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iRobot Corporation (NASDAQ:IRBT)

Q2 2010 Earnings Call

July 29, 2010; 08:30 am ET

Executives

Colin Angle - Chairman & Chief Executive Officer

John Leahy - Chief Financial Officer

Elise Caffrey - Investor Relations

Analysts

Jim Ricchiuti - Needham & Co.

Alex Hamilton - C.K. Cooper & Co.

Paul Coster - JP Morgan

Adam Fleck - Morningstar

James McIlree - Merriman

Brian Ruttenbur - Morgan Keegan

Operator

Good day everyone, and welcome to the iRobot second quarter 2010 financial results conference call. This call is being recorded.

At this time, for opening remarks and introduction, I would like to turn the call over to Elise Caffrey of iRobot Investor Relations. Please go ahead.

Elise Caffrey

Thank you, and good morning. Before I introduce the iRobot management team, I’d like to note that statements made on today’s call that are not based on historical information are forward-looking statements made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

This conference call may contain expressed or implied forward-looking statements relating to the company’s financial results, operations and tax rate for fiscal 2010, the third quarter ending October 2, 2010, and the fourth quarter ending January 1, 2011, demand for the company’s products and services, the timing of funding and contract awards under the FCS program, now referred to as the Brigade Combat Team Modernization program, our plans for expansion and new product development and shipment, backlog and demand for our government and industrial robots and related parts and services, timing and order fulfillment, demand for our home robots, mix of product revenue and business conditions.

These statements are neither promises nor guarantees, but are subject to a variety of risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those contemplated in the forward-looking statements.

In particular, the risks and uncertainties include those contained in our public filings with the Securities and Exchange Commission. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. iRobot undertakes no obligation to update or revise these forward-looking statements, whether as a result of new information, future events or circumstances or otherwise.

During this conference call, we will also disclose various non-GAAP financial measures as defined by SEC Regulation G, including adjusted EBITDA, which we define as earnings before interest, taxes, depreciation, amortization, merger and acquisition expenses and noncash stock compensation expense.

A reconciliation between net income, the GAAP measure most directly comparable to adjusted EBITDA and adjusted EBITDA is provided in the financial tables at the end of the Q2, 2010 earnings Press Release issued last evening, which is available on our website www.irobot.com.

A live audio broadcast of this conference call is also available on the Investor Relations page of our website and an archived version of the broadcast will be available on the same web page following the call. In addition, a replay of this conference call will be available through August 5, 2010 and can be accessed by dialing 617-801-6888, access code 692-65-770.

On today’s call, iRobot’s Chairman and CEO, Colin Angle, will provide a review of the company’s operations and achievements for the second quarter of 2010, as well as our financial expectations and outlook for the business for the rest of 2010. And John Leahy, Chief Financial Officer, will review our financial results for the second quarter of 2010 and provide additional detail on our financial expectations for fiscal 2010 to third quarter ending October 2, 2010 and the fourth quarter ending January 1, 2011. Then, we’ll open the call for questions.

At this point, I’ll turn the call over to Colin Angle.

Colin Angle

Good morning, and thank you for joining us. I’m very excited to report that we delivered record results for the second quarter and first half. Revenue of $98 million the quarter exceeded our expectations and was 59% greater than Q2 revenue in 2009. Adjusted EBITDA of $12 million and EPS of $0.20 also far exceeded expectations.

Following truly outstanding performance by both divisions in the second quarter and good visibility on the rest of 2010, we are once again increasing our full-year expectations.

Our revenue and EPS expectations for the second half have increased since our April call. However, we have taken the opportunity to both increase our investment in the business and increase our full-year expectations due to our significant over achievement in the first half.

We expect full-year 2010 revenue of between $385 million and $390 million, an increase of roughly 30% over 2009. We are increasing our expectations for adjusted EBITDA to $36 million to $38 million, an improvement of approximately 75% year-over-year and our EPS range to $0.51 to $0.54, more than quadruple our 2009 EPS.

