Sonos Powers into Digital Audio

Sonos ($SONO) is ready for their IPO closeup. This week they plan to come to market on Wednesday night and the deal is already well oversubscribed. The current range is $17-19 on 14m shares. Less than half the shares are being sold by the company, most are from selling shareholders. Here are links to the IPO prospectus and the IPO slide deck.

Post-IPO there will be about 100m shares outstanding for a market cap of $1.8B. That’s on a $1.3B revenue run rate and what looks like a profitable year this year. Growth has been slow but improving. The top line is growing at about 15% which compares to 10% last year and 7% the year before.

For background, Sonos has struggled to make consistent progress in the “consumer” market for digital audio. They launched their mainstream PLAY consumer line before the massive adoption of Amazon’s Alexa. Everyone wanted their Sonos system to work with systems like Alexa but Sonos was caught flat-footed and took months to come up with working integrations and a longer-term strategy of how to coexist with Alexa.

At this point, the Sonos systems work well and have much better integration with systems like Alexa. Based on current reviews the Sonos software and system workings are still a bit of a “work in progress.” For example, the Alexa integration isn’t complete, support for other systems like Google Home are still in the works and there are often little annoying limitations like being able to connect to older Sonos PLAY components.

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Positioning, Advantages & Challenges

Sonos grew out of the custom home audio market that depended on “installers” and relied on embedded wires and a custom server to deliver high-quality in-room or in some cases multi-room sounds. These systems often cost in the tens of thousands of dollars to install and required design, installation and maintenance services.

In this respect, the current Sonos product line is basically their old wired speakers on WiFi and using their own software to allow customers to set up their own multi-room systems. Given their heritage Sonos wasn’t quite ready for the mainstream consumer who basically wants to plug a device in, wait 10 seconds for a green light to come on and then use it. Sonos can be tricky to set up and can “forget” their settings which then require a redo, often with some technical assistance.

Sonos does deliver a higher-end audio product than most other consumer brands. Their speaker systems are clearly superior to simple Bluetooth systems from a wide variety of makers. And while their software and network interface is far from perfect they lead the industry. Anyone who complains about the Bose software should try what comes from competitors like Yamaha, Sony, even Bose.

Advantages:

  • Sonos has established themselves as the best maker of wireless speaker systems. There have been some exhaustive tests and reviews and the Sonos comes out on top. Here’s a good one from wirecutter, a New York Times Company: The Best Multiroom Wireless Speaker System.
  • Many customers have become “enthusiasts” and come back to make repeat purchases. They might start with a PLAY: 1 and then get another for a different room. If they have a nice living room they might upgrade to a Play:5 or other higher-end products. This type of consumer is also able to deal with the nuances and occasional challenges of setting up and tweaking the system.
  • A broad product line, substantial installed base and large patent portfolio make it difficult for Sonos to be unseated in their current market segment. They are investing in the level of software and integration that will be needed in the consumer market, other audio companies will have to play catch-up.
  • As an “audio only” company Sonos offers consumers the greatest choice of audio content and can openly work with any and all other platforms. Consumers often use multiple services like Spotify, iTunes, Pandora, Amazon Music, and Sonos supports them all.
  • Based on their footprint in the US they have substantial opportunity to expand geographically, especially in first world countries where consumers have an appetite for higher-end audio components.

Challenges:

  • Growth has not come easy for Sonos – this despite significant new product introductions. Overall growth has been in the high single digits for the last few years. Recently growth has improved but in their long-term financial model management pegs growth at 10%.
  • Lower-end smart speakers are “good enough” for many consumers. The biggest challenge is the Amazon Echo. It has excellent sound and better reviews than the new Sonos One. The Echo is also half the price of the Sonos One which is the cheapest one from Sonos at $199.
  • Premium pricing may limit the market opportunity for Sonos to just the upper end of the overall market. For example, the two newest products – the One and the Beam are priced at $199 and $399 respectively. This compares to the pricing for the higher end PLAY:5 and PLAYBAR at $499 and $699.
  • Growth will be lumpy – not an easy model for Wall Street to enjoy. Management noted that due to the staggered pace of product introductions the growth rate will vary significantly from quarter to quarter. For example, the company had 18% growth for the six months to March 31st but had a *decline* in revenue for the quarter ended June 30th. This was due to a new product introduced last year which made for a tough compare.
  • Despite new product introductions, a strong economy and a huge increase in the demand for streaming audio, growth has been low for the past few years. A few quarters ago things started to perk up but after a soft Q3 growth will probably be more moderate in the second half.

Competition

While investors may worry about Amazon ($AMZN) it appears that the direction for Alexa is not towards the market that Sonos serves. Amazon appears more focused on home automation and communication than they are in entertainment hardware. Sure they have FireTV but the vast majority of their customers access PrimeTV via other platforms like Roku or AppleTV.

One company we think is watching this IPO closely is Bose. Still privately held Bose is a $3.8B revenue company with a long history in consumer audio. Bose has some similar products but they have focused more on headphones and Bluetooth speakers rather than the multi-room wireless market. There are certainly new products being developed by Bose that could prove to be a better rival to the current Sonos lineup. Bose has most of the key products (large and small wireless speakers as well as soundbars and full home theater systems) but they haven’t developed them into the kind of system that Sonos has.

Apple ($AAPL) and Google ($GOOG) each have their own wireless speaker offerings (HomePod for Apple and Google Home) but they work mostly with their own music offerings. Neither company appears to want to get more directly into the enthusiast audio market.

One interesting company to consider as Sonos heads for an IPO is Roku $ROKU. First of all, they are an interesting “comp” for Sonos given their position as an independent provider of video streaming and content that is used with many brands of TV as well as with the Roku “box” which is similar to AppleTV. Roku has pushed more into content though and is focused on growing their “platform” revenues which are now greater than their traditional “player” revenues and doubling year on year.

With a market capitalization of $5B on what should be about $350m in sales this year, it’s clear that investors put a much higher value on the platform revenues. And Roku isn’t even making money yet.

Business Model & Valuation

Sonos is a hardware company without a true recurring revenue stream. Repeat purchasing from existing customers helps but they live or die on the strength of their products and grow by new introductions. Management admits that their growth will be lumpy based on the timing of past and future product releases.

One might expect Sonos to be acquired at some point. Perhaps by a very large player to add to their footprint, IP and consumer base or by a smaller content player who sees synergy with the platform and is willing to preserve the independent positioning of $SONO.

As a hardware company, they are afforded a lower valuation than content and software companies. Our IV includes a growth rate (15%) above management guidance (10%) and gives them a small premium multiple (20x) to account for their current market leadership.

Our generosity gets the shares an IV of $33. We have to point out that a few points off the growth rate take a big bite out of valuation so small changes can have a large impact.

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