Sonos Inc Q1 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the Sonos Fiscal First Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Cammeron McLaughlin, Vice President, Investor Relations. Thank you. Please go ahead.

Thank you. Good afternoon. And welcome to Sonos' first quarter fiscal 2021 earnings conference call. I am Cammeron McLaughlin, and with me today are Sonos' CEO, Patrick Spence; and CFO, Brittany Bagley. For those of you who joined the call early, today's hold music included highlights from the recently launched artist-curated stations by D'Angelo and FKA twigs on Sonos Radio HD. Before I hand it 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 as 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 certain non-GAAP financial measures. For information regarding our non-GAAP financials and a reconciliation of GAAP to non-GAAP measures, please refer to today's press release regarding our first quarter fiscal 2021 results posted to the IR portion of our website. As a reminder, the press release, a supplemental earnings slide presentation and conference call transcript will be available on our IR website at investors.sonos.com. I will now turn the call over to Patrick.

Thanks, Cammeron. 2021 is off to a great start for Sonos. I'm so proud and appreciative of all the hard work by our team and our partners. These results are incredible in their own right, but doubly so in the face of the pandemic and all the challenges it brings. We anticipated delivering a strong first quarter; our results were meaningfully ahead of our expectations. On the heels of the strength, the momentum we continue to see, and our ambitious roadmap, we have even greater confidence in our ability to drive transformational 2021 results. We are increasing our outlook for the year on all of our key metrics. As I highlighted last quarter, we have hit an important inflection point that proves that our unique model delivers for both customers and investors. Our approach from the beginning has been to build a system of premium products and now services that deliver an amazing experience whether you start with one of them or start with many. This creates a virtuous cycle where customers return to add additional Sonos products and services over time. Our model has two important drivers. The first is attracting new customers and the second is driving additional purchases from existing customers. We made big gains on both fronts in this quarter. We added a record number of new homes and we saw our existing customers return to add additional products at a record level. Brittany will cover the financials in detail but I wanted to highlight one thing. The first quarter illustrates the strong free cash flow and adjusted EBITDA our model delivers as we scale it. We delivered a record 25.8% adjusted EBITDA margin. Thanks to our innovative products, our ability to expand gross margins and our continued operating expense leverage. This is a strong proof point to the profitability and sustainability of our model. Revenue during the first quarter increased 15% year-over-year to a record $645.6 million. As you know, we've been focused on leading with direct-to-consumer and our DTC performance accelerated in the first quarter. We had a very strong holiday selling period led by growth across all of our product categories. As you know, we limit regular promotions, keep our campaigns few and targeted throughout the year and believe strongly in maintaining our premium position in the marketplace. The biggest driver of new customers continues to be existing customers telling their friends and family members about Sonos. There is no better testament to the power of a brand than that. While our efforts to improve availability proved helpful during the quarter to drive stronger performance than expected, we do remain out of stock on three products. We anticipate being largely in stock by the end of the second quarter. As a result of our strong performance and outlook for the remainder of the year, we are on track to deliver our 16th consecutive year of revenue growth, now expecting to deliver 17% to 21% growth for the year on a comparable 52-week basis, compared to our prior outlook of 11% to 15% growth. As we look forward to fiscal 2021, we see tremendous opportunity and remain focused on the following priorities for this year. The first is to continue to deliver innovative new products that both new and existing customers love, plus services that enhance and further differentiate the customer experience. We remain committed to maintaining a relentless focus on innovation in our traditional product segments and you'll see continued innovation and experimentation in services, as we believe there's plenty of opportunity given our highly engaged customer base. We remain committed to launching at least two new products per year and are well on track as we look at our fiscal 2021 product roadmap. We are excited to introduce our newest product next month. Stay tuned for details. We are pleased with the momentum we are seeing around Sonos Radio and Sonos Radio HD. We look forward to developing more direct paid relationships with our customers over time and we'll be talking more about this at our Investor event next month. Second, we will continue to focus on strengthening our direct-to-consumer efforts and engaging even more deeply with consumers. We are increasingly focused on direct distribution and engagement to ensure we are delivering a great end-to-end experience for our customers. We have seen that consumers are willing to engage and transact with a trusted brand like Sonos and expect that that will only increase over time. Third, we will continue to strengthen and support our incredible partnerships. We've been very pleased with the results of our IKEA partnership and the opportunity it has created to introduce new consumers to the Sonos brand and our platform. We will look to continue to enhance our partnership with IKEA this year and bring additional new partners onto the platform. As far as our longer-term strategic priorities in the future, I look forward to discussing this at our first Investor event on March 9th. We're excited to have all of you join for that and I've never been more excited about the opportunity ahead for Sonos. Let me turn it over to Brittany now.

