Sonos: Lost Battle Before It Started – Sonos, Inc. (NASDAQ: SONO)

Source: Sonos

Recommendation

We recommend selling Sonos (SONO) as it is quite appreciated now according to our DCF model (suggests $ 9.74). However, we have a bearish view of the company over the long term for three reasons. For securities, the company lacks a sustainable moat that will give SONO a long-term competitive advantage. Second, while multi-room synchronization technology helped launch the company, management failed to develop proprietary VPA technology that is critical to smart speakers. Finally, the market generally sees Sonos as a good buy-in and hopes it will be bought out at a premium; However, giants like Amazon (AMZN), Apple (AAPL) and Google (GOOGL) have no compelling reasons to burn cash to buy something that would be available in a few years (we're talking about the patent expiration). [19659004] Investment themes

Unsustainable economic moat

The company spied on the integration of network networks used in the military with speakers. The experience in several rooms is the selling point that has maintained the company since its inception. Nevertheless, the company identifies itself as a smart speaker company competing with Amazon, Google and Apple. Sonos has correctly identified the potential market and trend of the smart speaker segment, but the smart part or soul of Sonos speakers is from other companies, namely Alexa from Amazon and Google Assistant from Google. Source: Futuresource Consulting, JP Morgan estimates

We can see that it is a large addressable market for smart speakers, but it is safe to say that this market will primarily dominate by Amazon and Google, given their market share last year (see diagram). It may be easier for Apple to capture than Sonos because of Apple's existing customer base and internal VPA, Siri.

Source: Voicebot.ai

Sonos has a strong patent portfolio that not only gives it protection but also the influence to negotiate with the giants.

Bulls can claim that the ability to integrate multi-voice assistants is a competitive advantage. While it is true that Sonos is the first company to allow users to use both Alexa and Google Assistant, this benefit comes only from Sono's patent portfolio. Google approved to allow Sonos to use its VPA because it violated Sonos patent, so "Instead of suing Google or negotiating a license agreement, Sonos suggested a partnership with Google that allows Google Assistant integration into the Sonos speaker, a person nearby said. of situation. "

Playing patent hardball is not a sustainable approach to establishing competitive advantages. It is also not dependent on other companies' VPA. Although Sonos speakers have multiple VPAs, compatibility is a problem. Users can use Alexa for a Sonos speaker and Google Assitant for another, but cannot use both on a speaker. Also, the user experience suffers since Google Assistant is not designed for Sonos six-array MEMS microphones (see picture).

Sonos A microphone arrays for long-range speech recognition. Source: Ben Einstein's dismantling

Google's home button has two micro frames. Source: Fub on research (a sales page report)

People basically buy metals and plastics from SONO as the soul of the speakers, VPA, is from Amazon and Google. Amazon and Google may terminate the partnership at their sole discretion at any time. The only proprietary advantage that SONO has is its multi-room synchronization technology. This mound is temporary because it is only protected by SONO's strong patent portfolio. The core of the patent portfolio, the multi-room synchronization protection (US9164531B2) expires in 2026. And this technology is not very difficult to duplicate. Basically, there is an internal clock in each speaker. The master unit assigns a timestamp for playback to other "slave" speakers so they can play the music without time lag (aka lagging). We will be surprised if tech giants like Amazon cannot achieve the same, if not better, method.

Source: Google Patents

Lost Battle Before It Started

The company's core technology is on multi-room synchronization, which was relevant a few years earlier. However, the future potential of smart speakers is not the company's focus. Investing in speech recognition technologies did not succeed when Amazon and Google started up. The previous CEO declined this fact, which commented "I fell into the trap where I have been looking at voice recognition for many years … I tried Echo in the beginning and wrote it off. I had too many distractions at the time. did not play at the level I should have played with all frankness. "

At this point, the company has a strong cash position ($ 280m), which involves potential future buyouts, according to Patrick Spence (CEO) during the 1Q19 Earnings Call. However, we expect the company to buy peripheral technologies to expand the speaker volume to laptops and autos, rather than some voice revenue companies because it would not be a financial decision that 1) investors will suffer from short-term losses due to outlays and 2) it takes time and a significant customer base that SONO does not need to train AI.

Partnership with IKEA is a good idea to add more price points and innovative products. However, these products are only creative in design, the core technology has not changed, for example, is still dependent on Alexa / Google Assistant. It can bring more revenue to the company, but if the market sees it as a profitable method of integrating furniture speakers, giants like Amazon will get hold of quickly because of their customer base and strong negotiating powers.

