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Executives

Elise Caffrey – Head of Investor Relations

Colin M. Angle – Chief Executive Officer, Chairman

John Leahy – Chief Financial Officer, Executive Vice President

Analysts

Jim McIlree – Merriman

Josephine Millward – The Benchmark Company

Jim Ricchiuti – Needham & Company

Paul Kresser – JP Morgan

Brian Ruttenbur – Morgan Keegan

Adam Fleck – Morningstar

Brian Gesuale – Raymond James

iRobot Corporation (IRBT) Q1 2011 Earnings Call April 27, 2011 8:30 AM ET

Operator

Good day everyone and welcome to the iRobot Q1 2011 Financial Results Conference Call. (Operator instructions.) At this time, for opening remarks and introductions, 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.

These forward looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information on these risks and uncertainties can be found in our public filings with the Securities and Exchange Commission.

iRobot undertakes no obligation to update or revise these forward looking statements whether as a result of new information or circumstances. During this conference call we will also discuss non-GAAP financial measures as defined by FCC regulation G including adjusted EBITDA which we define as earnings before interest, taxes, depreciation, amortization, merger and acquisition expense and non-cash stock compensation expense. A reconciliation of GAAP and non-GAAP metrics can be found in the financial tables at the end of the Q1 2011 Earnings Press Release issued last evening which is available on our website.

On today’s call iRobot Chairman and CEO, Colin Angle, will provide a review of the company’s operations and achievements for Q1 2011 as well as our outlook for the business for the rest of 2011. And John Leahy, Chief Financial Officer, will review our financial results for Q1 and provide our outlook for financial expectations for Q2 ending July 2nd, 2011. Then we’ll open the call for questions.

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

Colin M. Angle – Chief Executive Officer, Chairman

Good morning and thank you for joining us. Before I get started with a discussion of our Q1 operations and outlook, I’d like to tell you how proud we are to have sent our robots and people to Japan. We shipped two Packbots and two Warrior Robots to explore reactor buildings in Japan’s crippled Fukushima diaty Nuclear Plant following the devastating tsunami. Six iRobot employees flew to that country to train Japanese personnel to use the robot. The robots equipped with HAZMAT detection sensors have been used to monitor radiation and oxygen levels to determine whether conditions are safe enough to allow human workers to go in to try to bring the nuclear crisis at the plant under control. This kind of humanitarian effort is at the core of who we are at iRobot making a difference in people’s lives.

Turning now to our Q1 performance, we kicked off 2011 with another outstanding quarter. Our financial results are especially impressive given the strength of Q1 last year. Gross margin was 41% for the quarter, up 700 basis points from last year. Driven by margin improvements in Home Robots.

International Home Robot revenue increased 37% largely due to demand from existing customers in established markets. Home Robot revenue in the US increased 12% in Q1 year-over-year. And we received several important contracts in our G&I business that provide us with improved visibility for the rest of the year.

Total revenue in Q1 increased 12% to $106 million. Adjusted EBITDA in Q1 increased to $15.1 million and adjusted EBITDA margin increased to approximately 15% of revenue. EPS of $.27 for the quarter increased by $.03 and exceeded expectations.

Our exceptional results reflect the increasing diversification of the company. We are successfully meeting the challenges of international economic uncertainty, political unrest overseas, devastating national disasters and continuing unresolved US budget issues by delivering multiple products into multi-billion dollar automated home maintenance and remote presence in global markets.

Based on our view of the rest of the year we are reaffirming the financial expectations we shared in February to deliver full-year 2011 revenue of $450 million to $465 million, EPS between $.90 and $1.00, and adjusted EBITDA of $58 million to $62 million.

In Q2 we expect international demand to drive revenue growth in Home Robots. The government contracts we recently announced for Packbot and SUGV robots should begin to generate revenue towards the end of Q2 and it will fuel second half growth in this division. As we discussed earlier this year, in Q2 adjusted EBITDA will be slightly lower sequentially as anticipated and discussed in our Q4 call due to lower revenue caused by the apparent lumpiness of our G&I business. For Q2 we anticipate revenue of $102 million to $106 million, EPS between $.18 and $.22 and adjusted EBITDA of $12 million to $14 million.

Now I’d like to take you through some of the details of Q1 and our expectations for the rest of 2011. In the Home Robot division strong demand overseas, particularly in long-term markets, continued to fuel Home Robot revenue growth. International Home Robot revenue increased 37% year-over-year and we expect overseas demand to continue to be the driving force for Home Robot revenue growth for the remainder of 2011.

In our domestic business Q1 results grew 12% over last year largely due to increased sales to retail stores. Our US retailers are reporting stronger sell through, in part reflecting pent up demand created by limited product availability at the end of last year as well as the impact of our marketing investments. However, our outlook remains cautious in the US given the macroeconomic environment. But early indicators are certainly positive.

