Readers may be familiar with the Roomba brand of robotic vacuum cleaners (RVCs)– these flat, circular devices are able to automate the tedious job of vacuuming floor surfaces within a home. By most accounts these products are excellent and lead the pack in terms of features and technology; the Amazon reviews are stellar. Whilst the Roomba product is good, we do not hold as sanguine a view for iRobot (Nasdaq: IRBT), the stock of the company that manufactures the Roomba range of robotic vacuum cleaners. This is a case study of how an excellent product does not equal an excellent business, and certainly not an excellent investment.
IRBT initially entered the radar of the Montaka team when I was at a conference in Laguna, California, during September 2017. The CFO gave a presentation, highlighting how competition was proliferating in the robotic vacuum cleaner market, but that IRBT was still maintaining market share. I was curious to learn how this was possible, particularly as IRBT sold exclusively into the premium-tier RVC category, which one would suspect would be vulnerable to an expanding suite of lower-priced competitor products.
After a deep dive into IRBT and the broader RVC space, IRBT made it into the Montaka portfolio as a short. The following paragraphs detail how IRBT fits into Montaka’s unique short framework.
Structural / Thematics
The RVC market has been growing healthily, aided by the currently low penetration levels of RVCs as a proportion of total households, particularly outside the U.S. IRBT has been a pioneer of this category, helping drive awareness and adoption of RVCs. However, we are now entering a commoditization stage: IRBT’s success has attracted numerous competitors who have managed to assemble competing RVCs with similar features, but at materially lower price points. While the RVC category will no doubt continue to grow, it is highly likely that this growth will be driven by the “mass segment” of RVCs, which come at lower average selling prices (ASPs) to IRBT’s Roomba range of RVCs.
IRBT faces a choice: maintain premium prices and lose share; or cut prices to maintain share, but face margin deterioration. As will be shown below in Divergent Expectations, the stock price simply wasn’t baking in either of these likely future scenarios.
Interestingly, IRBT provided some new disclosures in their 2017 Form 10-K, which detail rising competition and the risk of price erosion. Providing additional risk disclosures in an SEC document is no small finding – a management team typically will only provide these sorts of details if they believe that omitting them could expose the company to legal consequences. It is worth reproducing the slab of text in full, with key paragraphs highlighted. Note again that none of these risk disclosures appeared in the 2016 10-K, which lends support to our hypothesis that the competitive environment is intensifying for IRBT.
Divergent Expectations
When we shorted IRBT, the share price was implying an acceleration of revenue growth, expanding gross margins, and extremely strong operating profit growth and margin expansion. In light of the insights we had gathered around the changing competitive landscape, we felt that IRBT would struggle to meet the expectations the market had set for the business, both at the revenue and earnings level. The presence of a number of misperceptions in IRBT’s financial statements (discussed below) gave us additional confidence in this view.
Asymmetries
IRBT has a pristine balance sheet with no debt.
Misperceptions
There are a number of misperception elements to our IRBT thesis – in other words, a disconnect between the headline, reported business performance, and the underlying business performance, usually due to the way management has chosen to disclose company information to the public. The first red flag is IRBT purchasing two of its distributors.
IRBT closed the purchase of its Japanese distributor, Sales On Demand Corporation (SODC) in 2Q17, and its much larger European distributor, Robopolis SAS, in 4Q17. Through buying its distributors, IRBT is able to sell the same products twice, boosting the reported revenue growth numbers. For example, when selling a robot unit to a distributor, IRBT books the revenue for that sale. If IRBT then purchases that distributor, it acquires the inventory of the distributor (including that robot unit) which can then be sold a second time, allowing IRBT to recognize revenue for the same product twice. Furthermore, over time IRBT’s purchase of its distributors will help boost its gross margins, as IRBT is now able to capture the incremental margin that was previously going to third party distributors.
Another red flag is the continual adjustments IRBT makes to product returns reserves. Each year, IRBT releases part of these reserves which boost the gross margin, as can be seen below. In 2013, the SEC took notice and sent a letter to IRBT querying these reserve releases (https://www.sec.gov/Archives/edgar/data/1159167/000000000013031751/filename1.pdf).
As a further means of boosting gross margins, IRBT reclassified some items which were recorded in COGS and moved them into opex as part of a 2012 company reorganization. This resulted in a 200-300 bps gross margin boost.
In its 4Q17 earnings report, there was demonstrable evidence of competition starting to bite. IRBT’s operating profit guidance was a big disappointment to the market. The midpoint of the FY18 operating profit guidance given by the company was a 22% haircut to consensus expectations. Furthermore, three-year financial targets were given, with operating margins expected to increase to 10%. This was a large downgrade to Street expectations of IRBT’s margin potential, given that consensus operating margins were expected to be 14%+ in FY19 and FY20. The stock was down 32% on the day, a rewarding outcome for our Montaka investors.
Montaka is short the shares of iRobot (Nasdaq: IRBT)
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.
