Sonos, the maker of wireless and voice recognition speakers, may seem to a casual observer to be in the prime position to ride the surging smart speaker trend.

But Sonos’ initial public offering document revealed a critical flaw in its business model, which subjects it to Amazon’s whims on what the internet giant decides to do with its Alexa voice recognition technology.

Sonos sells Alexa-enabled speakers. In a stunning passage in the IPO document, filed on Friday, Sonos warned that Amazon can cut the company off from its partnership and add onerous business terms at practically anytime.

The company reported it had a net loss of $14.2 million on revenue of $992.5 million for its most recent September fiscal year, while posting net income of $13.1 million for the six months ended March 31, 2018.

Renaissance Capital’s Kathleen Smith said Sonos is likely to be the third-largest venture capital-backed IPO of the year after DropBox and DocuSign.

“Sonos is one of few consumer electronics IPOs to tap the IPO market. Past consumer electronics IPOs including Roku, GoPro and Fitbit have had highly volatile trading,” Smith said in an email Monday. “Investors will be interested in its strong brand name.”

Sonos touted the potential of the smart speaker market, saying in the IPO document that 50 percent of web searches will be voice-driven by 2022. In similar fashion, one top Wall Street firm agreed that the category will soar over the next five years.

Last month, Morgan Stanley predicted more than 70 percent of U.S. households will own a smart speaker with voice commerce capabilities by 2022. The firm said the potential to make money off the trend will likely go to Amazon and Google because of their voice recognition technologies and smart speaker market dominance.

But that is the key problem for Sonos. It relies on other companies for the key voice recognition technology and service that consumers find essential. The company released the Amazon Alexa-enabled Sonos One in October 2017 and plans to introduce the Sonos Beam next week.

”Our current agreement with Amazon allows Amazon to disable the Alexa integration in our Sonos One and Sonos Beam products with limited notice. As such, it is possible that Amazon, which sells products that compete with ours, may on limited notice disable the integration, which would cause our Sonos One or Sonos Beam products to lose their voice-enabled functionality,” the filing said. “Amazon could also begin charging us for this integration which would harm our operating results.”

In addition, private technology companies often go public after a several year track record of stunning sales growth. Sonos isn’t exactly a hyper-growth company.

While Sonos’ revenue grew by 18 percent in the six months ended in the March 2018 quarter, its revenue increased just 10 percent in its fiscal 2017, after rising 7 percent in fiscal 2016 and 9 percent in fiscal 2015.

Sonos also warned larger, better-capitalized companies such as Amazon and Google may further discount their speakers, hurting its profitability.

“Many of these partners may subsidize these prices and seek to monetize their customers through the sale of additional services rather than the speakers themselves,” the company said. “Our business model, by contrast, is dependent on the sale of our speakers. Should we be forced to lower the price of our products in order to compete on a price basis, our operating results could be harmed.”

Morgan Stanley even suggested Google should defend its retail ad sales turf from Amazon by giving away its Home Mini speaker devices.

Sonos’ profitability is already falling in the current competitive environment. The company posted a gross profit margin of 42.3 percent in the six months ended in March 2018 versus 44.3 percent in the comparable period in the previous year. It cited increased discounting as a driver of the lower gross margin and predicted lower profitability “over the near to intermediate term” due to its new products.

Investors typically reward subscription and services companies with higher valuation multiples because of stable revenue streams inherent in these business models. Conversely, hardware companies get lower valuations as they have to start selling products from scratch every year usually with lower profit margins.

CNBC looked at a basket of technology hardware companies’ price-to-sales ratios. Roku skewed the valuation comparable with its higher multiple, partly due to the fact that it generated more than half of its sales from platform services versus hardware player sales in its most recent quarter.

Sonos generated about $1 billion in trailing sales over the past year and with the average 3.5 times sales multiple for public hardware companies, the company may be worth around $3.5 billion.

But Sonos’ weak competitive position versus larger technology firms, its hardware-focused business model and lack of services or subscription revenue streams may limit upside beyond that valuation after it goes public.



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