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iRobot Corporation (NASDAQ:IRBT)

Acquisition of Evolution Robotics Call

September 18, 2012 8:30 am ET

Executives

Elise Caffrey – Investor Relations

Colin M. Angle – Chairman and Chief Executive Officer

John J. Leahy – Executive Vice President, Chief Financial Officer, Principal Accounting Officer and Treasurer

Analysts

Jim A. Ricchiuti – Needham & Co. LLC

Adam Fleck – Morningstar Research

Paul Coster – JPMorgan

Brian W. Ruttenbur – CRT Capital Group LLC

Scott H. Miller – Thompson, Siegel & Walmsley LLC

Operator

Good day everyone, and welcome to the iRobot Investor Conference Call. This call is being recorded. At this time for opening remarks and introduction’s, I'd like to turn the call over to Elise Caffrey of iRobot Investor Relations. Please go ahead.

Elise P. 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 Provisions 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 disclose non-GAAP financial measures as defined by SEC Regulation G, including adjusted EPS impact, which we define as earnings per share impact excluding amortization, merger and acquisition expenses, ASC805 inventory markup and stock compensation.

I’ll now turn the call over to Colin Angle, iRobot Chairman and CEO for a brief discussion of iRobot’s acquisition of Evolution Robotics. Then we’ll open the call for questions with Colin and John Leahy, Chief Financial Officer.

Colin M. Angle

Good morning and thank you for joining us. As you know, last night we announced that we had signed a definitive agreement to acquire Evolution Robotics, Inc., developer of Mint and Mint Plus automatic floor cleaning robot. Evolution Robotics operates in a business which we understand very well. Its products, customers and channels are adjacent and complementary to our floor care business. And we look at the potential for the combined entity with our resources and brand. Mint and Mint Plus offer different approaches to cleaning hard floor surfaces at lower market entry price points than iRobot’s products. There's a tremendous opportunity for us to take Evolution's products into overseas markets, first to Europe and then Japan.

This acquisition expands iRobot's technology leadership through a combination of intellectual property, engineering talent, and new products that will broaden iRobot's global portfolio of practical robot solutions. Specifically, Evolution brings visual navigation and simultaneous localization and mapping technology that can be deployed in future iRobot products to deliver greater customer value.

With iRobot developed technology plus that acquired through Evolution and license from InTouch Health, we've built a formidable robotic IP portfolio that further widens our competitive mount. With this transaction we're gaining a world class Chief Technology Officer; Paolo Pirjanian, Evolution Robotics, CEO, who will join iRobot as CTO. This team of robotic engineers will augment our existing engineering talent. And by maintaining capacity in the California office, we expand our West Coast presence, which will also give us access to new perspective employees.

From a financial perspective, we're paying $74 million in cash, by take two adjustments. We're also acquiring approximately $6 million of net operating losses, which will reduce the net cash outlay to $68 million or about three times 2013 revenue. We will integrate Evolution Robotics over the next 12 months and expect the transaction to be accretive on a non-GAAP basis in Q4 of 2013, while fully realizing the benefits in 2014.

In summary, I’m very excited about the opportunities for expanding our global robotics floor care footprint and incorporating the technology that this acquisition provides us.

With that, we’ll take your questions.

Question-and-Answer Session

Operator

Thank you. We’ll now begin the question-and-answer session. (Operator Instructions) And our first question comes from Jim Ricchiuti from Needham & Company. Please go ahead.

Jim A. Ricchiuti – Needham & Co. LLC

Hey, good morning. Just some questions on the revenues for ER, from published reports it appeared that they had – been doing about $20 million of revenue in 2011. Is that in the ballpark and does that imply some slowing in their growth rate, they had been growing pretty rapidly, so I wonder if you can comment first on that?

