Less than a year after smart speaker pure-play Sonos (NASDAQ:SONO) went public, one of its biggest threats became a reality: Amazon (NASDAQ:AMZN) unveiled a slate of new devices, including audio offerings that compete directly with Sonos.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma discuss the nature of this challenge for Sonos and what investors should be watching as the two companies face off.

A full transcript follows the video.

This video was recorded on Oct. 2, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector the stock market every day. I'm your host, Vincent Shen. It's Tuesday, October 2nd, and I'm joined by senior Motley Fool contributor, Asit Sharma, who's connecting with The Fool HQ studio via Skype. Hey, Asit! Great to have you back!

Asit Sharma: Hey, Vince! Hello, listeners! Great to be back, as always!

Shen: Are you excited for your trip?

Sharma: I am! I am so psyched. Really briefly, folks, I'm headed to Germany this weekend on Saturday. I will miss a really important and fun event, which is our annual Fool conference, where all the writers descend upon Alexandra and we meet up with our friends and trade notes. But I'm excited. I'm taking my oldest son and settling him into engineering school, in a university there in Germany sort of near Frankfurt. Once we find him a place, which will be the hardest thing, we've got all our leads, I'm looking forward to kicking back for a few days with him before I come back. I still have this one little glimmer of hope that I will head to Barcelona, maybe on my way out, after hearing about Spain from Vince last week.

Shen: How long is your son going to be studying in Germany?

Sharma: This is interesting. He took a gap year last year and deferred his admission into a local engineering school here in North Carolina, NC State University. Interestingly enough, engineering school in Germany takes place over six semesters. You finish it in three years. As long as he doesn't do like his dad and take the five-year plan, he'll actually finish in three years and won't have lost a step vs. his friends who are in school now. 

Shen: Perfect. I have to say, I'm glad that we were able to squeeze in one last discussion before you head out for that trip. It sounds like a great time. Fools, recall that last week we offered updates on three companies. They were Hudson, GoPro, and Procter and Gamble. We just wanted to see how each business has progressed since we last covered them on Industry Focus

One company that we didn't really have a chance to revisit was Sonos, which I think deserves some attention after the last several weeks of volatility and new updates. Asit and I first looked at the company's IPO filing in early July. I listened to that episode again. I'd say we were cautiously optimistic on this business. Would you say that's a pretty fair take on our previous discussion?

Sharma: I want to flip it a little bit and say that we were optimistically cautious, given the stock movement. [laughs] I always look at the bright side of things, so I want to put a little spin on that. You're right, Vince. I think we were cautiously optimistic on this stock. 

Shen: Some of the encouraging trends that we looked at were user adoption, some of the repeat purchases, and the relatively modest but consistent growth. The major red flag, however, was something we called the frenemy relationship that Sonos has with some of the bigger tech companies like Amazon, Apple and Alphabet with smart speakers, especially, becoming a very big part of Sonos' future roadmap. 

Today, I want to bring listeners up to speed on the state of Sonos, and to consider whether some of the recent developments that have come up for the company really change the big picture thesis for the stock. 

Since our initial takes, Sonos priced their deal at $15 per share, a valuation of $1.4 billion, which is below its target range of $17-19 per share. What that means is, when a company prices its IPO under the range like that, it means they failed to drum up sufficient demand from investors at their desired valuation. Sonos priced at $15. They actually closed their first day of trading at $19.91, so they were up 33%.

For the company's first month on the market, the stock largely stayed in that high teens range, at least until it released its first bout of quarterly earnings as a public company. Since then, Sonos is down about 30%. They've fallen below that $15 starting point.

Let's start with a brief discussion of that earnings report. What was your take, Asit?

Sharma: The biggest thing that leaped out at me was the company's top line. Sonos generated some $208 million in revenue in their fiscal third quarter. The volume of products that they sold jumped 11.4%. I started to do the math, and I'm looking for a revenue increase, but revenue actually decreased by almost 7%. That's because, in the third quarter of last year, the comparable quarter, the company launched its Play-based product, which has a manufacturer-suggested retail price of $699. A $700 product. This year, the company sold more of its wireless speakers, including this Sonos One product, which we talked about on the pre-IPO show. That speaker carries an MSRP of $199. So, even though the number of shipments grew, because that price point dropped off so drastically, the company actually had lower revenue than the previous year. 

We're going to get more into this in this discussion. I just want to foreshadow a little bit. Management perspective on that is, "We have product introductions, according to what consumers are responding to, not any kind of ramp where we're analyzing the average selling price of our products and trying to keep that consistent." That's something I want to peel the onion back on a little bit. 

