iROBOT CORP (Update 4)
- 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.