Colin M. Angle

So that we believe that Evolution will do 2012 revenue in the ballpark of 2011 revenue based on a maturation of their retail strategy and we see significant growth opportunities in North America and internationally on a go forward basis, based on the synergies and putting the iRobot’s resources behind their product line. Their same store sales are up significantly 2011 to 2012. So that there is very good evidence of growth in the North American marketplace in their key accounts.

Jim A. Ricchiuti – Needham & Co. LLC

Got it. And within the U.S. retail channel where there is the overlap I guess about roughly 65% overlap, I guess overlap. Colin can you comment about that other 35%, is that a meaningful part of their revenues? And by the day, is the revenue all coming from the consumer business for them?

Colin M. Angle

Yes. I mean the vast majority of the revenue is coming from their consumer operations. Some of that 35% represents channels that we have explored and decided are not the right types of channels for robot floor care. They needed to learn some of those lessons on their own. And some of that 35% could represent opportunities for channels that iRobot maybe interest in going back to, but the 65% overlap with us represents retailers with a long-term commitment to floor care robotics. And we see again, we are in a number of different retailers in North America that they are not in and there are opportunities for growth in indoors through bringing them into our channel.

Jim A. Ricchiuti – Needham & Co. LLC

Got it. And just a question on gross margins, can you talk a little bit about the near-term, intermediate term outlook for U.S. gross margins, of course they are using two contract manufacturers, clearly they’re going to benefit from your supply-chain capabilities and scale. Can you talk a little bit about that?

Colin M. Angle

Yeah, Jim I think clearly we will look to overtime, take some class out of what was then ERs business model particularly as you point it to in the cost of goods area. So we think there is good opportunity for savings and components, largely through a combined purchasing power that we now have. And also we will evaluate the CMs that they utilize in China, which are different companies than we use and we’ll look for economies to scale there. So we think, their gross margins typically have won about 30% of revenue and as you well know that's well below where our consumer businesses run. So we think there is pretty good sized headroom there for margin expansion.

Jim A. Ricchiuti – Needham & Co. LLC

Got it. Thanks. I’ll jump back in the queue.

Operator

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

Adam Fleck – Morningstar Research

Hi, thanks good morning.

Colin M. Angle

Good morning.

Adam Fleck – Morningstar Research

A quick question. Colin, you mentioned you believe now iRobot has now built up a formidable IT portfolio. Can you help us, give us some details on Evolution’s patent portfolio as far as its robustness and maybe the timing of some of their larger explorations?

Colin M. Angle

So Evolution has 31 U.S. patents, 24 pending, and 15 international patents with 18 pending. From a numeric basis, the patents that we are – think are most valuable has to do with some pretty fundamental work in Visual Simultaneous Localization and Mapping or VSLM. They we early pioneers in the development and reduction to practice of this type of technology, which we believe is emerging as the most compelling methodology for low cost navigation for robots of all scales, both indoor and outdoor. So this is some really important stuff and as they – we combine the acquisition of that IP with the organically developed IP at iRobot. And the IP that we licensed from InTouch last year and from remote presence to navigation, we’ve got a very powerful IP portfolio which will matter in creeping in an increasing fashion, as the industry continues to grow in economic power and value.

Adam Fleck – Morningstar Research

Okay great, thanks. And then just one more from me. It looks like the biggest potential area of immediate path overlap maybe in you Scooba business. Can you maybe talk about how you think about the strategy there?

Colin M. Angle

Well, the Scooba business I would say is not particularly overlapping today. There is the wet functionality of the Mint Plus, but that is a very different function from what Scooba were more actively putting down water and scrubbing and backing up the water. So it’s a different type of cleaning solution. So we don’t see those as particularly overlapping at this point, really we’ve got vacuuming for scrubbing and now wet and dry for sweeping, which have their own independent customer sets. And so we see this very complementary and not as cannibalizing one business or the other.

Adam Fleck – Morningstar Research

Okay, great, well thanks.

Colin M. Angle

You bet.

Operator

Our next question comes from Paul Coster from JPMorgan. Please go ahead.

