SONO - NASDAQ

Thank you for standing by. My name is Dale, and I will be your conference operator today. At this time, I would like to welcome everyone to the Sonos Third Quarter Fiscal 2024 Conference Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions]. I would now like to turn the conference over to James Baglanis, Head of Investor Relations and Treasury. You may begin.

Good afternoon, and welcome to Sonos' third quarter fiscal 2024 earnings conference call. I'm James Baglanis and with me today are Sonos CEO, Patrick Spence; CFO, Saori Casey; and Chief Legal and Strategy Officer, Eddie Lazarus. For those who joined the call early, today's hold music is a sampling from our Sonos Radio station, Backyard Barbecue. Before I hand it over to Patrick, I would like to remind everyone that today's discussion will include forward-looking statements regarding future events and our future financial performance. These statements reflect our views as of today only and should not be considered as representing our views of any subsequent date. These statements are also subject to material risks and uncertainties that could cause actual results to differ materially from expectations reflected in the forward-looking statements. A discussion of these risk factors is fully detailed under the caption Risk Factors in our filings with the SEC. During this call, we will 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 third quarter fiscal 2024 results posted to the Investor Relations portion of our website. As a reminder, the press release, supplemental earnings presentation and a conference call transcript will be available on our Investor Relations website, investors.sonos.com. I will now turn the call over to Patrick.

Thank you, James, and hello, everyone. It was the magic of the Sonos experience that brought me to the company 12 years ago. We pour our heart and soul into everything we do and we're proud of what we build and the way Sonos brings joy to our customers' lives. That's why it's so painful to let customers down the way we have with our new app. I am committed to making this right with our customers and partners. It's the company's #1 focus right now, and I will not rest until we're in a position where we've addressed the issues and have customers raving about Sonos again. A few years ago, we decided to embark on a complete ground-up rewrite of our app. One reason was to address the performance and reliability issues that had crept in over the last 20 years and were negatively affecting our customers' experience. This would have been reason enough, but as important, we viewed rearchitecting the app as essential to the growth of Sonos as we expand into new categories and move ambitiously outside the home. In addition to its more modern user interface, the new app has a modular developer platform based on modern programming languages that will allow us to drive more innovation faster. And thus, let Sonos deliver all kinds of new features over time that the old app simply could not accommodate. Some of these new features are already on our drawing boards and could represent our entry into new categories, others are still to be imagined, but without a modern app, they would have remained beyond our reach. For Sonos, a company built on innovation at the intersection of software and hardware and the delivery of joyful experiences, we needed the new app to set ourselves up for the future. While the redesign of the app was and remains the right thing to do, our execution, my execution fell short of the mark. Since I took over as CEO, one of my particular points of emphasis has been the imperative for Sonos to move faster. That is what led to my promise to deliver at least 2 new products every year, a promise we have successfully delivered on. With the app, however, my push for speed backfired. It's important to note that this was really a redesign of the entire system, not only the app but also the player side of our system as well as our cloud infrastructure, and this was an enormously complex undertaking. As we rolled out the new software to more and more users, it became evident that there were stubborn bugs we had not discovered in our testing. As a result, far too many of our customers, especially those with some of our older products in their systems, are having an experience that is worse than what they previously had. For some, this meant existing speakers missing from their Sonos systems, while others saw latency issues or errors while setting up new products. Regardless of the issues experienced, our customers deserve better from us. The app situation has become a headwind to existing product sales, and we believe our focus needs to be addressing the app ahead of everything else. This means delaying the 2 major new product releases we had planned for Q4 until our app experience meets the level of quality that we, our customers, and our partners expect from Sonos. While this has the painful effect of reducing our Q4 sales expectations, we believe it will set our future products up for greater success over the medium to long term. We have been working tirelessly on fixing the bugs in the new app, adding back certain features and exploring every option for improving the customer experience. Since launch, we've introduced 9 new software updates that address these issues. We expect the app will get better every 2 weeks with each subsequent release, and we're committed to continuing to improve the experience on that same cadence and even faster where we can. We are able to rapidly deliver these major software updates because of the modular developer platform of our new app. I want to highlight three important areas where we're taking action. First, fixing the app. I've asked Nick Millington, the original software architect of the Sonos experience, to do whatever it takes to address the issues with our new app. We have identified the key bugs, have a plan to fix them and are improving our processes and staffing to ensure we successfully execute our action plan. One of our Board members, Tom Conrad, has over 30 years of experience in software engineering, and Tom is helping us ensure our software efforts are on the right track as well as providing another expert perspective. Because we expect that our app will continue to get better every 2 weeks, we're making more and more customers happy with each release. We're doing everything we can to put all of these issues behind us in time for the important holiday season. The second is supporting our customers. We are increasing our investment in customer support to be able to engage with more of our customers and partners and do it faster. Our customer support has always been something that has set us apart, and we need to ramp this faster to help our customers navigate in the near term. And finally, winning back our customers and partners. We are enacting programs this quarter to both support and thank our customers and partners for sticking with us through this period and turn their dissatisfaction to delight. These programs will run across Q4 and Q1. We expect these investments will come at a cost in the range of $20 million to $30 million in the short term but are necessary to right the ship for the long term. And given we've been at this for 20 years, we know it's needed to win in the long-term. Now turning to the other important launch from the quarter. I'm pleased to share that even with the challenges of the app, our first headphones, Ace, are off to a good start. As you may have heard me say before, this is our most requested product ever. Headphones is a very exciting category for us to play in as the premium over-the-ear headphone category is a $5 billion addressable market, growing by double digits annually, which stands in contrast to the cyclical downswing we continue to navigate in our existing categories. Our goal of participating in more and more categories is to continue to diversify our revenue streams and headphones are a great opportunity to do just that. The customer reviews have been outstanding. As Sonos Ace is rated 4.6 of 5 stars on sonos.com and 4.5 of 5 stars on Best Buy. In its first month, Ace gained a meaningful share in the premium over-the-ear category in our key countries despite competitors dropping their prices and offering unprecedented promotions in tandem with our launch. We take those competitor actions as a compliment to the quality of our offering. To support the launch of Ace, we signed a number of new distribution partnerships. Last quarter, I mentioned we went live as a first-party seller on Amazon in the United States. We have since expanded this partnership to Europe. Additionally, you can now find Sonos Ace on the shelves of InMotion stores in many major airports around the world. InMotion is a premier airport electronics retailer, and we are delighted to build upon this partnership over time. Ace represents an evolution of the role that Sonos can play in your life. With our categories, we are very well established in the home, and we will continue to innovate there. For the first time, Ace enables us to be with you all day long to be a part of the major moments in your day, whether at home, in the office, on a plane or out for a walk. This is integral to our mission of being everywhere our customers experience sound. To recap, it is deeply disappointing for me personally and for all of us at Sonos to be on track for the first 3 quarters of the year and to have a successful new product launch in an exciting new category only to revise our expectations for the fourth quarter due to the challenges with our new app. Of all the reasons that could have taken us off track, knowing that it is because we failed our customers and partners is perhaps the most painful. I want to reiterate again that the entire team and I are committed to making this right with our customers and partners. It's my #1 focus, and I will not rest until we're in a position where we've addressed these issues and have customers raving about Sonos again. I'll now turn it over to Saori to take you through our financials.

