Value Investing

iRobot Corporation (IRBT): All Good Things Come To An End

Spruce Point Capital Management is pleased to provide a critical update on iRobot (Nasdaq: IRBT), a company our loyal readers know we follow very closely for its repeated failures to innovate, terrible management and governance, extreme overvaluation, and general poor investment merits.

A year ago, Spruce Point released a number of reports on iRobot highlighting impending competitive pressures (eg. SharkNinja) and defensive distributor acquisitions (Robopolis/SODC) designed to forestall revenue growth contraction and margin compression. We have evidence that the competitive forces which we foresaw are materializing, resulting in significant ASP declines, market share losses, and cash flow contraction. With the uplift benefit from distributor acquisitions set to lapse, and with punitive Chinese tariffs set to expand from 10% to 25% in 2019, we believe that iRobot’s is set up for significant revenue growth deceleration, margin contraction, and earnings headwinds next year. It is also becoming significantly more dependent on Amazon for its distribution as it loses its traditional brick and mortar partners such as Bed Bath & Beyond, which is a long-term negative that devalues its premium brand proposition.

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Q3 hedge fund letters, conference, scoops etc

As is typically the case, sell-side analysts are largely ignoring these impacts to earnings. Management is being particularly evasive about the financial impacts from tariffs, and what plans, if any, it has to cope with the problem. This hasn't stopped insiders from enacting a record number of 10b5-1 stock sale programs, as total insider ownership dwindles to a record low. We see up to ~50% downside in IRBT shares on valuation alone, even when taking consensus earnings estimates for granted and without considering tariffs. However, as each day passes, and the probability of a punitive 25% tariff increases, investors need to discount iRobot's earnings, and ascribe a normalized multiple to the "new" iRobot. As a result, we see 70%-80% downside risk or $20 - $30 per share.

iRobot Corporation (IRBT)

Highlights

  • Spruce Point has released a number of reports on iRobot (IRBT or “the Company”) highlighting impending competitive pressures and defensive distributor acquisitions designed to forestall revenue growth contraction and margin compression. We have evidence that the competitive forces which we foresaw are materializing, resulting in significant ASP declines, market share losses, and cash flow contraction. With the uplift benefit from distributor acquisitions set to lapse, and with punitive Chinese tariffs set to expand from 10% to 25% in 2019, we believe that iRobot’s is set up for significant revenue growth deceleration, margin contraction, and earnings headwinds next year. As a result, we see 70-80% downside risk.
  • Technological Advantages Dwindling: As the first mover in the robot vacuum space, iRobot has until now enjoyed perceived technological dominance over other brands. That advantage has narrowed materially: more established consumer technology brands have entered the market, and consumers have taken notice that competitors meet or exceed Roomba’s technological capabilities.
  • Amazon Enabling And Promoting Aggressive Competition: Amazon is becoming an increasingly important sales channel for iRobot: it was responsible for ~25% of iRobot sales in Q3, up from just ~10% in Q3 of the prior year. iRobot products generally do not receive preferential placement on Amazon search pages, due to both its high price tag and aggressive promotional activity among peers. Amazon also has less incentive to promote brands with high name recognition than do brick-and-mortar stores. Amazon enables a level of competition which undermines the importance of iRobot’s recognizable brand.
  • Industry Competition Dragging On Sales Prices: Robot vacuums are classic deflationary pieces of technology: commoditized products which experience rapid industry catch-up with each incremental technological development, and which have little room for substantive differentiation (but which require consistent R&D spend nonetheless). iRobot has not been able to raise product prices materially for years, and is pushing sales by offering a wider range of products priced below its top-line vacuum. This strategy will drag on margins over time.
  • Worrisome Cash Flow Developments: iRobot’s net spending on working capital has ballooned in the wake of its distributor acquisitions – a concerning development resulting in YTD operating cash flow contracting by 21% YoY. We believe the financial strain was telegraphed in July when iRobot unexpectedly doubled its line of credit from $75 to $150m for no obvious reason, given that it has $126m of cash on hand, and that it was on pace for $50m+ of operating cash flow. Rising DSOs may be a signal of channel-stuffing at its own distributors. Massive inventory growth and record DIOs may also be both a signal of slowing sales growth ahead and a result of management accumulating lower-cost inventory in anticipation of tariffs.
  • Tariffs Potentially A Highly Significant Drag On Earnings: Management has been dodgy about the potential impact of tariffs when asked about it on calls. Investors now have a better sense of the impact of a 10% tariff following the Q3 call, but management continues to avoid discussing the potential impact of the impending 25% tariff – perhaps in hopes that the tariffs are cancelled before it would have to do so. We expect iRobot to take a massive 70% hit to FY 2019 EPS should the 25% tariff to be instituted on Jan 1 remain in place through the year (barring the passing-on of tariffs cost increases to customers, which we feel iRobot has limited ability to do). Sell-side analysts are either ignoring tariff risks or entirely off on the potential magnitude of the impact.
  • Insider Selling Is Exploding Out Of Control: In our first report on iRobot, we noted that insiders were selling the stock aggressively: insider ownership fell from ~60% in 2005 to ~12% in 2013 – and then to 5% only a year later. Insiders have continued to be sellers through the last several years, and insider ownership is now at an all-time low of 3.5%. While iRobot appears desperate to dangle carrots to the press – in particular, partnerships with big name technology companies – its insiders have enacted a record amount of 10b5-1 stock sale programs. For example, in Feb 2017, only CEO Colin Angle had a 10b5-1 stock sale program in place, but by May 2018 a total of six directors and executives were unloading shares under similar stock sale programs.
  • Share Price Above Even Lofty Sell-Side Targets: IRBT shares have soared from ~$60 in mid-2018 to close to $100 today, and reached as high as ~$115 ahead of CEO Angle’s much-anticipated presentation at the Disrupt SF conference – where, yet again, after years of hyping the Company’s potential in other home robotics categories, he failed to deliver anything new beyond the stagnant Roomba product. All sell-side analysts remain perennially bullish on the Company’s growth story, but the rapid rise in IRBT shares forced some analysts to issue downgrades on the basis of valuation alone. Long-term institutional shareholders continue to sell, while those buying classify IRBT under “consumer discretionary” and “homebuilding” and not technology!
  • High Valuation, Slowing Growth, Changing Distribution Model And Tariff Threat All Pose Risks To IRBT Shares: We see up to ~50% downside in IRBT shares on valuation alone, even when taking consensus earnings estimates for granted. The prospect of slowing sales growth and margin compression would imply even more significant downside, and 25% tariffs would wipe out a large chunk of earnings for however long they remain in place. We can envision a scenario in which business deterioration and 25% tariffs wipe out all 2019 EPS. Given the fundamental threats to the business, current trading multiples, and the possibility that iRobot must bear 25% tariffs for an extended period of time, we value IRBT shares at $20 – $30/sh, 70%-80% below current levels.

