iRobot: Bad Odds On The Amazon Deal Make This One A Sell
- The wide discount to the agreed sale price to Amazon indicates that Wall Street is very skeptical of the actual consummation of the deal.
- I believe negative earnings surprises and recession in 2023 will put IRBT in turnaround mode. I like the firm’s products, but at $40, shares seem wildly overvalued and kept afloat by M&A.
- Avoid this arbitrage opportunity as the risk/reward does not seem favorable at all.
Almost eight months have passed since Amazon (AMZN) announced its acquisition of iRobot Corporation (NASDAQ:IRBT) for $1.7B in cash, valuing IRBT at $61/share. Although the market initially reacted positively, with shares briefly touching $60, the spread quickly widened due to news of FTC scrutiny over the deal. Last month, IRBT's shares came close to dropping below $40, offering a potential total return of over 50% if the deal closes. Even at the latest price of $43.7, a 40% profit is still possible.
The current market conditions maybe made the current potential 40% upside for IRBT shares even more valuable than the previous 50%, as a banking crisis has emerged in the meantime. However, there are two significant concerns. Firstly, the deal's closing is uncertain, with a big "if" hanging over it. Secondly, if the deal falls through, the downside risk is significant. Despite the wide merger spread, I believe the risk/reward profile for IRBT shares is very unattractive here, making IBRT an investment to avoid.
According to a report on March 20th, the FTC is preparing to take action against Amazon on several issues, including its acquisition of iRobot. The report highlights FTC chair Lina Khan's skepticism of "Big Tech" and her view of Amazon as a dominant player whose structure and conduct raise anticompetitive concerns. While this suggests that the FTC will scrutinize any Amazon deal, it is not enough to conclude that the iRobot acquisition will be blocked. In fact, another report last month suggested that Amazon's purchase of One Medical for $3.9 billion would not be challenged by the FTC.
What is different for iRobot?
For starters, the iRobot acquisition is not only being reviewed by the US regulator, but also by regulators in the EU and UK. This raises concerns as it increases the probability that at least one of these antitrust authorities will act against the deal. The fact that multiple regulators are reviewing and potentially challenging the deal also suggests that they have some material argument to be used against it.
The antitrust regulators are not suspicious of the deal for market share reasons, but for potential anticompetitive practices. Quite obviously, the robot vacuum and moppers market is already highly fragmented and cost-competitive. However, Amazon's double role as both a provider of the online platform to other independent retailers and a competitor with its own products is what keeps regulators concerned. In the recent past, the EU Commission investigated Amazon and it found an alleged misuse of marketplace retailers' data, which was used by Amazon to adjust its own offers and retail business strategy. This allegedly put pressure on established players by allowing Amazon to gain insights on which of their products are most relevant to customers and replicating them.
The EU Commission's investigation into Amazon's misuse of marketplace sellers' data was settled last year, with Amazon committing to refrain from using such data and ensuring equal access to sellers. However, the regulator remains vigilant, and further concessions could be demanded if Amazon's strategy goes against its commitments. Given this context, I believe that there is a 50% chance that the FTC or EU antitrust will file a suit to block the iRobot acquisition. If the deal is successfully blocked, Amazon may decide to walk away from the acquisition rather than challenging the ruling. A suit could even turn out to be the perfect excuse for Amazon to break away from a deal that may have become too expensive given the current macroeconomic conditions.
Small robots, big losses
iRobot Corporation reported a net loss of $286 million, or ($10.52) per diluted share, for FY2022, a significant decline from the pandemic profit of $30 million, or $1.08 EPS in 2021, and $147 million, or $5.14 EPS in 2020. Analysts predict that the company will experience a loss of ($3.79) per share in 2023 and ($1.28) per share in 2024, but these estimates seem to me wildly optimistic.
iRobot's sales benefited the pandemic and increased from $1.2 billion in 2019 to around $1.5 billion in both 2020 and 2021, but fell back to $1.1 billion in 2022. The change in shipped units and revenues suggests a slightly positive pricing trend, but there is no information on the product mix. IRBT commented positively on the performance of mid-tier ($300-$499 MSRP) and high-tier (>$500 MSRP) robots, which represented 84% of the total in the fourth quarter of 2022, up from 81% in 2021. It seems possible that the increase in net average selling price is due to a shift towards more premium models, although there is no product mix data to confirm this. Discounting held steady at 16%.
However, iRobot Corporation's gross margins have been impacted by a significant increase in COGS, which rose from below 55% to 70.4% in 2022. The ballooning COGS costed IRBT approximately $175 million in lost profits so, while iRobot was able to earn about $3 per share in 2018/2019, that was not the case for 2022, despite total turnover wasn’t that lower. Chip supply disruptions and shipping constraints affecting China are the main cause of this increase. The ongoing normalization of freight rates is expected to help reverse this negative impact, but I believe the company still faces big challenges in reducing its operating costs, which increased by about $133 million between 2019 and 2022.
Only $25 million of this increase was related to R&D, with G&A and Selling and Marketing costs increasing by $46 million and $62 million, respectively. The company's Selling and Marketing costs have grown from about 19% in 2018/2019 to almost 25% in 2022, which could indicate a deterioration in pricing and an increase in the cost of acquiring customers. The company has announced a 7% workforce cut, but it is unclear how much of an impact this will have. Additionally, in the same release, the company has announced muted orders and reduced production activity in Q1.
Valuing iRobot if the deal falls apart
Based on the reported financials, I tried to evaluate iRobot in case it was to continue as a standalone company. I took values from Actual 2018, 2019 and 2022 to understand the true earnings power of the business in a “normal” non-pandemic scenario. I also tried to factor in the recently communicated cuts for 2023. I believe this is truly going to be a reset year not only due low turnover, but as we navigate through a recession, IRBT will have to somehow rein in the selling & marketing costs to return to profits. I see two very difficult years in 2023 and 2024, with wide losses that have not been factored in by analysts who are waiting for the Amazon deal to consummate.
In my base case scenario, I see approximately $70M operating income by 2025 and about 52.5M EPS with a 25% tax rate. The effective tax rate of IRBT over the last decade has been a little bit all over the place ranging from 13.7% to 33.3% but averaged out at 24% so not too far away from my expectation. Considering a cash conversion of 80%, that would leave us with approximately $42M normalized Free Cash Flow. A fair multiple of 15x applied to IRBT would value the company at approximately $600M, indicating that IRBT shares are 50% overvalued and, in the absence of the deal, the company’s fair value could be around $20-$22.
iRobot continues to trade in the low-$40s, with an interestingly strong short interest hovering north of 15%. For an arb opportunity, there seem to be a whole lot of smart money thinking that IRBT is heading in the opposite direction than the one seeing the Amazon’s deal closing at $61. I concur.
Despite the intriguing 40% upside, I am uninterested in purchasing shares, and I would remain uninterested even if IRBT sinks further towards $40, and the spread widens again offering an upside of 50% to the acquisition price. On the other hand, a short position could be justified, but if Amazon challenges a suit and does not walk away, this could drag on for a while.
If the deal breaks apart, the stock could struggle to find a support. To be honest, as I was modeling, I thought that 70M operating income in 2025 and 15x FCF might have even been optimistic. In the event of a market overreaction, it is possible for IRBT to fall significantly below $20. As we all know, there is no short-term support for a stock provided by its fair value, and the short-term macro appears awful. I expect the next couple of quarters to be ugly, and the only backstop remains the hope of the AMZN deal closing. Hence, I believe investors best course of action is to avoid iRobot shares for the time being.
This article was written by
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