Sonos, Inc. (SONO) Earnings Call Transcript & Summary

Good afternoon. Thank you for joining us for the last session on the second day of the conference. I'm really pleased to welcome Brittany Bagley, CFO of Sonos. Brittany, many of you may know, she was instrumental in driving KKR's investment in the company. Sat in the Board for 2 years before taking over as CFO about a year ago. So welcome. Really appreciate you spending the time with us. Maybe just because some of the people in the room may be new to the story, just give an overview of what Sonos does and what you see is the investment thesis.

Yes. Well, thank you for having me. So Sonos is a premium audio company. For a long time, we really focused on the home, and more recently, we've gone outside of the home with our first product, the Sonos Move, which launched last fall. We really pride ourselves on a couple of things. One, we invented the category in a lot of ways. We were the first company to do multiroom, wireless home audio where you could have multiple speakers. They would all sound beautiful together, and you didn't have to go rip holes in your walls. So we were the first to do that, and we really think we continue to do it best today even with all of the competition that's in the space. There's always been competition, and we've continued to perform really well. Other than having great software and great features because we sell hardware, but we do it at a premium gross margin because we have so many features and software investments that go along with that, everything from how you set up your user experience, the fact that we integrate with over 100 music services, the fact that we now have both Alexa and Google on on our product. We really act at Switzerland and we integrate and provide consumer choice. And then we do that in a way that has premium design. The product lasts for a long time. So I'm sure I'll get a question about our legacy products that we just announced. So even with all of that, our products last for a really long time, so you get a beautifully designed, easy-to-use, high-quality product that works better than, in our view, any of the other products on the market. And so that's really what got me excited. Company has been public for about 2 years now. We invested -- when I was at KKR back in 2012, so have seen a long evolution, and I think the company still has a lot of really exciting things in front of it.

How do you think about Sonos' addressable market and the current penetration of that market?

So we look at the total market for our products right now as being about $20 billion. We think we have about 6% share of that. If you went up into the premium price points, we would have more share because that's really where we play and do a great job. And then we have talked about entering new categories, going further outside the home. We haven't gotten specific on that, but any of those new categories would further expand our addressable market.

Even before you get to expanding the addressable market, your growth is really driven by the growth of homes and then the penetration in homes. Talk about the life cycle of a customer because that repeat purchase is really important.

Yes. I mean the great thing is that people love our products. And we know that because 37% of our registration's in 2019, and that's been a pretty consistent number. Our existing customers coming back and repurchasing products. So everybody says, "Oh, hardware, you start from 0 on day 1." Well, we actually know that we're going to get our customers coming back and repurchasing our products. So we have a great existing installed base there. In 2019, we went from, on average, 2.8 products to 2.9 products. That includes a lot of households that only have 1 product. And so you can imagine how people who buy into the system continue to buy more and really have Sonos throughout their home. That's a bit of the magic of the product is when you get the whole home audio.

Yes. And so when you think about untapped opportunity or expanding the TAM, whether that be by geographies or by price points within the home or, as you said, starting to move out of the home, what are some of the most interesting opportunities in your mind?

We like all of those, yes. So it's really a combination for us of new household growth, getting new people to become Sonos customers. That can be in our existing markets. We do about half of our sales in North America, about 40% in EMEA and about 10% in APAC. So it could be expanding our new households and our existing homes. And then it could really be selling more to those new households. A couple of the ways that we can continue to access new households are through things like partnerships. So we partnered with IKEA, and IKEA reaches a different demographic. They're embedding our speakers in things like lamps and bookshelf speakers. So a different customer, a different channel and a different price point. So they have a speaker at $99. So that's bringing in a different demographic and new users into the Sonos ecosystem, which is great for us to see. And then there can be continued geographic expansion. APAC has been on our list of places where we would have to do something different than what we're doing today. A lot of the voice services and music services span both North America and Europe pretty easily. So you get some leverage out of those, but we would have to go do different things, have different partnerships to really penetrate China, for example. And so that's a long-term opportunity for us that we think about. But we've also been really happy with our existing growth and how we're doing. We gained share in Q1. In 2019, we added 1.7 million new households. So we got up to 9 -- a little over 9 million new households or 9 million total households in 2019. So we're continuing to add really nice growth. And then we said in Q1 of this year that we added more new households than we ever had before. So we're really excited about the progress we've made.

