Sonos Inc.
Disclaimer
Black Opal Research is a newsletter that provides our take on different publicly traded businesses. We do this to obtain feedback from our subscribers and test our thesis. We find this process keeps us accountable to make educated investment decisions with our own money and no one elses. Nothing in our articles should be taken as financial advice. We will always ask our readers to seek qualified financial advice before investing in any of the companies that we complete analysis on. Do your own research, fact check, and evaluate.
Note to our subscribers
Over the last few months we have been completing analysis’ on companies that we believed fit our value investment mindset. As we dug deeper on many of the names on our shortlist, we found ourselves struggling to find something we wanted to invest in that had a durable competitive advantage, low or no debt, as well as a shareholder friendly management team. We do still have several articles in the works but decided to share one today that we completed in December 2022.
Our view on this business is that it has a long way to fall before the price of entry would be lower than the value we see in the company. Even if the price did fall substantially, we would consider this investment highly speculative as there are many unforeseen risks in the medium and long term. Additionally, we feel the management team is not acting as an owner of this business. Below is our analysis on Sonos we look forward to our subscribers feedback.
Sonos Inc.
Summary
Management
Shareholder dilutive equity compensation ~5% per year
Competitive advantage
First Mover Advantage
Incredibly large patent portfolio
Margin of Safety price point
Ten Cap 10.05
DCF $3.94
Intrinsic Value $7.88
Current stock price - $18.18
The Company
Sonos is the leading wireless multi room home audio manufacturer in the world. The company was started by founders Jhon Macfarlane, Craig Shelburne, Tom Cullen, and Trung Mai in 2002. After several years of development Sonos began shipping their products in 2005. Sonos has developed their products for music lovers, focusing on uncompromising sound quality combined with ease of use. The latter being one of the most important aspects of their business.
Sonos primarily generates revenue from the sale of wireless speakers to their customers. In 2022 this represented almost all revenue. The business also generates a portion of revenue from advertising and licencing partnerships with IKEA. Sonos generates revenue in 60 countries world wide with 55% generated from the US customer base.
Their products are marketed as a luxury item and are generally priced as such. Sonos estimates that there are 113m homes that they could penetrate as long term customers. They currently have roughly 9% market penetration based on these numbers. One of the more interesting metrics about Sonos customers is the repeat business. In 2022, 44% of new sales in were attributed to existing customers. This high repeat customer and retention of customer rate speaks to the stickiness of the products as well as the quality, expandability, and useability of Sonos systems.
The Story
Sonos is a business that is somewhat protected from competition due to their large patent portfolio as well as their dedication to quality and useability. We see a product that a consumer purchases that is easy to integrate with customers existing home automation through the Sonos one speakers. We think this is something that differentiates Sonos from other brands.
Sonos is also focused on quality for music lovers. Their speakers are tunable via software in the Sonos controller app. They integrate their system into home theater, and have provided search functionality for music that not only utilises whatever music platform the consumer subscribes to but somehow does it better than the native app itself.
We think that Sonos has the ability to gain a significant amount of market share in this segment over the next decade. Their consumer sales data supports this narrative with existing customers making up +40% of annual sales every year. This is the stickiness that Sonos has created with their system.
Once the consumer starts building a high quality audio system, its hard to switch to a different brand to continue its expansion. As long as Sonos continues to be focus on quality products and a user friendly open platform they should continue to retain their customer base.
The Evaluation
10 Cap Evaluation
At Black Opal we value businesses as if we were going to buy the entire thing. Our Ten Cap analysis is very simple. It ensures that if we purchased the whole business, we would get a return of our entire initial investment over a ten year period. This analysis does not include any growth metrics and assumes that the business will be steady and constant throughout time.
For our analysis of Sonos we will utilize their 2019 annual report to avoid the oversupply of material intentionally ordered by management as well as the stimulus demand surge experienced in 2021. While we do know that the business has grown since that time, we believe that erring on the side of caution is beneficial for this calculation.
In 2019 Sonos generated $120.6m in cashflow from operating activities. They spent a total of $23.2m investing in the business of which only a portion would have been considered maintenance capital expenditures. The details are not clearly spelt out in the 10k so we will use 70% as a estimation of maintenance capex for the business. Sonos paid $3.69m In taxes. The pre tax owner earnings for Sonos is therefore $120.6-(23.2x.7)+3.69=$108.05m
Looking at the 2020 - 2022 outstanding share count it looks like Sonos has diluted shareholders by issuing additional shares. In the notes to the consolidated financial statement it appears that this shareholder dilution will continue to occur at a rate of 5% per year until 2028 as part of an equity incentive plan. At this point we completed the calculation but note that shareholders will be diluted until management changes the approved 2018 equity incentive structure. If the company does not grow free cash flow at a rate in excess of the 5% annual dilution (or more at the discretion of the board of directors) then this calculation will not provide an accurate picture of the perceived intrinsic value of the business.
In 2019 there were 103.78 shares outstanding.
Therefor the owner earnings per share is $108.5/103.78=$1.05/share
If we are looking to recover our entire investment in the business and it does not grow at all for the next ten years our ten cap entry price per share would be $10.05/share
DCF Evaluation
Sonos sells goods to consumers. In an inflationary environment Sonos will have increasing input costs for goods to make their speakers. They will also be faced with headwinds due to a smaller amount of disposable income for consumers. Although Sonos markets to a higher end demographic we feel that they will experience slow growth in earnings well into 2024. Additionally some of the new speakers they recently launched have been directed to the lower end of their customer base who will fare worse than those with higher levels of disposable income.
These short term macro challenges, combined with a shifting product line, and end of covid 19 restrictions will have a longer term impact on the company. If we also incorporate the dilutive nature of the equity incentive plan that the sonos board of directors have approved, then we think that adjusted growth after dilution could be around 7% over the next 10 years. Using a 7% growth rate and a 15 % discount rate we believe the intrinsic value of Sonos is $7.88/share. If we utilize a 50% margin of saftey for our investment we are left with an entry price of $3.94/share today.
For this calculation we started with $0.81 as an earnings number. This is just a simple average earnings between 2021 and 2022. We did this as Sonos was experiencing a positive event in 2021 with stay at home orders and significant increased demand as well a a supply chain shortage in 2022 that really hit their bottom line. We also assumed that Sonos would trade at a PE of 20 in a good market even if they continue to dilute their shareholders annually. This is just another assumption for this business that leads us to our ultimate conclusion.
Summary
Sonos has a sticky business model, and is easily a leader in quality and functionality in the wireless multi room speaker market. Marco headwinds will have an impact on this business and growth will be challenging as consumers buying power diminishes. The management team currently has a shareholder dilutive equity incentive plan that will last until 2028, and they will also need to continue to defend their intellectual property from other industry participants (google) which could become very costly. At this point we feel Sonos is worth putting on a watch list but not in a portfolio.