Wireless speaker company Sonos is looking to go public, and its S-1 filing has been available to the public for nearly a week now. With the speaker market currently made up of established audio brands like Sony and Bose, not to mention the Silicon Valley giants and their smart speaker offerings, Sonos will be the rare pure-play smart speaker stock. But how sweet does the company sound from a long-term investor's perspective?

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma go through the highlights of Sonos' S-1 filing. Find out how the company is doing in terms of its financials, why it's decided to go public now, and the biggest risks it faces.

A full transcript follows the video.

This video was recorded on July 10, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, July 10th, which means we're talking consumer and retail. Feels good to be back in the studio after some vacation time and the holiday last week. We have a great show lined up for you.

First, let me introduce my guest, the one and only Asit Sharma. Hey, Asit! Thanks for joining us!

Asit Sharma: Thanks very much! Hello, listeners! I'm also very excited to be back. I was telling Vince, I had a little bit of water heater problems. It got quickly resolved, but sometimes you just want to go back to work. I'm glad to be with you.

Shen: Nice. I actually wanted to ask you this random question related to the holiday. At this point, we're about a week out from the 4th. I'm still hearing fireworks just about every night in my neighborhood. I'm curious if you are experiencing anything like that in your neck of the woods.

Sharma: Sort of. We have a young-ish neighborhood with a growing number of teens, so I think it's going to go on for a couple of weeks more. But I enjoy it. [laughs] 

Shen: Well, correct me if I'm wrong, but the fireworks in North Carolina have quite a bit more oomph to them than what we can get in D.C., at least in the immediate vicinity. I don't know if it's even worse in your area, if they're particularly loud.

Sharma: Yeah, it's loud. South Carolina is the big state where folks go to load up on these very powerful, TNT-type fireworks.

Shen: [laughs] Yeah.

Sharma: If you're a heavy sleeper, you're blessed. If you're not, well, what can I say?

Shen: I feel like we're going to have people working through their fireworks hoard that they've gathered all summer, but it's kind of fun.

Getting into the main topic of our show today -- my two favorite topics tend to be IPOs and M&A. The business world has delivered, because the IPO filing for Sonos became available last Friday. Sonos produces wireless speakers and sound systems. It's built up a pretty impressive following and user base over the past decade. I'm curious, any chance that you have a Sonos in your home, Asit?

Sharma: I don't. I'm a big old-school audio guy, so I have the old hi-fi style equipment. We do have some speakers but not a Sonos yet. After reading through this filing for the IPO, I'm eager to buy one, actually.

Shen: Sure. I have family that own multiple Sonos speakers. They really rave about the company, its products. I have to say that going to their place and walking into each room of their apartment and being greeted by music, it's really nice. It feels like you have a soundtrack for your home. 

Getting into some of the nitty-gritty for this business -- the company's registration statement was released to the public last Friday. I'd like to remind Fools that you can check out that S-1 filing by going to the SEC website and using its EDGAR search tool. Asit and I will cover a lot of essentials behind this business, but nothing can beat performing your own research and due diligence into the company. 

The proposed ticker is SONO. The deal value that's listed in the prospectus is $100 million, but consider that a placeholder. It will very likely change as the company advances through its IPO process.

Sonos was founded in 2002. Their mission is to fill every home with music. They launched their first wireless multi-room speakers in 2005. Their product portfolio has only grown since then to various speakers, sound bars, and as of last year, they've also taken the plunge into the voice-enabled smart speaker market with the help of Amazon's (NASDAQ:AMZN) Alexa. We'll talk about that a little bit more. 

To date, Sonos has been backed by private equity and venture capital firms, with about $450 million raised since 2005. Prior estimates of the company's valuation have been as high as about $2 to $3 billion, to give you a sense of the size of this company that we're looking at. My last tidbit so listeners have an additional sense of scale for this company -- Sonos reported $992 million of revenue in fiscal 2017 and actually cleared the $1 billion mark for the one-year period ending in March.