These increased expectations demonstrate significant progress towards our three-year financial goals of mid-to-high teen revenue CAGR, mid-teen adjusted EBITDA margins and high single-digit operating cash flow margins.

Profitable growth in the quarter was driven by both divisions. Home robot revenue increase was driven by broad-based growth internationally in Europe and Asian markets as well as in the United States. Increasing demand for our products continues to outpace concerns about a softening EU economy and our current manufacturing capacity.

We were conservative in our planning as we brought on a new contract manufacturer, a scalable Tier 1 manufacturing partner. They will be online in Q4 to meet this growing demand in 2011 and beyond. Our government industrial division’s revenue growth resulted from shipments of more PackBot, FasTac robots and spare parts than a year ago as well as the sale of a significant number of small unmanned ground vehicles in Q2.

Our continued focus on strengthening the balance sheet resulted in quarter end cash and investments of $99 million, up significantly from $51 million a year ago. A critical component of improving our financial position over the past year has been driving adjusted EBITDA and operating cash flow. Adjusted EBITDA was $12 million or 13% of revenue compared with a breakeven figure in Q2 of 2009 and we generated $15 million of operating cash flow in the quarter.

Our U.S. strategy has been successful thus far, not only did revenues grow 20% in the second quarter year-over-year, but focus and creating the right mix of products and channels in domestic market significantly increased gross margins.

In Europe, most of our sales are dollar denominated, therefore the fluctuation of the Euro has minimal direct impact on international revenues. However, as the dollar strengthens against the Euro, our distributors’ profit margins decrease and they have less money to spend on marketing efforts to promote our products.

We have taken appropriate action to support our distributors and some of the planned marketing expense in the second half will go towards our European partners’ programs. In the military business, despite the ever shifting landscape in Washington, demand for our robots remain strong, our robots are making a difference for soldiers in theater, by providing increased situational awareness and improving mission success.

In fact, the simulation using one semi-automated force test methodology to measure the effectiveness of our SUGV, robot and combat shows that with the SUGV [non-light or sight] effectiveness improved by a 15 times’ factor, friendly casualties were reduced by 50% and in the losses per engagement increased by 50%.

These are compelling results that further support the use of our robots. As we have discussed over the past couple of quarters at our analyst day, continuing investment in our people, our technology, our products and our brand is critical to building a sustain ably profitable technology company.

In the second half of the year, we will put more resources against our common software and common platform long-term strategic vision, accelerated development of new products, marketing to support the holiday season and programs to support and continue building the iRobot brand.

The current and foreseeable market dynamics in both divisions position us well to deliver a more profitable year than we had anticipated in April while we continue making robust and long-term investments in building for our future and maintaining our market leading position.

Now, I would like to take you through some of the highlights of the second quarter. In home robots, strong demand for our Roomba 500 robots in international markets, as well as renewed demand domestically continues to fuel home robot growth. Home robot revenue overseas increased 80% year-over-year. Demand in Asian markets, particularly in Japan where our partner has invested extensively in Roomba video demos and retail displays contributed to second quarter growth.

In Europe, currency volatility has attacked our partner’s economic somewhat, but we are committed to building the business and expect continued strength in the second half. Our plan to enter Latin America and Southern American markets for the year-end holiday season is on track and we expect to begin generating nominal revenue there later this year.

In the United States, total domestic sales grew 20% year-over-year, a positive directional indicator. Consistent with the program we discussed last quarter to improve domestic profit margins through more strategic placement of product in select channels; we are delivering a full 9.6 percentage point improvement in home robot gross margins from 29.6% in Q2 last year to 39.2% this year.

We are committed to our strategy of profitable growth, continuing to focus on higher end products and exploring new channels. We see 2010 as a transitional year for the U.S. market. I have not built our financial expectations around improved U.S. macroeconomics. Our outlook for home robots is very positive and I’m confident about meeting expectations despite continuing concerns over recession in Europe.

Our government industrial division’s results were also very strong for the quarter as we delivered 138 PackBot robots, the majority of which was FasTacs ordered under contracts we received in Q3 of last year from the Robotics Joint Program office. In addition, we are beginning to ramp shipments of SUGVs, primarily SUGV 310s.

