iRobot: A Case Of Political Games Hampering Innovation

Summary

• The demand for on-trend iRobot products remains strong, with continuing growth (albeit at a slightly slower pace).
• China trade wars are resulting in a temporary hit for the company as management seeks to find pro-active solutions.
• At current price/EBIT, the stock provides a compelling entry point, with reasonable potential for recovery back to median price/EBIT levels.

Shares in innovative robotic vacuum, mop and lawn-mower maker iRobot (NASDAQ:IRBT) took a tumble on Wednesday, following a pattern of increasing (but slowing) revenues. Sales came in 15% higher than the same period in the previous year at $260.2 million, but a few points below analysts’ expectations of $268 million. Operating income took a substantial dive, down almost 60% from the previous year quarter at $5.3 million.

Source: iRobot Company Website

Investors realize the company is still at the growth stage with significant, necessary investments in R&D to establish a strong foothold, and wide moat in a business which will grow globally in accordance with the consumer trends towards convenience and affordable home automation. So, from an investors’ perspective, R&D and Capex expenditure is a given, as long as this produces a long-term competitive edge, and effective return.

China Trade War Rears Its Ugly Head Once Again

This brings me to one of my key points in this article. While R&D/Capex spend is expected in businesses like iRobot (in fact for many investors, the more spent intelligently the better), what iRobot has suffered from in the last quarter drop in profits, is not entirely the effect of investing expenses. It is in fact, as the CEO Colin Angle put it:

the direct and indirect impacts of the ongoing U.S.-China trade war and the recently implemented 25% tariffs which are likely to constrain U.S. market segment growth in the second half of the year below our expectations at the start of 2019.

This, to investors is a bitter pill to swallow, at least all in one go, and the trigger which led to the Wednesday sell-off. The stock opened at $72.70, 23% below the Tuesday close (just before reporting). It then recovered slightly on an overall positive Wednesday in the markets (alongside most stocks), closing at $74.51. On Thursday, the stock (along with most U.S. markets, which were negative) dropped slightly to close at $73.27, at the time of writing this article.

The Fundamental Picture

As a company, iRobot is pressing ahead, with impressive trends, almost everything as it should be. Below, I have produced a quick chart which shows 3 years of trends in key fundamental metrics.

While the stock price has dropped since March 2019, it is clear this - as the CEO rightfully suggested - has little to do with the top-line numbers. The demand for iRobot products remains steadfast. The correction has to do with the impact of the recently imposed 25% tariffs, which has inevitably impacted gross margins (shown in blue in the chart below).

Source: Portfolio123

As a result of the margin drop, the free cash flow (shown in green) has effectively been impacted. But remember, iRobot has a large R&D spend, including Capex, which I have also presented (in orange), showing a continually increasing spend quarter-after-quarter over the past 3 years.

I am positive about iRobot stock, primarily because the management is being pro-active during this period of the Trump trade war "stone in their shoe."

Firstly, CEO Colin Angle indicated in the conference call that the company has formally requested an exclusion from the tariffs, stating:

We believe that our position to gain an exemption from the tariffs is compelling.

I am not holding my breath on the outcome of this, but it’s a start. At the least, it does put some pressure on politicians to find a resolution before too much damage is done.

In addition, steps are being taken by the management, albeit tentatively (all of this may be unnecessary if there is a resolution between China and the U.S.), to diversify iRobot's supply chain towards moving a part of manufacturing outside of China. As reported in a previous quarter, this diversification would begin with some of the less complicated components - part of the plan includes moving a line of robots to Malaysia, with manufacturing beginning by the year-end.

Naturally, these moves will inevitably result in higher (one-time) costs for the company, but as an investor, I would rather see capital employed towards improving gross margins over the long term, which this would do by alleviating the tariff issues so heavily impacting iRobot's GPM right now. This would all work out fine in the end, and return to healthy free cash flows, and profitability - unless of course Trump decides to start a trade-war with Malaysia. One never knows.

Is iRobot A Buy Right Now?

In my opinion, there is a bit of a sweet spot entry point for iRobot here, and the recent drop in the share price provides a bonus discount (and the fact that the stock caught my eye this week).

Numerous analysts follow this innovative company, as it continues to grow amidst challenges. Taken with a pinch of salt, the analysts' mean target price metric for iRobot is currently 107.83 (Source: FinViz), which is 47% above the last close.

Price/Operating Income Valuation

During times of smooth operations and relative optimism, which for iRobot comes around as surely as the sun will rise tomorrow, the Price/Operating Income multiple (also known as PRICE/EBIT, generally hovers around 35x (see below chart). This multiple was reached in August 2017, February 2018, September 2018, and as recently May 2018.

If we model a price target based on conservative assumptions that iRobot's operating income remains relatively flat while the China trade talks resume, and the company diversifies its manufacturing as necessary, a reasonable Price/EBIT multiple would likely return to around 30x.

At present, the Price/EBIT stands at 21.7. At 30x operating income, the projected share price of iRobot would (post a recovery-from-current tariff challenges), point to the stock trading 38% above the current share price.

The recent correction in the share offers a potentially good entry point opportunity. The core business of iRobot is strong, demand for its products is on-trend into the long term, the company is actively investing in R&D to widen its moat, and the brand is strong.

As an investor, I always believe there is a risk in placing capital into any company - there are no guarantees no matter how compelling the opportunity.

But, based on relative calculations (with a historical perspective), I believe there is lower risk of the stock dropping much further, as much of the negativity, post the announcements and revised outlook for 2019, are factored in. At the current 21.7x operating income, shares appear to offer value.

iRobot is a growth business worth considering, as part of a long-term diversified portfolio.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IRBT over the next 72 hours. 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.