Particularly relevant that -- or important that you took share last quarter because it's the quarter when the competitors are very price aggressive, and you've really proven the value proposition without having to significantly discount the products.

Yes. I mean we took slightly deeper discounts than we had the prior holiday quarter because I think, in general, Black Friday and Cyber Monday are becoming bigger and bigger promotion events but relatively modest discount compared to competitors in the space. And I think that just goes to our value proposition. We really are a differentiated product in the space, and that's what our customers are seeing even as you're hearing some soft news out of some other players in the market.

So you brought up China, which allows me to ask the question about -- that everybody is asking this week just around coronavirus. And talk about the manufacturing exposure you have and whether you see it creating some disruption in the supply chain.

There was no way we were ending this without coronavirus. And thank you all for being here. Look, we have manufacturing in China. So obviously, that is something we're watching really closely. A lot of that manufacturing has come up and come back online, and so we're getting to the point where we're getting a better handle on what that will really look like and what that impact will be longer term. I would note that as part of tariffs and some of the things that have been going on with tariffs, we had already started to move our manufacturing to Malaysia in part. So we had already said that by the end of this fiscal year, we would have the majority of our U.S.-bound production moved to Malaysia. So that's one difference that we are certainly monitoring and will hopefully help us as we navigate coronavirus. And then because we don't have a lot of sales in China to this point, we really don't have an end-demand impact. It's really about how we manage our supply chain and any end-demand knock-on effects either in the U.S. or EMEA from how this continues to evolve and where it continues to go in the market, and that's changing. I mean every day, there's new news on that. So we're just continuing to watch it, and then we'll try and give a pretty clear update based on what we know, which is hopefully a lot more when we get to Q2.

That's great. Going back to the competitive landscape. One of the most often questions is, how does this relatively smaller company compete with the Goliaths in tech with big balance sheets and very, very large customer bases? And you've proven to be able to do that, as we talked about, with the share gains in the holiday quarter. Just talk about -- a little bit more about the competitive advantage and why you think there are barriers to entry for those companies.

Yes. We think it's a couple of things. We think it is the full package of what we offer. So if you look at any individual competitor, we can talk about sort of why we think we win against them. But if you look at the full package, it is continuing to do such a great job in the multiroom, wireless audio. It is continuing to innovate on software and features and ease of use, our UI. We have talked about how we're investing in R&D. Part of that is as we go into new hardware categories, but a lot of that is as we continue to differentiate and invest in our software features. A good chunk of that is just the premium design, the quality, the longevity, it looks good. People want to have it in their homes. There's strong brand recognition about what you're getting when you buy Sonos, and you know it's going to work well, and it's going to last. So I think -- so those are some of the really big pieces. Sound quality. Those are -- that's really important. It's table stakes in a lot of ways, but we continue to get great marks on and spend a bunch of time on our sound quality. And when you wrap that whole package together, and then you factor in the fact that we really make money on selling new hardware, and you know how we make our money, that's our business model. You know what you're getting. We continue to find that to be a very important value proposition to customers.

What's interesting is some of the newer entrants, the large technology companies you're also partnering with, you started out talking about Alexa and Google integrated in your products. So talk about how that partnership ecosystem is going and where it works well and where it maybe doesn't work as well.

Yes. We're big on customer choice. So we did it with the music services. We partnered with -- I think we're partnered with over 100 music services now. And we did it on voice. So we started by partnering with Alexa, and now we've added Google in. And then we also make speakers that don't have microphones in them. We make speakers where you can turn them off and mute the microphone. So we're really trying to balance people having the option of whatever features or technology they would like to have, whether or not that's voice or music services, with also having the choice of being more limited and having privacy, if that's where they're going. They're really important partners to us. I mean the music services are important partners. The voice services are important partners. We integrate on their platform. They're a core part of our experience. So I think that's just where tech has gone now, which is it's a really interconnected landscape, and you both compete and partner and everyone figures out how to navigate that.

