iRobot Cleans Up the Competition

You know iRobot's (IRBT 13.15%) Roomba. Someday, you might know its robotic lawn mower. But that's not all the manufacturer has to offer. In this week's episode of Industry Focus: Consumer Goods, host Vincent Shen and Motley Fool contributor Asit Sharma dive into the company. iRobot has been partnering with the likes of Amazon.com (AMZN 3.43%) and Alphabet (GOOGL 10.22%) (GOOG 9.96%) lately -- turns out all that house mapping it's been doing is pretty appealing for the smart-home giants.

Meanwhile, iRobot's flagship cleaners have been racking up great sales with consumers. But it's not all sunshine on the horizon for iRobot. Upcoming tariffs could hit the company for as much as 25% on its vacuums. How does that affect iRobot's medium and long-term picture? What risks should investors watch out for? Listen to the episode to find out more.

A full transcript follows the video.

This video was recorded on Dec. 18, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. Joining me today via Skype is senior Motley Fool contributor Asit Sharma. Hey, Asit! Thanks for hopping on!

Asit Sharma: Thanks so much, Vince! Happy to be here, as always!

Shen: As a reminder to anyone who has missed my previous announcements, this is the last show I pre-recorded before saying my goodbyes to the Industry Focus team. Some 200 episodes captured in this studio. I've said it before; I'll say it again -- thank you for being a part of this journey!

Asit, I'm glad we're going to wrap up 2018 with a company that I personally think is building something special, and that company is iRobot, ticker IRBT. It's been well over a year since our last update on the company. In that time, the stock declined as much as 40% before returning to positive territory for 2018. At least as of this recording, iRobot is up 10% year to date, topping the flat performance for the S&P 500. 

We're not going to rehash the entire business description. But for Fools who don't know this company or are only vaguely familiar with its consumer robots, really quick, what's the story here?

Sharma: iRobot is the manufacturer of the very popular Roomba device, which is a vacuuming device. It also makes a mopping device called the Brava. The company is a pioneer in the technology that allows you to have a hands-free experience and have your house vacuumed. Along the way, it's developed a lot of credentials in data mapping. It's a very tech-savvy company, and it's integrated some of its own learnings with companies like Alphabet, and also Amazon via Alexa. It's a very current and quite interesting product, between vacuuming and mopping. And it has posited that in the future, we'll see a lawn mowing product. That, in a nutshell, is this company's business. We'll talk more about its business model.

Sharma: Sure. Right now, there's absolutely no doubt that sales of these cleaning robots like the Roomba, like the Brava and other models, is driving the business at this moment. As you mentioned there, for a long time now, management has talked about the incredible assets that iRobot is amassing by mapping all of the homes that its products are in, that they're helping to clean and tidy up. They refer to this spatial awareness as something that could serve as a really important tool, a hub for various smart home integrations that have yet to debut to consumers, stuff of the future. I really feel like we're entering Jetsons territory here. We'll talk more about that in a bit. 

For their third quarter, iRobot had really strong results, showing a lot of momentum throughout 2018. What jumped out to you?

Sharma: Revenue growth of 29%. This is a on the heels of two new product introductions -- the i7, which is a more upscale model of the Roomba, and the e5, which is a more mid-price model. For the three months ended Sept. 29, 2018, sales were $264 million. Gross margin of 32%. That's pretty strong. Research and development expenses increased, as did selling and marketing expenses, but the company was able to increase its gross margin by almost 3% to 14%. 

What I like about iRobot, which we're starting to see as the quarters go on, is the business model has proved itself out. It's getting more of a direct result from the research and development expenses that it's investing. It's helping the top line, very healthy growth. 

This recent quarter shows to me, also, management's acumen at figuring out what features will hit consumers with product rollouts. This sounds simple. You have a great product, you spend a lot on research and development, it's time to upgrade your line. But longtime listeners will know, our favorite whipping horse, GoPro, has struggled, as an example of a company that's struggled with new product introduction. What is the feature that will bring customers in? For this mid-price model, in the most recent quarter, the company introduced self-cleaning, that's usually found in the higher models. That had a huge uptake among pet owners who want that debris cleaned. If your analysis is correct, you understand how you can price your next generation of products and swap features. And that really impressed me. As well as with the higher-end model, the company now has price points that range in a stepladder fashion, from $300 for entry level up to $600, and for the i7+, $900 to $950. There's something for everyone in the offering, and that's showing up in these financial numbers. 

Also, I'd quickly like to talk about the balance sheet. That really stands out to me, as well, how strong it is. Vince and I just got through taping an episode, which hopefully most of you have already listened to. We're pre-recording this episode. We just talked about a company which has quite a bit of new debt on its books, Carvana. You can find that episode on our podcast list. iRobot has been around for a while now, and it has no long-term debt on its books. It has a current ratio of about 2.5. That means current assets, current resources which aren't long term in nature, are about 2.5 times the current liabilities, like accounts payable and other types of one-year expenses that the company's obligated for. Inventory is up 50% since the beginning of the year. That's a function of this sales path, we're seeing that 30% growth that I talked about quarter over quarter. It's also a function of the new product launch. 