We begin producing the Scuba 230, our new floor washing robot, in limited quantities and sold them to select customers directly through our website. The response was overwhelming and we have now made the product fully available online. They have just initiated a similar limited launch of the new Roomba 700 series. We will expand distribution of both products throughout the rest of the year and to select US retail stores next year.

Our continued efforts to eliminate lower margin products, customers and channels helped us achieve gross margin of more than 45% in the Home Robot division. More then seven percentage points higher than Q1 of last year. Sales of the Roomba 700 and Scuba 230 robots should further enhance the division’s margins.

In 2010 we planned our entry into Latin America. Our expansion in that region is on track based on a successful blueprint we developed for entering and building markets in Europe, Japan and Latin America. We have begun to execute our strategic plan for expansion into China next year. The tier one contract manufacturer that began producing for us in Q4 of 2010 is fully operational and we expect to meet our 2011 product demand.

Turning now to our G&I division, we continue to see demands for our technical ground robots from war fighters in theater and the military leadership in Washington. The US’s budget negotiations and operating under a continuing resolution have delayed contract awards this year as we anticipated they would. These delays will impact Q2 revenue as well and we have reflected that impact in our expectations.

Now that a DOD budget is in place we do expect orders to start flowing and we are on track to deliver G&I results consistent with the expectations we set last quarter. We continue to expect 60% of G&I revenue to be generated in the second half. International revenues which increased 12% to a total of 21% of G&I product revenue partially offset the impact from the DOD.

Recently we received several significant contracts further indicating the underlying demand for both Packbots and SUGV robots. (Inaudible) awarded us a $230 million indefinite delivery, indefinite quantity contract for the delivery of up to 671 Packbot 510 robots over a four-year period. These robots are currently being used in Iraq and Afghanistan to identify and neutralize explosive devices, perform recognizance and clear routes for war fighters on the move. $230 million contract ceiling reflects (inaudible) estimate of the amount they will spend over that time period. When we provided our financial expectations last quarter we estimated that approximately 50% of GNI revenue derived from robot units would be the sale of Packbot systems. This contract, which we had expected, provided the vehicle for the governments purchase of those units. We anticipate receiving our first order under this contract in Q2.

Additionally we received two orders totaling $7.6 million for SUGV 310s. The robots will be used by the marines and the combat engineers. This is important for several reasons. First the SUGVs are being ordered outside of the brigade combat team monitorization program. And secondly they will go to two separate branches of the military, further supporting our position that there is demand for SUGV beyond the army. While SUGV 10s have been used in theater primarily by explosive ordinance disposal teams, as a result of ongoing positive user feedback and their success on the battlefield, they will now be used to perform an even wider variety of missions.

We completed delivery of 45 SUGV 320s under the first low rate industrial production order of the BCTM program in Q1. As we said on last quarter’s call, we expect to fill orders for two additional [LRIP] brigade sets of SUGVs later this year.

During the quarter we also completed delivery of the Aware 2 software upgrade to 1500 Packbot Fast Tack robots in theater which contributed to a 59% increase in product lifecycle revenue year-over-year. We anticipate deliver of a second round of software upgrades, which will provide the robots with increased autonomous capabilities to begin later this year.

On a new product front we unveiled prototypes of the iRobot 110 First Look earlier this month. The small lightweight throwable robot, First Look, provides immediate situational awareness, performs persistent observation and investigates in confined spaces. The robot weighs less than five pounds and is ten inches long, making it ideal for building clearing, [break in audio] given its small size, ruggedness and state of the art capabilities; the robot is ideal for a range of infantry missions and special operations. With four built in cameras and two-way audio communication, First Look provides multi directional situational awareness. It also has a digital mesh networking capability allowing multiple robots to relay radio communications over an even greater distance. Over the next several months we will demonstrate First Look for military and law enforcement personnel and we expect it to be available to delivering to customers in 2012.

As with our Home Robot market, the opportunity for a government robot is significant. We’ve delivered more than 4000 unmanned ground vehicles over the past few years primarily for the US military, principally for use by bomb disposal teams. We have the majority of the current market for this size robot and have proven the defensibility of our intellectual property in this sector. Expanding the fleet of robots provides not only current revenue but a stream of recurring revenue through product lifecycle revenue such as the software upgrades I described.

We continue to successfully navigate through the dynamic and challenging global marketplace in which we operate. We are making significant progress toward or three-year financial targets while making ongoing investments in building for our future and maintaining our market leading position. We will further widen our competitive mode by delivering robots that make a difference built on common platforms using highly integrated iRobot develop technology that incorporates artificial intelligence with advanced concepts in navigation, autonomy, testing and manipulation. Further, by leveraging technology developed by third parties, we will develop high quality robots for multibillion dollar automated home maintenance and remote presence markets.

