Ladies and gentlemen, thank you for standing by and welcome to the Sonos Fiscal Third Quarter 2020 Earnings Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker today Ms. Cammeron McLaughlin, Vice President of Investor Relations. Please go ahead.

Thank you. Good afternoon, and welcome to Sonos third quarter fiscal 2020 earnings conference call. I am Cammeron McLaughlin, and with me today are Sonos CEO, Patrick Spence; and CFO, Brittany Bagley. Before I hand the call over to Patrick, I'd 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 may also refer to several non-GAAP financial measures, including gross margin and adjusted EBITDA, excluding the impact of tariffs, adjusted EBITDA, adjusted EBITDA margin and free cash flow. For complete information regarding our non-GAAP financial information and a reconciliation of those measures, please refer to today's shareholder letter regarding our third quarter fiscal 2020 results posted to the Investor Relations portion of our Web site. With that, I will turn the call over to Patrick.

Thanks, Cammeron, and hello, everyone. Thank you for joining today. Before getting to our quarterly results, on behalf of all of us at Sonos, we are wishing everyone good health and sincerely hope you are continuing to manage your way through these challenging and unpredictable times, I would also like to take a moment to emphasize our commitment at Sonos to do our part to eliminate our society's systemic racism. We are focused on ensuring that Sonos is a place where our black colleagues feel welcome, included and represented. More broadly through our Sonos Soundwaves program, we will continue our efforts to support underrepresented groups, especially black and [indiscernible]. Sonos has also donated to the emergency fund for racial justice and I encourage our employees and all of you to educate, listen and contribute to help drive much needed change. Now, let me turn to our quarterly results. This past quarter has illustrated the strength of our culture and the Sonos brand. The adaptability and resilience displayed by our team has been deeply inspiring and gives me confidence that Sonos will continue to thrive in the face of whatever new challenges come our way. Despite the global pandemic, work from home restrictions and the closure of many physical retail stores, we were able to successfully launch three new products this quarter. Customers and reviewers alike have received them extremely well. Their sale helps support our better than expected third quarter financial results, which we achieved through record direct to consumer revenue. As reflected in the guidance we are posting for the rest of the fiscal year, we see continued strength and momentum as we look forward and are on track to deliver our 15th consecutive year of revenue growth. We delivered third quarter revenue of $249.3 million down only 4%…

Thank you, Patrick. Let me get a bit deeper into our financials. Total Revenue in the third quarter exceeded expectations, as it only declined 4% to 249.3 million and grew 42% over Q2. As a reminder, there were ongoing physical retail store closures and phase three openings which continued to negatively impact our revenue during the quarter. However, we were able to offset this to a large extent through the strength of our DTC channel and the success of our new product launches. The positive demand for our products exceeded our expectations and led to constrained product availability. As Patrick mentioned, we expect to catch up this quarter and have included that in our future guidance. We also saw strong gross margins this quarter, excluding the 4 million in China, U.S. tariffs, duties, gross margins would have increased 60 basis points to 45.7%. On a reported basis gross margin decreased 110 basis points to 44% during the quarter, due to the introduction of tariffs in September 2019. The increase was largely driven by volume and mix shift into higher margin products and channels, as well as product and material cost reduction. These gains were partially offset by expedited freight cost to increase inventory levels and fill back orders to meet the higher than expected demand. Even with the strong revenue performance in Q3 and our Q4 guidance, we are still not quite on a path to hit our original goals for the year. As a result, we have been actively managing our costs, which included reducing 12% of our workforce, closing our New York store and six smaller satellite offices. We are also continuing to manage our OpEx as discussed last quarter, which has included the reduction of marketing investments, suspending travel and limiting new hiring. As a result of…

[Operator Instructions] And your first question is from the line of Adam Tindle with Raymond James. Please go ahead sir.

This is Madison on for Adam and thanks for taking our questions. I wanted to start, during the quarter you introduced several new products as well as the new operating system. Specifically on the operating system upgrade these scenarios can result in both accelerated upgrade cycles and also potentially some churn. So can you just touch on what you're seeing from customers as it relates to the upgrading of legacy products potentially turning off the platform?

Yes. Hey, Madison. Its Patrick here. No churn to speak of in terms of anything that we've seen at this point. We have millions of homes that have moved up to as to. I think there's been a natural occurrence when we introduced the new app to see like a short-term decline in the star ratings for those apps on Android and iOS. But we usually see that moderate over time. And we've already seen that happen on iOS. And I think it's getting a little bit better in terms of where it is on Android. But I think, again, in terms of one of the themes of the quarter, I'd say, we've seen good resilience and a strong brand in terms of what we've seen as part of the move to S2. So feeling very good about customers sticking with us for the long-term.

