iRobot: Anatomy Of A 'vSLAM'-Dunk Investment - Part I

Dec. 02, 2015 11:40 AM ETiRobot Corporation (IRBT)18 Comments
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Bumbershoot Holdings
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Summary

  • Multi-part article intended to provide a comprehensive overview of iRobot, the robotics industry, and the future of the "connected home".
  • Price target of $100/share based on a detailed sum-of-the-parts methodology. Anatomy of a "vSLAM-dunk" investment with 200%+ upside from current price levels and one of my fund's largest positions.
  • Part II - Focus on the Home Robot segment. Valuation of $60/share based on 8x adjusted EBITDA for the Roomba/Braava product lines for vacuuming and floor cleaning.
  • Part III - Overview of the SUGV market for the Defense segment. Part IV - Aware2.0, vSLAM, Paracosm and the implications on augmented reality, driverless cars, and the connected home.
  • Part V - Earnings growth, multiple expansion and the ability to compound capital. A gifted management team led by industry-pioneer Colin Angle, $210mm of net cash, and one enormous opportunity.

Author's Note: Anatomy of a vSLAM-Dunk Investment is a five-part series intended to provide a comprehensive overview of iRobot, the robotics industry, and the future of the "connected home."

Before starting out on Part I, I'd like to first lay out the "bear" case.

I've seen it written that iRobot (NASDAQ:NASDAQ:IRBT) is a gimmicky consumer electronics company with a single successful product line. That the company's Roomba vacuum cleaner is the market leader in robotic floor cleaning, but that it is likely to face increasing competition from rival brands over the next few years. That the overall business is solidly profitable, but that the entire product category may prove to be a fad. That historically the company made most of its money from selling a small unmanned ground vehicle (SUGV) known as the PackBot to the U.S. military; and that these devices which were primarily used by counter-terrorism forces during the Iraq and Afghanistan wars to disarm/detonate IEDs are now in secular decline since the end of those campaigns. That the company's consolidated rate of growth has been underwhelming; that management has been a consistent seller of shares; and that the stock has underperformed the broader market by a relatively wide margin of nearly 50-70% over the past 5-10 years. That while the balance sheet provides investors with some form of downside protection, the negative trend is set in with growth continuing to slow and margin compression going forward.

And that's it. I lay bare to the negative case because from my vantage point it couldn't be further from the truth.

iRobot is a serious robotics company. It was founded in 1990 when an Aussie, a Brit, and an American left the MIT Artificial Intelligence Lab to set out on a journey of entrepreneurship. Armed with ideals and their respective specialties in electrical engineering, mechanical engineering and software design, they embarked on a mission to change the world... sorta. They just needed to figure out how first.

Similar to many of today's start-up "unicorns" (except without the funding or lofty price tag), iRobot was a company focused on making "cool stuff". It had some interesting technology, but no real business model. It was going to create large robots for inspecting nuclear power plants, and then tiny robots for cleaning plaque out of blood vessels. It contemplated selling movie rights for a robot space mission to the moon. Cycling through a host of failed business ideas, it seemed like the only thing iRobot was not set up to be was an overnight success.

But timing, perseverance, a low burn rate, and 12 years of hard work eventually paid off. This led to a major inflection point in 2002. This was when the company's tactical mobile robot known as the PackBot first joined with U.S. troops being deployed to Afghanistan in the aftermath of 9/11. On a brighter note, it was also the year the company launched its flagship consumer vacuum product known as the Roomba. It experienced a period of exponential growth in the years that followed, which culminated in filing a detailed Form S-1 in 2005 (another difference from today's unicorns) and going public through an IPO later that same year.

The company is now the "800-pound gorilla" in the robotics industry. It is still led by one of its original co-founders, CEO Colin Angle -- the American and the electrical engineer for those playing along. And it now appears poised to hit a second inflection point.

With apologies to fans of Peter Lynch and baseball analogies, iRobot has the potential to be a slam-dunk investment. More specifically, a "vSLAM" dunk, a nod in reference to the company's important intellectual property for visual simultaneous localization and mapping (vSLAM) in the field of algorithmic mapping/navigation -- but I'll eventually get to all that.

Right now though, I just want to explore the anatomy of a winning investment. The ingredients that make a stock move significantly higher. It doesn't simply happen by accident. There are a variety of factors that need to come together to drive a stock higher.

"It is not supposed to be easy. Anyone who finds it easy is stupid."