That's what jumped out at me, Vince, is this drop-off in revenue. Now, I should say that that still was within the projected range that management had put out. The company's still on track to meet its projections for somewhere between 11-12% total revenue growth for the year with one fiscal quarter left in the year.

Shen: This was, for me, a picture-perfect example of a mixed bag report. If you're a Sonos bear, that year over year decline in revenue that was reported, it's tough. Even though, as you mentioned, Sonos came in at the top end of the guidance they provided in August, no one really wants to see a recent IPO report negative growth, especially in their first quarter out of the gate. So, even if the decline for that makes sense, with the Play base having the higher price point, and the Sonos One having a lower price point, I think all that makes sense, in terms of how they have to fill the inventory channels with some of the sales with a new product release. I get that. But, as an investor, somebody seeing that as a headline report for Sonos' earnings, it can be a little bit discouraging. I think that reinforces some of the worries that people might have about competitors undercutting the company, which we'll get to momentarily. 

Also, in the report, on the bottom line, the company's loss widened to $0.45 per share from $0.26 last year. There's a weaker margin profile, as well, for some of these new smart speakers that Sonos is pushing, another thing that a lot of bears are looking at. 

If you're on the more bullish side, you probably point to the unit volume growth. It was 11%, like you mentioned, to about 887,000 units. That means more of the company's products are entering these households, creating more loyal new customers, and hopefully increasing the stickiness of the Sonos ecosystem for existing users. Keep in mind that 30% of product registrations in 2017 were for existing customers. That speaks to some of the points we made in the last discussion for this company, about how that initial purchase of one speaker usually leads to subsequent purchases of additional speakers, to essentially build out the Sonos ecosystem. Another positive point if you're more on the bullish side of this stock, the company also made its entry into Japan, which presents a lot of long-term growth potential as the second-largest music market. Very tech-savvy consumers there. 

Then, tagging along with that, in terms of growth opportunities, Sonos has begun to push into new target markets. They had a partnership with Sonance to build out an in-wall or outdoor audio solutions. The company's looking beyond the seven million households where Sonos already has a presence to other types of spaces, as well. 

Something that I would say falls more into the gray area is some of the guidance or the outlook that they issued for their full fiscal 2018. On the one hand, management has spoken before about their long-term targets for annual revenue being about 10% growth, and then for adjusted EBITDA, about 20% growth. Based on what they offered for their 2018 outlook -- and, they had pretty good insight on this, because when they reported their fiscal third quarter, there was only about three weeks left in their fiscal fourth quarter. They expect, as you mentioned, about 11-12% top line growth, which meets that goal. On the EBITDA side, they expect growth of just 8%. Again, you come away with that depending on where you're focused and what your take on the company is.

They caveat the growth targets by saying they won't hit them every year. This speaks to some of the nuance in the way the company looks at their business. Going back to the point that you made about how management doesn't care so much about their ASPs, average selling prices, for their products. They're thinking more about, what do their customers desire right now, in terms of their product lineup? They'll push things out that way. Management spoke about how the price range for their products ranges from $150-700, depending on what you're looking at. The blip that we've seen with this quarter with the lower selling prices and the reduction in revenue as a result, we're going to see if, in the next year or the year after that, with the new product releases, that manages to even out; or, if they're forced into these lower-margin profile products. We'll get into that as we talk about the new competitive landscape for smart speakers and what kind of long-term shift that might result in for the market and Sonos investors.

Something that certainly won't help Sonos during the holiday season, which is a very important quarter for the company, is the new batch of devices that Amazon announced last month. Dylan Lewis and Evan Niu talked about that product lineup recently on a Tech episode of Industry Focus. The ones that were most threatening to Sonos directly, their items like the Echo Plus, the Echo Sub, the Echo Link Amp. There are several others. In one way or another, they compete with Sonos products like the Sonos Sub, the Sonos Amp, where there's a direct matchup, or they essentially enable users to add Alexa capabilities to some of their existing audio equipment. Of course, the directly competing products are much, much cheaper from Amazon than Sonos. The Amp and Sub respectively: from Amazon, $130 and $300; the complementary products from Sonos, $600 and $700. 

This is something we talked about, Amazon's standard playbook. If you're partnered with them, as Sonos is with its Alexa integration, they'll still happily move into your territory and undercut you to bring people into their very large ecosystem. Asit, you mentioned this possibility in our previous discussion with your dribble pass and shoot analogy. Can you walk through that again quickly, given some of these latest developments? What play did Amazon end up running with here?