Paul Coster – JPMorgan

Yeah, first question, Colin, what’s the strategy if there is one, around the brand, for that name?

Colin M. Angle

So for the first six months to nine months, we’re not going to change anything, certainly long-term. The Evolution brand will be faced out in favor of the iRobot brand. We have not made any final decisions beyond that relative to the rest of the product branding perspective, but there will be iRobot products within a year.

Paul Coster – JPMorgan

Okay. Today there is an 8-K issued by the company announcing that Joseph Dyer is retiring and you’re now bringing in a new CTO and it seems to kind of increasing your strength – well, its definitely increasing the strength of the company in the floor cleaning space, does this mark a shift in the strategy and the change in personnel is related to that?

Colin M. Angle

It does not indicate a shift in strategy. The announcement of Joe is basically a long discussed career move for Joe. He’s been looking to retire for well over a year and bringing in Paolo as our Chief Technology Officer creates the opportunity to make that very logical transition.

The defense versus consumer mix, as you know, market conditions have driven a change in the revenue contribution to the company relatively significantly this year, but we are still very committed to the defense side of the business. We believe we are positioned extremely well for what we believe is a long-term growth opportunity for the business. Our commitment to our investors is to ensure that the defense business unit does materially contribute to the company’s performance, as well as the consumer side of the business. So there certainly is some shifting of resources from defense into other areas of the business to ensure that defense can perform financially.

What we saw here with the Evolution acquisition was just a fantastic fit. So more of a – so less strategy shift, more here as a company, which we understand very well, which has excellent product and technology, which put through our channel and our logistical capabilities could be made to radically improve it’s profitability and radically accelerate it’s growth making it a real opportunity for iRobot.

Paul Coster – JPMorgan

Okay. Thank you very much.

Operator

Our next question comes from Brian Ruttenbur from CRT Capital. Please go ahead.

Brian W. Ruttenbur – CRT Capital Group LLC

Thanks very much. Going along the lines of – was asked earlier about gross margins. Just to understand it. In the fourth quarter, you expect 30% growth margins from this acquisition and then when do you see the margins drifting up? Is it going to take a year that we should just model it at 30% or do you see margins slowly drifting up quarter-to-quarter?

Colin M. Angle

Brian, I – we can’t get into much detail at this point on the quarters, but the way you should think about it is, it probably will take us at least six months to be able to realize some benefits from the work that we’ve really already started in terms of evaluating their components, their component suppliers, their CMs, but as you, it takes time to work that through from a negotiating standpoint and if we were to make changes in suppliers that will take some time to work it’s way through the system as well. So it will be at least six months and realistically closer to nine before we start to realize benefits that will impact cost of goods.

Brian W. Ruttenbur – CRT Capital Group LLC

Okay. And then on D&A, how much will your D&A go up in the fourth quarter?

Colin M. Angle

Well, right now, we’ve only done a preliminary cut at the purchase price accounting.

Brian W. Ruttenbur – CRT Capital Group LLC

Right.

Colin M. Angle

And even though, right now, it looks like amortization from the deal would be about $1.5 million in Q4 and that’s the way right now we’ve got that model to cross for the next several years. But that is preliminary; we have not completed the assessment with our third party provider.

Brian W. Ruttenbur – CRT Capital Group LLC

Okay. So – but that’s probably counting a partial quarter, or is that including it for the full quarter? I’m trying to figure out for 2013 kind of what if amortization goes up, should it be going up $6 million on the year?

Colin M. Angle

Yeah, but right now that is for the full quarter and so that would be – our current thinking would be that’s the right number for full year about $6 million. So like I said, that could move up or down as we complete the analysis, but that’s a full Q4 number.

One other thing I want to point out that’s happening in Q4, you might have just noticed in the data sheet, due to accounting guidance, we have to mark up the value of the inventory that we are acquiring to fair market value, which basically means, we get almost zero gross margin on the existing inventory.