- Charlie Munger

For an investment to really work, it needs to start off by being misunderstood by the majority of potential investors. It needs something obscuring results. To be a stone that was somehow left unturned, typically as a result of either complexity and/or investor neglect.

It needs to have growth. Earnings growth. A relatively sharp improvement in results or some type of inflection point. It needs a strong margin profile with inherent operating leverage.

And it needs to have growth. Real growth. A company needs the ability to scale and compound capital over a long period of time. It needs a quality management team and an untarnished capital allocation policy.

iRobot appears to have all of those key characteristics.

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To assess the level of misunderstanding, it can be important to start with the analysts. The company currently has 9 reputable sell-side firms covering the stock and I've reproduced the consensus estimates in the chart below. At the current share price of approximately $33/share, it trades at roughly 7x FY'17 EBITDA.

The average price target of those analysts is $37.50/share, which from a valuation perspective would imply an enterprise value (EV) of approximately $950m. At the target, this would be an additional 1x turn of multiple at about 8x FY'17 EBITDA.

iRobot -- Implied Valuation

To the extent then that the analysts are right, shares would appear inexpensive. After all, both revenue and earnings are forecasted to grow at 10-15% over the next few years. But stocks can also become "cheap for a reason" -- a phenomenon I touched on in my last article about the "two sweetest words" to shareholders of Chicago Bridge & Iron (NYSE:CBI). The reason here would be the "bear case" laid out at the beginning... essentially just whether the entire market for robotic vacuums is a fad. No investor in their right mind would pay a multiple if that were the case; and people clearly are not believers in the long term growth story.

The analysts could be wrong the other way too, though. In particular, analysts may be being too conservative with respect to margin expansion. While consensus calls for solid revenue growth of about 12% per year through FY'17, it holds consolidated gross margin essentially flat at 47%. The Home Robot segment is expected to be the prime driver of growth going forward. Given that this business has already generated gross margin of 52% year to date - nearly 500bps above the consolidated average -- this forecast appears somewhat at odds with current results. Furthermore, year-to-date results were largely accomplished prior to the release of the new Roomba 980, which is expected to be additive to margin. At higher revenue levels, the business should also see increased benefits from economies of scale over time. And beyond just boosting gross margin, this should also help operating margins through fixed-cost leverage. This is particularly notable when considering the composition of SG&A expense -- sales & marketing, advertising, customer service, professional services, IT, and unallocated executive compensation -- each category has a component of "discretionary" spending which should not increase in lock-step with revenue. Consensus estimates are also applying a relatively high effective tax rate of 33%+ going forward, which is significantly above what the company recorded in prior years when it was able to take advantage of Federal R&D tax credits. Estimates also do not appear to have contemplated any progress on share repurchases from the company's $50m buyback which was re-authorized in May 2015.

With higher estimates and/or a modestly more aggressive multiple, it is easy to push for a higher price target of $40, $45, or even $50/share. But irrespective of the numbers, I believe that analysts and investors are missing the bigger picture. I am looking at the stock through an entirely different prism based on a sum-of-the-parts analysis.

Using that methodology leads to an internal target of $100/share, based on an EV of approximately $3bn. This would represent 200% upside from current trading levels and is approximately 160% higher than the average sell-side target.

The rest of this article -- Part II, Part III, Part IV, Part V -- is intended to cover how I'm looking at the various aspects of the company and how it may differ from the consensus view. Investors can decide on their own if it makes sense and whether they should making be similar adjustments.

-- -- -- -- --

Part II -- Home Robot

Part II of the article will focus on the Home Robot segment in more depth. I've modeled this business to a value of $60/share, based entirely on the existing Roomba & Braava product lines.

It breaks down into three components with $24/share coming from the "current" business based on a "consensus" view of 2.2m-2.5m units at an ASP of $250-300 -- leading to a revenue assumption of approx. $650m+ for the blended FY'16/FY'17. Absorbing all of the company's corporate expense and R&D costs, it implies EBITDA of approx. $90m based on margin of 13-15%. The target value reflects a multiple of 8x EBITDA based on an EV of $720m and 30m shares FD. It also includes $50m of the company's cash as "working capital" with no additional benefit.

It has an incremental $21/share value from "adjusted growth" based on a moderately more aggressive adoption trajectory of about 3m units at an ASP of $325 per device. This would drive revenue of $1bn and segment EBITDA of $175m at a 17.5% margin. I personally see EBITDA margins eclipsing 25% at that level of sales based on incremental operating leverage, however I've taken the company at its word with the 17.5% representing the midpoint of management's publicly articulated long-term goal for 15-20% margins.