Sharma: Triple pass and shoot, basketball metaphor, three options that Amazon had. One was to just continue to partner with Sonos and help it expand in the marketplace. The next option was to introduce complementary products of its own, not necessarily in direct competition. Shoot, which actually evolved into a rifle metaphor, is to introduce products that are direct competitors of Sonos', which we've seen Amazon do time and time again.

Why this is problematic, Sonos has a loyal following. They have a business model which basically entices people to add on to products they already have rather than replace them. In your home, you're building an ecosystem of Sonos products rather than replacing them. As they introduce new items, you're buying those and placing them in different rooms, etc. Why this is problematic is because Sonos has what it calls a unique model of building margin. Let me walk through that really briefly so that we can understand why, beyond the obvious, it's bad news that Amazon has entered this market with competing products that are extremely similar.

The company, going back to the bear case, actually had pretty decent gross margin this past quarter of almost 46%. That only dropped 2.3% below the prior year quarter. Remember, I mentioned that the company's top line compressed by almost 7%, yet gross margin was pretty stable considering that. Sonos launches products with a lower margin and then builds those margins over time. It has what it calls a sustaining engineering team. They source components from new manufacturers, they figure out ways that the company can be more efficient within its supply chain, within its outsource manufacturing processes. This helps support product introduction, and it also fattens that bottom line. 

So, when you have a player like Amazon come into the market, put Sonos into its crosshairs, and then shoot again -- again, switching from basketball to a rifle metaphor -- what that crimps is Sonos' ability to engineer those products better over time. It may find the efficiencies, but it also may find that its cachet as a high-end, more premium product which attracts audiophiles, is dissipating as Amazon mimics the architecture of its various components.

If you see, again, top line compression a year from now, you might not see gross margin hold up so well. Sonos will be forced, in other words, to price where Amazon is pricing in the marketplace. If you remove Amazon from the picture, this quarter made a lot of sense. The company had the Play:1 and Play:3 products, legacy products, and it lowered for the first time in its history the MSRP on those to make room for the Sonos One, which had a price point of around $200. When Sonos doesn't have to worry about competition, it can mix and match its products lower without regard to margin on older products, and then build margin going forward.

Entering this market, though, I'm concerned about operating cash flow, profitability going forward. Not that the company won't be profitable, but when you're in the position of having your IPO, as Vince mentioned, investors want to see everything growing. Positive revenue, positive income, positive operating cash flow. This makes it harder. Amazon, as listeners well know, which has its retail business which is profitable, it has Amazon Web Services, which brings in a lot more profit, it has an advertising business -- it always can afford to undercut competitors. 

It's not so much to me the top line threat. I think Sonos can differentiate. I'm worried about the margin threat. What about you, Vince?

Shen: I'll say that with this new competition that Amazon presents coming right into Sonos' main hunting ground, you have to think, whether you're a Sonos shareholder or an intrigued investor, is this the new normal that the company will have to adapt to, that we have to think about going forward when it comes to the growth and profitability dynamics that you mentioned? I don't think any company ultimately wants to find itself directly in Amazon's crosshairs. Sonos has to expand into smart speakers, though, to survive. 

That market overall, in terms of the bright side, is growing to an extent that I do think there is room for multiple companies to win and to succeed. There's a recent report from Nielsen, U.S. smart speaker adoption was up to 24% in the second quarter of 2018. Another piece of that is, four in 10 smart speaker users reported owning more than one device. When it comes to usage, 90% reported that they stream music at least once per week, one of the highest use cases for these devices. I think that still benefits Sonos, which still holds this reputational advantage of offering excellent sound quality and very easy integration of multiple speakers into an in-home system. Both of those elements reflect some of the results from this Nielsen survey. 

I remember the IPO prospectus said that new customers increased their music listening 80% after purchasing a Sonos product with something like 70 hours of listening time per month. If you're listening to that much content through a Sonos speaker, I can see the argument, at least for the bullish Sonos. If you're listening that often to your device, you want the sound quality to be there, you want the integration so that it becomes this audio ecosystem within your home. I do think that there's enough of a space there, a niche there, that Sonos can still succeed, regardless of the new competition that Amazon presents. Obviously, Amazon has these huge size and ecosystem advantages. But with any kind of technological device or hobby or whatever it comes down to, there's always a wide range of quality and pricing, especially in the audio world, in the music-listening world. I don't think Sonos is inherently a loser here, so long as they're able to sustain their brand image as the wireless speaker for true audiophiles.

How their long-term growth is affected by some of these competing devices, and I'm sure there's going to be other entrants to make this situation even more complicated. How that affects the company's long-term outlook, it remains to be seen. I'll ask you, Asit, has this fundamentally changed your view of Sonos? What do you think investors need to look to going forward?

