iRobot - Time Arbitrage
Summary
- Actions of investors concerned with the immediate term have outweighed that of those with a long horizon in the recent plunge of iRobot's share price.
- The future remains promising due to the company's strategy, expanded portfolio and potential role in the Smart Home.
- A possible exclusion from tariffs could reverse price movement.
- Valuation suggests a time arbitrage for exploitation.
One seeking to make sense of the recent price movement and discern the way ahead for iRobot’s (NASDAQ:IRBT) shares could perhaps look to the theories of Philip Zimbardo. Probably better known for the Stanford prison experiment, the psychologist also conjectures that every decision one makes is governed by his internal time perspective.
iRobot had two quarters that shaped up to be poorer than expected. It also has depressed guidance for the rest of the year due to the expanded tariffs to be imposed in September. This certainly justifies a correction from prices at which high expectations that will no longer be met was baked in. Yet, the same pricing efficiency does not extend beyond the immediate term. The company has enormous potential that is currently overlooked amidst the fear. More than just a distant uncertainty, some of iRobot’s promise is on the cusp of being realised while the company’s strategy continues to augur well for what could come after. Viewed through the lens of Zimbardo’s theory, the actions of present-oriented investors could be said to have outweighed that of the future-oriented. In this piece, I examine iRobot as an investment after the precipitous correction.
Business Geniuses and Tech Futurists
iRobot lauds its Roomba S9 as the world’s best robotic vacuum cleaner. Equipped with multiple proprietary features such as the Imprint TM Smart Mapping Technology and Clean Base TM automatic dirt disposal, it is the latest in their line of Robotic Vacuum Cleaners (RVC) that have allowed them to gain the majority of market share in every region other than China. Yet I would contend that these features are but the slightest of their competitive advantage. In a field where cutting edge quickly becomes run-of-the-mill and the most advanced remains but for awhile, iRobot’s greatest treasures are its talent and the environment that it has established.
At the core of iRobot’s strategy is talent recruitment and retention. The company is the founder and creator of the national robotics week. As a global leader in robotics technology, iRobot considers its corporate social responsibility to be supporting STEM education in schools and to ignite passion for a career in this field. Its Create 2 and the recent acquisition of Roots robotics are but some of its program on top of internship and mentoring to enable that. What this has done is to create goodwill and a reputation for iRobot as the developer of talents in attracting human capital and to sow the seeds for future cohorts of talents to join them.
This has born fruits. The company’s “Tech Futurists” have delivered a rapidly expanding portfolio of both international and U.S patents. Where this were infringed, iRobot had also proactively defended its intellectual property through litigation from the likes of Hoovers and Black & Decker. Its “Business Geniuses” have also deftly diversified its supply chain to Malaysia in preparing to mitigate the impending tariffs. They company had also forward integrated with distributors Robopolis and SDOC to drive growth in Europe and Japan respectively.
This, rather than transient proprietary features, could enable iRobot to stay ahead of its competitors by setting itself up to develop best-in-class technology and manoeuvre speed bumps for years to come.
The Price is Right
A common retort of bears has been the prices of iRobot’s products. When close substitutes are available at starkly lower prices, it is sensible to expect consumers to flock to the cheaper alternatives. Indeed, the growth of the “discount” segment has been higher than that of the premium in much of the world. Yet, where the former segment has been around longer, its growth has decelerated. This has been explained by the fact that innovative features matter to consumers. They hanker after the voice activated, spatially aware, self-emptying robot that can autonomously recharge and resume, and which also has 40 times the suction power of a typical RVC while not needing to be handled for up to a year.
A company that operates at the premium segment – where the barriers to entry is significantly higher, also earns a healthier margin which it can then plough back into developing even better products. This affords it a more desirable balance sheet which would not leave an investor “naked” when the proverbial tide goes out. In contrast, those that are dealing with the quickly commodified operate on meagre margins. They would likely find itself stuck in a rut and could have its continued existence called into question when buffeted by prolonged economic headwinds. Particularly if it is heavily financed by debt.