There is an additional $15/share value based on an "R&D transfer" which reallocates $50mE of the company's research and development costs using a 10%/90% split to the Defense segment and its intellectual property (IP) portfolio. This would effectively increase EBITDA at the forecasted level of sales to $225m on an adjusted basis. With a multiple of 8x EBITDA, the total EV of $1.8bn represents an incremental $15/share over the "adjusted growth" view.

From an earnings perspective, it implies adjusted earnings power of $4.50-5.00/share. At an aggregate price of $60/share for the segment, that would represent a relatively modest multiple of 12x-13x EPS. This is based on D&A of $25m, a tax rate of 30% and a FD sharecount of 30m.

As noted above, this valuation is entirely based on the Roomba & Braava product lines for vacuuming and floor cleaning. It assumes no expected value for the existing versions of the Scooba product line for the scrubbing/mopping applications, the Mirra (formerly Verro) product line for pool cleaning and the Looj product for gutter debris removal. It also builds in no expected value for the announced, but not yet launched lawn mower product line. This is despite recent approval from the FCC for a waiver on fixed RF infrastructure and the sizable long-term opportunity in that $35bn+ market which was discussed in more detail as part of the company's Investor Day held in mid-November. Similarly, it includes no expectations for telepresence robots or "home butlers" or any other type of unannounced product category.

These numbers are not far-fetched.

Consider that the company shipped approximately 2.2m Home Robot units in FY'14 and that the volume CAGR averaged 16%+ over the past three years. Even at a slightly lower pace of 10-15% going forward, it would be on track to hit 4m units by the end of the decade. And I actually see the business accelerating in the next few years. I think the company is poised to hit a second inflection point where unit growth could be in excess of 25%. The Roomba business is a pure growth story and there is no obvious reason it could not reach 5m-10m units by the end of the decade.

Those figures would constitute approximately 5-10% of global market share by volume; and roughly 15% of the global market by revenue based on a total consumer spend of approximately $20bnE annually.

I plan to walk through these financial assumptions in significantly more detail in Part II of the article. I will also evaluate the competitive dynamic of the vacuum market in terms of both product type and brands. Product type mostly relates to the bifurcation of growth rates for upright/canister/stick vacuums vs. cordless handhelds and robotic cleaners. Evaluating the market by brand I will look at various companies such as Dyson, Neato, Samsung, etc. I also plan to evaluate the long-term value potential from the company's addressable adjacencies in wet-clean and outdoor products. I have not assumed any value from these markets as part of the segment's $60/share target, but this in no way should signify that they are worthless.

-- -- -- -- --

Part III -- Defense & Security

Part III will concentrate on the Defense & Security segment which represents $5/share of the sum-of-the-parts analysis. Notably, this only reflects participation in the small unmanned ground vehicle (SUGV) market as prescribed by the company at its recent Investor Day. This is based on an EV of $150mm, reflecting a multiple of sales in the 2x-3x range. Valuation multiples based on short-term earnings performance may not be an accurate gauge of the value of the business.

The valuation does not incorporate any participation (revenue or expense) in any of the other potentially addressable unmanned/autonomous/robotic markets for large ground vehicles/tanks, unmanned aerial vehicles (UAV) (more commonly known as drones), or unmanned underwater vehicles (UUV), including remote (ROV) vehicles, autonomous vehicles (AUV), and autonomous systems such as sonobuoys. The company had previously done some work in the unmanned underwater market, primarily through its 2008 acquisition of Nekton Research, but it has since been suspended.

Since it is timely, I should also note that I strongly disagree with activist investor Red Mountain's suggestion that the company abandon its commitment to the U.S. military. While I support some of the proposals presented by Red Mountain in their open letter to management, I think de-emphasizing the business as prescribed by the company is the proper course of action. I view this business as an incredibly valuable long-term asset, somewhat irrespective of the moderate earnings drag in the near term. Unfortunately, I don't own $60m worth of stock though, so my view isn't particularly meaningful in that respect. I am interested to see who Red Mountain ends up nominating for Board seats at the next annual meeting and if over time they change their tune on a complete disbanding of the Defense business.

Some of the value from the Defense business is through shared technology development. To become a leader in the connected home, augmented reality, driverless cars, etc. it will likely take some joint development of advanced technologies in conjunction with the Department of Defense. This has proved to be a benefit to the company in the past. For example, the mine hunting technique used as the coverage algorithm in legacy versions of the Roomba never would have been possible without the company's previous work in the Defense sector.