Sharma: First, I don't think this has fundamentally changed my thesis on Sonos, but it has significantly changed it in that I feel that if you're invested in Sonos, it's time to pay attention to these longer-term advantages the company has. I would add to what Vince just walked us through. Sonos also wants to be seen by other manufacturers as a go-to product, even for a doorbell chime, because it can make that so much better. It has opened up its platform, its APIs, these are programming interfaces for developers, so that developers will adopt its product over others. I think that's a very robust system that it has.

Also, this foray into Japan, it's the world's second-largest market for audio. The company, surprisingly to me, said it will take a few quarters for us to see much of an impact from that. However, as we mentioned, that is a great market for Sonos to be. The Japanese, to a person, are audiophiles, and they will love Sonos' products, so we should see something material from that, maybe in three to four quarters. 

I think that for me, the thesis still remains. How can it exploit the advantages it has? I've turned a bit more cautious. I'm still optimistic despite the entrance of Amazon, and some new products that Apple has introduced, as well. 

I believe that what Sonos has to do, though, going forward, is to maybe divorce itself a little bit from this notion that it has a really unique business model. If you read the shareholder letter that they just put out with earnings, or read the transcript of their conference call, management is convinced that the company has this really unique model, innate to its own DNA. It's different from others, because of things like what I mentioned, this long-term growth in gross margins, the fact that it doesn't really pay attention to the sequencing of its product launches, the fact that consumers add on to its products rather than switching them out. 

But I want to say about that, if you look at any successful publicly traded company, business models are like fingerprints. They're like human faces. They're all unique in some way or another. The trick that a great management team discovers and sets them beyond a good management team is that you have to take what's unique about yourself but also learn from what the market, what investors, and what analysts are telling you. 

This company reminds me a bit of Etsy. The first management team at Etsy also believed it had this really unique business model. You see some similarities in the way Sonos has come out in its most recent shareholder letter and reminded investors "Hey, we don't manage for quarterly results. We manage for year-long stretches." Etsy had the same philosophy. And I think that's a good philosophy. However, the market is wanting to hear from Sonos that it will have less variability in its top line, and maybe less variability commensurately on the bottom line. This last quarter took the company's nine-month loss and doubled it just in one quarter because they had this drop-off in revenue. You have to look at your products as a portfolio. You have to plan so that even if you're jumping between price points, from $200 to $700, you've got either medium price point products, which are growing, or you don't have as much of a deceleration between product launches. This is a thing that I think management may be missing. Everyone who's invested in the company wants to see consistent growth, as Vince said right at the outset of this podcast. Listen to investors. Take heed of that and work these product innovations in such a manner that we see a very smooth ascent of revenue, and I think the company will be off to the races.

Yes, it's unique. Is it unique to the extent that it's going to change the way people do business and look at how to run what's basically technology innovator? Np. What are your thoughts, Vince?

Shen: We have a couple of more minutes here. I have to say, I really liked this realistic view that you have to take on here, which you described, in terms of the company talking about how unique their business is. They also alluded to that, in terms of the challenges that they indicated that they had during their IPO roadshow. They had a $17-19 range for the pricing at the IPO. Came in under the range. They seemed to describe the situation as, "We couldn't get these institutional investors to understand that we're not just any device hardware business. There are these elements, like the repeat purchases and the brand reputation, that we have that set us apart." But, again, you have to adapt even what might be a unique system or business like this to the realistic expectations of the market, of customers, when you have changes to your competitive environment when an 800-pound gorilla decides to come in and directly compete with some of your higher-margin, more expensive devices.

Another lesson to take away from this -- and we beat on this drum a lot on this show -- is reinforcing the view that, when it comes to IPOs, newer companies on the public markets, give them at least six months in the public markets to get their footing, track their progress, before necessarily making a decision and diving interest. Things like this can pop up. I don't think anybody could have foreseen the exact lineup of Amazon products and how that definitely spells some challenges for Sonos. It reinforces the idea that this six months or year that you wait after the company makes its debut is time for the company to see how management addresses challenges like this, how they adapt to new variables like this. That's something that we always hit on for investors, in terms of advice when it comes to IPOs.

Asit, thanks for joining us! We'll definitely be updating on Sonos again, seeing where they land in next year, in terms of their international expansion and some of the other new competitive dynamics. 

Sharma: Thanks a lot! This was fun!

Shen: Thanks, Fools, for listening! 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. Suzanne Frey, an executive at Alphabet, 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 Alphabet (A shares) and Amazon. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and Etsy. 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 recommends GoPro. The Motley Fool has a disclosure policy.