In summary we had a strong Q1 and are on track to meet expectation for the rest of the year. I will now turn the call over to John to review our Q1 results and Q2 expectations in more detail.

John Leahy

Thank you, Colin. Our performance in Q1 was once again very strong with revenue growing 12% over last year’s record Q1 driven by our international Home Robot business.

Earnings per share and EBITDA both exceeded expectations. Earnings per share for the quarter were $.27, growing 13% over Q1 last year. EBITDA for Q1 was $15.1 million compared with $13.7 million in Q1 last year. Our continued focus on driving EBITDA continues to produce great results.

In our Home Robot division shipments grew 22% while revenue of $68 million increased 29% from a year ago. International revenue increased 37% in the quarter to $50 million and comprised 73% of Home Robot revenue.

Total domestic revenues were up 12% in Q1. More importantly, sell through at our top five US retailers was up more than 40% year-over-year, reflecting improved consumer sentiment and the impact of our marketing program. With our tier one contract manufacturer in full production mode, we will be able to meet demand for 2011.

Home Robot gross margin improvement of more than 750 basis points for the quarter was due to an increase in international as a percent of total revenue, improved products and mix.

G&I’s revenue of $38 million decreased from a year ago due to the timing of product shipments. Gross margin in the division improved nearly 300 basis points in Q1 over last year due to favorable mix. G&I product revenue was $29 million in Q1 compared with $34 million last year. Product life cycle revenue was $13 million, up from $8 million on 2010.

For the total company, gross margin was 41% for the quarter, up 700 basis points from last year. The improvement, which is consistent with our expectation for an increase in full year gross margins of 200 basis points was driven primarily by improved Home Robot mix and product costs.

Operating expenses increased as a percentage of revenue to 30% in Q1 from 24% last year due to the higher spend in IR&D in marketing we discussed on last quarter’s call. Inventory was $35 million at quarter end compared with $30 million a year ago as we rebuild our low year-end inventory stock. At the end of Q1 we had cash, including investments, totaling $124 million compared with $85 million a year ago. Operating cash flow is break even due to the inventory build.

Now I’d like to provide you with additional detail and some of the underlying assumptions for Q2 financial expectations Colin discussed.

As we said last quarter, we are lapping a very strong first half 2010 in which revenue grew 63% over 2009. Therefore year-over-year growth will be stronger in the second half then the first half. In Q2 we expect revenue of $102 to $106 million, a slight increase over Q2 of 2010, driven by growth and Home Robots.

G&I revenue will be lower, as we anticipated, due to delays in the contract awards Colin discussed. We expect EPS in the range of $.18 to $.22 and EBITDA of $12 million to $14 million dollars.

Improving domestic sales, the introductions of new products, further penetration into long term international markets and acceleration of selling into Latin America will drive the Home Robot business in the second half. Orders under the IDIQ contract received from the US military, sales to foreign countries and block software upgrades of G&I robots in theater would drive our G&I business for the second half. These factors provide us with the confidence to confirm the full year financial expectations we shared in February.

Now I’d like to turn the call back to Colin.

Colin M. Angle

Our results in Q1 were great and I am bullish about the balance in 2011 despite macro challenges. As we look at the rest of the year we will diligently balance our investment in technology and the iRobot brand to maintain or market-leading position with our commitment to delivering increasingly profitable growth.

This year we are launching new products and entering new geographic markets enabled by our investments. Beyond this year we’re exploring opportunities to leverage an integrate technology developed by others to accelerate our development of high quality robots for the multi-billion dollar automated home maintenance and remote presence markets.

With that we will take your questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the Question & Answer session. (Operator Instructions.) Our first question comes from Jim McIlree from Merriman. Please go ahead.

Jim McIlree - Merriman

Thank you and good morning. Could you talk a little bit about the gross margins in the G&I division; why they were down versus Q4 of last year?

John Leahy

Jim, the gross margins in G&I, they do bounce around a bit by quarter, largely revenue driven because we have overhead absorption that we need to deal with. But in Q1 gross margins for G&I were up 300 basis points from Q1 a year ago and that was largely due to mix, particularly a heavy or strong performance (inaudible) as a result of the upgrade.

Colin M. Angle

The other thing to add is that in Q4 we shipped a significant number of the software upgrades which favorable impact gross margins and we are finishing closing that out in Q1. So the combined effect. But certainly the G&I margins do track revenue fairly carefully because of the overhead absorption affect that John mentioned.

