Q3 2020 Sonos Inc Earnings Call

Ladies and gentlemen, thank you for stormy night and welcome to the Sonus fiscal third quarter 2020, <unk> earnings Conference call. At this time, all participants are only listen only mode. After the speakers presentation. There will be a question answer session I've two questions.

On the session. Please press star one on your telephone keypad, if you're acquiring any further assistance. Please press star zero.

I'd like to have the conference over to your speaker today, Ms. Cammeron Mclaughlin Vice President Investor Relations. Please go ahead.

Thank you good afternoon, and welcome to someone else third quarter fiscal 2020 earnings conference call I am Cammeron Mclaughlin and with me today are so no CEO, Patrick spends and CFO Britney Bagley before I hand, the call over the Patrick I would like to remind everyone that today's discussion will include forward looking statements regarding future events in 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 Mexico 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 FCC. During this call. We may also refer to several non-GAAP financial measures, including growth margin and adjusted EBITDA, excluding the impact of tariff adjusted EBITDA adjusted EBITDA margin and free cash flow for a complete information regarding our non-GAAP financial information and I'm.

One of those measures. Please refer to the day shareholder letter regarding our third quarter fiscal 2020 results posted to the Investor Relations portion of our website with that I'll turn the call over to Patrick.

Thanks, Cameron and Hello, everybody. Thank you for joining today before getting to our quarterly results on behalf of all of US. It's gone else. We're 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. Besides our commitment that's on us to do our.

Mark to eliminate our society systemic racism, we're focused on ensuring that sonos is a place where our black colleagues feel welcome included and represented.

More broadly through our Shadow Soundwaves program, we will continue our efforts to support underrepresented groups, especially block and lot next year.

So no has also donated to the emergency fund for original Justin and I encourage our employees and all of you to educate listen thank you attribute to help drive much needed Jane.

Now, let me turn to our quarterly results. This past quarter had illustrating the strength of our culture and the saw sprint.

The adaptability and resilience displayed by our team has been equally 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 launched three new products this quarter.

Customers and reviewers alike have received them extremely well their sale help support are better than expected third quarter financial results, which we achieved record direct to consumer revenue.

Reflected in the guidance, we're 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 fiftyth consecutive year of revenue growth.

We delivered third quarter revenue of $249.3 million down only 4% year over year. Despite the physical retail store closures, we performed especially well in the United States and United Kingdom, where total revenue grew 4% at 13% year over year, respectively.

Those were so strong that we ex exited the quarter out of stock on seven of our key products as demand exceeded our expectations. We're working hard to get these orders filled and we will be in a better inventory position in the fourth quarter.

A key factor in our ability to achieve this excellent performance was the investments we've made in our direct to consumer channel.

We quickly adopted when physical retail stores started to close and drove a 299% year over year increase in direct to consumer revenue in Q3.

Listening hours were up approximately 40% this quarter compared to last year as we continue to be more relevant than ever and how people enjoy their lives through music TV podcasts and anything they want to listen to.

We kicked off the third quarter on a strong note with the success of our at home with Sonus marketing campaign.

Our ambition was to help make people's lives a little more joyful, while there were spending more time at home to do this we pivoted our marketing efforts to digital campaign with tips on how to get the most out of your sort of system, coupled with a targeted promotional offer.

The campaign yielded strong momentum, which continued through the rest of the quarter, even without a promotion.

As our newest product introductions arc, five and sub as well as our relatively new product move generated tremendous demand.

Designed great products and experiences that are easy to use deliver brilliant sound and give users freedom of choice of music and voice services. We were thrilled to launched three new premium products into the marketplace in June and to have those products resonate strongly with both professional reviewers and customers.

Arc is our premium sound bar, delivering our most immersive home theater experience and setting a new standard for premium home theater sound.

Despite a higher price point, we sold significantly more ARX during preorder than we did during the pre over a period for being two years ago.