It is worth noting that we have seen some dynamic change in the company's revenue making (see diagram). The wireless category has declined QoQ while the home theater segment has increased QoQ. Talking with the company, we get a sensible explanation behind the change: "The success of our Beam product positively affects FY19 home theater performance. In the wireless category, the removal of the PLAY: 3 product has created a headwind to grow in a year over the year. "

Source: Business Register, SnowPeak Securities

the management has not succeeded in getting started with VPA trend. Now the management decides to roll out several products in the coming year. However, the company sacrifices the quality of the facilities. For the flagship product Sonos One, the second generation looks like a rushed-out product without innovation other than some minor hardware updates that do not significantly improve the user experience.

Seasonal Length of Sonos Quarterly Revenue. Source: Company deposits, Bloomberg

The time of the Gen 2 release can be interpreted as an attempt to inflate revenues to withstand the season of revenue development (see chart). However, due to lack of functions, we do not expect the release of Gen 2 to have any significant impact on the top line. Please note that the CEO of the company has extensive market experience from his time at Blackberry and as a CMO at Sonos. Spence emphasizes holiday promotions, which suit his specialty. But it gives us the season we see. The company has used twice as much S&M as R&D. Winning through marketing is not sustainable.

We also see some operating expenses related inefficiencies due to the company's sales channel through third-party retailers. The company is shifting its sales strategy towards direct-to-customer channels and e-commerce. The income manager for Sonos depends on the products sold and the release of new products. Revenue comes mainly from new customers and existing customers who buy more products. So it's just a revenue stream that revolves around the goods. In addition, existing customers for new product registrations account for only 38% of the new products sold. It would be difficult for Sonos to gain customer loyalty without providing special services and ecosystems such as Amazon, Google and Apple.

As mentioned in the 1Q earnings call, there was some slowdown in the throughput rate, which meant a higher than expected inventory level. It indicates inefficient management and lack of understanding of market demand. It takes about 69 days on average to reverse the overview, which is in line with the time it takes for the company to pay its suppliers.

The bottom line is, Sonos is a hardware business that is facing fierce competition and a high barrier in the VPA field.

Unlikely a buyback target

The market believes that Sonos can be a good buyout target for the giants. But valuing at $ 1.02 billion, Sonos is expensive for what it offers.

Think of the synergy that can be added to the merger. Apple had to pay who was at a premium to get the technical know-how they could get easily if Apple decided to donate resources to the HomePod development. Furthermore, Sonos does not have an attractive profit margin and customer base, which does not facilitate Apple's investment philosophy. Sonos' 4% market share would not help Apple much to compete with Amazon. So, we can eliminate Apple from the potential buyer list.

Would Amazon buy Sonos? Maybe not because of the reasons mentioned. Would Google Do It? Very unlikely because Sonos devices are not even compatible with Google Assistant.

A likely synergy would be the reduction in price when Sonos uses the same vendor group that other giants do.

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Source: Jefferies, Bloomberg, SnowPeak Securities

Catalysts

catalysts that will push the stock price to our lower target price include the FY2Q value release, new product release from competitors incorporating multiple room synchronization without violating Sonos & # 39; patents, and, most importantly, the expiration of Sonos & # 39; core patents.

The management has no 2Q performance guidance, but the consensus agrees on $ 229.74m for revenue, factoring the Gen 2 release, and the IKEA partnership. Any loss of revenue will help push the shares down.

Risk

The company only has IPOed and it is still growing. Potential risks to our short position will be new products that are interfering with new technology.

Better than expected earnings will also work against us.

Finally, if the company is acquired by another company, we can expect a 10-25% premium on the stock price.

Valuation

Assuming a growth of 10% for revenue, 9.21% for WACC and 2% terminal growth, we get $ 9.74 as the target price. Of course, we must consider the ups and downs. So, an area of ​​7.52-12.68 is what we expect here.

Source: SnowPeak Securities

Last word

The company has a simple business model, so it's a little room for us to find the wrong price in this stock. At this point, the company is reasonably valued, investors should consider selling their holdings. However, we are not optimistic about the company's long-term development as it would be irrelevant in the market for smart speakers in the future due to the lack of proprietary VPA. It would be interesting to see where the company is when patents expire.

Enlightenment: I / We have no positions in any of the aforementioned shares, and no plans to start any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for it (other than from Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.