Jim McIlree – Merriman

Was the software upgrade revenue in Q1 greater or less than the software revenue in Q4 of last year?

John Leahy

A little down and thus the effect that I described.

Jim McIlree – Merriman

Okay and then lastly I think that you mentioned in your script some additional orders related to autonomous control expected later in the year. Can you site that either in precise dollars or kind of bigger or smaller than the Aware 2 upgrade?

John Leahy

I cannot at this time but it certainly is a significant opportunity for us. We see our business evolving in a way where we do typically provide upgrades for our install base. But this is a growing over time opportunity. But we do not have the order in house. We expect it as Q4 event and we’ll provide more details as we have them.

Jim McIlree – Merriman

Great. Thank you.

Operator

Our next question comes from Josephine Millward from Benchmark. Please go ahead.

Josephine Millward - The Benchmark Company

Good morning. Colin, the order you’re expecting from the (inaudible) IDIQ, do you expect requirement above what’s planned in the defense budget for the MTRS program? I believe it’s around $36 million from the ’11 budget. Or is this just part of, are you expecting an order inline with that’s planned in the budget?

Colin M. Angle

At this time I think we expect what is inline. But I would tell you that there is a lot of noise as far as what is required to meet the demand in theatre. So it is a little bit of a moving target.

Josephine Millward - The Benchmark Company

I was going to ask you about that because I thought the army was getting very close to their acquisition target on MTRS. I was a little surprised by the ceiling value and the duration on this new contracting vehicle. Is that what’s going on there, that they’re thinking about maybe taking up their requirement?

Colin M Angle

I really can’t comment on that Josephine but certainly the aggressiveness and size of the contract indicates a very strong appetite for the robots, the upgrades, the additional capabilities that we are developing and a continuing and growing pull from the field for the utilization of the robots. Every time we talk to soldiers in the field, it is a very validating and exciting experience.

Josephine Millward - The Benchmark Company

That’s good to know. On that note, on the SUGV, was one of your SUGV orders under a new IDIQ? And if so can you tell us assuming on that contract and whether the army can buy both SUGV 310s and 320s on that contract.

John Leahy

Josephine, we received an IDIQ for I think $7.6 million and an order right along with that. And so we’ll be fulfilling that over the next quarter or so.

Josephine Millward - The Benchmark Company

Got it. Now previously I think you talked about seeing, you know, demand for SUGV 320s outside of BCTM, in light of uncertainty related to the Afghan draw down this summer, are you still anticipating the same level of requirements for SUGV 320s outside of BCTM?

John Leahy

Well as you’ve mentioned we’ve been wrestling with a lot of uncertainty surrounding the budget. The demand is there, we’ve had a number of different opportunities which raves go up and down in their seriousness but we do have a rich and diverse backlog including opportunities for SUGV outside of BCTM. So that the way we look at our year it’s a portfolio of risk-adjusted opportunities and we think we like our guidance where it is at this point and certainly as we get more clarity that will give us, we’ll pass our feelings around along. But short answer, yes we believe that there are opportunities for the SUGV 320 outside of BCTM.

Josephine Millward - The Benchmark Company

That’s great. Let me shift gears a little bit. There’s a lot of excitement around your new scuba. Can you talk about what’s assumed in your guidance for this new scuba introduction?

Colin M. Angle

Sure. We’re assuming a very small amount of revenue in 2011 associated with it. So that if we can continue the momentum that we see with this current launch that would be good. But remember that our marketing program and our distribution strategy for the Scuba 320 is a largely web-based in 2011 and we are very slowly ramping up production because this is a very complicated device to create. We don’t want to get ahead of our skis on that. So we like where it is today. We’re enthusiastic about the demand that seems to be there and so it is really a limitation of ramping up production and carefully rolling this product out in a sensible way to retailers. So this is a good news story. I think you probably picked up on this call, I mentioned several times new products having some impact in 2011, growing in 2012.

So I love our long-term growth story. I feel like our product backlog of new introductions is growing very strongly and we have the opportunity to systematically bring these products out in ways that allow us to ensure the right pricing, the right quality levels and do this in a phase and rational way. So this is all good news.

Josephine Millward - The Benchmark Company

Thank you Colin, and congratulations on a great quarter.

Operator

Our next question comes from Jim Ricchiuti from Needham and Company. Please go ahead.

Jim Ricchiuti – Needham & Company

Thank you. Just with respect to your 2011 guidance, I think in the past you talked about increases of approximately 30% in both consumer and G&I. Just given the delays in the G&I side, has that changed at all? Are you assuming perhaps the consumer business could be up a little stronger, G&I up a little less this year?