Tip of the Iceberg
Compelling or not, the viability of the premium RVC segment and iRobot’s dominance of it is ultimately still the tip of the ice-berg. iRobot has recently expanded its portfolio and will make available two other high-end robots for the household by the end of the year. The first of this is the Braava m6, a robotic mop with precision jet spray that can learn, map and adapt to a home. The m6 also boasts of the ability to collaborate with the Roomba in coordinating their cleaning schedules. The second, the Terra t7 lawn mower which operates on a wire-free boundary system will soon be launched in Germany and be made available under a beta program in the U.S. These diversifies the revenue stream for iRobot, opening up opportunities for multiple Roomba-esque revenue stream even as the company continues to remain dominant in the RVC segment.
Beyond targeted R&D spending in core areas that contribute significantly to its bottom-line, iRobot also allocates capital for the development of emerging and future technology that can enhance its growth. In addition, the company actively conducts acquisition and even has a venture capital arm with stakes in multiple related and promising start-ups.
For many years now, Colin Angle, the CEO of iRobot has espoused the value of spatial understanding in realizing the truly intelligent Smart Home. That is a dimension which its free-roaming and pervasive robots are uniquely positioned to map-out and bring to the table. Where an exponential number of devices are made connectable to the Smart Home each year, spatial understanding could mean the difference between having to individually program the multitude of devices or their autonomous operation in response to human behaviour. Angle had most recently made the case for that at Amazon’s re:Mars conference as the keynote speaker where he highlighted the synergy that such a feature would have with a voice recognition system in making a home truly intelligent. Although this cannot be directly monetized – consumers abhor the infringement of privacy for corporate profits – it multiplies the value that iRobot’s products bring and the premium that they can justifiably fetch. It is therefore fallacious to view iRobot as a typical RVC company.
Possible Exclusion of Tariffs
Many who are for the trade war sees as its impetus the protection of strategic American industries and intellectual property from theft and unfair competition by the Chinese. Tariffs on consumer robotics, a key dimension of such industries, runs contrary to the reasons behind its implementation by hurting U.S companies and putting them at a disadvantage with competitors. On this compelling basis, iRobot has made applications to be excluded from tariffs. While uncertain in success and the time that might take, any approval could conceivably reverse the exaggerated correction that recently took place.
Valuation
When share prices are halved in a span of 4 months, from the highs of $130 to close to $65 today, it would be natural for even the steeliest of investors to second-guess what might have been a well-deliberated move. Yet, colloquial wisdom and empirical evidence abound on fortunes lost when temperament yields to the vicissitudes of the market. A disciplined investor might therefore see it fit to derive an estimate of the intrinsic worth of iRobot to stay the course. Here I propose my valuation of the company.
Adjusted Operating Income
I first stitched together information from the company’s 10Q and 10K to derive the TTM financial data. I then adjusted operating income to arrive at a stable figure which could be used as a basis to project future cash flow. iRobot estimates 60% of its annual revenue to accrue from the second half of the year. As Amazon manoeuvres to mitigate the impact of the tariffs, much of this is expected to shift to 4Q, leaving only 20% of that to be earned in 3Q. This would lead to negative YoY growth for that quarter but is otherwise negligible in the complete view of things. I therefore did not make adjustments.
While the benefits of R&D is expected to accrue over several future periods, I decided not to capitalize and amortize that as the common-size income statement of iRobot reveals a consistent R&D spending as a proportion of revenue over the last several years. Not adjusting for this is therefore unlikely to lead to an under/overestimation of R&D expense and an unsuitable figure for use in projection. Even though SG&A has been creeping up as a percentage of revenue, I also did not adjust that as I expect the higher spending to persist due to the introduction of new products. However, I normalized the amortization of acquired intangibles and other operating income as they had been volatile without an obvious economic rationale.
