Sonos, Inc. (SONO) Q1 2019 Earnings Report, Transcript and Summary

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to Sonos Fiscal First Quarter 2019 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. I will now turn the call over to VP of Corporate Finance, Mike Groeninger. You may begin your conference.

Thank you. Good afternoon, and welcome to Sonos' first quarter 2019 earnings conference call. I'm Mike Groeninger, VP of Corporate Finance. And with me today are Sonos' CEO, Patrick Spence; and CFO, Mike Giannetto. For those joining call early, today's whole music comes from the Q1 playlist included in our shareholder letter. The 64-track playlist is created by our Black @ Sonos employee resource group to celebrate Black History Month. Before I hand it over to Patrick, I would like to remind everyone that today's discussion will include forward-looking statements regarding future events and our future financial performance. These statements reflect our views as of today only and should not be considered as representing our views of any subsequent date. These statements are also subject to material risks and uncertainties that could cause actual results to differ materially from expectations reflected in the forward-looking statements. A discussion of these risk factors is fully detailed under the caption Risk Factors in our filings with the SEC. During this call, we will also refer to non-GAAP financial measures, including adjusted EBITDA and adjusted EBITDA margin. For a complete information regarding our non-GAAP financial information and a quantitative reconciliation of those measures, please refer to today's shareholder letter regarding our first quarter fiscal 2019 results posted to the Investor Relations portion of our website. I'll now turn the call over to Patrick Spence.

Thanks, Mike, and good afternoon, everyone. Thanks for joining. We made good progress this quarter towards our long-term goal of sustainable, profitable growth. Q1 was the most profitable quarter in Sonos' history, thanks to our record sales and increasing efficiency in our investments. Our adjusted EBITDA in Q1 grew 34% year-over-year, reaching a 17.6% adjusted EBITDA margin, and we achieved record revenue for the quarter at $496 million and generated $87 million in free cash flow. And we’re also glad to share that we are now helping over 8 million homes around the world listen better, which is a gratifying milestone for everyone that works here. If I were to highlight one thing form Q1, it would be the success of our home theater portfolio, Beam led the way, and we achieved 42% year-over-year growth across the home theater portfolio. Our home theater products earned two of the top three market share positions by dollar value in the U.S. according to NPD, three of the top four value share positions in the UK and four of the top eight value share positions in Germany according to GfK. These market share positions demonstrate a powerful longevity of our existing products, like Playbar and the market receptivity of innovative new products like Beam. 2019 is off to a good start, thanks to our strong portfolio of products, and we have some exciting things coming. We've got Google Assistant coming to Sonos. We’ll bring our first products to market with IKEA, which means new form factors, new countries and new price points. We’ll make our first moves outside the home, and last but certainly not least is what we announced yesterday, around Sonos Amp and Sonos Architectural, Sonance. We've been reinvigorating our installed solutions channel with new products and a renewed commitment to the professional installer community. Sonos' customers served pre-installed solutions channel, traditionally deliver our highest revenue per household and our highest net promoter scores. That's why we are excited to have the all new Sonos Amp available around the world this month. We are also excited to deliver Sonos Architectural speakers. That’s a collection of in-wall, in-ceiling and outdoor speakers designed specifically for use with the Sonos Amp. We've had component products to power other non- Sonos speakers for a decade, but until now we've been missing a clear revenue attach opportunity. This helps us create the best experience for customers and capture more of the revenue. Sonos in-wall and Sonos in-ceiling are available for preorder now and will be globally available at the end of February. Sonos' outdoor will be available in April. As I'm sure you saw in my shareholder letter, our CFO, Mike Giannetto is planning to retire. Mike has graciously agreed to stay on until we identify and on-board his replacement to ensure a seamless transition. Mike joined Sonos over seven years ago when the finance department was only a handful of people. He has done a tremendous job building a strong team and a set of processes and controls that has enabled us to scale the Company to over $1 billion in revenue and to go public last year. Even more importantly, Mike has been a leader who has embodied the Sonos behaviors and values and is a person of incredible character and integrity. Everyone at Sonos is incredibly thankful for all Mike has done for the Company. It's been an honor to work with Mike. And while we’re sad as he will leave us, we are excited for what the future holds for him in his next phase. I'll now pass it over to Mike.

