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Investment thesis

It seems that like in one famous cartoon everything Nvidia (NVDA) touches turns to gold. Sometimes this perception goes too far, like SoundHound’s (NASDAQ:SOUN) massive rally in 2024. The stock soared in February when Nvidia reveled its investment in it. In reality, Nvidia invested almost nothing in SOUN compared to its $3 trillion market cap. I think that Nvidia makes hundreds of investments like this every year, but the hype around SOUN was especially strong.

Of course, there are reasons to be positive about SOUN. The company delivers massive revenue growth and current momentum is indeed strong. On the other hand, the company generates less than $20 million revenue per quarter in an industry that is worth $3.8 billion. This means that the company’s footprint is almost invisible. The industry is expected to thrive over the next decade, but SOUN’s razor thin CAPEX spending suggests that entry barriers are extremely low.

All in all, I think that negatives and positives offset each other. In this context of extremely high uncertainty, I think that a massive premium revealed by my valuation analysis is not justified. That said, I assign SOUN a “Strong Sell” rating.

Financials

SOUN went public not so far ago and that is the reason why its P&L is available only since FY2019. On the other hand, five years is quite a horizon to make conclusions about the company’s key financial trends. The company delivered a 56% revenue CAGR, but the scale is relatively small with the TTM revenue still far below $100 million. The business model looks sound since the gross margin demonstrates robust expansion as the business scales up.

SOUN long-term financial performance — Author’s calculations

The operating margin also demonstrates solid positive trend as revenue compounds with robust pace. SOUN still burns cash because the company needs to invest massively to drive growth. This does not look like a big problem because SOUN is in a solid financial position with more than $200 million in cash and substantially lower outstanding debt. I think that SOUN’s financial position is solid and positions the company well to continue reinvesting in innovation.

The latest quarterly earnings were released on May 9, when the company delivered positive revenue and adjusted EPS surprises. Revenue growth momentum is immense as the company delivered a 73% YoY topline expansion. On the other hand, figures are quite low with Q1 revenue of $11.6 million and growth in percentage might be misleading. Additionally, on a sequential basis revenue dropped from $17.2 million to $11.6 million.

The upcoming quarter’s earnings release is scheduled for August 8. Consensus estimates expect Q2 revenue to be $13.1 million, which will be around 50% higher than in the same quarter last year. While a 50% topline growth is impressive, the deceleration of growth is also massive. Moreover, the adjusted EPS is expected to dip from -$0.07 to -$0.09 despite revenue growth.

SOUN upcoming earnings release — Seeking Alpha

To summarize, SOUN’s financial performance looks like typical for a young and relatively small company. The company demonstrates massive revenue growth with quite volatile expansion pace, its bottom line is also yet instable. For a growth company it is also crucial to understand its future revenue growth potential.

Therefore, let me zoom out from a purely financial perspective and take a look at other crucial aspects. A bullish sign is that the industry is growing and is expected to demonstrate massive growth over the next decade. According to various sources, the industry is expected to demonstrate double-digit CAGR over the next decade. For example, Spherical Insights expect the global voice assistant market to compound with a 30.5% CAGR for the next decade. I also want to emphasize that the same source estimated that the total industry to be worth $3.8 billion in 2023. If this assessment is accurate, it means that SOUN’s market share is around 1.5%.

While the industry is expected to be hot for longer, I also have to emphasize that the competition will likely be tough. SOUN’s cash flow statement suggests that the company spends less than one million USD on CAPEX per year, meaning that barriers to enter the market are extremely low and loads of talented engineers can start up potential competitors for SOUN. Moreover, it is difficult to say that SOUN is a pioneer in the industry where Apple’s (AAPL) Siri is already 12 years old and Amazon’s (AMZN) Alexa will celebrate its first anniversary this year.

To conclude, SOUN demonstrates solid revenue growth and operating leverage. This means that the company successfully navigates in a booming industry, absorbing its tailwinds. On the other hand, the company’s scale is too small and growth figures in relative terms might be misleading. The industry is expected to sustain a 30% CAGR over the next decade, but barriers to enter the market are extremely low which means that it will be extremely difficult for SOUN to protect and expand its market share. Moreover, the giants like Apple and Amazon are in the industry for around ten years and there is little evidence that these companies were able to capitalize much on it.

Valuation

The stock gained 6% over the last twelve months, significantly lagging behind the broader U.S. stock market. On the other hand, the stock’s YTD performance is massive with an 89% rally. Due to lack of profitability, most of valuation ratios are unavailable. However, the ones that are unlocked look extremely high.

On the other hand, ratios might be misleading when we speak about valuation of young growth companies. Therefore, I certainly must proceed with the discounted cash flow [DCF] simulation. I start with figuring out the discount rate, which should be the cost of equity due to SOUN’s low debt levels. The CAPM approach is the way I calculate the company’s cost of equity; all variables are easily available on the Internet.

SOUN cost of equity — Author’s calculations

Two other critical assumptions are much trickier. Consensus estimates for revenue growth are available only for FYs 2024 and 2025. Therefore, for the rest of the next decade I rely on the industry CAGR forecasted by Spherical Insights, which is 30.5%. As we saw in my financial analysis, the company’s FCF margin is deeply negative. For the next two years consensus does not expect the adjusted EPS to become close to zero. Therefore, I think that the earliest we can expect positive FCF margin is FY 2027. Due to the aggressive expected revenue growth, I incorporate an optimistic assumption of the FCF margin expanding by 150 basis points yearly.

My DCF simulation suggests that SOUN’s fair value is $564 million, which is around two times lower than the current market cap. My critics will likely comment that a 22.7% discount rate is way too high, but in the below spreadsheet we see that even with a much softer discount rate SOUN is still 30% overvalued.

Risks to my bearish thesis

My DCF model is based on assumptions. These assumptions are highly uncertain, and they are very fluid. Consensus revenue estimates might go much more aggressive in case the company delivers solid revenue beats, or big guidance boosts. If SOUN moves to positive FCF margin faster than my DCF model expects, it will also highly likely positively affect the fair value.

As I highlighted above, the big hype around the stock this year was caused by the information that Nvidia is SOUN’s investor. I might be underestimating the synergetic effect of Nvidia’s presence among shareholders. Or the stock might spike again if there is new information about Nvidia buying more SOUN’s shares.

Last but not least, there is a massive 24% short interest in SOUN. Therefore, a possibility of a short squeeze exists, which might send the stock much higher due to shorts covering their positions.

Bottom line

To conclude, SOUN is a “Strong Sell”. I think that all risks and uncertainties offset the positives, which makes the current premium to the fair value absolutely irrelevant.