In May 2014 we published a report on iRobot (NASDAQ:IRBT) entitled “iRobot: About to Short-Circuit,” in which we warned investors that the company is being hyped and promoted as a must own stock to play a ‘robotics revolution,’ when in fact it appears to just be a maturing consumer product company under significant competitive pressures. We also warned investors that iRobot appears to be using aggressive accounting gimmicks to mask its deteriorating financial condition, and deflecting investor attention to its “valuable intellectual property” and “growth opportunities in China,” while insiders relentlessly sell stock at each opportunity. Since the publication of our initial report, there have been material developments that strengthen our conviction in the short case. In our opinion, iRobot’s Q2’14 earnings released on July 22nd show further indications of financial strain, and place the company at an escalated risk of missing its full year financial targets, despite the company reaffirming its full year guidance. We believe iRobot is pinning its future, and investors’ hopes, on its ability to grow home robot sales in China. However, our recent visit and channel checks in China left us with significant doubts of its ability to succeed in a rapidly saturating Chinese marketplace.
Digging A Ditch Behind the Headline Q2’14 Results?
Proclaiming that it was pleased with its Q2 results that ‘met expectations’ and that home robot sales grew by double digit percentages, iRobot seemingly had a good quarter. iRobot went further on to raise modestly the low end of its full year revenue guidance, “driven by home robot growth of 18-20%.” However, upon closer inspection of the quarter, we found significant concerns about its earnings quality, and question its ability to hit its full year revenue and EPS guidance of $555–$566m and $1.10-$1.20, respectively. iRobot’s headline quarterly EPS of $0.28c met Wall Street estimates. However, after reviewing its 10Q SEC filing released 10 days after its glowing press release, it appears its financials were again aided by two more “one-time” adjustments. We warned investors previously about the company’s repeated and surreptitious use of non-recurring gains to bolster financial results. According to page 18 of the 10Q:
“During the three month period ended June 28, 2014, we recorded a net benefit to revenue and income before income taxes of $1.2 million and $2.6 million, respectively, related to adjustments to our product returns reserves, compared to a net benefit to revenue and income before income taxes of $3.5 million related to adjustments to our product returns reserves during the three month period ended June 29, 2013. The adjustments recorded in both periods resulted from lower product returns experience.
Additionally, we released $2.1 million of valuation allowance related to certain tax attributes of Evolution Robotics, Inc. during the three month period ended June 28, 2014, compared to the release of $2.7 million of certain income tax reserves due to favorable conclusions of the IRS examination of our income tax returns for the years 2008, 2009 and 2010 during the three month period ended June 29, 2013.”
We estimate these adjustments added approximately $0.09c of earnings benefit year-to-date. Accordingly, we estimate iRobot’s adjusted sales and EPS year-to-date to be $252.8m and $0.37c, respectively. The company provided its Q3’14 outlook, which calls for a deceleration of quarterly revenue and earnings – a big disappointment to Wall Street. We note that iRobot did not cut its full year outlook. This implies that iRobot will have to show explosive Q4 sales and earnings growth of approximately 30% just to hit its full year guidance. We estimate iRobot will have to a produce a clean $173m and $0.44c in Q4’14 (at the midpoint) to hit full year numbers.
What on earth can the company do to hit these targets? It seems unlikely that its new Roomba 880 will bridge the revenue gap. The new 880 model is still competing with excess inventory of older models. For example, iRobot recently promoted on its website a “Labor Day Sale,” and offered incentives to purchase Roomba 650 and 770 models! Also, a recent visit to a local Best Buy (NYSE:BBY) revealed the Roomba 770 and 650 being promoted right next to another struggling consumer product company – SodaStream (NASDAQ:SODA)! Furthermore, investors shouldn’t bet on iRobot’s other products such as the Braava and Scooba to pick up the sales slack. On its last earnings call, the company admitted that they “still have some work to do as far as clarifying some of the message and differentiation in the marketplace on Scooba and Braava.” Our interpretation of this statement is, “Scooba and Braava aren’t selling!” Perhaps a 10,000 foot view of the dire situation can be seen from iRobot’s days in inventory, and days sales outstanding, both of which remain elevated near all-time highs, and provide evidence of significant unsold inventory in the channel.
Overall, we believe the company will be significantly challenged to hit its financial targets in the face of both declining home robot margins and increasing competition. In the charts below, we show that home robot gross margins plunged in Q2’14 to a yearly low of 48.8%. Along with declining defense margins, total company gross margins have also sagged to a low of 44.4%.