That's a healthy increase in inventory. It's like the three little bears. Based on sales, this feels just about right. You don't want too much inventory going into your channels, because that can be inefficient. But you don't want too little when there's demand on the products you've introduced. I like this relationship between the 30% top-line growth and 50% in inventory. 

All in all, I had not looked at iRobot's financials in a while, very impressed with what I see. It feels like a very solid company with a product that, as Vince mentioned, is seeing a lot of demand in the marketplace. What are your thoughts, Vince?

Shen: I'll go back to this most recent quarter with that 29% year-over-year growth. That's accelerating from the second quarter, which had a 24% pace. Bottom line net income was up 44%. These are numbers that all exceeded analyst expectations across the board. Units sold came in at 1.1 million units during the quarter. Again, up big from the prior year. Something that management has stressed is that revenue growth for the company will largely be driven by units rather than average selling prices. One, that supports the broader trend of greater smart home device adoption. Even then, as you mentioned, that step change in terms of the pricing for their products, $300-$600 to as much as $900. Clearly, customers feel that the features that the company's introducing are compelling, because average selling prices are increasing. They went from $260 to $289 year over year in this period. Gross margins expanding, I think you said 3%. 

I think for the time being, this should be enough to hold off some of the critics, some of the bears who have argued that iRobot will struggle to compete with a growing number of low-cost competitors. The features, for example, for the premium i7 and i7+ that it released are just incredible, looking at how it can really become a seamless part of your home. Asit, do you actually own anything like this, any of these robotic vacuums, even from a competitor or anything?

Sharma: For those who can watch the video later, I only shoot myself shoulders up. I say that to make the point that I need all the exercise I can get. I use a broom manual process. We have some friends who bought a Roomba when it first came out, and many since then have converted, so I'm very familiar with it. It's one of those pieces of tech that I'll probably give into. But for now, I think I will hold out for as long as I can. I have to keep this waistline in. Curious, Vince -- of course, you're moving on and traveling. Do you happen to have a Roomba?

Shen: No, I don't. But honestly, the more I look into what some of these products offer, especially from iRobot, it really becomes tempting. With this latest i7 release, if you purchase it with a dock, it can clean a room and detect on its own when its dustbin is full. Then it will return to the dock to automatically empty the bin within the unit before moving on to clean more. It can also learn room names. An owner of one of these devices can give the command to the Roomba to clean specific places in the house. All the while, the machine will map and learn to optimize the cleaning process. It's a pretty impressive feature set in the top-of-the-line for these Roomba vacuums.

Demand for these new models, like this i7, they really helped domestic sales outpace other markets at 45% in this most recent quarter. As they expand the launch for them abroad, I think that will be a really strong tailwind as they reach these other markets and drum up demand on their own. 

This latest report is undeniably strong, but there were some elements outside of the company's control that are, I think, driving the near-term story for iRobot. Some of the issues with tariffs, for example, have investors concerned. I'm curious, Asit, how worried do you think investors should actually be about these tariffs and how they might hurt the bottom line in the near to medium term?

Sharma: Investors should be aware of the impact. Sometime ago, Secretary of Commerce Wilbur Ross had projected that effective tariffs would be very minimal on any company. He used Campbell's soup cans as an example, a cent or two on a Campbell's soup can. What we're finding is, in reality, the effects of imposing tariffs become concrete over time. The fear factor ratchets up commodity prices, and then the actual imposition of tariffs, of course, makes things more expensive. 

This is one of the companies that has actually quantified an impact. The company says it's about a $5 million impact, which is going to affect total year gross margins by about 1%. While that's not a huge number, you also have to balance it with the fact that management said, "Look, for now, we're not going to pass that on to customers, we're going to absorb that in our gross margin." This is something, like a developing story, that investors should watch.

I would say, over time, Roomba products are leading the market in innovation, so there's some price elasticity there, which Vince talked about a couple of episodes ago. Again, we'll go back to Econ 101. The company has some pricing power in its products. I think the tariffs is a great example of this. Let's say, after a couple of quarters, iRobot decides that it will pass on $5-10 increase, let's say on its middle-of-the-line product. Customers will probably pay for that. Essentially the same with the higher end. What management has said recently, I think in the most recent earnings conference call, is that at the higher end of the product spectrum, there is price elasticity which exists, and that's where the company wants to innovate. 