Asit, I'll pass the baton to you. Where would you like to dive in in terms of the business?

Sharma: I'd like to give our fellow investors and listeners some background on the market opportunity for Sonos, talking about what their current base looks like. That's always important in an IPO, to figure out what kind of market this company has and how can it grow. These are stats provided in this registration statement. This is as of March 31st, 2018. That's their latest reporting period, and it covers six months of their current fiscal year. 

Sonos customers, as of that end date, have registered over 19 million products in about 6.9 million households globally. They estimate that their customers listen to about 70 hours of content per month and that they listen to 80% more music after purchasing a Sonos product. Also, out of these 6.9 million households, 61% of these had registered more than one Sonos product. 

There's this phenomenon -- which, Vince, your family can attest to -- of buying your first Sonos product and then you add on. I always look for recurring revenue sources for companies where I can find them. I think it's a great way to grow revenue, because you build a core that then becomes incremental each year. I like that statistic. 

They say their customers who initially purchase one Sonos product, end up purchasing an additional 1.4 products. You can't really buy a half of a product, but that's how the statistics average out. Those customers who have purchased more than one started with an average of 2.9 Sonos products, and they purchased an average of an additional two products over a period of years.

I think this is a really good statistic to think about, considering that the market for multi-room wireless speakers is nascent, and it's only scheduled to grow globally. We'll talk in a little bit about the global picture for this company. Those statistics really hit me up.

One more that I want listeners to be aware of is how they track the use of their speakers over time -- 93% of Sonos products that have been registered since 2005 have received a software update in the 12 months ended that March 31st period that I talked about. Sonos automatically updates its software and hardware, as is de rigueur for most good products that are technologically oriented these days. 

They've been tracking since they launched the company, and they have about a 93% update rate. To me, that's incredible, and it speaks to the utility of this product. Some of the IPOs that Vince and I have talked about over the last year have metrics which fall off. Customers buy a product or subscribe to a subscription service, and then they tend to drop off. Sonos is the other way. It's a hardware product, it stays in your home, it has more utility as you go on.

Shen: I think that's a really big part of the allure for these products. Even their older speakers released years and years ago are still getting those updates so that the functionality is there for users. I think that helps to build up a loyalty among their customers. That proves out in terms of the numbers, in terms of these follow-up purchases that they will make that you mentioned, whether they're purchasing a single speaker at first or multiple speakers. I think, the way the Sonos speakers connect -- in terms of my personal experience with them, at least -- the experience with their product improves as you build up how many of them you have. I think that's a big part of filling your home with music.

Next, let's look a little bit at some of the financials and numbers. In terms of revenue growth and margins, revenue was up 7% in fiscal 2016, but the rate accelerated in 2017 to 10%. It continues to pick up steam. It hit 18% year over year for the first half of fiscal 2018, reaching about $656 million. The company has attributed a lot of its recent growth to the release of its Sonos One smart speaker, which was released last October. 

While that is promising, gross margins have declined in the latest fiscal year, going from historical levels, 45%, down to about 42%. I'd usually consider that a red flag, since that implies that these new smart speaker offerings have lower margins, but management notes that their gross margins are weakest for new products at launch, and improvements generally come over time as they achieve scale. 

Given the fact that unit volumes jumped almost 30% from 2.4 million to 3.1 million products sold for the first half of fiscal 2018, I think Sonos management is in a position here where they're probably willing to take a little bit of the margin hit to boost growth in preparation for the IPO. As part of that effort, Sonos cut its workforce recently in May, which brings some of its costs down -- again, improving a little bit of the optics for this business as investors are diving into it before it hits the public market.

Some of the revenue profile and customer characteristics I wanted to get into, you covered those, Asit. I think that's really the beauty of when you can dive into these S-1 filings. The company will discuss things about its customer base, how users engage with the product, new and returning customer trends, that you can't get elsewhere. 