Reception to arc has been incredibly positive and arc has quickly earn top recommendations in the category focused on its premium sound experience with the introduction of Dolby Atmos its design ease of use and the ability to expand to a full home theater set up as part of the system.

We also launched as soon as five which is our most powerful speaker delivering the same studio quality sound is the beloved play five well, adding increased memory processing power and a new wireless radio.

Finally, we introduced our new sub featuring the same iconic design and both beef as its predecessor, but featuring upgrades in memory processing power and more.

Alongside the three new products in June we launched sent us as to a powerful new up and operating system to enable the next generation of Sonus products and experiences.

Addition to new features usability updates and more personalization moving forward as two will enable higher resolution audio technologies for music and home theater.

We have focused on driving adoption of the new out and is being well received I reviewed by owners as they transition their systems had become familiar with the new features and functionality.

Despite work from home in travel restrictions the team were creatively to market and watch these products with great success.

The product announcement, we made a full pivot to a digital press experience, where media could find bespoke creative materials that illustrated the audio and engineering feat of ARX capabilities, coupled with Indepth commentary from the product and engineering teams.

Without the benefit of in person demos, we shipped arc to reviewers around the world to secure unbiased third party reviews head of launch.

On a separate note we continue to work towards realizing the value of our intellectual property assets, while also investing in expanding our patent portfolio to capture those ongoing innovations.

As we continue our history of inventing new capabilities, we are receiving dozens of new patents every year.

We have demonstrated a commitment to protecting our IP through litigation, we previously achieved a successful outcome against tenant and as announced last week. We've now done so in our litigation against lender industries that maker at bluestone products.

Under a confidential settlement lender Brooke industries has entered into a multi year licensing agreement associated with all blue Blue enabled solutions worldwide.

In the meantime, we've been proceeding against Google in the International Trade Commission, we remain confident in our case, which is set for trial towards the end of February 2021.

Given the rapidly changing environment, we've made some tough decisions that we believe better positioned the company for long term success in late June we made the decision to say goodbye to 12% of our global team and closed down six satellite offices, and our New York retail store.

While the reduction in force touched all incentives the team most impacted were within our sales and marketing organization. We continue to prioritize our investment in new products and services I believe this reorganization positions us to seize new opportunities that we see on the horizon.

We remain focused on our long term product roadmap and cadence of two new products a year well also continue to experience experiment with new business models and partnerships like Ikea service for business and sent us radio among others.

We are confident that the actions we have taken this quarter and the way we are operating today set us up for continued momentum and long term success.

Ill now turn the call over to Britney to provide more details on the third quarter and our outlook.

Thank you Patrick.

Let me get a bit deeper into our financial.

Total revenue in the third quarter exceeded expectations as the only declined 4% to 249.3 million I'd grew 42% over Q2.

As a reminder, there were ongoing physical retail store closures and phase three openings, which continued to negatively impact our revenues 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 constrain 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. tariff you 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 terrorists in September 2000. Thanks.

The increase was largely driven by volume and mix shifts into higher margin products and channels as well its product and material cost reduction.

These gains were partially offset by expedited freight costs to increase inventory levels and still 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 holds for the here.

As a result, we have been actively managing our costs, which included reducing 12% of our workforce closing, our New York store in six smaller satellite offices.

We're also continuing to manage our Opex as discussed last quarter, which has included the reduction of marketing investments the spending travel and limiting new hiring.

As a result of this restructuring plan, we incurred 26 million in restructuring and related impairment charges during the quarter.

We have provided a table in our shareholder letter today that breaks out the charges by operating expense line item for better comparability.

We expect this restructuring to result in seven and a half million of Opex savings in Q4.

Excluding the 26 million in restructuring related expenses at 4.1 billion, an IP litigation fees during the quarter total operating expenses increased 3% year over year, largely due to our increase in R&D investments.

Including restructuring and IP litigation expense total operating expenses increased 26% to 166.7 million during the quarter.