During the quarter, we shipped 100 SUGVs and as anticipated in July we received a new $15 million order for 94 robots, our fifth under the existing IDIQ of which $32 million has been delivered through the second quarter 2010. Since we began shipping SUGVs in Q4, 2009, we have received orders totaling $47 million for 325 units and spare parts. This ramp rate is nearly four times that of PackBot, at the same point following its introduction, which further illustrates the overwhelming adoption of robots by the military and the urgent need from soldiers in theatre.

To this end, in the fourth quarter, we will begin delivering our newest robot, the SUGV 320, to support the first increment of the Brigade Combat Team Modernization program. Under the LRIP (Low Rate Initial Production) contract, we will deliver 45 robots. In ongoing performance tests, our robots have substantially exceeded requirements and we’re determined to be fully compliant. This is a significance milestone for us and sets the stage for 2011, when we expect the majority of G&I revenue to come from the sale of SUGVs.

Another of our recently introduced products, the Seaglider, unmanned underwater robot, was shipped to the Gulf of Mexico on May 22. We saw an opportunity to respond to the need in the Gulf and sent an iRobot owned and operated Seaglider to search for underwater oil plumes and other anomalies.

Based on the data sent back from the robot, scientists were able to estimate the density of the oil in the water as well as the extent to which it was spreading. Although we volunteered our products and services to help characterize this horrible disaster, we expect our increased exposure to yield future opportunities.

As we discussed each quarter, a key component in growth driver of our government and industrial business is Product Lifecycle Revenue or PLR. Our rapidly growing installed base of robots requires spare parts, support, maintenance and training. PLR more than doubled year-over-year of the second quarter and we are on track to provide software-enabled solutions through upgrades to more than 500 robots in the field during the second half of the year.

Beyond supplying robots to the U.S. Government, we continue to expand our international footprint. International revenue for the first half increased 46% over the same quarter last year and comprised 10% of G&I product revenue for the half.

In summary, both of our businesses are performing well in an uncertain environment and we expect both to grow approximately 30% at the top line in 2010, while contributing a greater percentage to the bottom line. Because of our confidence in delivering more profitable results than we discussed in April, we are increasing our expectations for the full year.

For the full year, we expect revenue to be between $385 million and $390 million, EPS to be between $0.51 and $0.54 and adjusted EBITDA to be between $36 million and $38 million.

I will now turn the call over to John, to review our second quarter results in more detail.

John Leahy

Thank you, Colin. Our performance in the second quarter was very strong as we achieved our first profitable Q2 and first half since the company went public. Revenue, earnings per share and EBITDA all exceeded expectations. Revenue was $98 million and $193 million for the second quarter and first half respectively, both all-time highs for the company.

Growth in our international home robot business continue to be robust, up 80% for the quarter year-over-year and our government and industrial business was up 65% for the quarter.

Our overall revenue growth of nearly 60% follows the strongest Q1 in the company’s history. Earnings per share for the quarter were $0.20 compared with a loss of $0.10 in Q2 last year. EBITDA was $12 million for Q2 and $26 million year-to date, compared with breakeven last year.

Operating cash flow of $15 million in the second quarter has driven our cash and investments position to $99 million, up $48 million from Q2 last year. Year-to-date operating cash flow is $25 million compared with $12 million in the first half of 2009. Our focus on EBITDA and cash flow continues to drive strong financial performance for the company.

In the home robot division, shipments grew 52% to 294,000 units and revenue of $53 million increased 55% from a year ago. International revenue increased more than 80% in the quarter year-over-year and comprised 67% of home robot revenue. Total domestic revenues increased 20% year-over-year, an encouraging sign that U.S. consumers are beginning to spend again.

Improvements in home robot gross margins were partly due to this increase in international as a percent of total revenue and to our efforts to optimize our product in channel mix.

