of these tailwinds fading, macro pressures and mounting layoffs in white-collar professions are going to continue to put strain on Sonos’ sales momentum.

Forget financial metrics and margins for the moment: the chart below illustrates Sonos’ current reality. Install base growth slowed to 1.4 million net-new households last year, the slowest pace since FY17. This is in spite of the fact that in that timeframe, Sonos has dramatically broadened its product offering, including entry-level products through its partnership with IKEA.

This helps illustrate the notion that fiscal years ’20 and ’21 were heavily benefited by COVID pull-forward demand, rather than a true strengthening of Sonos’ underlying brand. And macro headwinds, particularly in the U.S., certainly won’t help Sonos in 2023.

Is Sonos cheap? Yes, we can’t argue that it’s not a value stock. At current share prices near $21, Sonos trades at a market cap of $2.64 billion. After we net off the $431.5 million of cash on Sonos’ most recent balance sheet, the company’s resulting enterprise value is $2.21 billion.

For the current year, Sonos has guided to $1.7-$1.8 billion in revenue, representing flat growth at the midpoint, and $145-$180 million in adjusted EBITDA, representing up to a 440bps contraction in margin and a decline range of -21% to -36% y/y.

Sonos’ valuation against the midpoint of this adjusted EBITDA outlook is 13.6x EV/FY23 adjusted EBITDA – which certainly isn’t expensive, but against expectations for continued performance deterioration in FY23, I consider the stock to be fairly valued at best.

The bottom line here: I don’t see a near-term recovery in the cards for Sonos as its growth falters, margins decay, and profitability suffers. Avoid this value trap and lock in gains if possible.

Q1 download

Let’s now go through Sonos’ latest fiscal Q1 (December quarter) results in greater detail. The Q4 earnings summary is shown below:

Sonos only achieved flat +1% y/y growth to $672.6 million in the quarter, though this did beat Wall Street’ expectations for a double-digit decline in the quarter. Growth was held down by FX headwinds which had six points of impact to the quarter; on a constant-currency basis, Sonos’ revenue would have grown 7% y/y.

It’s worth noting, however, that Sonos achieved this growth with the help of aggressive promotional activity, which the company was able to do now with healthier supply. Per CEO Patrick Spence’s prepared remarks on the Q1 earnings call:

On the last earnings call, we discussed how being in stock in our products would enable us to run our typical focused promotions for the first time in 3 years. As we expected, customers responded in force to these promotions. We saw very strong customer response to our sets’ offering, resulting in our highest level of sets as a percent of direct-to-consumer orders in years. We are keenly focused on driving multiproduct starts because they have proven to have greater lifetime value than single product starts as well as a higher propensity to repurchase over time.

We were pleased with the balance of sales to new households as well as the repurchase activity by our existing household base, which we believe is yet another validation of our flywheel. As a reminder, in any given period, we tend to see existing households account for 40% to 45% of our registrations, providing us with a sticky, predictable revenue stream from our installed base.”

This heavier promotional spend, however, took its toll on margins. Gross margins declined 540bps y/y, driven by three points of FX headwinds and the balance due to true business headwinds including promotions and higher raw component costs.

In spite of decaying gross margins and tepid revenue growth, however, Sonos did not pull back on opex spending as many other struggling companies have. As shown in the chart below, Sonos grew R&D spend heavily at a 25% y/y rate, consuming 10% of revenue with R&D spend – 190bps higher than last year. As a whole, total opex grew 8% y/y on a pro forma basis, 110bps higher as a percentage of revenue.

The impact to adjusted EBITDA was not trivial. Adjusted EBITDA declined -24% y/y to $123.9 million, and the company shed 600bps of adjusted EBITDA margin to 18.4% – weighed down by opex increases on top of gross margin decay.

Recall that Sonos’ guidance for FY23 calls for 290-440bps of adjusted EBITDA margin contraction this year.

Key takeaways

With weak revenue growth, a slowdown in install base accretion, deteriorating margins, and seemingly no actions to taper off corporate spend, I see very little incentive to stay invested in Sonos. Move to the sidelines here and wait for the stock to sink to a better price before diving back in.