Thank you, Patrick for the kind words. Good afternoon, everyone. After 34 years in the corporate finance world, I’ve decided to retire as the CFO, and it's a big decision and something I've been thinking about for a while. The last seven years at Sonos have been truly remarkable; it's a special place filled with incredibly talented people who show love for music and a passion for building great sound experiences. I’ll retire [technical difficulty] accomplished, confident in the future of the business and internally grateful for the many great friends and colleagues I’ve met along the way. I’m in no rush. I will be here to help bring on a new CFO and help out with the transition. So, now back to business at hand. I want to comment on our financial outlook for fiscal 2019, as described in our shareholder letter we issued earlier today. We are reaffirming the outlook we initially provided in our Q4 FY18 shareholder letter back in November. Our outlook highlights revenue and adjusted EBITDA growth ranges, and these are the metrics we focus on to deliver sustainable profitable growth. As a reminder, our long-term financial targets are to grow revenue by greater than 10% year-after-year, while growing adjusted EBITDA by at least 20%.For the full fiscal year 2019 ending September 28, 2019, we expect annual revenue in the range of $1.25 billion to $1.275 billion or 10% to 12% growth year-over-year. We expect annual adjusted EBITDA in the range of $83 million to $88 million or 20% to 27% growth year-over-year. In the very short-term, reduced sell-through velocity toward the end of our Q1 2019, created higher channel inventory levels than we would have liked, heading into Q2. We have also firmed up our manufacturing and product launch schedule with IKEA. We initially expected manufacturing and revenue to begin in late Q2. We now have visibility into revenue shifting into Q3 and Q4, while the expected product volumes are unchanged. This combination of channel inventory and our IKEA production schedule will impact Q2 revenue, but does not alter our full-year revenue or adjusted EBITDA outlook. With that we’ll open it up for questions.

[Operator Instructions] Your first question comes from Rod Hall from Goldman Sachs.

I wanted to start off just by asking about the EBITDA guidance. It sounds like you did have this inventory probably in Q1. And it kind of sounds like you were surprised by demand right at the end of the quarter. So, I wonder if you could just comment on why you're holding that EBITDA guidance, what gives you the confidence. And then, I have a follow-up.

Sure, Rodd. This is Mike. Yes ,we -- as I said, we did see some sell-through velocity turn down a little bit in December, but finished strong and you see it. We finished at the top end for Q1 in terms of revenue and had a real strong performance from our bottom line standpoint. So, as we look to the rest of the year, we feel quite confident with the revenue range as well as the EBITDA range. We’re seeing -- from a profit standpoint, we’re seeing the strategies work, gross margin actually came up very strong. We feel good about that going forward. And the efficiencies we are driving within operating expenses, you can certainly see it in our Q1 with the sales and market leverage, and we expect to see that kind of performance throughout the year. So, we feel very confident with the range we have.

Okay. Thanks for that, Mike. And then -- and congratulations, by the way, on retirement or moving on to something else, I'm not sure which. The second question I had was Europe, you guys called out weakness there. Is there any way you could size that for us and give us some idea of how big a contributor to this late quarter demand deterioration Europe was?

Really, what I would point to is there has been a trend in North America over the last few holiday periods where we've seen a huge uptick in voice-enabled smart speakers and a ton of money poured into the category. It was interesting because we've seen that for the first time kind of happening in Europe, if you will. And so, like any of the -- so, I think it’s a precursor to kind of getting Europe going around the voice category, which bodes well for us, given what we saw in this holiday period in North America. We saw weakness across both North America and Europe as we came to the end of the first quarter. But, I think the good news is we've seen a bounce back in the January timeframe too in both. So, we're feeling pretty good about what we've seen lately.

Your next question comes from Yuuji Anderson from Morgan Stanley.

Just a couple on the channel inventories here. Could you just give us a little bit more clarity on where you're seeing the higher channel inventories? Is this just across the board, is it related to Europe? Any color on the product level there?

It's not across the board. I mean, some channels are just fine, some has some excess. It is not just the European issue, we see in some channels in the U.S. as well. To think about in terms of the excess channel inventory level, it's about 10 to 12 days as we enter the quarter or higher than we would target, to give you kind of a sense of the magnitude. So, it's not a large over stock, but it's enough as we wanted to call it out. And as Patrick mentioned, January is off to a pretty solid start. So, we're starting to see the sell-through registrations come through and some of that excess or higher inventory come down.