In the G&I division, revenue was $45 million, up 65% from a year ago. This growth was driven by higher product shipments, primarily PackBot, FasTacs and higher contract revenue. Contract revenue comprised 26% of G&I revenue for the quarter and was up 35% year-over-year.

G&I product revenue was $33 million in the second quarter compared with $19 million last year. Product Lifecycle Revenue was nearly $10 million or 29% of G&I product revenue, up from $5 million in 2009. We continue to expect PLR to average 25% to 30% of G&I product revenue annually, although this can vary significantly quarter to quarter.

Product backlog at the end of the quarter was $12 million compared with $18 million at the end of Q2, 2009. However, this backlog position does not include the recent $15 million order for SUGV 310s or a $20 million order for 125 PackBots, both of which we expect to fulfill this year. Including these two orders, we have 80% visibility of G&I annual revenue contemplated by our full-year guidance.

For the total company, gross margin for the quarter was 35% compared with 27% last year. The year-over-year increase was driven primarily by the improved home robot mix I mentioned earlier and overhead leverage in G&I.

Operating expenses improved as a percentage of revenue to 26% this year from 33% in Q2 last year. The improvement resulted primarily from operating expense leverage as well as marketing spend we deferred to the second half. However, we have added more than 100 employees mostly in engineering and sales since Q2 of last year.

Q2 operating cash flow was nearly $15 million compared with a $3 million negative cash flow last year. Year-to-date operating cash flow is $25 million. Inventory was $31 million at quarter-end relatively flat from a year ago despite higher revenues, and DII improved significantly.

Accounts receivable continue to be well managed as evidenced by our DSO of 27 days compared with 52 days a year ago. At the end of Q2, we had cash including investments totaling $99 million compared with $51 million a year ago.

Now, I would like to provide you with additional details for the financial expectations Colin discussed as well as color on how we see the rest of the year unfolding.

For the full year, we now expect home robot revenue to grow roughly 30% to a range of $214 million to $216 million. Our G&I revenue expectations are unchanged; however, we have narrowed the range to $172 million to $174 million, also an increase of about 30% year-over-year.

We expect Q3 to be another strong quarter with revenue up roughly 20% over last year. We anticipate revenue in the range of $91 million to $94 million dollars, EPS of $0.05 to $0.06 and EBITDA of between $5 million and $6 million.

Q4 revenues should be slightly higher than Q3, but lower than our record setting fourth quarter last year. A leveled distribution of revenues quarter-to-quarter throughout 2010 is largely due to our international home robot mix and G&I revenues that have been much less lumpy than we have seen in the past.

We expect improved full-year gross margins of 34% to 35% as a result of favorable mix management and savings in product costs realized through supply chain management in home robots and through overhead expense leverage in G&I.

Operating expenses in Q3 and Q4 will be higher than the first half, due to marketing program commitments we have made to our international partners, expenditures to support and strengthen our brand and increased technical headcount. These expenses coupled with the increased investment in R&D for new product development in software enhancements will result in lower EPS in the second half when compared to our very strong results in our first half.

However, our expectations for revenue and EPS in the second half are higher than we anticipated in our April call. As Colin mentioned earlier, for the full year we are increasing our expectations for revenue, EPS and EBITDA.

Finally, we expect our increased full-year earnings to translate into strong operating cash flow. For the full year, operating cash flow will be over $35 million and our cash and investments will exceed $100 million at year-end.

Now, I would like to turn the call back to Colin.

Colin Angle

I’m very excited to be talking with you today following great first-half results, with the confidence to increase our full-year 2010 expectations. Just to reiterate those expectations, we anticipate revenue of $385 million to $390 million; EPS of $0.51 to $0.54 and adjusted EBITDA of $36 million to $38 million.

We continue to successfully navigate through the dynamic and challenging global marketplace in which we operate. We are making significant progress towards our three-year financial targets. We are making ongoing investments in building for a future and maintaining our market leading position.

With that, we will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Jim Ricchiuti with Needham & Co.

Jim Ricchiuti - Needham & Co.

Thank you, good morning.

Colin Angle

Good morning.

