After Amazon.com's (NASDAQ:AMZN) introduction of a new line-up of wireless home speakers and accessories, shareholders of newly public Sonos (NASDAQ:SONO) have reason to be worried. But the damage Amazon can wreak isn't limited to customer acquisition. Below, the Motley Fool Industry Focus: Consumer Goods podcast team analyzes the novel way Sonos thinks about product margin, and how its approach may spell trouble if Amazon starts to muscle in on the company's market share.
A full transcript follows the video.
This video was recorded on Oct. 2, 2018.
Vincent Shen: 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?
Asit 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.
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. The Motley Fool has a disclosure policy.