How Sonos Can Win Investors' Confidence in the Long Run

Smart speaker and wireless home audio manufacturer Sonos (SONO 3.02%) has only been a public company for a couple of months, yet shares already face pressure after a disappointing fiscal third quarter report, and new competition from the likes of online retail disruptor Amazon.com (AMZN 1.30%). In the following segment, our Motley Fool Industry Focus podcast team discusses the company's strengths and new market opportunities -- and a few points of disconnect between investors' and management's perspectives on the business.

While management believes that Sonos' business model is unique, investors still want to see the company mimic aspects of other successful corporations, including revenue with less variability. Click below to gain insight on the introspection Sonos may need to perform to maintain the confidence of investors going forward.

A full transcript follows the video.

This video was recorded on Oct. 2, 2018.

Vincent 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?

Asit 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? No. 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.