Excluding the 4.9 million of restructuring costs research and development expenses increased 19%, primarily due to increased headcount and personnel cost as we continue to invest in new products services and features.

Inclusive of restructuring costs, R&D increased 30% to 57.8 million.

Sales and marketing, excluding 19.8 million in restructuring costs decreased approximately 7%, primarily due to lower marketing and advertising spend during the quarter.

Offset by an increase in expenses related to our higher DTC revenue.

Including restructuring costs.

Marketing increased 26% to 77.3 million.

General and administrative expenses, excluding the 1.4 million in restructuring costs, and the 4.1 million and legal fees related to our IP litigation litigation decreased approximately 2% during the quarter.

Including restructuring and IP litigation costs.

Increased 19% to 31.7 million.

Excluding the 4 million in tariffs duties, our adjusted EBITDA for the quarter was 1.3 million compared to adjusted EBITDA of 6.8 million last year.

Including tariff duties adjusted EBITDA was a loss of 2.7 million during the third quarter.

Turning to our balance sheet cash flow, we ended the quarter with 329 million in cash and cash equivalents and 20 million in long term debt.

We generated 44 million of free cash flow in the quarter through working capital.

We continue to believe our strong cash position is critical for our ability to make smart long term decisions, especially as we continue to operate in an uncertain environment.

We do you think we have enough visibility into Q4 to reinstate our guidance for fiscal year 20.

We expect fiscal 2020 revenue to be in the range of 1.277 billion to 1.92 billion, representing 2% year over year growth at the midpoint.

We expect gross margins in the range of 45.2% to 45.3%, excluding approximately 33 million and tariff duties in fiscal 2020.

This represents gross margin expansion of 90 basis points at the midpoint versus last year.

Including the effect of tariff GAAP gross margins are expected to be in the range of 42.6% to 42.8% in fiscal 2020.

As a reminder, selling those products manufactured manufactured in China shipped to the U.S. are subject to a 15% tariff to February 13th.

After that date subject to 7.5% Kara.

We're pleased to report that our request for exclusion from the section 301 tariff action lists for ebay has been granted.

Our speakers and component products essentially all products currently subject to tariff will enjoy an exemption retroactive from September 1st 2019 through to August 31st 2020.

We have begun the process of seeking refunds for the approximately 30 million in tariff.

Period, but we do not expect this process to be completed for a number of months.

We have also began the process of applying for an extension beyond August 31st 2020.

In the event that our extension application is not granted we will start paying the 7.5% tear up again.

Yes bound products manufactured in China on September 1st 2020.

We also continue to focus on our important efforts to diversify our supply chain into Malaysia.

However, due to cope with 19 related government restrictions in Malaysia, We now expect that our ramp up will not be fully complete until mid 2021.

Through that transition time, we will continue to successfully manufacture products in China.

Our efforts to reduce operating expenses, coupled with our continued gross margin expansion should result in adjusted EBITDA in the range of 85 to 95 million in fiscal 2020.

Excluding tariff duties this would represent adjusted EBITDA of 100.

Millions, so hundred 20 million, representing 33% to 44% growth over last year.

We're pleased to report that at the midpoint of our fiscal 2020 outlook. We are on track to deliver growth in total revenue gross margin and adjusted EBITDA versus last year.

This translates to fourth quarter 2020 revenue guidance in the range of 290 million to 305 million, representing 1% year over year growth at the midpoint.

We expect to maintain strong gross margin trends, we have a teams throughout the year driven largely by product and channel mix and anticipate gross margin, excluding approximately 3 million in tariff costs in the range of 47.2% to 47.4% during the fourth floor quarter.

Including tariffs, we expect gross margin to be in the range of 46% to 46.5%.

We expect adjusted EBITDA, including tariffs in the range of 23 to 33 million.

Well the pandemic has certainly presented challenges our products continue to be highly relevant and bring July during this difficult period.