We are expecting right now that we’ll flush itself out completely in Q4, but that is contingent to sales volume. And that as well is worth about $1.5 million negative in Q4 and that will hit in the gross margin line in Q4. So that 30% or so that I mentioned earlier what ER typically runs at, that will not be the case in Q4. Q4 will be an anomaly with the accounting of inventory.

Brian W. Ruttenbur – CRT Capital Group LLC

Okay. And I assume that sales and marketing line won’t change a whole lot with this acquisition, but the G&A and R&D line will go up some?

Colin M. Angle

Well, it’s a little early to say, we still at the former plans. But we do think that there may be efficiencies in the selling model just as we role ERs activities into our iRobot. And as well in terms of marketing spend; we’ve doing due diligence accessing the marketing spend and our view of its efficiency, and so there maybe some opportunities over time. But I think what you are seeing with the financial projections we’ve given is that we are being very cautious in the early days, the first few quarters to make sure that we protect the business, we protect the revenue and the customer relationships. In over the course of the next year or so we attack COGS as well as other operating expense opportunities.

Brian W. Ruttenbur – CRT Capital Group LLC

Fine. And then last question, is – just from the face of it, from looking at the website and looking at the – this appears to be kind of a lower end product, is your plan to keep it at that price point that it currently is roughly 50%, I’m rounding here, of your traditional iRobot products? You were – you had lower, two years ago you abandoned some lower end products and it appears that you are getting back into some lower end products, is that, you find a space in the market that needs to be filled on that lower end, is that why you are making this acquisition, part of it?

Colin M. Angle

Well, I think that this acquisition does allow us to have very high quality product at some lower price points by embracing the sweeper category. And so that, yes, I think that there are consumers out there that are looking, our fans of sweeping as the preferred method of cleaning their floors and as apposed to the vacuum filled household to have a lot of hard floor, are typically used to using the electrostatic [claw] sweepers. And so that – this is a very elegant and high quality methodology of robotically performing that task, because you don’t carry the cost of a vacuum around with you, we are able to deliver that functionality at lower price points than the vacuum cleaning line. So again, we this is a really very synergistic opportunity that we’ll – that performs well, adjacent to the vacuum – the robot vacuum offerings that we have today, complementary and offering a lower entry into the iRobot franchise.

Brian W. Ruttenbur – CRT Capital Group LLC

Great. Thank you very much.

Colin M. Angle

You bet.

Operator

Our next question comes from [Frederick Wu] from (inaudible) Research. Please go ahead.

Unidentified Analyst

Hi, guys, good morning.

Colin M. Angle

Good morning.

Unidentified Analyst

I just want to clarify the IP count. Can you guys repeat that very quickly?

Colin M. Angle

Sure. So through this acquisition, iRobot is acquiring 31 issued U.S. patents, 24 pending U.S. patents, 15 international issued patents, and 18 pending international patents.

Unidentified Analyst

Got it. Thanks. Second question is, I know you guys talked about the complementary nature of the two – the two part of the Mint as well as the Scooba, but moving forward at full run rate, do you guys envision, I guess both products to sort of line up against each other on the isles or do you guys foresee maybe a shift in the design, maybe from Scooba right now, it has a circular design to a Mint, where it has more of a square design. What do you guys envision the long run, I guess relationship between the two is on the shelves?

Colin M. Angle

Okay. Well, our experience today is wherever iRobot is sold, next to Mint, our sales have increased most significantly.

So we definitely believe that a strategy where we’re able to merchandize a larger product assortment in retail is a good place to be. It provides more visual impact and credibility at the store front, and so we will certainly be pursuing a strategy whereby we had a broadened assortment at retail as our – as the buyers at retail will allow. And the performance of both Roomba and Mint are for many retailers have allowed them to expand the robot cleaning category. That’s a good thing. If you think about the square versus round question, really the function of the robot dictates the shape of the robot and their advantages to both shapes in sweeping. The square shape does have a clear advantage over the round shape which is why Evolution went down that particular path. And so, yes, we will maintain the square shape for our sweeping robots.