Jim Ricchiuti - Needham & Co.

Couple of questions. Congratulations on the quarter by the way. On the consumer business, you continue to make some brilliant impressive improvement in home robot gross margins and yes, I wonder how we should think of that, the potential for further improvement. Can you give us some sense as to where we might see the gross margins go in this business?

Colin Angle

I think that what you are observing is continued improvements in our supply chain, continued improvements in our domestic positioning where we have that remarkable improvement in gross margins of almost 10 points and that’s coming from our selection of both product mix in-store and our selection of emphasis for our retailers.

And I think that you could anticipate that, sort of the biggest chunks of improvement have been taken, but there is still margin expansion available to achieve.

As we think about where we are now, we estimate through additional cost out in the products, additional positioning and inclusion of software content in products which we’ll bring out in the future, and on the government side, continued improvement in the increase of software content in our robots, margins could easily see another 4 to 6 points of improvement over the next few years to 35% to 37% full company basis.

Jim Ricchiuti - Needham & Co.

Okay, that’s helpful. And Colin, I believe you made some comment in your presentation about bringing on a new contract-manufacturing partner, but I think in your commentary you mentioned some capacity issues. I wasn’t clear on this, were you capacity constrained in the consumer business in the quarter?

Colin Angle

We are currently capacity constrained. We started the program almost 12 months ago to bring on a first Tier new contract manufacturer. It’s a long process to do it properly and we will start seeing products coming into the marketplace produced by that manufacturer in Q1 of next year. So, it’s an issue where in 2009 we took a very conservative approach but recognized we need to be looking ahead to source and supply anticipated growth and there has been some constraints on our ability to meet all of the demand that might exist for products in the back half. That does contribute to our guidance; it does contribute to predicting relatively flat revenue in the back half of the year.

Jim Ricchiuti - Needham & Co.

Okay and one final question if I May. Just on the issue of backlog for the G&I business. John you mentioned, I think in your comments a $20 million order for PackBot. Just to be clear, is that the order that the DOD recently announced on their website?

John Leahy

Yes, Jim. These two orders that I mentioned, neither one of which we have been able to do our press release yet, we’ve been waiting on the customer, but the two orders are one for about $14.5 million for SUGV 310s and then the other order which I think is the one you are referring to is for about $20 million for 125 PackBots.

So, both of those have popped up off of the DOD website. We have not press released on those yet, but those are what add up to, along with the previous backlog the 80% visibility.

Jim Ricchiuti - Needham & Co.

Got it. Thanks very much.

John Leahy

Your welcome.

Operator

Your next question comes from the line of Alex Hamilton, C.K. Cooper.

Alex Hamilton - C.K. Cooper & Co.

Hi, good morning.

Colin Angle

Hi, Alex.

Alex Hamilton - C.K. Cooper & Co.

Two questions; the first one, I don’t know if you went through it, I apologize I have 15 companies reporting today. Home robots, the growth in home robots is impressive, can you give a flavor as to what the mix is? In other words, how much of that improvement was from existing markets versus markets and is there a change there?

Colin Angle

It’s a broad-based set of growth figures driving the increase. U.S. markets were up 20% and so that has been down significantly in 2009, so that’s a great reversal, especially on top of the fact that we were doing some things in the channels that might otherwise have reduced revenue growth and then probably the area internationally that saw the most significant growth in Q2 was Japan.

Alex Hamilton - C.K. Cooper & Co.

Okay. And then secondly, going into sort of a holiday season you talked about sort of the capacity constraint that you have, and new manufacturers. What’s sort of the thought process around that? In a sense, are you comfortable with your inventories? Should we expect a ramp-up? Knowing that you have that, how are you sort of modeling around that if you will?

Colin Angle

Well, we are manufacturing at capacity for our current manufacturer, and there is strong demand from our retailers to fill their product with robots and then what we need to do is the traditional ramp-up in the backhouse of marketing dollars to drive sell through in the stores so that we exit the year with the retailers clamoring for more, the great model and leads to a strong first half of next year.