Thank you, Patrick. Hi, everyone. Q3 revenues came in slightly ahead of our expectations at $397 million, up 6% year-over-year. Our positive year-over-year growth was driven by the introduction of our first over-the-ear headphone, Ace. This brings our year-to-date revenue to $1.2627 billion, down 6.5% year-over-year. Though our financial results over the past 3 quarters had put us on track to meet our annual expectations, the challenges from the launch of our app requires us to adjust our Q4 expectations, as Patrick mentioned earlier. I'll come back to this after I finish recapping our Q3 performance. GAAP gross margin was 48.3%, up 230 bps year-over-year, considerably better than our guidance we gave last quarter. This overperformance was primarily due to a onetime benefit from improved inventory management. Gross margin increased sequentially from our second quarter due to fixed cost leverage from higher revenue in Q3 and inventory management. Our Q3 performance brings our year-to-date gross margin to 46.4%, up from 43.6% in the comparable period last year. Non-GAAP adjusted operating expenses were $155 million in the quarter, down $2 million sequentially. Adjusted EBITDA was $48.9 million, representing a margin of 12.3%, ahead of our guidance, driven by higher gross margins and to a lesser extent higher revenue. This brings our year-to-date adjusted EBITDA to $130.5 million, representing a margin of 10.3%. We ended the quarter with $277 million of net cash, which includes $50 million of marketable securities as we hold some excess cash and short duration treasury bills. Free cash flow in Q3 was $40.3 million, bringing our year-to-date free cash flow to $188 million compared to $38 million in the comparable period last year. This increase was primarily driven by working capital improvements, resulting from focus on better managing our inventory through adjustments to our sourcing plans as well as implementation of newly adopted payment terms with our suppliers. Our period-end inventory balance was $155 million, down 48% year-over-year and down 14% from last quarter. This consists of $102 million of finished goods and $53 million of components. We are working hard to keep inventory balances in check. And finally, we returned $52.5 million to our shareholders through stock repurchases in the quarter, representing 2.6% of common shares outstanding as of Q2. We have $71 million remaining under our current $200 million share repurchase authorization. We expect to continue to be active in the market purchasing our stock. Turning to our guidance. The Q4 outlook we are providing reflects our best estimates as of today. As previously mentioned, we're reducing our expectations for the fourth quarter fiscal 2024 as a result of challenges stemming from the rollout of our new app. We expect Q4 revenue in the range of $240 million to $260 million. The challenges with our app have had a twofold impact to our Q4 revenue expectations. One, lower sales across our portfolio due to app launch issues. Two, the decision to delay the launch of 2 major new products until our app experience meets the level of quality that we, our customers and our partners expect from Sonos. As a result of the reduction to Q4, we expect the revenue in the range of $1.503 billion to $1.523 billion for the full year. We expect Q4 GAAP gross margins in the range of 40% to 42%, down sequentially from Q3, driven by deleverage resulting from lower revenue. For the full year, we expect GAAP gross profit dollars in the range of $682 million to $696 million, representing a gross margin of 45.4% to 45.7%. We expect non-GAAP gross margins to be approximately 40 bps higher due to approximately $6 million of stock-based compensation and amortization of intangibles included in GAAP cost of revenue. We expect Q4 adjusted EBITDA to be in the range of minus $37 million to minus $14 million, resulting in full-year adjusted EBITDA in the range of $93 million to $117 million, representing a margin of 6.2% to 7.7%. The reduction in our expectation for adjusted EBITDA is primarily due to lower revenue. As Patrick mentioned, from now through the holidays, we're investing approximately $20 million to $30 million in fixing the app, supporting our customers and regaining their trust. We expect that this will come in the form of revenue and gross profit reductions as well as operating expense increases. A portion of this investment that will be incurred in Q4 has not been factored into our guidance range. Despite the reduction in our expectations for Q4, we still expect to show significantly improved free cash flow conversions versus last year due to our efforts to improve working capital. We have spoken in the past about our focus of expense management driving efficiencies across the organization. In the spring, it became clear that we needed to do more structurally, and evolve how we operate. As a result, we began working on a transformational cost initiative that we will provide an update in November. With that, I'd like to turn the call over for questions.