Perhaps maybe what would be helpful, could you help -- could you describe how much you have to draw down this year versus what you had to last year?

Yes. I think the drawdown in terms -- if you think in terms of days of channel inventory, it's similar year-over-year as we ended December. But again, what we're seeing now, and that's that 10 to 12 days, as we're seeing now, January was solid and we’re seeing the inventories come down as the sell-through continues.

Your next question comes from Adam Tindle from Raymond James.

I just wanted to start, Patrick, in the shareholder letter, you talked about believing to be the most compelling long-term hardware and software roadmap you've seen since you've been at Sonos. Obviously, you talked about outside the home, there's been a number of rumors from headphones, portable speakers, Bluetooth enablement. Just want to know if you maybe want to clear the air on the roadmap. And then also maybe how you prioritize the many opportunities to leverage the brand and platform outside the whole?

I think, there is not going to be any clearing in the air because we're pretty thoughtful about when we share details or when products are ready as we go through this. But we’re excited, I’m excited for what we have planned. I think, there is a lot of opportunity, a lot of categories that we don’t play in today. And the way we think about that is can we bring -- how big is that category in terms of category size and how does it help the Sonos System, so how does it build on what we are already strong in, in terms of our expertise around experience sound, design the wireless expertise we have, the cloud connectivity and services we do. And so, as we’re looking at all of these new categories, we’re considering the innovation we can bring and really make sure that if -- you can count on it. If we enter a category, we're going to do it with an innovator perspective and bring something new to the table. And so, that combined with the category size, it's something that we think about and we’ll guide the products that you see from us over the next two to three years.

Maybe just as a follow-up on capital allocation, the balance sheet is quite clean, you've had strong cash generation, you've got over $200 million in net cash. Maybe just help me think about the sustainability of positive cash flow, what’s the right cash level to run the business? I think, you've got a lot of excess. And then, how you think about potential uses of cash?

In terms of strong cash flow, you can see we have very positive free cash flow for the quarter and expect to be for the year and ongoing. So, for 2019, if you look at our EBITDA guidance and we talked about CapEx, it will be free cash flow for ‘19 and we plan to be so going forward. In terms of cash on the balance sheet, we raised it for a few reasons, one is just more solid position from working capital standpoint but another is potential as we look around M&A, to give us some capital to do so. We are not closing anything specific. But as we look at the roadmap and what we are trying to do, as Pat was just talking about, it is something we will consider in terms of speed to market, if there is already some technology out there that we could make good use of and come up with some [indiscernible] products. That's something we would look at doing. So, that's the way we are thinking about it at this point to help drive the growth in the business.

Okay. Just one last clarification. I know you talked about the 10 to 12 days of excess inventory. I just wanted to know -- I mean, you had really nice gross margin in Q1, beat by quite a bit, had a lot of wiggle room there. Why not promote more heavily to have a better inventory situation entering Q2 because I think you could have got into quite a bit on that based on the back of the envelop math.

The holiday quarter which is just ended is a promotional period. We did participate in that which I’m sure you saw around Black Friday and beyond. We feel good about the level of promotion we did. We’re premium brand and we use the promotion as we think is appropriate and it certainly is appropriate in the period we just ended. We just did Super Bowl promotion in United States because it's a time of increased CD [ph] buying. So, we have detached with the other products. So, we feel comfortable with our level of promotion and what that -- and what those results gave us for the quarter…

Your next question comes from Brent Thill with Jefferies.

Patrick, just from your 40,000 when you think about the tailwinds that you see this year that maybe haven't existed since you’ve been running the come. If you could talk about anything new you're seeing, I guess one thing this morning was Spotify buying some podcasting companies. There's a obviously a tailwind to the overall category there. There are other things that you're seeing that maybe are new on your radar that you haven't seen. And I had a quick follow-up.