We also have warned investors about the material difference between iRobot’s GAAP net income and its cash flow from operations (“CFO”). We believe large departures between these financials are a strong indicator of low earnings quality, and may be an early warning signal that investors should heed carefully. We have compared iRobot’s two most recent cash flow statements to isolate the change in the recent Q2 quarter. In the table below, we observe that iRobot reported $8.5m of net income, but consumed $0.2m of cash flow, for a difference of $8.7m. Year-to-date, the departure is even more stunning; iRobot has reported $13.8m of net income, but consumed almost $8m of cash, for a difference of $21.8m! While the bulls might be content trumpeting iRobot’s great sales and earnings, we’ll quickly point out that its cash balance has fallen by $17.7m year-to-date. It’s also worth noting that despite announcing a $50m share repurchase program on April 2nd, the company has still not repurchased a single share!
Do Not Bet on the China Growth Story
“Home Robots growth will be driven by further penetration of long time overseas markets, coupled with expansion in China and wider distribution of the Roomba 800, Scooba 450 and Braava. Overall we expect home robots to grow 17% to 20% in 2014.” - iRobot Earnings Call
With having openly acknowledged challenges in its military robot business, iRobot’s back seems to be up against a wall, and it has been left with only one real alternative – transform itself into a consumer marketing machine to sell vacuum cleaners. Our conclusion is supported by the company’s recent announcement to recruit a new board member with a background in consumer marketing, as well as its own financial decisions, which show a large surge in sales and marketing expense. In the most recent quarter, the company’s sales and marketing margin surged to a multiyear high of 16.8%, while its research and development expense margin dropped to 11.8% over the same period. Underinvestment in R&D is a worrisome development for a technology company that could hinder future growth through new product development.
While consumer sales in developed markets like the U.S. and Europe have been struggling, iRobot has pinned its hopes on Asia, and China in particular, as a fertile ground to increase market share and penetration. Commenting on the China opportunity and why it is bullish during a recent earnings conference call:
“China is the only region in the world where iRobot was not first to market and that is exciting because it means we don’t have to go and build the market all ourselves. We saw significant growth in 2013 where we have entered and started taking substantial market share from the players that were in China prior to our rolling out and expansion of our product line in China and we see every indication of that continuing to be the case. So we’re still enjoying high growth percentages because of a relatively small base but there is a general appreciation for robot vacuuming in china already and we’re able to leverage that.”
To investigate iRobot’s opportunity firsthand, we recently visited China and spoke with sales people at Suning, Gome and Sundan - three of the country’s largest electronics retailers. We walked away with the firm belief that iRobot may not have to build the market in China as it claims, but it certainly has to explain to the Chinese consumer why it should pay a substantial premium for its products in an already extremely competitive and cluttered Chinese marketplace! The overwhelming feeling we received was that iRobot’s products are a tough sell to the consumer because of the extremely high product price point. To illustrate, we’ve shown the most current Roomba model 780 available at Suning and Gome, each being offered at RMB 8,490 (US$ 1,380) and RMB 8,890 (US$ 1,445), respectively. To put these prices in perspective, the monthly minimum wage in China is approximately RMB 1,820 (US$ 290) and the average annual private sector wage was RMB 28,752 (US$ 4,755) according to a recent study. In other words, to make the highly discretionary decision to purchase the latest Roomba would require approximately 3 months of wages (25% of annual income!) for your average Chinese consumer…not exactly a trivial decision to splurge on a Roomba!
Chinese consumers aren’t exactly stupid either, and assuming they do want to purchase a home vacuum robot, can easily shop around for a better deal! We found plenty of competitive products sitting on the shelves next to iRobot at each of these three retailers such as Phillips, Midea, Ecovacs, FMart, Samsung, Lexy-iSmart, Mazuba and Whirlpool. On the low end, the Whirlpool and Mazuba models retail for RMB 1,600 (US$ 260), while the Ecovacs 600 series ranged from RMB 1,860–3,980 (US$ 300–650). On the high end, the Samsung Navibot was offered at Sundan for RMB 7490 (US$ 1,218). If iRobot is trying to position itself as the Lamborghini of robotic vacuums, then Samsung’s model is equally a Ferrari and gives iRobot some competition at the super high end.
Regardless, Chinese consumers are savvy and can do better than going into a store and paying the retail offer price. Internet shopping is a global phenomenon and provides even more alternatives and substantially lower prices! For example, a quick search of Alibaba reveals that China has 79,343 suppliers of robotic vacuums at prices well under $100! There is also a popular website called Taobao.com where middlemen can facilitate the purchase of iRobot products at significant discounts to the retail prices. For example, we found a Roomba 780 offered at RMB 6,383 (B$1,038). Below are current offerings at both Alibaba and Gome.