Something else I'd like to share, in terms of some of the profile, is the fact that Sonos sells its speakers through third-party brick-and-mortar retail partners, over 10,000 of them. The company actually generates over half of its revenue abroad in more than 50 countries. I was actually quite surprised to see that. I'm curious what your thoughts are there, in terms of how the markets break out for the company.

Sharma: I'm pretty interested in their geographical distribution. It's pretty nice for a young company. If you look at the revenue breakdown in the first half of 2018, in the Americas -- North America, basically -- the company had 50% of its revenue derived from that region. 45% came from Europe, the Middle East, and Africa. Atypical in a company which is so young and fast-growing, especially in the hardware business. Asia Pacific represented just 5% of sales. The company mentions in its filing that this is a region of enormous opportunity. 

Of course, we talk ad nauseam on this show about how important markets like China are. I want to talk about a different market for just a second, and that's the market of Japan, which the company singles out in its filing. It's under-penetrated. I've had the opportunity to go to Japan. It's a music-mad country, and it's a very technologically advanced country. This country in particular is a market where I think they could find millions of dollars of revenue in the future once they penetrate it. I really like the way that revenue is composed. 

I want to say one more thing about revenue, going back to Vince's point about the multi-year acceleration trend in revenue. It's not sky-high, as we've seen with some software companies. On this show, we might talk about fast-growing consumer goods companies -- let's say Canada Goose, for example -- which have double-digit revenue growth year after year after year when they show their filings. This company is more an 8% to 9% compounded annual growth revenue company. That's not such a bad thing.

The one thing, if you do buy into Sonos, which you have to be familiar with -- the revenue cycle is driven by product introduction, as Vince alluded to. It can be lumpy. They're warning you in this filing that, "You may buy this stock, and next year, instead of an 11% to 17% gain, which we're on track for this year, we might have a flat year." There's a note of caution in this. It depends upon the introduction of new speakers to drive the next revenue cycle.

Shen: That's a really great point to keep in mind. Driving some of the additional growth that we've seen recently, they have the Sonos One, they also have the Sonos Beam. They're expected to release additional smart speakers that feature Google's voice assistant technology, and then hopefully some backdoor approaches to how to partner with Apple products, as well.

Moving on to the bottom line margins, some of the profitability side there, as well. I want to cover this quickly. The company has reported shrinking net losses. I think the picture looks even a little bit better if you consider the adjusted EBITDA metric -- that's earnings before interest, taxes, depreciation, and amortization. In Sonos' case, they also back out stock-based compensation. 

Overall, I think we have a situation here where the company is in a pretty solid and improving financial position. As of March 31st, Sonos had about $120 million of cash on hand; debt of just $40 million. Combining that perspective with the more than $60 million of positive operating cash flow last year, I think this company is in better shape than many of the other IPO candidates that are out there that are trying to go public. 

I'm curious, any thoughts here in terms of the bottom line and other financial aspects before we move on to the bigger picture competitive elements and landscape for this company?

Sharma: Sure, two quick points. That gross margin that you talked about, Vince, that's partly due to the fact that Sonos uses one single contract manufacturer. It does a lot of R&D and a lot of testing at its home base office, but it outsources the manufacturing of its products to a company called Inventec. That's a source of profit generation, but it's also risk to be aware of. If that supplier has a disruption, that could be bad news in a particular quarter for Sonos. That's something to keep in mind.

Also on that bottom line, I think that this speaks to the use of proceeds. It's something that I always try to discuss when we talk about these IPOs. The use of proceeds for Sonos is pretty general. They don't have a specific goal in mind like, "We want to raise $X million and acquire a competitor." What they're saying in their filing is, "We want this to introduce ourselves to the public markets. We want to use these funds or whatever is remaining after all the transaction fees are taken care of to just add to working capital, general corporate purchases," very plain vanilla type of uses for the cash that they're going to raise. 