But there ultimately has to be value that is brought to the table for Sonos, particularly given that your IP portfolio is ranked incredibly high, #2 in consumer electronics, 19th overall. And you have proven your ability to defend those patents in the courts. And so you can speak to it, but in the case of Google, you decided to bring a lawsuit against the company, a partner and a competitor. Talk about what led you to that decision and what drives the confidence around your ability to protect your IP.

Yes. We did not make that decision lightly. They are not only a partner, but they're obviously pretty sizable. And we tried to resolve it in other ways. We have been -- if you read the brief, we have talked about for years, we have been alerting them to the fact that we think they're infringing on our IP and that we would like to resolve that. And unfortunately, we got to the point where the only way to resolve that was in the court. So we filed 2 cases. We filed with the ITC, and we filed in federal court. At this point, the ITC has accepted the case. And so we have agreed to stay the federal court case while we resolve this in the ITC. The ITC is usually an 18-month process. And so to everyone who is really worried that this is going to drag on endlessly for us, I think that's one of the reasons we decided to file in the ITC as well is to try and come to a more rapid resolution of this. We would not have taken it on if we didn't think we had a really good case. I mean you don't take on suing Google lightly. Lots of respect for them in their patent portfolio and how they defend against these things. But at the end of the day, I don't think there's that many companies who can really say that they invented the category and have some truly fundamental IP in the category. And we did sue Denon and win against Denon with 2 out of the 5 patents that we have asserted against Google. And so to the extent that you can ever feel good, we think we have a pretty good case going into this.

Patrick has said, even back to the IPO, that most of these companies are actually infringing on Sonos' patents. And if there's a partnership where there's value provided to both parties, that, that's sort of acceptable. And so I guess the question would be, why Google versus potentially many companies that you could have brought that case against?

I think it's really just the state of where we got to in the conversations with Google, which is we had ran out of room for sort of any kind of other discussion to happen. So this is where it left us.

Okay. Understood. You brought up in the beginning that back in January, you announced end-of-life in terms of software upgrades and at least new features coming to older product. And the passion of your customers showed through in their feedback. So just talk about the rationale of that, the customer response and how you sort of put out the smoke around that announcement.

Yes. I think one of the e-mails we got was that you're as bad as Apple now. So we were like...

Is that a complement? Or...

[ No ]. We'll take it. Look, I think with -- it's clear that we have really passionate customer base, and that's great. We want people who really care about our products. The products that we announced, we would be ending software updates on -- came out in 2006 and 2009. And so at the end of the day, we continue to make really long-term, sustainable products that last, I think, probably more so than most other people in the CE industry. But even with that, they are computers at the end of the day. They have memory in them. They have processors in them. And we have run out of our ability to really provide all of the software features and upgrades that we would like to provide on those older internals. And so we gave a lot of thought to doing this because I think this is the first time we've had to do it. Our products have been -- our customers have been used to our products just getting better over time. And I think that we did not do a great job on the messaging, as evidenced by sort of all of the chatter and the news coming out of that. And I think part of that was probably fair in terms of -- there's probably some things we should go back and relook at like our recycling program, and we're really listening to that and thinking about what that can mean and taking in that customer feedback. And there's part of that, that is an unfortunate reality of having your speakers be technology products at this point. And so we do have to end-of-life these software upgrades. But we didn't make it nearly clear enough that, that meant your speaker wasn't going to stop working in May. I mean your old speakers are going to continue to work for as long as we can make that work, but we just can't do everything new with them. And so that's really where we didn't do a good job on the messaging as we left a lot of customers thinking this product they bought is just going to stop working, and why can't it at least play music the way it does now for a while. And so Patrick, to his credit, penned a personal note. He said, "That is not what we meant, and we got the messaging wrong. And we're going to fix it. And we're going to listen to all of you. And we will come back. But we're not going to come back and say that we don't actually have to end software upgrades for these products because, unfortunately, that's just the limitation."