Thank you, Patrick. We are thrilled to be starting fiscal 2021 on such a positive note, delivering well in excess of our expectations and further solidifying our ability to deliver a record year. Let me add some color on our strong first quarter results and our increased fiscal 2021 outlook. Starting with the first quarter, we delivered adjusted EBITDA of $166 million. This was a 78% increase compared to our $93 million last year. Excluding tariffs, duties and refunds in each of the quarters, adjusted EBITDA increased 45% over Q1 of last year. Our adjusted EBITDA represents a 25.8% EBITDA margin, compared to 16.6% last year. This is our most profitable quarter ever. We were able to deliver this tremendous result due to strong operating leverage and topline growth. Revenue in the first quarter increased 15% or 12% on a constant currency basis to nearly $646 million, as we continue to experience strong demand for our new and existing products, and an overall strong holiday selling season. Revenue exceeded our expectations because we pulled more supply into the quarter through our efforts around air freight and overall shipping and logistics processes globally. The Americas grew 21% and EMEA grew 13% or 5% adjusted for the positive currency impact. APAC decreased 17%, primarily because of slower module orders out of IKEA, given the lighter foot traffic in their stores due to COVID-19 and the cyclicality around product launch timing. Sonos Speaker revenue was up 13% year-over-year, driven in part by the continued success of Arc and Move. Sonos System Products revenue increased an impressive 59%, driven by the continued strength of our installer channel and component products. Partner products and other revenue decreased 40%, driven by the lower IKEA revenue noted earlier. Gross margins were also incredibly strong in the quarter and reached a record 46.4%. This was a 590-basis-point improvement, of which 400 basis points was due to the benefit from tariff refunds compared to tariff expenses in the first quarter last year. We were mostly exempt from tariffs in the first quarter and started receiving refunds for tariffs previously paid. Net of the two impacts we had a $3 million benefit to gross profit during the first quarter. The 190 basis point increase excluding the impact from tariffs was primarily driven by mix shifts to higher margin products and higher margin channel mix, especially as we continue to see strong DTC performance, as well as product and material cost reduction. These benefits were partially offset by industry-wide increased shipping and logistics costs, and additional air freight to meet our demand. Given the incredibly strong demand both in our products and across the global supply chain, we continue to be out of stock on a number of our products through the beginning of the second quarter. In addition to the shipping and logistics challenges, we also faced challenges in our supply chain from ongoing COVID restrictions in Malaysia, as well as component shortages. Our terrific supply chain team continues to ramp to meet this demand and we are still working to be fully transitioned to Malaysia by the end of the summer. Overall, we are starting to see improved availability for our products and we expect to be largely back in stock by the end of the quarter. However, Arc, Amp and Move specifically may continue to face supply shortages into the third quarter on the back of continued stronger demand and supply chain constraints. This is included in our fiscal '21 outlook. Turning to operating expenses, we saw strong leverage during the first quarter, as we continue to benefit from efficiencies resulting from our restructuring efforts implemented last year and