I also have confidence in management and CEO Colin Angle in particular to make the right decisions for long-term shareholders -- a view which does not appear to be shared by Red Mountain. By taking steps to "de-emphasize" the Defense business, it implies that the company will exclusively focus on its niche within small unmanned ground vehicle (SUGV) market. This should curb a significant portion of the earnings drag, while ultimately retaining the tremendous long-term opportunity within the Defense sector for that specific market. It has already taken steps to do this through the elimination of its work on the Seaglider, etc.

Investors need to keep in mind that the SUGV business has high barriers to entry and the potential to generate substantial cash flow in the future. The market resembles an oligopoly with competitors Northrop Grumman (NYSE:NOC) and QinetiQ (LSE:QQ). iRobot has maintained the lead dog position, which is something it should be wary to relinquish -- particularly since unmanned systems are expected to play a major role in the Combat Vehicle Modernization Strategy, regardless of whether the country becomes involved in another conflict.

All information pertaining to the Defense & Security segment, including financial model assumptions and valuation, will be reviewed in detail within Part III.

-- -- -- -- --

Part IV -- Intellectual Property

Part IV focuses on the company's intellectual property and patents. I've estimated a value of $35/share, equating to an EV of $1bn. This group primarily includes the company's robotic framework known as Aware 2.0, as well as its patents and process knowledge of navigation and mapping algorithms (vSLAM). It also includes the company's minority investment in Paracosm, which is focused on enabling robotic perception through the creation of a 3D reconstruction model.

As a valuation exercise, I looked at the "emerging technology" group as a standalone entity. While I did not allocate any of the company's corporate overhead to the group, I am having it absorb approximately $45m of annual R&D expense as part of the "R&D Transfer" from the Home Robot segment. For purposes of this exercise, it would be "pre-revenue" and have a cash burn rate of a similar or greater magnitude. Reallocating $100m-150m of the company's net cash to the division for working capital purposes would therefore provide 2-3 years of funding absent the corporate umbrella. However, I want to be clear that this is simply an exercise for valuation purposes as a sum-of-parts; and I would not advocate separating this division from the Home Robot segment.

All of these financial assumptions will be covered in more detail in Part IV of the article. I plan to conduct a deep dive of the company's Aware 2.0 robotic framework vs. robot operating system (ROS). I will also address the strategic landscape of companies vying to become part of the platform for the connected home -- which could make iRobot an attractive takeover candidate. This would include major technology players such as Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) - both of which have already shown a significant interest in 3D mapping and augmented reality through acquisitions of companies such as PrimeSense, Mataio, MagicLeap, and DeepMind. It also includes other technology leaders such as Microsoft, Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Comcast, etc. that are vying for the platform. I also plan to evaluate some of the strategic "minors" such as Control4 (NASDAQ:CTRL), Universal Electronics (NASDAQ:UEIC), Rovi (NASDAQ:ROVI), and Nuance (NASDAQ:NUAN) that may have essential technology capabilities or control standards which could be incorporated into a winning platform.

-- -- -- -- --

Part V -- Capital Allocation & Multiple Expansion

Lastly, Part V will conclude with a recap of the investment thesis. It will take a closer look at the dynamics that lead to multiple expansion. And I hope to dig deeper on the company's management, balance sheet, cash flow generation, and capital allocation.

Thank you for taking the time to read through Part I of this article. I hope you enjoyed the introduction and I look forward to sharing the other parts in the coming weeks.

This article was written by

Bumbershoot Holdings profile picture
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Bumbershoot Holdings L.P. is a private investment partnership launched in Oct-2015.The partnership uses a fundamental investment strategy as a “quality over quantity” approach to identifying and evaluating great businesses. It primarily invests in small- and mid- capitalization public companies which are headquartered in the U.S. and listed on a domestic exchange. It maintains a relatively concentrated portfolio with approximately 60%-75% of assets in its top-15 holdings. The partnership utilizes low levels of leverage and hedges net long exposure through various short positions and equity derivatives, as dictated by overall market conditions.
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Disclosure: I am/we are long IRBT, AAPL, CBI, UEIC, CTRL, ROVI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am/we are also long QQ.L. I am/we are also short NUAN, FB. I previously covered Universal Electronics (UEIC) as a sell-side analyst from Jul-2010 to Jul-2015.

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