iRobot: Time To Be Greedy

Summary

• iRobot presents fabulous long term prospects with risky short term prospects.
• The trade war impacted the stock severely, but the war chest it has will enable it to come out on top.
• It could deliver 30% annual returns for those who hold it until it can recover.

iRobot Corp (NASDAQ:IRBT) is expected to deliver significantly lower results in 2020 than in 2019, but it will be growing lovely in the following years.

Investing in the company presents a secure risk-reward proposition with a dream come true downside and incredible upside potential at a reasonable price. The catch is that 2020 will be a rocky year, and those who venture forward should be prepared for a lot of stress.

The Trade War strategy

iRobot got struck by tariffs of 10% initially, but by May of this year, they increased to 25%. Management decided to raise prices to protect the gross margin, which was a mistake. iRobot´s strategy long term is to grow in users and dominate the market and then use its pricing power to improve financially. Competitors decided to absorb the tariffs and keep the prices, and thus, iRobot's revenue was hurt.

Fortunately, management reconsidered, and since October, the prices have returned to pre-tariff levels, and Q4 should reflect healthy revenue growth. The shift in strategy will not be cheap, and the gross margin for 2020 could go lower than 40%, which significantly impacts the bottom line of the company.

The company is deciding to diversify its manufacturing strategy and produce select SKU´s in Malaysia. While it is not ideal to be forced to do so, there is a silver lining. Rarely do a company can build a meaningful portion of its production facilities from scratch. While the capital expenditure that the company will need to put forward will impact the depreciation, the company could take this opportunity to improve its production processes and improve production costs and time to manufacture.

Source: Investor Relations

iRobot is compensating for the loss with careful control of administrative expenses and appears to be determined to keep investing in R&D.

Finally, we continue to control operating costs by curbing discretionary spending, and carefully managing the timing and pacing of hiring. These actions are expected to help us keep operating costs relatively flat in the fourth quarter versus the same quarter one year ago, and will help limit expense growth in 2020. Colin Angle - CEO Q3 Earnings call

Maintaining R&D expenditure is vital, as it is what will hold the company in the future, and iRobot´s real value will only come to light if it can continue to innovate.

Valuation

In the recent past, revenue growth has been between 7.1% and 33.8%, with a tendency to be positive. The estimate considers an average revenue growth of 10.6% compared to the past average of 18.7%. R&D as a percentage of revenue has oscillated from 12.1% and 12.9%, with a tendency to be positive. The forecast modeled average R&D as a percentage of revenue of 13.1% compared to the past average of 12.5%, and G&A as a percentage of revenue of 24.4% compared to the previous average of 26.5%

Source: Author´s Charts

These approximations are in line with the market expectations for iRobot Corp in the next couple of years, as the image below shows.

Source: Seeking Alpha

I like to use Peter Lynch's ratio when valuing a stock. This method uses the ratio between the expected earnings growth plus dividends and the P/E of the stock to determine its fair value. A stock that has a 1:1 ratio is reasonably priced. The higher the number, the more underpriced the stock is.

Source: Author´s Charts

This valuation does not take into account the assets and liabilities of the company. The growth considered in the valuation is the average yearly growth of the next years.

With this valuation, arguably, the stock is at worst overvalued by 15% and, at best, undervalued by 18%. So the stock is fairly valued.

Source: Author´s Charts

iRobot has a substantial war chest and no debt. The chart below shows the fair price of the stock, including its assets and liabilities. Still, in order to present a valuation closer to the worst-case scenario, the rest of the analysis will consider the fair value without the assets and liabilities of the company.

Source: Author´s Charts

Building an adjusted Beta Pert risk profile for the current fair price of the stock, we can calculate the risk profile for purchasing the stock now.

The risk profile shows there is a 62.98% probability that iRobot Corp will trade at a lower price than it is today. Considering the potential downside, upside and the likelihood of each, the statistical value of the opportunity of investing now is of -1.8%

Constructing an adjusted Beta Pert risk profile for the long-term prospects of the stock, we can calculate the risk profile for the company.

Source: Author´s Charts

The risk profile shows there is an 8% probability that iRobot Corp will end up trading at a lower price than it is today. Considering the potential downside, upside and the likelihood of each, the statistical value of the opportunity of investing now is of 25.7%

Conclusions

Given the very good growth in revenue that the company has shown in the past, the firm financials, and the hefty war chest that the company has, it just might be a time to get the stock.

Sure there are plenty of risks and problems; the expected performance for next year is far from ideal, and the new manufacturing strategy will be hard to implement, and its results will not be shown immediately.

When I first wrote about iRobot, I did not go in as it was ridiculously overvalued. Then the price dropped to a more comfortable level, and I decided to go in. While the stock has underperformed and dropped significantly, it is essential to note that macroeconomic effects caused the price drop, and the company has been getting better.

While 2020 will be a complicated year for the stock, its long term future seems as bright as before, and the company has a substantial war chest that will enable it to survive the trade war and come out on top. After all, what are war chests for if not for war?

If there is anything in this article, you agree or disagree with or would like me to expand further on; I would sincerely appreciate you leaving a comment. I will address it as soon as possible.

Analyst’s 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.