[Operator Instructions] Your first question comes from the line of Adam Tindle of Raymond James. Your line is open.

I wanted to start, Patrick, on the 2 products that are being pushed. And appreciate you taking responsibility, and I think have garnered a lot of trust from customers over time. On those 2 products that are pushed, can you give us a sense of how far along those products were? And as we think forward to a time where these near-term headwinds are through us and into fiscal '25. Would that be a potential year where you might envision, if that stuff gets behind us, we'd have something like 4 product introductions? Or are those kind of indefinitely pushed?

Thanks for the question, Adam. These products were ready to be shipped in Q4. But as we've mentioned, we felt like that we had to address the app issues first because we hold a high bar on the experience we want customers to have. So that is the #1 focus at this particular point in time. And so I don't want to get too far into fiscal '25, but I will say these products were ready to ship in Q4.

Got it. Okay. And understand, obviously, all the near-term pain that you're enduring on the app. But as you kind of think about the longer-term vision once we get through this, you talked about being with customers all day long. I wonder if you might just expand on that vision over time, what that could bring from a Sonos perspective? Could there be a time where this app, given the modular development that you're talking about, could introduce new monetization streams? Just anything that you could give us from an investor standpoint as help as to what the long-term vision would be as we endure some of the short-term pain.

Yes. Thanks, Adam. I think that's a good one. We remain confident that over the long-term, we can take more and more of that $100 billion audio market. We're only less than 2% of it today. And definitely, the work that we've done on the app was the right work as we position ourselves for the future and kind of build what we need from a future proofing and allowing us to be outside the home in all of those areas. And so we feel we have a lot of opportunity ahead in new categories. But also right now, the #1 thing for our customers is to make sure that we address the app and earn back that trust so we can extend into all of those new categories we have plans for.

Your next question comes from the line of Steve Frankel of Rosenblatt. Your line is open.

Patrick, obviously, a lot to work through here. When we look at the magnitude of the revenue reduction in Q4, maybe give us some help parsing through how much of that is to new products that aren't going into the channel. And how much is the app issues causing a significant slowdown in sell-through? And to the extent that's the case, where are channel inventories relative to where you want them to be for Q4?

Hi, Steve. This is Saori. I can take that. And so the way we characterize the impact of the Q4 reduction to our expectation in two-folds. One, first and the larger of the 2 is the lower sales across our portfolio due to the app issues. And second, material enough to mention and certainly, it's the delay in the launch of our 2 major new products that were ready to go, as Patrick just mentioned. And so those were sort of in order of magnitude to the impact of the guidance reduction. As far as channel inventory at the end of Q3, knowing our Q4 revenue now that we're continuing to monitor very carefully. That would put us a little bit higher than we would have liked now knowing our trend currently. But certainly, that impact is comprehended in our Q4 guidance that we gave today, best we know as of today.