(Source: Created by Author using company's 10K and 10Q)
Reinvestments
Likewise, with the stitched Balance Sheet and Statement of Cash flow, I derived the adjusted reinvestments of iRobot. Of note, I normalized capital expenditure while leaving depreciation and amortization untouched. They former has been fluctuating, likely due to the development of production facilities in Malaysia and the introduction of new products. I did not adjust the latter as it is already spread out over time. Further, I also normalized the net mergers, acquisition and divestiture costs as it has been highly irregular. While iRobot acquired Robopolis and SDOC in 2017 and Root Robotics in 2019, activities on this front was rather quiet in 2018.
(Source: Created by Author using company's 10K and 10Q)
Free Cash Flow
Revenue
iRobot's future revenue level is highly unpredictable due to the unknown price sensitivities of consumers to increased prices arising from the tariffs. Further, iRobot’s Braava and Terra lines of products are only recently introduced and their traction with consumers in the longer term cannot be determined with high accuracy. However, I believe that in uncertainty and difficulty lies opportunities, and ventured my estimates of what future revenue could be based on conservative estimates.
The CAGR of the global RVC segment has been estimated to be 18.6% (Market Study Report) up till 2024. However, this comprises both the premium and “discount” segment, with the former known to be comparatively lower. I therefore approximated the growth of the Roomba line of products to be 12%. iRobot expects the Braava series to grow at a rate of 20 – 25% annually, with its contribution to revenue in 2019 being <10%. Erring on the side of caution and using TTM data, I estimate these to be 22% and 8% respectively. With the Terra yet to be available, my shot in the dark estimate is for it be a conservative and negligible 3% of revenue in 2020.
Expenses, Taxes and Reinvestment
iRobot incurs expenses in the research and development of new products and innovative features, a dimension which it considers as its competitive advantage. While this would continue to increase in absolute dollar as the company maintains its edge, management expects the proportion of this as part of revenue to remain constant. With the introduction of multiple new products, management expects sales & marketing expenses to increase. However, like the former, this is expected to remain stable as a percentage of revenue. Another source of its expenses is the remuneration for personnel and litigation expenses. This is comparatively slight and is assumed to remain stable with time. I therefore used a constant 41% of revenue in the projection of operating expenses. I also assumed a constant tax and reinvestment rate for the company in arriving at the free cash flow to the firm.
(Source: Created by Author using company's 10K and 10Q)
Intrinsic Value
In projecting FCF beyond 2024, I used a terminal growth rate of 5%. While this is higher than the global GDP growth rate, iRobot’s products and the Smart Home revolution are but in their early innings. The estimated rate would also represent a significant deceleration from that last used. Cost of debt is estimated to be 0.5% plus the Fed fund rate, last reduced to 2.25% in July. Based on the parsimonious principal, I used my preferred CAPM model to estimate the cost of equity. These led me to arrive at an intrinsic value of $82 per share. This is significantly higher than the current price even as I had been conservative at every step.
(Source: Created by Author)
Sensitivity Analysis
The DCF is as subjective as the future is uncertain. I therefore carried out a simulation to observe how the share prices might change with variation in these estimates. In doing so, I bore in mind the likelihood of how the trade tensions and economy could go south by setting my earlier estimates as the upper bound. For instance, while I used 12% CAGR for Roomba in my base model, I allow this to fluctuate between 10 to 12% in the simulation.
I generated 5000 iterations of share prices and plotted the results below. With that and my earlier qualitative analysis, I conclude that there the actions of investors focused on the immediate term have outweighed that of those who adopt a long horizon, generating a time arbitrage for those belonging to the second category to exploit.
(Source: Created by Author)
14 years after his seminal experiment, another psychologist, Walter Mischel found that the children who did not eat that first marshmallow in his famous study went on to score significantly better in their SATs. Considering iRobot’s strategy and forays for the future, the likelihood seems to be that future-orientation and delayed gratification would pay.
Author's Note: Do follow me if you enjoyed my article. I respect my readers' time and will spare no effort in bringing my diligence to bear for each topic that I write on. I also do not mass produce articles and rehash news for the purpose of building up a following or earning revenue.
This article was written by
Disclosure: I am/we are long IRBT. 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.