Okay, thanks. And then just a follow up, I know you have a gross margin target range between 42% and 44% out there, but your direct business has obviously been growing pretty meaningfully as a percentage of your overall revenue. And it looks like you're going to be well above this range in Q4. So can you just touch on, one, do you have a target in terms of growing your direct business to a certain percent of total revenue. And then secondly, how much of a tailwind to gross margin is this shift? And do you ultimately think that it could make you revisit some of those longer term targets in the near future here?

Thanks for the great question. I think a couple things are going on. Yes, certainly, DTC was no higher than normal in this period of time. We're not going to give any long-term guidance on that right now, though, given that there's a lot going on in the marketplace currently, including the fact that physical retail has been partially shut down going through the process of reopening. So we would need to see things stabilize and settle out, I think before we really changed anything from a long-term guidance perspective. I would also add in addition to DTC helping, I mean, there are some great things going on product mix. We talked about a couple of factors, including reducing cost. So a lot of good things happening from a gross margin standpoint right now.

Okay. Thanks and congrats on the strong results despite the pandemic.

And your next question is from the line of Rod Hall with Goldman Sachs. Please go ahead.

I just wanted to start by asking what the supply shortage impact might have been on the revenue in the quarter. You guys said you're going to catch up in the next quarter but just curious how big a drag on revenues do you think that was? And then secondly, I wanted to check with you on the number of homes, clearly you guys have seen a lot of positive demand impact you in the pandemic and done well through that? I'm just curious how many homes now you think you're in? And what you think the behavior here was, was it [indiscernible] growing as much people penetrating more into it -- buying more products. Did you get a lot of new home penetration? Can you just kind of help us understand maybe a little bit more what happened there?

Yes, absolutely. So from a supply standpoint, I would say that really it was demand exceeding our supply chain capabilities and relative to our expectations for what we thought was going to happen in Q3. We haven't specifically quantified that in Q3, because we'll be fully caught up in Q4. So probably the best way to look at it as sort of second half of the year averaged out. I think at the top end of our guidance for Q4, you'd be basically flat on the second half of this year over the second half of last year. So it's probably a good way to sort of think about it normalized. And then I would say, very similar trends in terms of what we've seen from a household adoption rate, probably a little bit more existing home Buying as we went through Q3 and I think that's partly because physical retail, does still offer an avenue for discovery for people. So we've been able to shift a large part of that on to online, but as you can imagine, it's a little bit easier for an existing customer to get excited about a big new purchase through our DTC platform, but nothing sort of material to really call out from that. That's just a little bit of color on some of the trends we're seeing.

And your next question is from the line of Katy Huberty with Morgan Stanley. Please go ahead.

Congrats on the quarter. I wanted to go back to the discussion around this mix shift towards your direct to consumer business. If we assume that at least a portion will be sustainable and you will run at higher addressed level going forward. Should we think about over the long run profitability of the business being higher just generally speaking, or are there investments that you have to make that will offset the higher gross margin? And then, Britney, can you talk about some other potential business model impacts of the direct business, I imagine you'll have better visibility into sales and predicting a revenue that seasonality may smooth out about? Can you just talk about what the business model might look like once we settle out at some higher level of direct business?

Yes, absolutely. Thanks, Katy. So I would say that, from a gross margin standpoint, we have been making investments in our direct to consumer business. We'll continue to make investments in our direct to consumer business, but we're actually pretty happy that that business was able to sustain the 299% growth that we saw in the quarter. So as we think going forward, it will really just be the balance between our channels. And then, our products, all of our products have slightly different gross margins. So what that mix looks like. So we're not ready to update the sort of long-term business model or long-term guidance on our gross margin, because there is a lot of factors beyond just channel that go into that. But, it has been great from a business model perspective for us to have more through the DTC business. I think it's something that has been very helpful for us from a profitability standpoint and certainly something that as we look out long-term and as we look at a more normalized retail environment will continue to be very important to us. That said, our physical retail partners are also very important to us. So that continues to be a balance for us going forward. I think you highlighted some of the good business model impacts, we certainly having a direct relationship with our customers. We have that anyway because they come and they register our products and we do get product registrations, but having that, sort of direct connection with them is great through our direct to consumer channels. I would say, we don't have the challenge of having inventory build up in the channel with our direct to consumer business. So, we hold more inventory, but certainly you don't have that lag that we saw in Q2 as we saw the replenishment cycle shift out. So I would say that's a big benefit from my perspective. Patrick, anything you would add to the DTC benefit?

Definitely the bond with customers in terms of what's there but I do think from a financial perspective, the cash conversion cycle is the big one that you hit on Brittany.

And then as retail stores reopened in June and July, how did you see the mix shift within your business and what if any contribution did you have in the third quarter? And do you expect in the fourth quarter as it relates to any selling and inventory as the retailers start to prepare for perhaps more foot traffic going into the end of the calendar year?