John Leahy

Jim, just to clarify, for 2010 both businesses grew over 30% top line. Our guidance for ’11 was for HRD to grow mid to high teens and G&I to grow low to mid teens. And we still feel that’s appropriate. Certainly we’ve come out of the gates stronger in HRD then we have in G&I. But as you heard in Colin’s remarks, we feel good about the back half for G&I as well. So I would stick with that direction for now.

Jim Ricchiuti – Needham & Company

Good. Thanks for clearing that up, clarifying that for me. Colin maybe you can elaborate just on what your plans are to expand the distribution for the new Scuba 230 and Roomba 700. It sounds like you’re not going to be going heavily into the retail channel until next year. And so what should we expect in terms of the distribution strategy for the product later this year when presumable you’ll have a little bit more production?

Colin M. Angle

Well from the highest level, when we create a new product, what we’ve learned from the past is that we benefit by being conservative in the rollout and so that the first channel that you’ll see our products in are sort of more boutique, higher priced but very high touch retailers like specialty, like our website, where we have the ability to understand who we’re selling to and maximize the information coming back from our customers. And so that is sort of the first phase of a product’s launch. And then from there we go into more mass market retail and then over time we’ll go into sort of the more value-based retail to maximize distribution. But this is a long-term strategy and by the time we’re in to the discount channels or the lower value based channels, you should expect us to be coming out with a new higher end model up at the top of the market. So this distribution model is what’s playing out. And so that right now our newest product, the Scuba 230, is available on our website only. And as the year rolls out you’ll see us carefully broaden that distribution.

So retail, I think that with the Roomba 700, by the end of the year you’ll see limited retail, international and perhaps some US if we can negotiate and find the right partners to bring it into retail. Certainly broad web-based sales going on and then growing our retail presence in 2012. That is our current plan and I think that that gives us maximum confidence that we can get all, capture all of the feedback from our customers and carefully control the growth of the distribution.

Jim Ricchiuti – Needham & Company

That’s helpful. Just with respect to the domestic business, HRD in Q2, I guess you had a stronger Q2 last year and albeit it was off, it was a recovery quarter but you still seem somewhat cautious about the domestic business and I’m just curious just given the sell through that you’re seeing.

Colin M. Angle

Well remember that what we’re doing domestically is repositioning the product in the marketplace where we are, and our top retailers we’re up 40%, that’s huge. We have pulled out of some lower priced channels, which were creating revenue but not particularly helping our bottom line and actively hurting our margins. And so that as we have strengthened as a business we have been able to do a better job of capturing the uniqueness embodied in our products. These are extremely differentiated products in the marketplace. This is something that is revolutionizing an industry and we believe that as the market leader it is a, we’re at the point where it’s not a great strategy to be selling at extremely low margins. Our ambitions for the gross margins in the Roomba business are above even where we are today.

So what you’re seeing happen in North America is successfully repositioning our product. Huge improvements in gross margin without, last year, without seeing reduction in revenue and here going into Q1 2011 you’re seeing a 12% increase overall in North America and with our retailers that we’re focused on, a 40% increase. So this is a success story and I think that as far as setting expectations go, we are seeing North America respond to the market investments we’ve made, we’re seeing tangible, just look at our results, impact in improvement in gross margin and we see a lot of running room to grown North America back into a dominant position from a Home Robot sales perspective.

Jim Ricchiuti – Needham & Company

I assume in Q2 last year you still had a fairly sizeable or higher somewhat meaningful percentage of business coming from these low-margin retail channels?

Colin M. Angle

That is correct. It is a stark change and it was executed sort of in the back half of last year and continues to this day.

John Leahy

And Jim I would just add as a reminder that we had an incredibly first half in HRD last year. The overall revenue for HRD in Q2 last year was up 55% versus prior. So we’re both in Q1 and Q2 we’re lapping some pretty big numbers.

Jim Ricchiuti – Needham & Company

Okay. Thank you.

Operator

Our next question comes from Paul Kresser from JP Morgan. Please go ahead.

Paul Kresser – JP Morgan

Thank you good morning. I think it’s now five quarters in a row that you’ve seen an increase in the average selling price of your G&I robots. Can you talk to us a little bit about what the drivers for the ASP increase or preserve in terms of the tax rate for payloads or the actual platforms. And also how you believe that will evolve moving forward particularly in the concepts to the stock fee and the BCTM program?

Colin M. Angle

The main driver, Paul, for the increase in ASPs over the last few quarters has been SUGV. Now the DOD has opted to take a relatively patient approach to acquiring SUGV, meaning that they’ve been lower volume, they have not yet kicked into the economically beneficial quantities that they’d have to reach to get better pricing so that they’ve been, they have been more expensive based on their acquisition strategy which has driven ASPs.