Spruce Point Reiterates Strong Sell On IRBT And Sees 70% - 80% Downside Risk

Spruce Point has released a number of reports on iRobot (IRBT or “the Company”) highlighting impending competitive pressures and defensive distributor acquisitions designed to forestall revenue growth contraction and margin compression. We have evidence that the competitive forces which we foresaw are materializing, resulting in significant ASP declines, market share losses, and cash flow contraction. With the uplift benefit from distributor acquisitions set to lapse, and with punitive Chinese tariffs set to expand from 10% to 25% in 2019, we believe that iRobot’s is set up for significant revenue growth deceleration, margin contraction, and earnings headwinds next year. As a result, we see 70-80% downside risk.

Industry Competition Now On Even Footing With iRobot, Pressuring Market Share

  • Technological Advantages Dwindling: As the first mover in the robot vacuum space, iRobot has until now enjoyed perceived technological dominance over other brands. That advantage has narrowed materially: more established consumer technology brands have entered the market, and consumers have taken notice that competitors meet or exceed Roomba’s technological
  • Amazon Enabling And Promoting Aggressive Competition: Amazon is becoming an increasingly important sales channel for iRobot: it was responsible for ~25% of iRobot sales in Q3, up from just ~10% in Q3 of the prior year. iRobot products generally do not receive preferential placement on Amazon search pages, due to both its high price tag and aggressive promotional activity among peers. Amazon also has less incentive to promote brands with high name recognition than do brick-and-mortar stores. Amazon enables a level of competition which undermines the importance of iRobot’s recognizable brand.
  • Industry Competition Dragging On Sales Prices: Robot vacuums are classic deflationary pieces of technology: commoditized products which experience rapid industry catch-up with each incremental technological development, and which have little room for substantive differentiation (but which require consistent R&D spend nonetheless). iRobot has not been able to raise product prices materially for years, and is pushing sales by offering a wider range of products priced below its top-line This strategy will drag on margins over time.