Yes. It is pretty unbelievable that you're talking about products that, in some cases, are 14 years old in the technology market. I can't think of anything that really lasts that long and that companies support, let alone just, generally, in the consumer products market. So it's definitely a testament to where you started, which is the quality of the products. You recently, late last year, acquired Snips. Talk about what drove that decision. What customer needs do you think that, that technology and the team that you acquired brings to Sonos?

Yes. So it brings 2 great things in our mind. One, when we look at a voice assistant data or when anybody looks at public voice assistant data, the things that are most commonly used on your voice assistant at home is to play music, set timers and ask about the weather. Because a lot of the ask-anything voice assistants are doing a lot more than that, they don't always have the deep integration with music and the quality of retrieving your music that we would like to see from a customer experience standpoint. And at the end of the day, why we continue to win over and over is a differentiated customer experience, and we didn't feel like our customers were necessarily having that specifically in the music vertical on our products. And so that was one of the things that we really liked about Snips is that by controlling our own voice service, we would be able to control the customer experience and deeply integrate that. That is not to say we're going to do an ask-anything voice assistant. We're not looking to compete with Amazon and Google on that at all. We're really just looking to improve the experience for our customers. The other thing that we really value about Snips is how they approached their voice assistant in a very privacy-first type of way. So they are a privacy-by-design voice engine. We take privacy really seriously. I mean we don't sell data. We sell hardware, and we sell a music experience, and that's what we're looking to do. And so being able to have our own voice assistant and provide voice as an option to our customers who aren't comfortable with the ask-anything voice agents sitting in their homes felt like a real opportunity to us. So we're really excited to have that team on board.

You brought up the IKEA partnership. You also announced the partnership with Sonance. What -- how do you think internally about deciding where IKEA invests? I mean you could have done a cheaper bookshelf speaker instead of IKEA, as an example, or in-wall integrated speakers on your own. How do you think about where it makes sense for Sonos to invest and focus versus where you want a partner?

Yes. I mean we aren't going to do everything. And so we look at where we think that we can really make a huge difference and bring a very Sonos-esque product when we do our own hardware. And then we look at where our partners really bring something valuable to the table or have experience that we don't have. And so for Sonance, they are well known and well regarded in the installed outdoor speaker market category. So it was a great way for us to partner with them and reach that market without diverting resources to doing that ourselves and instead focusing on some of the other new products that we have been working on like Move, for example, to address the outdoor market. IKEA has a different customer base. They have a different channel. They have a different go-to-market strategy. And they have a different design aesthetic, right? I don't -- they would design a different lamp than we would design, and we're not in the lamp design business anyway. And so they really brought something differentiated to that partnership. They also have a great geographic footprint, and they have an incredibly passionate, energized customer base that comes back and buys from IKEA over and over again. And so one of the things is we love that match-up in terms of what they brought to the table.

On the last earnings call, you talked about new business models and potentially services being added to the financial aspects of Sonos. Talk about what those might look like.

So the 2 that we had started to talk about publicly are called Sonos Flex, which is a consumer subscription service, piloting it in Amsterdam; and then, Sonos for Business. While these are early, we're starting to talk about them because people rightly ask us over and over again, have you thought about more recurring revenue? Have you thought about other ways to monetize your base? And it goes back to how do we expand who we're reaching. So there is more and more of an attitude about people renting things, right? There's -- certainly, you can do the buy-versus-rent math, and that's out there, but lots of times, people just want to rent things to try them. And so we think that it's important to offer people that as an option, and we think we'll get in a potentially different customer who wants to rent versus buying upfront. We also think it, long term, could be a helpful way of dealing with some of these legacy product issues because if you're on a rental program, you're not going to run into legacy products. You're just always going to have what you need in your home to continue to get the software upgrades. So we're starting to play with that, it's really early. We'll make sure that, that thesis is right and that we're adding real value before you see us flow it out more widely. But we're just excited to be able to offer our products in a different way to customers. And then I think Sonos for Business is a similar thesis, but we really haven't spent as much time as we can and should with some of the small business customers, coffee shops, restaurants, gyms, dance studios. And what we can do there is we're actually bundling in some of the commercial music services. So in some ways, either they know they need a commercial music service and we're making it easier for them or we're helping them with an education process. Both of those are really early, but we're excited for both of them. And importantly, I think we're spending time thinking about our business in different ways and different ways to go out and create different revenue streams from customers.