the higher first quarter sales volume. R&D as a percentage of revenue decreased to 120 basis points. Sales and marketing as a percentage of revenue decreased 230 basis points. And G&A excluding IP litigation and transaction-related costs as a percentage of revenue decreased 70 basis points. Our model continues to generate strong free cash flow and we saw another significant increase this quarter. We generated cash flow from operating activities of $250 million and free cash flow of $203 million, up 97% from $103 million last year. We are ending the quarter with $678 million in cash, which puts us in a strong position to invest organically in our business, pursue M&A and return capital to shareholders through our authorized share repurchases. We currently have no debt on our balance sheet as we paid down our outstanding $25 million in short-term debt in January. Given the tight inventory position this quarter, we had particularly strong free cash flow from working capital, which will normalize as we work towards a sustainable inventory position during the rest of the year. We are very proud of the strong quarter we were able to deliver looking across profitability, revenue and cash flow, and are excited about what is to come. With that, I will turn to our upwardly revised fiscal 2021 outlook. We remain aware of the continued uncertainty in the broader macro environment with COVID-19 and we continue to face challenges in the supply chain. However, we feel confident in our outlook given the continued momentum and the strong first quarter we were able to deliver. Our new products are performing particularly well and we think the trend of spending more time in your home, whether that is listening to audio content or home theater products, will likely endure even as vaccines roll out and life begins to look more normal again. We now expect adjusted EBITDA in the range of $195 million to $225 million, up from our prior outlook of $170 million to $205 million. This represents 13% to 14% adjusted EBITDA margin and expansion of 460 basis points to 610 basis points from the prior year. Gross margin is now expected to be in the range of 46% to 46.5%, compared to our prior range of 45.3% to 45.8%. This benefit is due to the strong first quarter we experienced, as well as ongoing benefits from channel mix, material cost reduction and the expected continued benefit from our higher revenue. We also continue to have $25 to $29 million of tariff refunds we expect to receive. However, given the timing is uncertain this is not included in our outlook and will be recognized only when we receive the refund. We do expect to make additional OpEx investments in our marketing, operations and incentive compensation to support the revised topline growth and outlook for the year. Total revenues for fiscal 2021 are now expected to be in the range of $1.525 billion to $1.575 billion, representing growth of 15% to 19% as reported. Excluding the 53rd week from fiscal 2020, this represents growth of 17% to 21% for the year. This compares to our prior revenue outlook in the range of $1.44 billion to $1.5 billion, which represented growth of 9% to 13% or 11% to 15% excluding the extra weeks. We continue to execute and deliver strong results in the first quarter, positioning us well to deliver an even stronger fiscal 2021 across profitability and revenue growth. We have a strong balance sheet, which will allow us to continue to invest in growth organically and through M&A, and to return capital to our shareholders through share repurchases. We look forward to connecting with you all again at our Virtual Investor event on March 9th. With that, I would like to turn the call over to questions. Thank you.

