iRobot's R&D Investments Could Go A Long Way

| About: iRobot Corporation (IRBT)

I’ve always been a fan of iRobot (NASDAQ:IRBT) as a consumer, but I’ve never been a big fan of its stock. When the company first went public, there was a lot of buzz, but I could never get past its razor thin margins. I knew that it was doing interesting things, but my interests were elsewhere, so I didn’t pay much attention to the company.

Having recently become an iRobot customer has made me more interested in finding out more about it, so when I saw that Helen Greiner, iRobot’s Co-Founder and Chairman, was presenting at a JP Morgan technology conference, I figured that it would be a good conference to listen in on.

I knew that iRobot was selling robots to the government, but I didn’t realize how much of its revenue was coming from its military contracts. Its revenue is split about 60% consumer products and 40% government and industrial robots. It hasn’t restricted its sales to just the U.S. market, so it has some decent international exposure. It sells its consumer robots in Japan, South Korea, Australia, as well as a number of other countries.

Since going public, it has introduced several new products including the Scooba and a pool cleaning robot. There is a strong seasonality to its business with most of its earnings' payload coming at the second half of the year. The company likes to build its robots internally, but hasn’t been afraid to partner when it’s advantageous. It's working with Boeing (NYSE:BA) on a new ground robot and has also been developing a 1,500 pound military robot with the help of John Deere.

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Much to investors' chagrin, iRobot has been investing a pretty good chunk of cash into research & development. In the past it has targeted 6-8% of revenues and this year has been running at 7%. Because of its military work, it also receives grants from the Government, that boost its R&D budget closer to 15%. The company’s continued commitment to R&D has been painful for shareholders in the short run, but the investment has gone a long way towards creating new products and speeding up the introduction of pipeline products to the market.

Greiner told investors that it had good visibility on its government orders and that 70% of its guidance was business that was already lined up. The consumer market is harder to predict, but with a 30% cushion, the numbers don’t seem all that hard to hit, especially with new products on the market. Management has disappointed investors in the past, but this may be a case where it has underpromised, so that it could make sure to over deliver.

Most of the conference was about boring financial stuff, but during the middle of the presentation, Greiner said that iRobot was introducing two new consumer robots to the market. She refused to divulge information about what they were, but the robots will be out in time for the holidays. Investors had apparently already heard this news, but it was the first time I had heard about new products and it made me wonder whether it would be something that I might find useful.

Greiner refused to play 20 questions about the new products, but she did drop hints and that only made me more curious. She said that it was not a talking robot and at a previous conference she told investors that it wasn’t a floor cleaning product. These are good hints to start with, but it still leaves too much out.

Oddly enough, while she was defining the potential markets that iRobot could go after, she did mention healthcare robots, as a possible growth area. I’m not sure how iRobot would go after the hospital market, but if it started making smarter robots that could take out your spleen instead of mopping your floor, it would open up large addressable markets for it.

During the Q&A session of the conference, I was pleased to hear one investor raise my concerns about gross margins. This investor told management point blank that

profit margins are a great barometer of healthy new emerging businesses and yet your profit margins do not look like they’re high enough to me. They don’t look like a lot of new emerging businesses often have looked and I wonder two things about your margins. Number 1, do you invest much of your R&D into production technology to lower costs the way Intel (NASDAQ:INTC) was known to do? What percentage of your R&D goes there and second, what do you think of your own profit margins, do you have objectives for those margins, is there anything you can do about them?

iRobot CFO, Geoff Clear, fielded the question and did a pretty good job of addressing this criticism of its business model. He outlined a plan to bring margins up to a point where investors could be more comfortable with them. In his response to the potential investor, Clear told him that the company tracks two different metrics in evaluating the business. It looks at revenue growth and pre-tax operating margins. Its margins have been steady, but not high over the last few years. The company thinks that it can start to increase operating margins as soon as the second half of this year. Eventually, it would like to get to a point where it can move from 2% operating margins to margins someplace in the mid teens. This would be a big accomplishment and would validate its business model.

To do this it needs to get its gross profits higher. Last year it was at 37%, but Clear felt that it needed to get to 40% to accomplish the growth that it's after. The company isn’t willing to cut R&D to enhance margins, but he did mention that there were other areas of the company, where it could improve operating margins.
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One of the highlights during the presentation was when JP Morgan Analyst Paul Costner started fishing for information on how receptive management would be to an outside company acquiring it. Normally, executives try and avoid answering these types of questions, because they only lead to rumors, but Greiner took the bait. She did say that it wanted to acquire other companies and grow the company independently, but was also very quick to point out that the UK defense company QinetiQ has recently had a large appetite for robots. She also suggested that the defense industry has always been interested in its technology.

With management being at least a little open to shopping the company, investors could see a takeover premium, if someone stepped in. If Boeing is not interested, I am sure that there are private equity shops that would love to take it private and then spin it off again. I wouldn’t bet on a takeover happening, but as an investor, it’s always nice when management is open to this sort of potential event.

Towards the end of the presentation, Costner asked Greiner why investors shouldn’t just skip iRobot’s growing pains now and jump in after it's more fully developed. She responded by defending the robot industry and told investors that the company is at a tipping point.

I cannot imagine a future world without robots and they’ve already been adopted. They’ve already been adopted by our armed forces and there is no going back and they have already been adopted by 2.5 million consumers across the country. This is a tremendous time for the robot industry. It really is at the tipping point now and I believe that the company is at a tipping point going into the back half of the year.

After listening to the call, I’m still not in love with its margins, but am more comfortable with its strategy for increasing the bottom line. I think that iRobot has tremendous brand value and a lot of flexibility over the markets that it can address. The military contracts should help to stabilize revenues, while it continues to reinvest in new product development. I’m not in love with the stock, but over the last two years, it is down 40%. With its market cap down to $390 million, this could be a value opportunity for the right investor.

Between its healthy queue of military orders and its $70 million in cash, iRobot looks cheap for a company that took in $180 million in sales last year. There is always the possibility that its stock could fall another 40%, but given the barriers of entry in its industry, I think that there would be companies willing to pay a premium to get access to its robot think tank. It has patents, it has engineers that specialize in advanced robots and it has developing revenue streams that will add diversification to the business. There is a lot that iRobot is doing right, even if it hasn’t translated into profits.

Overall, I’m not 100% enthusiastic about iRobot’s business model, but I do like its valuation. I don’t think that the robot revolution will happen overnight, but iRobot is leading the consumer component of it. There is always the possibility that its stock could go down further, but with 17% of the float short, I think that the markets have been too harsh is assessing iRobot’s prospects. Without knowing more about the company, it’s hard for me to get a sense of what I think the company should really be worth, but Greiner’s presentation was enough to get my attention and at least put iRobot onto my radar.

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