Sonos' lack of 'smarts' could lead to a lackluster IPO

• Sonos, which filed to go public on Friday, has built up a respectable business.
• But the speaker market is undergoing a major shift to smart speakers, and Sonos runs the risk of being relegated to being a secondary player - or being boxed out of the market.
  
• The company's sales growth has already slowed down and it has struggled with red ink.

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Sonos has amassed a fervent fan base over the years. But that doesn't mean investors should get overly enthusiastic about the company's stock when it hits the public markets.

The consumer electronics company, which filed on Friday to go public, has carved out a nice niche for itself with its line of wifi connected speakers. But the company's sales growth has moderated from its heyday, and in recent years it's struggled to post a profit. Meanwhile, it's dependent on some of the biggest and most powerful companies in tech for a core new technology that's transforming the home audio market even as it faces growing competition from those same companies.

In other words, I wouldn't bet the house on Sonos - no matter how much you may love its connected speakers.

By some measures, Sonos has built up a respectable business. Since 2013, its sales have nearly doubled to almost $1 billion. Its gross margin - the portion of its sales it has left after accounting for the direct costs of producing its profits - has generally been in the 45% range or higher. That's a healthy figure for a hardware company, indicating that it's able to charge a premium price for its products. It also gives the company plenty of room to spend money on marketing and research-and-development.

Sonos has some fanatical fans

Consumers have been catching on. In the last 12 months, the company sold 4.6 million speakers, more than triple the number it sold in its 2013 fiscal year.

And Sonos' fans really seem to love its products. Of the 6.9 million households that have a registered Sonos speaker, 61% have at least two of the company's products. Some 27% have four or more.

The average customer who starts off with just one Sonos speaker will buy more than two more over time, according to the company. On average, customers who start off with more than one Sonos product initially buy about three at the start and then purchase another two over time.

All that sounds great. But there are signs that Sonos has struggled to build a profitable business outside its niche of geeky audiophiles.

Warning: The best days may be behind it

Most of its sales growth over the last five years happened between Sonos' 2013 and 2014 fiscal years, when its revenue soared 75%. Since then, the company's revenue hasn't grown faster than about 10% on an annual basis.

The bulk of the growth in Sonos' device sales happened in that same period, when they nearly doubled. Ever since, the growth in its product sales have been much more modest, rising just 11% in its last year.

As Sonos' growth slowed, its bottom line deteriorated. The company went from posting a modest profit in fiscal 2014 to a big loss the following year. On an annual basis, it's been operating in the red ever since, although it's gradually improved its bottom line.

Things improved for the company in the first half of its current fiscal year. Sales were up 18% over the same period a year earlier and the company posted a profit for the period. But that improvement could prove to be a chimera.

Sonos' fiscal year ends around the end of September, meaning that its first half includes the all-important holiday season, where it almost certainly gets the bulk of its sales. The company posted a profit for the first half of its fiscal year last year too only to end up posting a full-year loss.

The speaker market is being transformed by "smarts"

Beyond just the numbers, there are bigger reasons to be concerned about Sonos' prospects. Even as the company is hitting the public market, the industry it competes in is changing dramatically.

From when it debuted its first speaker in 2005 until the last year or so, Sonos had the connected speaker market pretty much to itself. If you wanted a whole-home audio system that allowed you to stream music from the internet that you could set up yourself without a custom installer, Sonos was generally the way to go.

But that's no longer the case. Amazon's line of Echo smart speakers offers the same capability. So do Google's Home devices and now Apple's HomePod.

The Echo and the Home weren't initially on par with Sonos' devices in terms of audio quality. But both Amazon and Google last year released new versions of their smart speakers with improved sound. And audio quality is the main selling point of Apple's HomePod.

But all three companies offer something with their speakers that Sonos traditionally hasn't - a built-in intelligent agent. You can control Amazon, Google, and Apple's smart speakers with just your voice. And you can do a lot more with them that than. You can use them to turn on and off your lights, tell you the news and weather, answer trivia questions, and give you the latest sports scores.

The smart speaker market has started to catch fire. In the first quarter of this year, unit sales grew a whopping 210% from the same period last year, according to market research firm Canalys, hitting 9 million worldwide. That's nearly twice as many speakers sold in one quarter as Sonos sold in the last year. Canalys expects worldwide sales of smart speakers to reach 56.3 million this year, up from about 35 million last year and fewer than 10 million in 2016.

That kind of growth obviously far outpaces what Sonos has been doing lately. It also illustrates how smart speakers are starting to dominate the speaker market, just as smartphones pushed aside dumb phones and nearly all televisions are now smart TVs.

Sonos' smart speaker strategy is really risky

Sonos has recognized that market shift toward smart speakers. Last fall, it introduced its first one and it has more in the works.

But there's a big flaw in Sonos' strategy - it doesn't have its own voice-assistant technology. Instead, for now, it's relying on Amazon's Alexa assistant, although it plans to add in Google's Assistant and Apple's Siri in the future.

At best, that will relegate Sonos to being a second fiddle to the big players. When people think of an Amazon-powered smart speaker, they think of the company's Echo line. Sonos faces a huge marketing challenge to make consumers aware that one of its smart speakers can offer the same Alexa assistant that they'd get on an Echo.

Even it's able to do so, it may find it tough convincing customers to pay up for one of its speakers, when they can get an entry-level Echo Dot for $50. That challenge could prove even more difficult when you consider that Amazon has full control over which smart speakers it promotes in its web store - and has taken full advantage of that control to promote its Echo line.

Sonos' reliance on the big tech companies could become more problematic over time. Right now, as Sonos acknowledged in the document it filed to go public, it doesn't pay Amazon anything to use Alexa. But that could change if Amazon ever perceives Sonos' devices to be a competitive threat - or as a potential money-maker

Worse yet for Sonos, Amazon and the other tech companies could just cut Sonos off, leaving it without any voice assistant for its smart speakers - both the ones it's already sold to its customers and any future devices. In fact, according to Sonos' regulatory filing, Amazon can sever ties with the company with only "limited notice."

"If these partners disable the integration of their technology into our products, demand for our products may decrease and our sales may be harmed," Sonos warned investors. "We cannot assure you that the resources we invest in research and development, existing or alternative technology partnerships, marketing and sales will be adequate for us to be successful in establishing and maintaining a large share of the voice-enabled speaker market.

"If we are not able to capture and sustain market share, our future revenue growth will be negatively impacted."

For me, that's good reason to be cautious about Sonos. It may make great speakers. But in the smart-speaker era, it's much more important to have the technology to make them intelligent.