Okay. And then on the $20 million to $30 million number, if a portion of that is price protection in the channel, is that already reflected in gross margins, or might gross margins end up lower if you end up putting more price protection or discounts into effect to boost sale?

Yes. The Q4 guidance we gave out does not fully comprehend the $20 million to $30 million that we mentioned today. That has impact as I mentioned to multiple line items of the P&L, revenue, gross profit and operating expenses and also the timing in which it would hit between Q4 and Q1. And so some actions are already underway, but there are others that are a little bit more in progress in determining exactly how to position that to your point about whether that's a price protection type of activity that we would hit in Q4 versus Q1. We believe more will hit in Q1 than Q4 at this point, best we know.

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

This is Rayyana Matraji on for Brent Thill. Thanks for the question. Could you speak a bit more to the issues from the app rollout and the impact it could have on purchase intent for hardware going forward?

Yes. Thanks, Rayyana. So a few years ago, we embarked on a complete roundup, rewrite of the app. We wanted to address the performance and reliability issues, and we also wanted to create something that would allow us to expand into new categories and bring a lot of new features to the system. So redesigning the app was definitely the right move for Sonos, but we fell short on our execution of this one. And I think we're seeing the short-term pain that we're having right now in that rollout, but it's our #1 priority right now to address this. And so I believe we will be able to address this, determined that we will address it in the short-term and be able to make sure that we keep our flywheel intact for the future.

Okay. Cool. And then what are you seeing in the demand environment in general? Has a weaker macro further impacted consumer spend, or is that hard to tell with the app problems as well?

Our categories have really been under pressure for the last 2 years. So we continue to believe that they will recover at some point. But what we are focused on is best positioning for what we see today, right now. Part of this is also why we are undergoing the cost transformation initiative that Saori had mentioned and also why it's so important that we entered the premium over-the-ear headphone category as that is a $5 billion market and growing double digits.

Your next question comes from the line of Erik Woodring of Morgan Stanley. Your line is open.

Patrick, I know you guys are alluding to the $20 million to $30 million of costs in the near term. I'm just wondering if you'd take a step back and think about the potential reputational damage that you could have from this app update. Could that be longer lasting and more kind of cost intensity than just $20 million to $30 million? I mean if you go through, I'm sure you have a number of message boards, there's a lot of backlash. And so I'm just wondering if there's a longer-term plan here in place outside of fixing the app and promoting. What else you have in store to try to get those customers that have either been loyal customers or new customers that were potentially considering Sonos products to actually come back after this? And then I have a follow-up. Thanks.

Yes. Thanks, Erik. So I think the key is to address the pain points that we have right now and those customers that are having issues with the new app for sure. But remember, we're not standing still on the innovation front. So we have 2 major new products that we're pushing out again to make sure that we're in a position where the app issues are behind us. As we do that and as we launch those, we launch other products we have planned, we do our day-to-day execution in the channels and in marketing and all our other areas, people will be able to see the products, they'll experience our products. And I'm confident that with the roadmap we have, with the innovation we have coming, this will be just one chapter in our long history. And so we do feel like the $20 million to $30 million is what it takes to address the short-term pain. And that with everything we have coming, we'll be able to ultimately address that pain and then get back to a place of customers raving about Sonos.

Okay. Understood. And then just maybe as my follow-up, I wanted to make sure I was fully understanding, Saori, some of your comments. So the 4Q guide does not incorporate those $20 million to $30 million of cost. I'm just trying to understand, if you flag them for us, but then you're not including it in the guide, does that mean we need to include $20 million to $30 million of cost in 4Q? Or are you saying that those are likely to come in fiscal year '25? Thanks.

You are correct that the $20 million to $30 million is not comprehended in our Q4 guidance. Part of it is because the $20 million to $30 million will be incurred over Q4 and Q1. And majority of it we expect it to be incurred in Q1. There are some activities that are already in progress, but there are others that we're still vetting through the details. And so we did not want to detail that out in our guidance until we have better clarity for Q4 specifically.

Thank you. There are no further questions at this time, thus concluding our Q&A session. I will now turn the conference back over to the CEO, Patrick Spence, for closing remarks.

Thanks, Dale, and thanks to all of you for your time today. Just 3 things I want to hit in closing. First, building a new software foundation was the right investment for the future of Sonos, but our rollout in May has fallen short of the mark. We will not rest until we've addressed the issues with our app and have delivered new versions that materially improve our customers' experiences. Second, while our app setback is regrettable, it is one chapter in our over 20 years of delighting customers. I speak for everyone at Sonos when I say that our #1 priority is to make this right and ensure that the next chapter is even better than the previous ones. And finally, our entry into headphones, Ace, is off to a good start and presents a great opportunity for us in a new, large and growing category. Thank you, and we'll talk to you again next quarter.