So, this is a model that we have done before and the fact that we may disappoint a few retailers by not being able to fully supply them is a transitory event as our new contract manufacturer will be online right at the end of the year going to Q1 and we should be able to further fuel the growth that we anticipate in the future.

Alex Hamilton - C.K. Cooper & Co.

Great.

John Leahy

Alex, I would just add, that our management of our supply chain, the quality of our production planning and forecasting is the best it’s ever been. So, that operations team has done an incredible job and we do have their Tier 1 player coming on stream, but that really has not affected at all the capacity constraint that Colin references, that on-streaming is on schedule or actually slightly ahead of schedule.

This is more a function of the revenue performance, just greatly exceeding all of our expectations. So, operations management has done a great job. We just happen to be knocking the ball out of the park in terms of revenue growth.

Alex Hamilton - C.K. Cooper & Co.

Great, fantastic, understood.

Operator

Thank you. Your next question comes from the line of Paul Coster - JP Morgan.

Paul Coster – JP Morgan

Thank you. Good morning. John, I wonder if you could just elaborate on your statement about the revenues being less lumpy, so it’s been very difficult to forecast the third and fourth quarters, but it sounds like it’s becoming a bit more predictable and do you expect this kind of smooth growth during the year to extend in 2011?

John Leahy

Predicting DOD budgets and spending as you know, Paul it’s always tricky. And so, it’s hard for us to say whether this is an anomaly where the revenue has been more flattened this year. Certainly, the fact that our contract revenue and our PLR revenue is becoming a greater part of the mix, I suspect will probably help over time because you’re not just depending solely upon the timing of orders.

But it’s hard to predict whether this is what we will see going forward, although this sort of pattern certainly eases the burden on operations and our contract manufacturers, in that we have more predictability.

Paul Coster – JP Morgan

How do expect [Inaudible] for the Roomba product family to evolve in the second half?

Colin Angle

In the second half, I would expect ASPs to be consistent with where they were in the first half of the year, Paul.

Paul Coster – JP Morgan

Okay. I mean that seems to shift, Colin, the unit volumes are actually down in the second half versus the first half, why is that? Versus the same period last year, I should say, sorry.

Colin Angle

We’re anticipating that the fourth quarter revenue to be slightly off the record Q4 that we had and the volumes that are reflected in our guidance represent the manufacturing constraints that we’ve seen, so that any true unit changes are sort of in the noise there, we’re running at capacity, our revenue is modeled at run rate.

Paul Coster – JP Morgan

Okay, got it. Thank you. Where do we stand on the upgrade of the existing PackBots in field with the AWARE platform, and when will that be done in large form?

Colin Angle

So, that the upgrades for AWARE are going to represent a significant part of the anticipated revenue that we’re predicting for G&I in the back half of the year. We said there’s about 500 robots currently anticipated to be upgraded and we hope that, that upgrade program will continue into 2011 and so that our installed base of AWARE 2 robots will continue to be growing over the next few years.

Paul Coster – JP Morgan

Okay. Last question, I will ask this. What about Warrior? When are we going to see that thing start to ship?

Colin Angle

We’re currently developing the initial prototypes that which we think are appropriate for early adaptors, and those will be going into marketplace next year.

Paul Coster – JP Morgan

Okay. Thank you.

Operator

Thank you. Your next question comes from the line of Adam Fleck - Morningstar.

Adam Fleck – Morningstar

Hi guys, good morning.

Colin Angle

Good morning.

Adam Fleck – Morningstar

A question about your direct revenue, I saw year-over-year, year-to-date, it’s down slightly even as U.S. sales have increased. Just curious if you could provide some details as far as where that stands and kind of the push going forward on the direct side?

Colin Angle

Sure. Direct has always been a very important part of our retail business. In 2009, we made some decisions because of the economy to cut back on a lot of our direct advertising, our national TV advertising and that decision has a carryover effect where we drive slightly fewer numbers of people to our website, and thus the sales in the website are reduced, although our conversion rates of people coming to the website are actually improved.