As unit quantities increase in SUGVs the base platform cost will not continue to rise. Now moving counter to that is the notion that as these robots combine more and more autonomous and sophisticated capabilities born out of the software work we’re doing, born out of the partnering work that we do with third party payload development as well as our own payload development, you’ll see systems being delivered which could very well carry with them higher ASPs. But now we’re starting to look out into the future and it is hard to get more concrete than what I’ve just said.

But short term increases in ASPs has been first switch over SUGVs and switch over to SUGVs at relatively low volume orders, longer term you’ve got economies of scale pushing down, you’ve got more sophisticated high value payloads being integrated into solution purchases which would raise ASPs. Not sure which way the winning force will be at this time.

Paul Kresser – JP Morgan

Okay. Got it. So we shouldn’t extrapolate from this trend indefinitely and of course you’ve also got the one thing that will kick in and try a different kind of price point for your products.

John Leahy

Now of course as revenues continue to increase on a division wide basis, we’ve already mentioned today that our overhead spending as a percentage is tightly coupled to revenue. So that as revenue continues to increase we will see and there are opportunities for continued improvement based on scale and more complete absorption of our overhead structure. So we have built the organization to be able to operate at substantially larger revenues without adding commensurate new costs into the business. So again there’s opportunities there as well.

Paul Kresser – JP Morgan

Okay, I’m curious about the Aware 2 upgrade cycle. I mean you announced that you had this big opportunity only a year ago and then executed and then already we’re on to the second upgrade cycle. Is it touching every single robot out in the field or pretty much every robot out in the field and is this what we should expect moving forward that you’re aiming at creating a new release once a year and that you’ll try and drive that into the entire installed base?

Colin M. Angle

I’ll tell you that this is a merit-based strategy meaning that we need to compellingly demonstrate the benefit of these upgrades. It is not built into a contract and this upgrade that we are talking about this year is not guaranteed, by any stretch of the imagination, to touch every robot upgraded to Aware 2. That said, it is our ambition to systematically upgrade as much of the install base as we can and we believe that an annual basis for a new upgrade pack for software upgrade does make sense.

We’re already working on the 2012 upgrade, which at the last analyst day we previewed it’s the Aware Ahead navigation system. We believe that there are opportunities in 2012 to start helping our soldiers in the field with the capabilities that that system can deliver. That’s a major one and if we got started in 2012 that certainly would push into 2013 before all was said and done. But you are correct that we see this as a recurring opportunity to increase platform performance to our customers. But it is not correct to say that this is all baked at this moment in time and that we have any lock or guarantee that all 1500 robots upgraded to Aware 2 would get an upgrade at the end of the year. So that’s the strategy.

Paul Kresser – JP Morgan

Well my last question is probably for John and that is, John, can you remind us what exposure you have in terms of margins and even EBITDA and EPS from foreign currency fluctuations and how does the deteriorating dollar exchange rate benefit or hurt you?

John Leahy

Paul, the direct exposure is very minimal particularly in 2011 for two reasons. One is you might recall that the bulk of the HRD international business is dollar denominated. When the Euro softened dramatically last year we actually had to provide some incremental marketing support for our distributors to help continue to grow their business. That obviously is not an issue this year.

And then secondly with the appreciation of the run being that is not a factor this year because our pricing for with the CMs and the major components are all locked in. in 2012 between currency rise or strengthen out of china and inflation, you know, there will be challenges for us and I would assume most companies that produce consumer electronics in china. So there will be challenges down the road that we’ll have to face. But for 2011 we see little to no currency exposure either out of Europe from a retail standpoint or out of China from a supply standpoint.

Paul Kresser – JP Morgan

All right. Thank you very much.

Operator

Our next question comes from Brian Ruttenbur from Morgan Keegan. Please go ahead.

Brian Ruttenbur – Morgan Keegan

Thank you very much. In cash from operations, first of all Q1 was around the $100,000 mark, what do you anticipate happening for the year in terms of cash from operations and was it just timing that was weak in Q1?

John Leahy

Yeah Brian, the OCF in Q1 was pretty much as we expected because we knew going into the year that we needed to build inventory and actually build inventory in both divisions. In HRD because we had run inventory stocks down so low but also in G&I we build inventory in anticipation of orders; these orders that Colin was referring to.

For the year our thinking really has not changed so we expect that we’ll generate operating cash flow somewhere between $35 million and $40 million and have an ending cash position of somewhere in the $140 to $145 million range.

Brian Ruttenbur – Morgan Keegan

Perfect. That was the easy question; too easy for you. The next question will have to get harder then as we move to double jeopardy. Gross margin, is 41% now the norm?