Unidentified Analyst

Got it. I just wanted to clarify, you guys talked about 30% gross margin. That’s from ER’s business right, or you guys are thinking that would be the run rate for you guys as well for the next couple of quarters?

Colin M. Angle

No, that is historical run rate for ER.

Unidentified Analyst

Right.

Colin M. Angle

And I’m sorry, as I said to the previous sort of questions, for the next few quarters we’ll pretty much run at the rate they have been running until we can start to achieve some cost of good savings with the exception being in Q4 of this year where we have the accounting for the inventory that we have to deal with.

Unidentified Analyst

Okay.

Colin M. Angle

But certainly our intention by the end of next year to a significantly improved gross margins and then going into 2014, we see other opportunities for improved gross margins. Our model of a mid to high 40% margins over time is our target for these products as well.

Unidentified Analyst

Okay. Thanks. That’s all I have.

Colin M. Angle

Okay.

Operator

Our next question comes from Scott Miller from TSW. Please go ahead.

Scott H. Miller – Thompson, Siegel & Walmsley LLC

Hi, good morning. I was wondering if our Mint robots currently being sold or to what extent are being sold in the mass channel?

Colin M. Angle

They are absolutely being sold in the mass channel, Bed Bath & Beyond being the largest retailer of Mint robots, also they were sold at [COVs] and sold at Amazon and I think there is some distribution target as well.

Scott H. Miller – Thompson, Siegel & Walmsley LLC

Okay. And then what is the expected timeframe of getting Mint robots placed in some of the retail accounts where iRobot has historically had a presence and they haven’t?

Colin M. Angle

If that’s going to be something that is actively worked, I’m reluctant to give you an exact timeframe certainly. You should assume that, there will be expanded North American distribution in 2013 and because we are going into a time when the purchase plans for the fourth quarter retailer have already been set. So we don’t expect to see significant changes in the merchandizing of the products through the balance of this year.

In 2013, we have planned to bring the Mint product line into Europe and already see some demand from our European distributor for the product as a result of the announcement yesterday. So we think that’s a – we have a very strong demand signal and it will be a question of getting out the infrastructure prepared and the training done in order to support an appropriate launch there.

Scott H. Miller – Thompson, Siegel & Walmsley LLC

Okay, great, thank you.

Operator

Your next question comes from Jim Ricchiuti from Needham & Company. Please go ahead.

Jim A. Ricchiuti – Needham & Co. LLC

On – more of the longer term question, what I was struck by is, kind of the shared vision that you and Paolo seem to have in terms of where this technology might go into adjacent markets, in the commercial market and then even looking further out into areas that you've talked about in the home. To what extent does this technology perhaps accelerate that transition and that process?

Colin M. Angle

I think it absolutely does accelerate our ability to field robust navigation at low prices. So that we’ve been now having navigating robots at iRobot for quite some time, they are based on more expensive competitional footprints on our robots. So this allows us to rapidly consider and evaluate products that require navigation in a lower cost fashion. We also are, from an IP perspective ensuring our right to play using this visual SLAM technology, which we think is the leading go forward candidate long-term for navigation systems. So you put those two together and you think about where value is going to be derived from the robot industry for the next few decades, it’s going to be our ability to deliver a mobility solution into the market place that can map, that can avoid obstacles, that can navigate at price points that make the applications they serve very profitable and viable.

Jim A. Ricchiuti – Needham & Co. LLC

Okay, thanks a lot.

Colin M. Angle

You bet.

Operator

And we have no further questions at this time.

Colin M. Angle

Okay. So in closing, we view this acquisition of Evolution Robotics as a complete home run. We understand the business they are in, extremely well. We are very excited at the opportunity to take their very impressive product line internationally into markets, and thus provide an opportunity for significant growth. That concludes our call. Thank you for you continued interest in iRobot and we look forward to speaking with you in October to discuss our third quarter financial results. Thank you.

Operator

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.

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