You’ll probably see that turnaround in the back half as we are able to put more energy against awareness campaigns, which create that demand. But direct is just is immediately tied to the number of eyeballs going to our website. So, while that is down, we have more than made up for it through the retail channel domestically.

Adam Fleck – Morningstar

Sure. John, a question we talked about last quarter, but obviously you guys are still sitting on a good pile of cash. We talked about M&A sort of coming at the forefront as far as the use of that cash, just curios if there is any progression there and maybe some sort of timetable you’re looking at?

John Leahy

Adam, as we did talk about, we’ve put added resources against our M&A efforts this year. We’ve hired a boutique banker to help us source and evaluate deals, and we’ve just put more management time. Because we do think going forward M&A can be an important part of our growth strategy.

As you know, these things take quite a while to sort of work their way through a system and in the industries we play in, there are not a lot of very straightforward logical deals to be done given the fact it’s not really a consolidating industry.

So, it’s hard to predict when you’ll start to see some results from this, but we are committed, we think that M&A when properly done will be a good use of the cash that we have built up, but there is nothing definitive to report on that right now.

Adam Fleck – Morningstar

Got you, that makes sense. Sorry, that’s it for me guys. Thanks a lot.

Colin Angle

Thank you.

Operator

Thank you. Your next question comes from the line of James McIlree - Merriman.

James McIlree – Merriman

Thank you. Good morning.

Colin Angle

Good morning.

James McIlree – Merriman

Can you share with us what the new capacity is going to be relative to your current capacity?

Colin Angle

The first Tier manufacturing partner that we are going to bring on will truly be able to scale ahead of our need, and so that it’s a question of tooling capacity, how much are we going to invest in tooling right out of the gate. But we certainly will not find ourselves in a situation where capacity limits our revenue growth for the next few years in most imaginable scenarios.

So, I think this is a problem that we got on and started looking at over 18 months ago. I have taken a very appropriate and systematic approach to finding the right partner, being able to improve and focus on quality as we bring up a new manufacturing partner and this is a good long-term solution.

So, I can say with great confidence that capacity constraint is not going to be our challenge on a go-forward basis.

James McIlree – Merriman

Okay. Well, let me ask in a slightly different way then. In the second half of this year, in the home robot division, you are assuming kind of flattish versus the first half, but the demand in the market, is that experiencing a similar type of increase in the second half that you’re just unable to satisfy because of your capacity or has the market demand flattened out as well?

Colin Angle

We are going to be leaving retailers with less products than they ideally would like, based on their current request to us. The perspective of our visibility, we could have sold more if we had capacity to do so, which is somewhat consistent with historical revenue patterns which show backend loading on revenue. Now, that traditional shape of our revenue in home is changing with the growth of international, because international robot sales tend to be much flatter over the year.

So, we’re definitely seeing some macro shifts in the idealized revenue distribution throughout the year because of the rise of international, but 2010 in particular, you’ll see a forcing function on the flatness of HRD revenue due to this capacity constraint.

James McIlree – Merriman

Great, that’s helpful. And then the $91 and $94 million Q3 revenue guidance, does that assume that the contract revenues come down from the $11.8 million they posted in Q2 or another way to ask it is; why did you have a $3 million Q-to-Q increase in your contract revenues?

Colin Angle

Jim, contract revenue can just be lumpy as opportunities come and go. In terms of guidance, we don’t break it down beyond just the total revenue by division, but there is nothing unusual going on relative to contract. They can just pop-up and down quarter by quarter.

James McIlree – Merriman

Okay and the last one, I think last quarter you talked about a dollar amount that increase you’re targeting for second half, backs over to second half of 2009. Are those numbers roughly the same or have you increased that amount due to the strong result in Q2?

Colin Angle

We have increased the amount somewhat to allow us to do more investment based on the very, very strong results that we have and we think we can do more aggressive job investing in new products, inner branding and awareness as discussed, well still staying, frankly ahead of plan in achieving our long-term financial model we previously discussed.

So, this is an opportunity to both get ahead of the game and that’s more heavily in our future, which is the win-win that we have been hoping for and very exciting news for us.