The first question comes from Adam Tindle of Raymond James. Your line is open.

Okay. Thanks. Good afternoon. Patrick, I just wanted to start with additional color on the record number of new customers in the quarter. Historically, something like the IKEA partnership allowed you to reach a new demographic, but there isn't anything obvious I can point to this quarter. So I'm just wondering if there's some additional color as to what's driving that this quarter. And I imagine you'll allude to a network effect essentially. So why is that reaching an inflection now?

Yeah. Thanks, Adam. I would say there are really three things. First, there are more people at home, and I think that has something to do with it. Second, streaming video has driven many customers to adopt home theater and related services, with more first-run movies available at home and more people spending time there. Our home theater results were fantastic, and that has been a tailwind for us. Third, the flywheel or network effect you mentioned: the number one driver remains people telling their friends and family about Sonos. We've seen this build on itself, and it built to another degree in this quarter. Those are the three catalysts we saw this quarter.

That's helpful. And maybe just as a follow-up, I wanted to ask on the Google litigation. You had the Legrand license win a couple months ago. If I recall correctly, there are some dates approaching for the Google litigation in the spring/summer timeframe. So just wondering if this Legrand licensing win gives you some momentum into the Google decision and any color or context you can give us around the Google litigation update? Thank you.

Adam, it's Eddie Lazarus, the Chief Legal Officer, to respond. Hi, everybody. We have two very active cases against Google right now. The first is in the International Trade Commission and that will go to trial on February 22nd, so coming right up. We would expect a preliminary decision out of the ITC in early May. That case involves five patents. We have a second case in the Western District of Texas that involves five completely different patents. That case is expected to go to a Markman Hearing in July of this year — that's a hearing where certain patent terms are defined — and that case is scheduled for trial in June of 2022. So both cases are on active schedules. I wouldn't draw any direct connection between the Legrand agreement and the Google litigation. We have started entering into license agreements with a number of companies; that process is ongoing, and it reflects the strength and vitality of our IP portfolio, which has been ranked among the most valuable consistently by outside experts.

Okay. Thanks to you both and congrats on the strong results.

Your next question comes from the line of Katy Huberty from Morgan Stanley. Your line is open.

Thank you. Good afternoon. Did the upside in the quarter come mostly from the direct business or have you started to see retailers ramping inventory levels as foot traffic recovers? I'm trying to understand whether that restocking catalyst is still in front of you or you started to see that in the December quarter. I have a follow-up.

Hey, Katy. We saw strengthened performance across our products. Because we were supply constrained for the quarter, it's safe to say there is restocking in front of us as we continue to get all those products back in stock.

Okay. Great. And you did not flow through the entire EBITDA beat from the first quarter to the full-year guide. I want some color as to whether your view of profitability in the coming quarters has changed and whether because of the strength in the first quarter you're looking to step up investments — I know you mentioned higher compensation expense?

Overall, we still expect higher profitability for the year and higher gross and EBITDA margins for the year than what we were looking at before. But we do have some additional OpEx investments to make to support that higher revenue. Those investments will be in sales and marketing, in our direct channel, and they will include incentive compensation.

Okay. And then one for Patrick: in the past we've seen three categories of launches — upgrades of existing products, price point expansion within an existing TAM, and real TAM expansion. Any color as to which of those three categories we should expect you might address over the next year with the two new product launches?

I think it's fair to say all of them.

Okay. Thank you. Congrats on the quarter.

Your next question comes from the line of Rod Hall from Goldman Sachs. Your line is open.

Hi. Thanks for the question and great quarter. I wanted to start with the litigation, in particular the ITC situation. We've seen ITC cases before where even if the ITC rules in one direction, there tends to be a delay and often no immediate implementation of that ruling. Is there anything you can say that would make us think an ITC ruling in your favor would be implemented, or do you expect a lengthy process of back and forth where nothing gets implemented?

I would just say that we have a great deal of confidence in all the cases we bring. We believe that Google is infringing a very substantial portion of our patent portfolio and that we're going to continue with this process until we vindicate our IP rights.

Okay. Great. Thanks, Patrick.

Your next question comes from the line of John Babcock from Bank of America. Your line is open.

Thanks for taking my questions. You launched Sonos Radio HD in November. How is that performing relative to expectations?

Hey, John. It's a little early for us to provide detailed metrics; we've only had it in the market a couple of months. Look for us to provide an update on both HD and our ad-supported business at our Investor event in March.

Okay. Thanks. I don't recall any specific numbers around DTC growth as a percentage of revenue. Can you provide some color around that? Also, gross margin was above guidance — can you provide more detail on where the variance came from relative to what you expected last quarter?

Patrick mentioned that DTC continued to accelerate and remain very strong. We didn't change the guidance relative to what we outlined in Q4 for the year, and we'll provide an update at the end of the year on where we land on DTC as a percentage of revenue. As I said, DTC has been a positive driver for gross margin. The gross margin improvement was driven by better product mix than we expected, better channel mix — much of that benefit comes from DTC — and material cost reductions the supply chain team achieved despite challenging conditions. Those benefits were partially offset by increased logistics and shipping costs that affected the industry this quarter.

Okay. And one quick follow-up on EBITDA for the quarter — can you quantify the overall benefit you had from tariffs? It sounds like there were some refunds that benefited EBITDA.

