Earnings Call: Q3 2020

Aug 5, 2020

Ladies and gentlemen, thank you for standing by, and welcome to the Sonos Fiscal Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer I I'd now like to hand the conference over to your speaker today, Ms. Cameron Mollison, Vice President of Investor Relations. Please go ahead. Thank you. Good afternoon, and welcome to Sonos' 3rd quarter fiscal 2020 earnings conference call. I am Cameron McLaughlin, and with me today are Sonos' CEO, Patrick Spence and CFO, Brittany Bagley. Before I hand the call 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 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 3rd 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 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 Sound waves program, we will continue our efforts to support underrepresented groups, especially Black and Latinx youth. 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 3 new products this quarter. Customers and reviewers alike have received them extremely well. Their sales helped support our better than expected Q3 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 50th consecutive year of revenue growth. We delivered 3rd quarter revenue of $249,300,000 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% 13% year over year respectively. Sales were so strong that we exited the quarter out of stock on 7 of our key products as demand exceeded our expectations. We are working hard to get these orders filled and we will be in a better inventory position in the 4th 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 2 99% 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 in how people enjoy their lives through music, TV, podcasts and anything they want to listen to. We kicked off the Q3 on a strong note with the success of our At Home with Sonos marketing campaign. Our ambition was to help make people's lives a little more joyful while they were spending more time at home. To do this, we pivoted our marketing efforts to a digital campaign with tips on how to get the most out of your Sonos 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, 5 and SUB, as well as our relatively new product move generated tremendous demand. We 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 launch 3 new premium products into the marketplace in June and to have those products resonate so strongly with both professional reviewers and customers. ARC is our premium soundbar, 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 ARCs during pre order than we did during the pre order period for Beam 2 years ago. Media reception to Arc has been incredibly positive and Arc has quickly earned 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 setup as part of the system. We also launched the Sonos 5, which is our most powerful speaker, delivering the same studio quality sound as the beloved PLAY 5, while adding increased memory, processing power and a new wireless radio. Finally, we introduced our new sub featuring the same iconic design and bold base as its predecessor, but featuring upgrades in memory, processing power and more. Alongside the 3 new products in June, we launched Sonos S2, a powerful new app and operating system to enable the next generation of Sonos products and experiences. In addition to new features, usability updates and more personalization moving forward, S2 will enable higher resolution audio technologies for music and home theater. We are focused on driving adoption of the new app and it is being well received and reviewed by owners as they transition their systems and become familiar with the new features and functionality. Despite work from home and travel restrictions, the team worked creatively to market and launch these products with great success. Ahead of 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 Arc's capabilities, coupled with in-depth 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 ahead 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 Denon and as announced last week, we have now done so in our litigation against Lenbrook Industries, the maker of Bluestone Products. Under a confidential settlement, Lenbrook Industries has entered into a multiyear licensing agreement associated with all BlueOS enabled solutions worldwide. In the meantime, we've been proceeding against Google and 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 have made some tough decisions that we believe better position 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 6 satellite offices and our New York retail store. While the reduction in force touched all of Zynos, the team most impacted were within our sales and marketing organization. We continue to prioritize our investment in new products and services and believe that 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 2 new products a year, while also continuing to experiment with new business models and partnerships like IKEA, Sonos for Business and Sonos 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. I will now turn the call over to Britney to provide more details on the Q3 and our outlook. Thank you, Patrick. Let me get a bit deeper into our financials. Total revenue in the Q3 exceeded expectations as we only declined 4% to $249,300,000 and grew 42% over Q2. As a reminder, there were ongoing physical retail store closures and phased reopenings, 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 $4,000,000 in China U. S. Tariff duties, gross margins would have increased 60 basis points to 45.7%. On a reported basis, gross margin decreased 110 basis points to 44 percent during the quarter due to the introduction of tariffs in September 2019. The increase was largely driven by volume and mix shifts into higher margin products and channels as well as product and material cost reductions. These gains were partially offset by expedited freight costs 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 6 smaller satellite offices. We are 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 $26,000,000 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 $7,500,000 of OpEx savings in Q4. Excluding the $26,000,000 in restructuring related expenses and $4,100,000 in IT litigation fees during the quarter, total operating expenses increased 3% year over year, largely due to our increase in R and D investments. Including restructuring and IP litigation expense, total operating expenses increased 26% to $166,700,000 during the quarter. Excluding $4,900,000 of restructuring costs, research and development expenses increased 19%, primarily due to increased headcount and personnel costs as we continue to invest in new products, services and features. Inclusive of restructuring costs, R and D increased 30% to $57,800,000 Sales and marketing excluding $19,800,000 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, sales and marketing increased 26% to 77 $300,000 General and administrative expenses, excluding the $1,400,000 in restructuring costs and the $4,100,000 in legal fees related to our IP litigation, decreased approximately 2% during the quarter. Including restructuring and IP litigation costs, G and A increased 19% to 31,700,000 Excluding the 4,000,000 in tariff duties, our adjusted EBITDA for the quarter was 1,300,000 compared to adjusted EBITDA of 6,800,000 last year. Including tariff duties, adjusted EBITDA was a loss of $2,700,000 during the 3rd quarter. Turning to our balance sheet and cash flow, we ended the quarter with $329,000,000 in cash and cash equivalents and $20,000,000 in long term debt. We generated $44,000,000 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 think we have enough visibility into Q4 to reinstate our guidance for fiscal year 'twenty. We expect fiscal 2020 revenue to be in the range of $1,277,000,000 to $1,292,000,000 representing 2% year over year growth at the midpoint. We expect gross margins in the range of 45.2% to 45.3%, excluding approximately 33,000,000 dollars in tariff duties in fiscal 2020. This represents gross margin expansion of 90 basis points at the midpoint versus last year. Including the effect of tariffs, GAAP gross margins are expected to be in the range of 42.6% to 42.8% in fiscal 2020. As a reminder, Sonos products manufactured in China and shipped to the U. S. Were subject to a 15% tariff through February 13, and after that date, subject to a 7.5% tariff. We are pleased to report that our request for exclusion from the Section 301 Tariff Action List 4A has been granted. Our speaker and component products, essentially all products currently subject to tariff, will enjoy an exemption retroactive from September 1, 2019 through to August 31, 2020. We have begun the process of seeking refunds for the approximately $30,000,000 in tariff paid through this period, but we do not expect this process to be completed for a number of months. We have also begun the process of applying for an extension beyond August 31, 2020. In the event that our extension application is now granted, we will start paying the 7.5% tariff again on US bound products manufactured in China on September 1, 2020. We also continue to focus on our important efforts to diversify our supply chain into Malaysia. However, due to COVID-nineteen related government restrictions in Malaysia, we now expect that our ramp up will not be fully complete until mid-twenty 21. 