John Leahy

Brian, so this question is not much more difficult than the first one. We’re well prepared. You know we had a very good Q1 in terms of gross margin. We probably exceeded our expectation somewhat. For the full year we still think that our gross margins will be in the range of 35% to 37% and so that would be up about 200 basis points over our prior year.

Brian Ruttenbur – Morgan Keegan

Okay. So do you anticipate then the second half of the year gross margins will be weaker than the first half of the year? Because of the mix of business?

John Leahy

Yeah, that’s what our guidance would imply.

Brian Ruttenbur – Morgan Keegan

But more government business versus commercial?

John Leahy

[Break in audio], so you know our revenue in G&I was down year-over-year and, you know, we’ll pretty much see that sort of performance or close to flat perhaps in Q2. And so in the back half G&I as a percentage of the overall mix will be quite a bit higher than what you’ve seen in the first half.

Brian Ruttenbur – Morgan Keegan

Okay and then just moving on to operating and expenses. Should we be looking at Q1 as the norm now in terms of R&D at these levels and G&A at these levels? Was there anything one time in nature in any of those?

John Leahy

Again for OPEX we would still stick with our full year guidance, which is OPEX of 30, up 25% to 27% as a percentage of revenue. So that would imply, you know, slightly lower OPEX as a percentage of revenue in the second half. In part because of the fact that revenue in the second half will be higher. But really the important part of the story there is as you saw in the second half of last year, our investment in R&D and sales and marketing, we have increased significantly.

So in Q1 the combination spend on R&D and sales and marketing was up almost 60% year-over-year, and obviously that ties into the new product development that Colin talked about, but also the rebound in HRD North America performance that we saw in Q1, in part due to that marketing support that we’re giving that business, which really until the second half of last year had not seen a lot of marketing support for a couple of years.

Brian Ruttenbur – Morgan Keegan

Okay. On the commercial business, what are the number of distributors that you have now and what do you expect by year-end?

John Leahy

Domestically we don’t use a distributor model, so we direct sell into our retail channel. So if you’re asking about-

Brian Ruttenbur – Morgan Keegan

I was asking international. That’s where all your growth is.

John Leahy

Right, so that in our major markets we have a stable set of distributors, so that is unchanged. We have, are actively adding distributors in Latin America and we have our principal distributors signed up for the major markets like Brazil and Mexico and Argentina and Peru. So that is they are signed up and are scaling up operations, so that’s as per our plan; and we are in process adding our Chinese distributor for mainland China. We’re negotiating that relationship today, and if you think about the timing of getting into the Latin American market, that would be appropriate as far as setting expectations of what will happen there. And that is a, we view China as a huge potential new market although it will be immaterial in 2011. It will be modestly material next year and could grow. We have great optimism as far as where it can go from there. So those are the major [break in audio] Europe and Japan and Korea, Australia, and our other locations, we feel like we have superior-performing distributors and we’re very comfortable growing with them and are not adding or supplementing them in those regions.

Brian Ruttenbur – Morgan Keegan

So are we talking about you’re at 500 distributors or how many distributors are you?

John Leahy

About 40.

Brian Ruttenbur – Morgan Keegan

About 40 distributors and you expect that to grow by 10 or 15 by year-end as you move into those new markets?

John Leahy

No, cause typically a distributor handles one country.

Brian Ruttenbur – Morgan Keegan

Okay. So you wouldn’t have two or three in China – you’d have one.

John Leahy

We would have one in China, and that distributor would have to build up obviously a very sophisticated network to handle full distribution in China, but that is our winning strategy where we combine our local presence… So we will have iRobot personnel based in Hong Kong supporting a local distributor which brings to us the knowledge of how to operate in the country and invest in appropriate marketing programs, and it just seems to work for us to do (crosstalk).

Brian Ruttenbur – Morgan Keegan

Sure, thanks.

Operator

Our next question comes from Brian Gesuale from Raymond James. Please go ahead.

Brian Gesuale – Raymond James

Good morning guys, nice job on the quarter. Just a couple of questions. Maybe first off, Colin, can you give us an update on the healthcare segment for you guys? It’s been almost 18 months since you made some hirings and just wanted to get an update on where that business was going.

Colin M Angle

Well, as I tried to set expectations back when we did it, this is a program which is going to go in stealth mode for awhile before we make any large announcements. One thing that you have seen is the AVA concept prototype that we started showing off at Consumer Electronics Show at the beginning of the year, so that is a platform that is designed to allow for very sophisticated interactions with people. And obviously one of the applications there is healthcare although it is a multi-purpose platform. So I would say that that robot project, which is operating under and out of the Home Robot Division, is our first peek if you will as far as what we’re up to. So unfortunately you’re going to have to be satisfied with that for now.