Our topline resilience and focused on great new products, coupled with strong operational discipline positions us well for the long term.

We are excited to keep delivering on our promise of a strong topline an increasing profitability as we look to finish up fiscal year 20.

And with that we will open the lines for questions.

Thank you.

Ladies and gentlemen, if he would like to ask audio question. At this time. Please press star one of your telephone keypad to withdraw your question pressed down or Heskey.

Please standby Halloween, coupled with you and I roster.

Your first question is on the line of Adam Tindle with Raymond James. Please go ahead Sir.

Good afternoon, and 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 a 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 regards.

Relates to the upgrading of legacy products first potentially churning off the platform.

Yes, Hey, Madison its Patrick your no churn to speak of in terms anything that we've seen at this point and we have millions of homes that.

Moved up to asked you I think there that there's been and there's a natural occurrence when we introduce a new app to see like 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 happened on iOS.

I think it's getting a little bit better in terms of where it is on Android, but I think you know again in terms of what are the themes for the quarter I'd say we've seen.

Good resilience in a strong brand in terms of what we've seen as part of the move to as too 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 percent of your overall revenue and it looks like youre 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 percentage 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 the Great question I think a couple of things are going on Ah, 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.

Active.

I would also add in addition to DTC, helping I mean, there are some great thing going on product mix, we talked about a couple of factors, including reducing cost. So a lot a lot of good things happening from a gross margin standpoint right now.

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

Thank you very much.

And your next question is from a lot of raw Paul with Goldman Sachs. Please go ahead.

Yes. Thanks for the question I just wanted to start by asking what the supply shortage impact might have been on the revenue for the quarter you got that you're going to catch up into next quarter, but just curious how how big a drag on revenues 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 demand positive demand impact here in the independent Mick and done well through that Im just curious how many homes you think you're in and what you think the behavior. Here was was it was at home, but growing its.

Much people penetrating more into buying more products or where do you get a lot of new home penetration can you just kind of help us understand maybe a little bit more what happened there.

Yeah absolutely.

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 is sort of second half of the year averaged out.

I think you know at the at the top end of our guidance for Q4, you'd be basically flat on second half of this year over the second half of last year.

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 you know does still offer an avenue for discovery for people that weve been able to shift a large part of that onto online, but as you can imagine that's a little.

Easier for an existing customer to get excited about it but you purchased through our DTC platform.

But nothing sort of material to really call out from that that's just a little bit of color on on some of the trends foresee.

Great. Okay. Thanks Britney.

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

Hi, Thanks, good afternoon, 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 direct level going forward should we think about over the long Ron.

Profitability of the business.

Being higher just gen generally speaking or are there investments that you'd have to make that so 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 will have better visibility into sales and predicting.

Revenue that seasonality may smoothed out at that can you just talked about what what the business model might look like once we settle out at some higher level of of direct business.

Yes, absolutely.

So I would say that.

Gross margin standpoint, we have been making investments in our direct to consumer business will continue to make investments in our direct to consumer business, but were 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 the.

The balance between our channels at then our products all of our products at slightly different gross margin, 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 Theres a lot of factors beyond just channel that go into that.

But you know 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 would as we look out long term and as we look at a more normalized retail environment continued 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 impact certainly having a direct relationship with our customers.

We have that anyway, because they common they register our products and we can get product registrations, but having that sort of direct connection with them is great through our direct to consumer channel I would say.

Don't have the challenge of having inventory buildup in the channel with our direct to consumer business. So we hold more inventory, but certainly you don't have that lag.

We saw in Q2 with as we saw the replenishment cycle shift out so I would say dossett big benefit from my perspective.

Eric anything you would add to the PTC bountiful.

I think the definitely the Boston with customers in terms of what's there, but I do think from a financial perspective cash conversion cycle.

The big ones that you hit on Brittany.

And then as retail stores reopened in June and July how did you see the mix shift within within your business.