I think, the first thing I would call out from the holiday period is I’m very encouraged by our business in North America and what -- I’ve talked about this a little bit last year, this notion of the Google and Amazon several hundred dollar products being stepping stones at Sonos. And I what we saw in the holiday quarter is people starting to step up to premium products like Sonos and Beam and [indiscernible]. So, I think that’s a great tailwind as people get more comfortable with voice assistance, Sonos is the natural step-up point for them, and that's our job is to get them to do that. You called out the other one, which is something ironically we called out I think a year ago, which is really what we call the Sonic internet and the move for everything on the internet moving to audio, moving to Sonic. And so, what you saw from Spotify today and buying to podcast companies that is another testament to that. We've seen a huge explosion in listing hours. There are 39% year-over-year and I think some of that is to do with the explosion of podcast, we had audible join the platform last year. And what we always watch is engagement. And every time we've introduced something new, whether it's air play or audible or we added Alexa, engage people and that to me is a great thing because it gets customers thinking more of about adding Sonos data room [ph] and other area. So, I think this whole explosion of podcast and audio book with everything growing Sonic is a huge tailwind for us ultimately. And so, what's good for the music industry, what’s good for audio in general, I think it is good for Sonos.

And just to follow up, not to go into specifics of products. But, is your cadence still on track to deliver a couple of new meaningful products, here is that that came for shooting for or is that changed?

No. Absolutely right, I think -- yes, so that's absolutely right.

[Operator Instructions] The next question comes from Matt Sheerin from Stifel.

Just regarding the inventory issue you talked about, it sounds like it's different than the inventory issues you saw in December, a year ago, when it seems like a mismatch of products relative to demand. It sounds like this time it was more sort of a broad-based issue at the end of the quarter or was there another product to issue in terms of the mismatch of parts or products?

Yes. Matt, I wouldn’t call it a mismatch. It’s broader base. We play in a business. And as we've gone through the quarter, October and November were strong, Sonos' in December was strong, which is of course what we are seeing, When our retailer is the same. And we saw the search as we normally, just to hit counts, some of the peaks that we have planned for. So, it was -- is broader based I mean it's across a few different products. So, I wouldn’t call it a mismatch. But it is just -- it was a little slower in December than what we planned for.

Okay. And I appreciate you are not giving specific guidance for the March quarter. But last year, you were down something 65% or so sequentially, because there was an inventory work down in your channels. Last year -- are we talking about that kind of magnitude this time or just a little bit worse than seasonal?

Yes. So, there is obviously a seasonality in the business, which is obvious. What I would say Matt is that I would kind of go back to my comments on the shareholder in terms of excess days of inventory, the 10 to 12 was something -- that's how the way I think about it, in terms of looking at Q2 revenue potential. I wouldn’t compare to last year, I was just -- that's focused on the 10 to 12 days that we will be working through in January and February.

And just lastly on the IKEA program ramps, another reason why you sort of pushed out some of the revenue expectations to further out in the year, but it also sounds like it could be fairly significant. Could you give us an idea of the potential size of that kind of program in that relationship.

Yes. I'm really -- Matt it’s Patrick here. I'm really excited about the relationship we just spent more time together recently. I think both parties are very committed to it. And it opens some new opportunities. There is going to be new form factors, all this up to -- new countries, obviously price points as well. It’s a great way to get a lot of new listeners into the Sonos family. But really excited about that. But, we do think with our tradition we're also being very prudent about what we are putting into the plan around that. We want to see -- want to get out, we want to launch it, we want to see the market reception, but already start to build too big an expectation around some of these things. So, I’m excited to see the launch and see it arrive in customers’ homes and we’ll provide more color and keep building on it from there. But, relationship is in a great spot and I'm super excited about the products that come.

And just last quick housekeeping question. I didn't see the geographic revenue breakdown in the letter or I may have missed it. Do you have that or did you give that number, your versus North America…

Yes. From our growth standpoint, the Americas grew constant currency, about 12.5% and EMEA is about 2.5% constant currency.

There are no further questions at this time. I will turn the call back over to the presenters.

Thanks, Mike. In closing, I’d just reiterate that 2019 is off to a good start. We’re excited about what we have planned for the year ahead. We’re looking further into the future than ever before and there is no shortage of opportunity, thanks to the amazing people that we have here, our capabilities in software, cloud, wireless and hardware, and thanks to our strong and loyal customer base that’s now over 8 million homes. Of course, it wouldn’t be a Sonos' call without some music. Mike mentioned at the beginning. But I want to draw your attention to the playlist noted at the end of the shareholder letter. It's been crafted in honor of Black History Month by our Black @ Sonos employee resource group. Employee resource groups at Sonos are open forms for employees with share backgrounds or interest and are important part of our culture. I am proud of the work these groups do every day to support each other and educate and support a broader Sonos community and the communities in which we live and work. Thanks again for joining us today, and we look forward to speaking with you again soon.

This concludes today's conference call. You may now disconnect.