Brian Gesuale – Raymond James

So less filling on the answer but I’ll stay, I’ll take it. Hey, John, maybe the second question for you. You know, a few years ago you came over and EBIDTA margins were in the low single digits, a little bit lumpy. You’ve done a terrific job on executing the business here and you know, we’re sitting at mid-teen levels which I believe, that was the bogey at the time. Is it time to redraw those given the gross margin strength, the installed base of government robots out there driving higher margin [PLR] sales? How should we look at this?

John Leahy

That’s a fair question, and the good news is when we laid out those goals, those were goals we were looking to attain by 2012. And obviously we’re on a good pace and we’re starting to get into that range. This summer we’ll be going into our traditional strategy discussions and sorting through where we think the next set of goals are, so right now it would be premature for me to comment on where we look to reach eventually but the good news is we’re ahead of pace on the goals we laid out; and I think Colin and I have both been very clear that when we set that goal of mid-teens that that was not the end game – that was part of the journey.

Brian Gesuale – Raymond James

Great, thanks, and then just one final question. I might have missed it – did you give the split of [Pac bot] versus Sub V revenue in the quarter? And how is that tracking to the 60/40 split you’ve talked about?

John Leahy

In Q1, it was in terms of revenue, about roughly split 50/50, which would be consistent with what we thought for the full year.

Brian Gesuale – Raymond James

Okay, terrific. Thanks a lot guys.

Colin Angle

Thank you!

Operator

Our next question comes from Adam Fleck from Morningstar. Please go head.

Adam Fleck – Morningstar

Good morning. I just wanted to circle back to the conversation about China. As you look to enter that market obviously longer-term, in your early analysis can you talk a little bit about maybe some of the competitive forces there, and especially in regards to IP or patent issues?

Colin M Angle

Well, the key for operating in China is to have a strong partner who is sophisticated enough to address those types of questions. There are many precedents of high-tech consumer companies succeeding in China, and we look to those as our model which we will follow. For example, Bose has a very successful operation in China. That is a very IP-rich company and they have found a way through careful partnering and through having a strong presence on the ground. And so we think that it is not a simple task but certainly far from an insurmountable task, and we believe the distributor partner with we’re currently negotiating with is very sophisticated in that regard. So you have to have a combination of enforcement, of speed, of appropriate pricing and marketing in order to make it all work, so there’s no one silver bullet on how to do it. But certainly you go in with eyes wide open and choose good people to work with.

Adam Fleck – Morningstar

Sure, thanks, that’s helpful. John, real quick, just a [break in audio] rebuilding in the first quarter that you talked about, but do you have a target level of say days in inventory on an annual basis that you hope to achieve over the long run?

John Leahy

I can tell you, Adam, in the near-term what we’re looking at. You know, DII has bounced around a little bit over the last year but obviously has come down dramatically from where we were two, three years ago. And so in Q1 we did about 55 days in DII; over the last year it ranged between 40 and the high 50’s. I think the low 50’s is about the right point. We definitely ran extremely tight in HRD in the second half of last year so we needed to rebuild, and the slight uptick in Q1 was also as a result of G&I building a bit ahead of demand, knowing that we’ve got these contracts or possible contracts in the second half. So 55 is probably a little high but I think the right number’s probably in the low 50’s.

Adam Fleck – Morningstar

Great, thanks for that.

John Leahy

You’re welcome.

Operator

A follow-up from Jim Ricchiuti, Needham & Company. Please go ahead.

Jim Ricchiuti – Needham & Company

Thanks. I’m just wondering, where does Japan rank in terms of your largest international markets? It might be helpful if you could just give us the top three or four international countries. And then if you did see any impact late in the month of March in Japan and what you might anticipate in Q2.

Colin M Angle

Well Japan is one of our top distributors, certainly in the top three. The other top distributors – France is one of them, actually Spain and Italy and Germany are also extremely strong for us. But relative to anxiety about the impact of the disaster of Japan on sales, it’s been interesting. The retail community in Japan is predicting a 15% negative impact based on the disaster there. From our perspective, much less than 10% of our retail locations where we sell Roomba were impacted. And we have seen very little impact in demand; in fact, perhaps based on the substantial amount of publicity that iRobot has gotten in Japan we’ve seen some strengthening of demand in Japan. So we have conservatively booked and incorporated into our guidance that we’ve given today an assumption of some softness in Japan. Obviously there is a lot more to play out in the year but right now we are guardedly optimistic. But it’ll be prudent to take those numbers down somewhat.

Jim Ricchiuti – Needham & Company

Okay, thanks. Great, thank you.

Colin M Angle

So that concludes our Q1 earnings call. We appreciate your support and look forward to talking with you again in July to discuss our Q2 results. Thank you.

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