What they're saying in their filing is that, "Going forward, we want to perhaps do a secondary offering, maybe offer some debt on Wall Street." This is a way for the company to move to a larger playing field, to have more name recognition. I like that versus what we've seen in some other IPOs in the last two years, which is, "Hey, if you don't send the money right away, there won't be a wedding in May." Have you seen that commercial, Vince?

Shen: Yeah, I hear you.

Sharma: We've seen that, we've talked about one or two of those companies on the show. Blue Apron is one example. This is a much more stable company. I think Vince gave you a great rundown. The balance sheet is solid.

Shen: Alright. Next up, we're going to hone in on some of the other risk factors and competitive landscape here for audio and smart speakers, because there are quite a few players. 

Asit, what does the competition look like here? We've started to mention it, at least a little bit. This is one part of the filing that really set off some actual alarm bells for me, in terms of who they're dealing with in the competitive landscape.

Sharma: Me too, Vince. The company has two sets of competitors. On the one hand, you have audio component makers. Many of these have been around for decades. Again, I mentioned I'm a hi-fi guy. I grew up with these names. Harman Kardon, JBL, Hooke Audio, Bang & Olufsen. These are mostly now owned by larger companies like Samsung and Sony. They have deep-pocketed owners. 

In the components market, that's just if you think about these multi-room wireless devices, most of the companies I just mentioned have already developed their own products which compete with Sonos' products. Bose is another great example. One of the biggest channels that Sonos has is through Best Buy. They list out, "These are the channels that we sell to." Bose sits right beside Sonos on the shelves, and we've seen them be a formidable competitor to many different speaker makers that have come. That's one side of the competitors.

Then, you have what I want to call not enemy competitors but "frenemy" competitors. We haven't mentioned yet that Sonos has a really great ecosystem of content providers. It integrates with companies like Pandora and Apple via iTunes for streaming content. It lists about 100 partners. In this business, you have to have frenemies. 

Shift just a little bit over to another type of cooperation, and this is in the voice-activated speaker market. The big elephant frenemy for Sonos is, of course, Amazon.com. Sonos One and Sonos Beam both feature voice control. It's powered by Amazon's Alexa technology. Amazon is a competitor in that market. Amazon, of course, offers its own components. 

To bring up a metaphor, I guess the best one that I can think of would be a point guard in basketball. Think of Amazon as the playmaker on a basketball team. When I was growing up, the point guard was always described as a triple threat. That means that the point guard can dribble, can pass the ball, or shoot. Amazon can, with any company it deems to hold a strategic interest, it will say, "This could be a competitor or something we could roll into our company," it pays attention to. We've seen it do this. On this show, we've talked about Ring, the home security devices. Everyone is familiar with the acquisition of Whole Foods Market by Amazon.

Amazon cooperating with Sonos, putting its technology into Sonos products, has this decision tree to make -- dribble, pass, or shoot. To me, dribble means, "Maybe we can acquire Sonos at some time. We've done that with other companies. We like their technology. We should just swallow them and extend the product line." Pass means, "Let's give them a pass. Let's let them keep going. They're not in our way just now, we like the product. It spreads Alexa's technology into the world. Let them be." Shoot, that's the most dangerous outcome. In that outcome, Amazon simply decides to undercut its frenemy. We've seen it do this repeatedly once it finds a market that it wants to dominate and underprice competitors out of the market. It doesn't have anything binding long-term with Sonos that would prevent it from doing so. 

I think you hit that nail on the head, Vince, this is a red flag. I'm really curious to see what your thoughts are. Don't worry about this too much, or we need to think about it?

Shen: I love the analogy. For me, the issue ultimately comes down to the fact that, given the emphasis that Sonos has placed on smart speakers as an important source of their future growth, their roadmap looking forward, investors do have to consider this predicament that the company is in when both a hardware competitor, with the Echo and the Dot. Then, there are also the offerings from Alphabet, as well. They have this upcoming speaker that will feature Alphabet's own voice assistant technology. 