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 $85,000,000 to $95,000,000 in fiscal 2020. Excluding tariff duties, this would represent adjusted EBITDA of $118,000,000 to $128,000,000 representing 33% to 44% growth over last year. We are 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 Q4 2020 revenue guidance in the range of $290,000,000 to 305 $1,000,000 representing 1% year over year growth at the midpoint. We expect to maintain the strong gross margin trends we have attained throughout the year, driven largely by product and channel mix and anticipate gross margin excluding approximately $3,000,000 in tariff costs in the range of 47.2% to 47.4% during the 4th quarter. Including tariffs, we expect gross margin to be in the range of 46% to 46.5%. We expect adjusted EBITDA including tariff in the range of $23,000,000 to $33,000,000 While the pandemic has certainly presented challenges, our products continue to be highly relevant and bring joy during this difficult period. Our top line resilience and focus on great new product, coupled with strong operational discipline positions us well for the long term. We are excited to keep delivering on our promise of a strong top line and increasing profitability as we look to finish up fiscal year 2020. And with that, we will open the line for questions. Thank you. And your first question is from the line of Adam Tindle with Raymond James. Please go ahead, sir. Good afternoon. 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 relates to the upgrading of legacy products versus potentially churning off the platform? Yes. Hey, Madison, it's 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 S2. I think there's been a there's a natural occurrence when we introduce a 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% 44% out there, but your direct business has obviously been growing pretty meaningfully as a percent 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, 1, 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 of things are going on. Yes, certainly DTC was 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 costs. 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. Thank you very much. And your next question is from the line of Rob Hall 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 revenues in the quarter. You guys said you're going to catch up in the next quarter, but just curious how big a drag on revenue 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 demand, positive demand impact here in the pandemic and have 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 homes not growing as much, people penetrating more into it, buying more products? Or 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 is 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 that'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. Great. Okay. Thanks, Britney. And 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 levels 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, Brittney, 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 of revenue that seasonality may smooth out a bit. 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, Katie. So I would say that from a gross margin standpoint, we have been making investments 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 with 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's 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 continues to be a balance for us going forward. I think you highlighted some of the good business model impacts. I mean, 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 channel. 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? I think the 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, Britney. And then as retail stores reopened in June July, how did you see the mix shift within your business? And what, if any, contribution did you have in the Q3? And do you expect in the Q4 as it relates to any sell in 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, 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 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 orders. So you saw some of that in Q3 and you'll see some more of it in Q4, which is factored in. That's great. Thank you. And your next question is from the line of John Babcock with Bank of America. Please go ahead. Hey, good afternoon, Dash, evening. I guess I just want to add quickly on the demand and inventory side here. I mean ultimately if demand does remain at currently strong levels, do you have any sense that it might be difficult to rebuild inventories? Any color you could 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, we'll 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 Q4, not the calendar Q4, right? Correct. That's our fiscal 4th quarter, yes. Okay. And then with regards to the tariffs here, obviously you're going to get about $30,000,000 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 an extension may only last, at least for certain other consumer products manufacturers through 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 2 pronged process and approach for us to mitigate tariffs. Okay. Thank you. And your next question is from the line of Brent Thill with Jefferies. Please go ahead. Great. This is James on for Brent. Thanks for taking my 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 pulling later once you've built the engagement first? And that's my first question. Thanks, James. Really that's come from Sonos Radio has come from a place of enhancing the experience that was there. It was something that we hadn't really touched it about 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 for the future, but we're just getting started with. So I'd say stay tuned as we get further out on that one. Great. And then just another one. You spoke about on the last call about having pretty solid demand for the Sonos move, especially at the end of the quarter. Just curious how that trended into June July as more reopening started to happen? And then I guess I'm just curious how you think more broadly about your strategy towards out of home products going forward? Thank you. So I would say, Moove 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, it's continuing to perform really nicely. Great. Thank you, both. And your final question comes from the line of Alan Park with Stifel. Please go ahead. Yes. Hi. Thank you for taking the call. It's coming in for Matthew Sheerin. I was just following up on the Malaysia transition and the tariff 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. We've gotten 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 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 Danone and etcetera, is this strategy expected to continue on? Are there more counterparties that you expect to proceed with further litigation on? And we just wanted to get a gauge of what the overall strategy will be regarding this litigation going forward. Maybe, yes, this is Eddie Majes, the Chief Legal Officer. And I'd say, Judith, we expect to Google we've been to file that case to be more confident in it, and we remain confident in it today. With respect to the broader program, yes, there are quite a few companies in the States who we believe are infringing on our patents that we mentioned, and we're in touch with many of them. And the goal would be to continue to establish a set of precedents around licensing agreements with a number of those companies. Thank you very much. I now would like to turn our 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.