Because of the share gains you talked about over the holiday period, you beat the last quarter revenue by about 3%, but you left the full year. Talk about that dynamic.

Yes. So we ran a slightly deeper promotion in the holiday quarter and we saw a really great response to that, better than we thought we would see. And so our view based on the best information that we could get from other promotions we had run, some of our suppliers, what we were seeing in terms of patterns after the Black Friday, Cyber Monday, was that people had pulled in their demand. And so we did think that there was a pull-in from demand from Q2 to Q1 just based on how good some of those deals were and how excited some people were to buy those products. Certainly, we'll see as we go through Q2, and we'll give everyone an update on Q2 earnings in terms of how that's actually turned out.

From a margin perspective, if you normalize for the manufacturing shift and tariff-related costs, margins expanded pretty significantly last quarter, about 450 basis points. Is that sustainable? How do you view the trajectory of gross margins?

Yes. Excluding tariffs, we continue to think about our margins in the 42% to 44% range, long term. They're going to go up and down in that range, depending on our product mix. Each product that we release has a different gross margin structure. And so the mix in any quarter or any period of time, depending on what we sell, can change based on what that product mix looks like. So in Q1, really great margin expansion. Lots of that was driven by product mix. And then some of that is, we're also always working to get our materials costs down, and continue to do a better job with our supply chain and sourcing and all of that. So you saw sort of a double benefit in Q1.

Let me stop there. We only have a minute or 2 left to see if there are any questions in the audience.

Your go-forward capital allocation process [indiscernible] pipeline versus...

The question is about capital allocation and using the balance sheet for return versus M&A.

Yes. We finished Q1 with over $400 million in cash. So one, we're happy to be in a strong cash balance sheet position, especially as you think about something like what coronavirus could do. Knowing that we're in a good cash position helps us all sleep at night. But then we are going to be really responsible in terms of how we think about deploying and using our cash, and that will be a balance of organic investments, inorganic investments like M&A. I'm not sure that we will be responsible and thoughtful as we do it, but something like Snips can make a real difference to us long term, and we're out looking to find other things like that for the business model. And then in September, we had authorized a $50 million share buyback program. So we will also continue to look for smart and thoughtful and responsible ways to return some of that cash to our shareholders.

Okay.

Are you planning any major technological changes to your product?

I wouldn't say anything major. We're always looking to innovate and differentiate our products. And so with every product we release, we try and do some improvements and try and continue to make them better, and we're pretty focused on that, both through hardware and software.

Just to wrap up, Brittany, talk about what you think -- you speak to a lot of investors, what do you think is most underappreciated about the Sonos story?

Yes. I mean I really think it's that software differentiation piece. I think we get looked at as a hardware company over and over again. And I think it's underappreciated how much we invest in software and how much we're really monetizing our software through hardware and what that means for us in terms of long-term opportunities. We don't look like exactly anybody else. And so I think that's hard. But it really is that software that answers a lot of the competition questions and a lot of the -- sort of, "why we're going to continue to win" questions.

We see the comparison of Sonos to other consumer electronics companies. And the problem there is that the software drives this ease of use and engagement that just is incomparable to any other consumer electronics company, at least of your size. And so I think that's certainly -- you hit the nail on the head on what seems to be underappreciated. So thank you so much for your time.

Thank you.