Troublesome Financial Developments Of Late And On The Horizon

  • SODT and Robopolis Acquisitions Set To Lapse: iRobot annual sales growth had fallen to high single-digit levels prior to its acquisition of two New product releases may support somewhat stronger sales growth through 1H 2019, but growth is set to return to prior levels (or lower) as the acquisitions lapse. Management has said that it does not see additional acquisition opportunities on the immediate horizon.
  • Worrisome Cash Flow Developments: iRobot’s net spending on working capital has ballooned in the wake of its distributor acquisitions – a concerning development resulting in YTD operating cash flow contracting by 21% YoY. We believe the financial strain was telegraphed in July when iRobot unexpectedly doubled its line of credit from $75 to $150m for no obvious reason, given that it has $126m of cash on hand, and that it was on pace for $50m+ of operating cash flow. Rising DSOs may be a signal of channel-stuffing at its own distributors. Massive inventory growth and record DIOs may also be both a signal of slowing sales growth ahead and a result of management accumulating lower-cost inventory in anticipation of tariffs.
  • Tariffs Potentially A Highly Significant Drag On Earnings: Management has been dodgy about the potential impact of tariffs when asked about it on calls. Investors now have a better sense of the impact of a 10% tariff following the Q3 call, but management continues to avoid discussing the potential impact of the impending 25% tariff – perhaps in hopes that the tariffs are cancelled before it would have to do We expect iRobot to take a massive 70% hit to FY 2019 EPS should the 25% tariff to be instituted on Jan 1 remain in place through the year (barring the passing-on of tariffs cost increases to customers, which we feel iRobot has limited ability to do). Sell-side analysts are either ignoring tariff risks or entirely off on the potential magnitude of the impact.

Spruce Point Reiterates Strong Sell On IRBT In Light Of  Competition, Cash Flow Issues, And Tariff Risks

Ongoing Concerns Regarding Management And Governance

  • Aggressive Company Promotion By Management: Management is aggressive about pushing juicy headlines in the press, drumming up excitement over the business and inevitably driving enthusiasm among shareholders who believe that iRobot is truly a high-tech growth We saw this most recently when iRobot announced a “partnership” with Google: a titillating headline to a story with effectively no material content behind it – yet which catapulted shares up >10%, just days after Q3’18 financial results and tariff-related concerns rattled investors and sent IRBT’s share price down by ~10%. This isn’t the first time that news of a big partnership mysteriously appeared after iRobot’s shares were hammered after weak financial results. In July 2017 – shortly after we released our critical update in late June 2017 warning that Shark would enter its market, after which shares fell from over $100 to close to $80 – the press reported that Softbank had “reportedly” taken a <5% stake in iRobot that would not require regulatory disclosure, according to “people familiar with the matter.” To date, we can find no evidence that Softbank has aided iRobot in any strategic, financial, or operational capacity.
  • Insider Selling Is Exploding Out Of Control: In our first report on iRobot, we noted that insiders were selling the stock aggressively: insider ownership fell from ~60% in 2005 to ~12% in 2013 – and then to 5% only a year later. Insiders have continued to be sellers through the last several years, and insider ownership is now at an all-time low of 3.5%. While iRobot appears desperate to dangle carrots to the press – in particular, partnerships with big name technology companies – its insiders have enacted a record amount of 10b5-1 stock sale For example, in Feb 2017, only CEO Colin Angle had a 10b5-1 stock sale program in place, but by May 2018 a total of six directors and executives were unloading shares under similar stock sale programs.
  • Wasteful Capital Deployment For Share Repurchases: We frequently warn investors to be careful when insiders sell stock while the company is buying back iRobot approved a $50m share repurchase in February 2018 and subsequently completed the purchase of 798,794 shares. So what benefit have shareholders received from this buyback? The answer: virtually nothing. IRBT’s YTD diluted share count is 28.6m vs. 28.7m a year ago, yielding effectively zero EPS benefit – perhaps due to aggressive insider selling. As a mature technology hardware company, we believe that iRobot would have better served shareholders with a dividend, synergistic acquisition, or more R&D spending to extend the Company beyond its one-trick-pony Roomba product. Instead, we believe management used capital for its own benefit as buybacks supported IRBT shares while executives dumped stock.

IRBT Shares Are A Poor Risk/Reward Proposition And Fully Valued At Current Levels Already Close To The Average Analyst PT Of$100/Share

  • Share Price Above Even Lofty Sell-Side Targets: IRBT shares have soared from ~$60 in mid-2018 to close to $100 today, and reached as high as ~$115 ahead of CEO Angle’s much-anticipated presentation at the Disrupt SF conference – where, yet again, after years of hyping the Company’s potential in other home robotics categories, he failed to deliver anything new beyond the stagnant Roomba All sell-side analysts remain perennially bullish on the Company’s growth story, but the rapid rise in IRBT shares forced some analysts to issue downgrades on the basis of valuation alone. Long-term institutional shareholders continue to sell, while those buying classify IRBT under “consumer discretionary” and “homebuilding” and not technology!
  • High Valuation, Slowing Growth, Changing Distribution Model And Tariff Threat All Pose Risks To IRBT Shares: We see up to ~50% downside in IRBT shares on valuation alone, even when taking consensus earnings estimates for granted. The prospect of slowing sales growth and margin compression would imply even more significant downside, and 25% tariffs would wipe out a large chunk of earnings for however long they remain in We can envision a scenario in which business deterioration and 25% tariffs wipe out all 2019 EPS. Given the fundamental threats to the business, current trading multiples, and the possibility that iRobot must bear 25% tariffs for an extended period of time, we value IRBT shares at $20 - $30/sh, 70%-80% below current levels.

Read the full article here by Spruce Point Capital Management