I was first attracted to iRobot (IRBT) because it tied into what I perceive to be a strong secular investment theme, the automation of services. The automation of services is the third in a series of trends that have been recreating the world. The first being the automation of agriculture, which freed the majority of people (in Europe and North America) from working on the land, and the second being the automation of manufacturing, which is still freeing people from working in the factory. The automation of services has been going on for some time but remains at a much earlier stage in its progression. We see it in automated checkouts, automated warehousing, robot assisted surgery and a variety of tools and technologies that are replacing or significantly increasing the productivity of service workers (including household services).
And I liked the movie too!
The bulls believe that iRobot is close to being a double from here. Its share price has been devastated due to the deceleration of revenue and earnings growth into the single digits as a result of the decline in its defense business (from $40 million a quarter to $15 million per quarter). This decline in the defense business masks a strongly growing consumer business, which is worth over $35 on its own. March results will probably be a catalyst for a recovery as high defense spending will fall off the comparison quarter.
On the other side the bears believe that iRobot's consumer business is on a tear right now, but overly focused on the high end, and does not have sufficient critical mass to defend against an onslaught of traditional vacuum companies such as Hoover, Dyson, Panasonic and others, who will leverage their extensive distribution networks and manufacturing economies to force down pricing and no doubt decimate iRobot's margins. iRobot is not the only company that can make acquisitions and there are enough small players for anyone who has an interest.
So what's my opinion, does iRobot make a good investment?
iRobot is a high-quality company. It is the leader in consumer robots and is two to three years ahead of major competition. It has a weak competitive advantage in that it has many patents that give it limited protection. However, competitors have been able to get around some of them (though at high cost). Its recent acquisition of Evolution Robotics widens its lead and helps it move into the lower end of the market.
Its earnings quality is good overall (RoA 13.7%, RoE 19.2%) and excellent on the consumer business (consumer gross margins are 50% vs. 20% on the defense side). It generates loads of free cash ($43m last year compared with $40m of earnings).
Over the next few quarters the continued increase in its consumer business relative to its defense business is likely to increase its earnings quality further. Consumer accounted for 70% of its business over the past four quarters (and 76% in the last quarter) compared with 60% in the prior year. Our expectation is that it will surpass 80% over the next four quarters.
It also has a solid balance sheet with no debt (total assets $351m, cash $190m and shareholder equity of $279m) and lots of liquidity (current assets of $297m - mainly cash and current liabilities of $68m).
Overall iRobot has excellent growth prospects. Whilst growth in its defense business is cloudy and tied to potential public sector and defense spending cuts, its consumer market is currently at low levels of penetration, with every expectation that over the long run most households will have one. Growth forecasts are in excess of 20% per annum over the next five years.
iRobot's own growth has not been spectacular over the past few quarters
- 3-year revenue growth: 2009: -2%, 2010: 34%, 2011: 16%
- 3-year EPS growth: 2009: 333%, 2010: 640%, 2011: 50%.
- 3-quarter revenue growth: Mar 2012: -8%, Jun 2012: +3%, Sep 2012: +5%
- 3-quarter EPS growth: Mar 2012: -93%, Jun 2012: -10%, Sep 2012: +8%
However, the weakness is the result of a decline in defense business (-58%, -65% and -37% for defense in each of these quarters). This compares with the consumer business has been growing (and now accounts for 70% of revenue) (+20%, +50%, +33% consumer revenue growth for the last 3 quarters).
The December quarter will also likely be soft as a result of poor comparisons for the defense business - defense revenue peaked in the December quarter of 2011 - and costs related to the acquisition of Evolution).
The March quarter should be a catalyst for recovery, defense comparisons and acquisition costs drop out of the denominator.
A conservative DCF valuation values the consumer business around $36 (PAT margin13.5%, growth 11% over the next five years.) Assuming the military business is worthless (which it is not) still gives a generous margin of safety.
I think iRobot is a good stock to buy right now. The market is in a steady uptrend, the stock has been under accumulation since November, with only one day of serious selling since then. Results will likely be poor for the December quarter (out February 5) - in terms of revenue and EPS growth, this may result in some price volatility. Though the price is somewhat up from its lows of $16.50 late last year, I think that moving forward the 50-day moving average should provide support.
Overall I buy into the bullish thesis; it is a good quality company, with excellent growth prospects selling at a significant discount to intrinsic value. The opportunity has been brought on by weaknesses in one of its divisions, which will likely be a thing of the past by March.