Another big macro factor working against iRobot is that average home sizes in Hong Kong and China are among the smallest in the world according to a recent study. With on average 3 people living in a home size of 161 – 215 sqft, the value proposition of investing $500-$1,500 for an iRobot branded vacuum is an extremely difficult sell!
Despite our realistic and sober view that China will be a tough market for iRobot to succeed, the company sees reason for unbridled optimism, and claims the market is still young and fertile! According to a recent earnings conference call,
“…again we’re early days in China. We see a long and very positive growth runway ahead of us. There is plenty of comparable premium consumer electronic goods stories which show very, very substantial success where China has become one of the top global markets for those premium consumer products. So again that gives me more confidence that we are in fact early days and we do have a very positive runway for many years in front of us and should anticipate China growing into one of our major marketplaces.”
What To Do When David Meets Goliath…Sell More Stock!
There is currently speculation in the marketplace that Dyson intends to announce a new robotic vacuum cleaner on September 4th. Dyson recently released a video (viewable here), which previews its new product release. We warned investors in our first report that Dyson has been tinkering with robotic vacuums, and that increasing competition would not bode well for iRobot. Dyson reportedly has revenues of $2 billion and extraordinary profits of $600 million, easily dwarfing iRobot’s size and profitability. The bulls seem to believe that Dyson’s entry validates the robotic vacuum market, but we believe this is just a cognitive bias putting wishful thinking on a clearly negative outcome.
We believe it’s always best to see what insiders are doing to glean their views on the share price. In our first report, we pointed out that insiders now own less than 5% of the company, down from almost 60% in 2005. Since May 2014, insiders have continued to unload shares at levels higher than the current share price. For certain bulls that believe iRobot is a “takeover target,” we question why management would persistently sell stock.
Don’t Be a Fool and Outsmart the Street: Avoid iRobot’s Stock
Despite overwhelming evidence of low quality earnings, underinvestment in R&D, an uphill battle to grow in China, and mounting competition, there is still a cadre of bulls that make claims (often supported with no hard evidence) that iRobot is leading a ‘robotics revolution’ and a must buy stock. Articles on sites such as Motley Fool tell investors “Don’t Fret Over iRobot’s Mixed Results” while The Street says “iRobot’s Selloff is an Opportunity to Buy Shares on the Cheap.” We believe iRobot’s shares are richly valued on unrealistic growth expectations that are at high risk of disappointing investors. Furthermore, for investors buying into the hope that iRobot has substantial hidden value in its IP portfolio, we are still waiting for the company to show evidence or a plan for a monetization strategy. We believe iRobot is a sub $20 stock, and should be viewed as mature consumer product company with a valuation peer set of names such as SodaStream (SODA), LeapFrog (NYSE:LF), Skullcandy (NASDAQ:SKUL), and Zagg (NASDAQ:ZAGG).
Disclosure: The author is short IRBT.
Disclaimer: This research report expresses Spruce Point Capital Management LLC's ("Spruce Point") opinions. Use of the research produced by Spruce Point is at your own risk. This is a short-biased article and you should assume the author of this report and its clients and/or investors hold a short position and derivatives tied to the security of iRobot Corp. that will benefit from a decline in the price of the common stock. Following publication of the report, the author (including members, partners, affiliates, employees, and/or consultants) along with its clients and/or investors intend to continue transacting in the securities covered therein, and may be long, short, or neutral at any time hereafter regardless of the initial recommendation. The author of this report has obtained all information contained herein from sources believed to be accurate and reliable and has included references where available and practical. However, such information is presented "as is," without warranty of any kind- whether express or implied. The author of this report makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. Forward looking statement and projections are inherently susceptible to uncertainty and involve many risks (known and unknown) that could cause actual results to differ materially from expected results. For a list of the risk factors specific to iRobot Corp. and its industry, review the company’s Risk Factors in its financial filings at the SEC. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any of the information contained herein. Spruce Point is not a broker/dealer or financial advisor and nothing contained herein should be construed as an offer or solicitation to buy or sell any investment or security mentioned in this report. You should do your own research and due diligence before making any investment decision with respect to securities covered herein, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and consult your own tax, financial and legal experts as warranted. Please visit www.sprucepointcap.com for our full legal disclaimer.