James McIlree – Merriman

Okay and then over time, you would target towards those long-term goals that you articulated?

Colin Angle

Absolutely, you should expect us to continue marching very aggressively to achievement of those goals and again taking advantage of our progress in margin improvement to invest more in future products and realizing the very rapidly growing potential that this maturing industry is creating for us.

James McIlree – Merriman

Very good, thanks.

Colin Angle

You are welcome.

Operator

Your next question comes from the line of Brian Ruttenbur from Morgan Keegan.

Brian Ruttenbur - Morgan Keegan

Great, thank you very much. Couple of questions. First of all, on the amount of sales and marketing, I don’t think you mentioned the exact dollar amount that you are talking about for third and fourth quarter. Can you give us some dollar amount, so you going to be up $2 million from the previous quarter, from Q2 to Q3? Can you give us some rough dollar amount?

Colin Angle

Brian, there are three broad areas that are contributing to the OpEx increase, in areas where we are investing. First is the fulfillment cost for our direct businesses. Those costs do hit operating expenses, and with the holiday season usually our direct business does tick-up, so that’s the first item drive in the OpEx change.

Second, our marketing costs, both to support as we said in the remarks, are international distributors, in part due to the challenges with the euro and also marketing spend behind the brand which we really have not been able to do adequately over the last couple of years. So those are the two primary components of the marketing spend.

Then the third element relative to OpEx is IR&D, where we will continue to invest more dollars into new product development and developments around where two software. Our IR&D spending year-to-date is actually up about 25% year-over-year. So we plan to continue to invest in that area. So I am not prepared to break out the spend increase across those three areas, but those are the drivers and those are the areas that we are looking to invest in the second half.

Brian Ruttenbur – Morgan Keegan

Okay, now typically in the fourth quarter on a year-over-year basis, you have on selling marketing, usually dramatically increases about $4 million from the third quarter levels. Is that a good way to look at things? It’s going to be primarily fourth quarter weighted on the sales and marketing.

Colin Angle

That is in fact traditionally and you should anticipate more of that sales and marketing spend to hit in the fourth quarter, because well we account revenue on a sell in basis, which creates some of the flatness you see there. The action in the marketplace, at least domestically tends to, for sell through is a Q4 phenomenon, and so we want to time our advertising programs to hit in the fourth quarter.

Brian Ruttenbur – Morgan Keegan

Okay, and in R&D you are taking about, as a percentage of revenue what you targeting for the year and then maybe for next year kind to going forward.

Colin Angle

We’ve given information that says our long-term model for IR&D is in the 6% to 8% range. In 2009 we are actually below that 6% line, and so that the investments that we are talking about in the back half of the year, bring up back into that range. So that as you develop and look at your long-term models for us, that 6% to 8% is a good figure to be using and I think is consistent with companies of our category in investment.

But let me say that those figures need to be augmented because of our business model, by the substantial amounts of money we bring in from the governments to do advanced research and development and so that if you look at run rate, IR&D plus government funded IR&D, you are looking at 13%.

Brian Ruttenbur – Morgan Keegan

Okay and then the last question that I have is, as I look at your guidance and your revenue, you are going to have to have a dramatic increase and it appears to be sales marketing in the third quarter. We are talking $3 million or $4 million. Is that the right ballpark to be thinking or am I missing something?

Colin Angle

Well, that as John said, you got to divide that figure up into those four different buckets, the two sales and marketing buckets, then the increased cost of sales and then the increased IR&D, but if you do that, you do see an increase in the OpEx and that is what’s required to make the math work.

Brian Ruttenbur – Morgan Keegan

Okay. Thank you very much.

Operator

Thank you. At this time I would now like to hand the call to Colin Angle for closing remarks.

Colin Angle

Well that concludes our second quarter earnings call. We appreciate your support and look forward to talking to you again in October to discuss Q3 results. Thank you again.

Operator

Thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a great day.

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Source: iRobot Corporation Q2 2010 Earnings Call Transcript

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