Sure. We had minimal tariff expense for the quarter and then started receiving refunds in the quarter. Our net benefit was $3 million, and that hit gross margins. So there's a net $3 million benefit coming through in gross margin, and that flows through to EBITDA.

Okay. Thanks, Brittany.

Your next question comes from the line of Brent Thill from Jefferies. Your line is open.

Good afternoon. This is James on for Brent. Thank you for taking my questions. Could you talk about the promotional activity you saw in the holiday quarter and how much you think that impacted your revenue and profitability? Compared to prior holiday quarters, was this year more or less promotional than prior years? I have a follow-up.

I would say our promotional activity this year was very consistent with last year. Probably the difference was that promotional activity started a bit earlier this year given shipping lead times and logistics around the holiday quarter. That earlier activity benefited us; the holiday quarter is seasonally our biggest quarter and you can see that reflected throughout the P&L, as we outperformed on gross margin and EBITDA. There was no negative impact from typical promotional activity.

Great. Digging deeper into geographic performance, what are your expectations for APAC this year given the work with IKEA? Are you starting to see any evidence of a rebound following store closures in that region, and does your guidance assume any material snapback in that region?

Inside APAC we report both APAC and IKEA. The APAC numbers are being impacted right now because of IKEA. IKEA has had in-store closures across their stores and that will depend on COVID and when they reopen. As Patrick noted, we expect new product launches with them coming up, and the timing of those launches and how they transition to new products is factored into our outlook and IKEA-related revenue.

Great. Thanks so much.

Your next question comes from the line of Tevis Robinson from D.A. Davidson. Your line is open.

Thanks so much and congrats on a fantastic quarter. I wanted a better understanding of where we stand on inventory, including your ability to maintain supply of top-selling products. You mentioned being out of stock on three products and expecting to be back in stock by Q2 for most. Do you think those are lost sales or do consumers wait for products to become available?

Sure. We expect to be back in a better in-stock position on the majority of our products in Q2, but Arc, Amp and Move will likely continue to be out of stock into Q3 because demand remains very strong. That's been a challenge for the last couple of quarters as we've chased supply. We've been pleasantly surprised by how willing our customers are to wait for their products. Shipping times and lead times on some products have been longer, and the fact that we are still beating revenue forecasts shows customers' willingness to wait. That demonstrates customer loyalty and the benefit of being part of the Sonos system.

Thank you.

Your next question comes from the line of Matt Sheerin from Stifel. Your line is open.

Yes. Thank you. I wanted to ask about your topline guidance for the year, which you raised by roughly $75 million. You just came off a quarter that beat consensus by roughly $55 million. Is that a conservative view reflecting product constraints? Should we expect typical seasonality or a different cadence given inventory positions heading into Q2?

We do our best to share what we know today. We continue to have supply chain challenges and there are questions about how the world will look as vaccines roll out. We are confident in our ability to manage through supply chain challenges and to maintain relevant products for the home. Even as vaccines roll out, the world won't go back to normal overnight; remote work and at-home consumption trends are likely to persist, which supports our outlook. We factored these dynamics into our guidance. We are not providing quarterly guidance beyond the color on when we expect to be back in stock on some products, so nothing unusual to call out on seasonality beyond that.

Okay. And on gross margin guidance for the year: how should we think about the impact of a higher percentage of sales through channel partners as retailers like Best Buy and IKEA come back? Will that be offset by continued strength in direct-to-consumer and improving product mix with new products?

We factored in everything we know about product mix, new product timing, and channel mix into the gross margin forecast we provided.

Okay. Thanks very much.

And there are no further questions at this time. Patrick Spence, I turn the call back over to you for some closing remarks.

Great. Thanks, Rob, and thanks to all of you for joining us. It was a fantastic quarter. We're off to a great start for the year. I've never been more excited about the future of Sonos. I think we've got great momentum, a great brand and an amazing roadmap. We look forward to seeing everybody on March 9th for our very first Investor event and sharing more details of the future then. Take care everybody.

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