They're powering the software on these Sonos devices. Again, if they decide to pull the rug out from beneath the company, as much as Sonos might try to spend on R&D -- they talk about their strong patent portfolio and things along those lines -- it will be a huge challenge for them to build up the software services side if these frenemies that they have decide, "Hey, strategically, it doesn't make sense for us to support what is ultimately a hardware competitor anymore."

Here, we're going to start to wrap up and share some of our final thoughts. I think there's still a few important aspects to this Sonos story to keep in mind. On one hand, Sonos is arguably the company that many investors have been waiting for if they want clean exposure to the smart speaker market. This really going to be the only pure-play option trading publicly in the near future. It's tough to look at an Apple, an Alphabet, or an Amazon, or even a Samsung or a Sony, in terms of the larger companies having these portfolio brands that you mentioned -- you can't really see those stocks as a play on smart speakers, given how small the contribution is that that business is for these huge, huge companies. 

In the end, I also can consider that a curse in that Sonos has this open platform, these partnerships with the hundred streaming content providers that you mentioned. But the market has generally been unkind to hardware-focused companies in the consumer electronics space, and for good reason. I think it's an unfortunate comparison, but Asit, what's the cautionary tale that came to mind when you were looking at Sonos? It came to mind for me, too.

Sharma: GoPro. GoPro had a similar profile. Very innovative product. The management of that company tried to sell investors on this prospect, "We'll differentiate into content, and that will keep us from being just a hardware manufacturer." When you look through Sonos' filing, they do have a persuasive argument in that, "Look, we have a lot of patent technology. We pioneered this stuff. Our app is very seamless, and it helps our ecosystem expand." They have a persuasive argument.

But at the end of the day, if the frenemies do decide to compete -- Apple with Siri is yet another competitor that we haven't mentioned. You mentioned Alphabet, Vince. Sonos is also integrating with Siri in its speakers, but Apple has its own product. GoPro is the example that came right up to the surface of both of our minds. We hope this isn't another GoPro. 

My final thought is, after reading about Sonos, I really like the way the company's run. I like its innovation. I think, if you are someone whose heart is in this business, you've been waiting for that investment in the pure-play speaker market, as Vince says, then I'd consider buying this. If you're not, then I'm going to give the standard advice that we've given for many IPOs which don't have that huge, tugging, "You have to buy in now," which is: wait. Watch this thing over a few quarters. The train won't leave the station immediately. It rarely does in hardware components. You have time to figure out if this company is for you or not. Vince, I'm curious what your thoughts are. Would you buy this next month? Would you wait?

Shen: I'll say, I'll wait just to get the official S-1 prospectus. Once they've shared more details, in terms of, how much proceeds they're raising, what the valuation will be based on the range they provide. There's always that base information that, of course, we'll be looking out for and will update on in a future episode. 

Otherwise, at this point, it does worry me. I think the GoPro comparison is apt. Though, maybe I'll call it a hybrid of GoPro and Roku because it's this open, agnostic platform, in terms of the content providers. But unfortunately, there's no ad business for this to rely on, whereas Roku has been able to leverage that and move away from being branded as purely a hardware play. 

That's my take on it. I'm curious, any final other thoughts that you think investors should have before we roll off?

Sharma: Sure, just one last thought. The company is projecting that it will move into other services, hasn't really clarified that. Ultimately, management wants to extend beyond this into other product lines. You can take your imagination into cars, office. I think they did actually mention office as an outlet. There are some peripheral revenue streams that Sonos can tap into. That needs capital, but hey, that's why they're going public. For me, keep an eye on it. It's a very interesting company, very intriguing company.

Shen: It can be tough sometimes, when you have a company where you're maybe not so certain about the business itself, but in terms of my personal experience with products, I quite like them. It's a bit of a tough situation there. 

Fools, we will definitely be providing updates for Sonos as they come closer to pricing their IPO, and in the quarters after that, how the business performs. Asit, thanks for being here.

Sharma: Absolutely, it was a pleasure.

Shen: Fools, thank you so much for tuning in. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Apple, GoPro, and Pandora Media. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.