And what if any contribution did you have in the third quarter in do you expect in the fourth quarter as it relates to any selling of inventory at the retailers start to prepare for perhaps more foot traffic going into the ended the calendar year.

Yeah, 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 like we also you know the beginning of the quarter had our at home So no campaign.

And that was where most physical retail was shut down and then we had the launch of the new products, which when you know sort of far better than than we could have expected them, though you know I would say couple those all of those trends with also the fact that we were out of stock in a number of places including on our own a website. 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.

That's great. Thank you.

Your next question is from the line.

Your next question is on the line of John Babcock with Bank of America. Please go ahead.

Hey, good afternoon, thus even in.

I guess I just wanted to ask quickly on.

The demand and inventory side here.

So I mean ultimately demand does remain that currently at strong levels do you have any sense that it might be difficult to rebuild inventories.

Any color you can kind of provider on that would be helpful.

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

In stock.

Okay, and Thats, a fiscal fourth quarter, not the calendar fourth quarter right.

Correct, that's our fiscal fourth quarter Yep.

Okay.

And then with the with regards to the tariffs share.

Obviously, you're going to get about $39 refunds there.

And now you have applied for around if you.

You are going to apply for an extension.

And what we've heard on that side is that an extension may only last.

Sure for certain other consumer products manufacturers through the end of 2020 are you hearing something comparable.

Do you think you might be able to get an extension that might go further than that.

You know I think it's really hard to predict it's hard to tell so we're going to apply for an extension well, we like an extension for as long as as long as we could get one but at the same time, we're continuing on our path to really bring.

Asia up so that we have a diversified manufacturing footprint. So you know the closer we get to hopping argue s. bound production for from Malaysia. The closer we got 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 Tara.

Okay. Thanks.

Your next question is from the line Brett deal with Jefferies. Please go ahead.

Great. This is James on for Brian. Thanks for taking my questions are there any stats are mile markers you can share about the Sonus radio launch so far just anything in terms of listening hours. There overall engagement will 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 up but as soon as radios come from a place.

Enhancing the experience that was there it was something that we hadn't really touched about 15 years. So we we've enhanced our experience and seeing great engagement.

In terms of.

We are sitting in terms of services on the platform. So we feel good about that right now.

Just recently introduced advertising into it and we're just putting our toe in the water at this point so.

It is something that we are excited about for the future, but we're just getting started yet so I'd say stay tuned.

As we get further out on on that one.

Great and then just another one you spoke about on the last call about having pretty solid demand for the sentence moves, especially at the end of the quarter. Just curious how that trended in June and July is more reopening started to happen and then on guess Im just curious how you think more broadly.

About your strategy toward 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 await loop 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 so we don't we don't really chat through our future roadmap, but.

It's a great product, it's doing well FRE, though.

Even with a a pandemic where people are probably more likely using it in our backyard. So so who knows it's it's continuing to perform really nicely.

Great. Thank you both.

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

Yes, hi, Thank you for taking the call filling in for Matt You. Sharon I was just following up on the Malaysia transition and the tariff.

And the involving a 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 your Cogs line item.

Yes, we've got.

This question, it's a great question for a couple of quarters and we continue to say that there is 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 it's not something that we're calling out adds amber.

The impact to our gross margins or sort of noteworthy at this point.

I see thank you and also regarding the continuous legal legal activity with Google and then on et cetera.

Is the strategy expected to continue on are there more counterparties that you expect proceed with further litigation on and we just want to get a gauge of overall strategy will be regarding litigation going forward.

Maybe.

The loss or is that.

JGB set to Google.

Going to file that Jason we're confident it and we may have any today.

With respect.

But yes, there are quite a few companies in space and we believe our.

Ranging on that appended eventually.

So many goldman.

The goal is the gene.

To establish.

So precedents around like ingredients.

Those are those.

Thank you very much.

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

Great. Thanks, everybody I appreciate the questions in 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.