Yes. I mean, I would say we had a lot going on in the quarter. So it's hard to sort of isolate any one of those factors, right, because we also, at the beginning of the quarter had our at home with Sonos campaign and that was where most physical retail was shut down. And then, we had the launch of the new products, which went sort of far better than we could have expected. And so, I would say couple all of those trends, but also the fact that we were out of stock in a number of places, including on our own Web site. So I think it's sort of too hard to pull apart specific things inside of Q3. And then, we factored in physical retail sort of being open and replenishing all of their order. So, you saw some of that in Q3. And you'll see some more of it in Q4, which is which is factored in.

And your next question is from the line of John Babcock with Bank of America. Please go ahead.

I guess I just want to add quickly on the demand and inventory side here. So I mean, ultimately, if demand does remain currently at strong levels. Do you have any sense that it might be difficult to rebuild inventories, any color you can kind of provide around that would be helpful?

I mean, I think that we're planning to be back in stock in Q4. I think the challenge would be if demand continues to outstrip our expectations will continue to play catch up, but as long as we're sort of forecasting it right for Q4, we are expecting to be back in stock.

Okay. And that's the fiscal fourth quarter, not the calendar fourth quarter, right?

Correct. That's our fiscal fourth quarter. Yes.

Okay. And then with to the tariffs here, obviously, you're going to get about $3 million in refunds there. And now you've applied for or rather you're going to apply for an extension. And what we've heard on that side is that extension may only last, at least for certain other consumer products manufacturers to the end of 2020. Are you hearing something comparable or do you think you might be able to get an extension that might go further than that?

I think it's really hard to predict, it's hard to tell. So, we're going to apply for an extension. We'd like an extension for as long as we could get one. But at the same time, we're continuing on our path to really bring Malaysia up so that we have a diversified manufacturing footprint. And so, the closer we get to having our U.S. bound production served from Malaysia, the closer we get to having tariffs be -- much less of an issue for us with or without an extension. So it's really sort of a two-prong process and approach for us to mitigate tariffs.

And your next question is from the line of Brent Thill with Jefferies. Please go ahead.

Great. This is James on for brand. Thanks for taking the questions. Are there any stats or mile markers you can share about the Sonos radio launch so far? Just anything in terms of listening hours or overall engagement would be really helpful? And then, in terms of monetization, is there any contribution yet from advertising, or is that a lever that you plan on point later once you've built the engagement first? That's my first question.

Thanks, James. Really, that's come from a -- Sonos Radio has come from a place of enhancing the experience that was there. It was something that we hadn't really touched on 15 years. So we've enhanced that experience, we've seen great engagement in terms of where it's sitting in terms of services on the platform. So we feel good about that right now. We've just recently introduced advertising into it. And we're just putting our toe in the water at this point. So, that is something that we are excited about the future, but we're just getting started with. So I'd say stay tuned as you get further along on that one.

Great. And then just another one, you spoke about on the last call about having pretty solid demand for the Sonos moves, especially at the end of the quarter, just curious how that trended into June and July as more reopening started to happen. And then, I'm guessing just curious how you think more broadly, about your strategy towards out of home products going forward. Thank you.

So I would say Move continued to perform well, it was one of the products that we were out of stock on because demand exceeded expectations. We also introduced a white Move during the summer quarter. So we now have black and white in that product, which is also out of stock. So really, really great products across the board there. That is our out of home product right now. And so we don't really chat through our future roadmap, but it's a great product, it's doing well for us. And so even with a pandemic, where people are probably more likely using it in their backyard, so who knows if it's continuing to perform really nicely.

And your final question comes from the line of Alvin Park with Stifel. Please go ahead.

So Alvin in from Matthew Sheerin. Just following up on the Malaysia transition and involving the tariffs, as you move transition more production from China to Malaysia to get around with the tariffs, is there any significant material difference in terms of the cost structure at Malaysia versus China that might have an impact to your COGS line item?

Yes. This question is a great question, for a couple quarters, and we continue to say that there was nothing sort of material that that we would call out. So I know that others have called it out. So I totally get where it's coming from. But it's not something that we're calling out as a big impact to our gross margins or sort of noteworthy at this point.

I see. Thank you. And also regarding the continuous legal activity with Google and Denon and et cetera. Is the strategy expected to continue on? Are there more counterparties that you expect to proceed with further litigation on and we just want to get a gauge of what the overall strategy will be regarding litigation going forward?

[Indiscernible] Google, we are going to file that case, we are confident in it and we remain confident in it today. We are expecting a broader program. But, yes, there are quite a few companies in the space and we believe are infringing on our patented invention. And we're in touch with many of them. And the goal would be to continue to establish a set of precedents around like ingredients with number of those companies.

And I now would like to turn the call back to Patrick Spence for closing remarks.

Great. Thanks, everybody. I appreciate the questions and your attendance and we will see you next quarter. Take care.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.