That's the counter argument for the bears. If you can keep ahead of the lower-price competition -- just to give you an example, I think Samsung has an excellent entry-level product for $300. That's a very formidable competitor, with massive resources. If you can keep ahead of a competitor like Samsung with innovation, then, when you have these external events like a trade war, which impact your commodity costs and makes it more expensive for you, you can pass on some of that effect to customers. 

Now, we don't know eventually how serious the trade war will be when all is said and done, or how long it will last. But I think that an event like this makes management keener to roll out new products with an ever-higher attachment rate among those people who are willing to pay for the features that Vince just described -- the ability for a Roomba to empty itself 30 times before you have to take action, which is an incredible feature to me. What do you think about the tariffs and the effect on their P&L?

Shen: Just quantifying it, you mentioned the $5 million, that's the hit to iRobot's operating income in the fourth quarter as a result of a 10% tariff on specifically vacuums made in China. But even worse, the tariff will increase the 25% at the start of 2019. So iRobot is stuck here, where they have to grapple with the increased costs. This is a situation where iRobot contracts all of their production for the robots to Chinese manufacturers. It's not going to be easy for them to find a quick solution to avoiding the tariffs. 

On top of that, also, in the near term, like you said, management has indicated they want to avoid passing the cost increases onto consumers and raising prices. They're working on cost reductions, other ways of handling the elevated 2019 tariffs. But at some point, it may require that they do that to protect a little bit of the profitability. 25% is pretty significant in terms of the potential hit there for the company. It could hurt the strong momentum that they've so far built in 2018 as they enter the new year.

I will say, softening the blow from that, nine U.S. customers make up more than half of total revenue. The smaller but growing Brava line for the mops, that's unimpacted by the tariffs. Right now, Brava makes up less than 10% of revenue, but there's a big market for that in regions like China, for example, where hardwood or tiled floors are more common than carpeting. They've mentioned that as a potentially major growth driver looking ahead. 

Given the solid financial footing that iRobot's in, they have this pretty solid cash pile, about $135 million, no debt. That cash reserve has reduced recently, since 2017, because iRobot shelled out about $150 million to report to acquire their distribution arms for their products in Japan and Europe. I think that was the right move, given it has allowed the company to control the marketing, the messaging, better for these international markets. I think they've improved some of their volumes there, and also their selling prices there as a result of those moves. 

The cash flow that this company is generating is sufficient to sustain its R&D spending. That's going to be essential for a tech-focused consumer products business like this. R&D was at $113 million in 2017, $135 million in the trailing 12-month period. It's good for about 25% of the company's gross profits. 

Related to that spending, and the pretty bright long-term outlook that I think exists for this company, iRobot announced in October a deeper relationship with Alphabet. You mentioned this at the beginning of the show. Alphabet, obviously, a pretty big player at this point, in terms of their smart home technology. On the surface, there's this obvious value-add for consumers. For example, they have the ability to use Google smart home devices to give commands to iRobot products. That's something that's available both through Google and Amazon's Alexa. But as smart home solutions become more and more prevalent in homes -- I visited some friends in your neck of the woods in North Carolina a couple of weekends ago. I was pretty impressed to see that they have all their security, their HVAC system, and all these other elements in their home that they purchased recently, already integrated into a smart home apparatus. The more functionality that these smart home devices offer, they'll need more and more data and insight into the physical space. Again, iRobot is the company right now that's best positioned to provide that kind of information, given they've sold 20 million robots around the world, they're in so many homes doing that mapping, collecting that data. So, on the horizon.

You also mentioned the hints of a robotic lawn mower that might be coming soon. There's the greater adoption of the Brava that we've talked about. I think a strong holiday season will also be in the cards for the company thanks to the new product launches. 

Let's wrap up. Any final takes? Also, valuation? What are your thoughts there?

Sharma: I absolutely want to talk about valuation. It's pertinent to everything that you just discussed, Vince. Currently, the stock trades at a forward P/E ratio of 30. The stock is trading at 30 times one-year forward earnings. The market cap of this company is about $2.5 billion. How are these two pieces of information related? This is essentially still a small-cap stock. I was surprised to see the market cap, which I hadn't looked at in a while. I thought it would be greater. What that tells me -- I spoke about this a couple of months ago on a show -- for a small-cap company, to trade at 30 times earnings means that you're right in line with the Russell 2000 index. That's the average forward valuation for a company of this size, all things considered. 

So, in my opinion, although 30 times forward earning sounds a little pricey, there's not really much of a premium there. Investors who are short-term oriented may feel that's great. Those who are longer-term oriented may see that the market is discounting the forward opportunity of integration that Vince talked about -- again, going back to a concept that he mentioned at the very beginning of the show, the spatial awareness. The data that a Roomba can provide to other components in a house that are integrated, the Internet of Things devices, which are all communicating with each other, those potentialities are enormous if you just start to brainstorm what a Roomba might be able to provide. Myself, a random one I came up with -- what if your Roomba could tell your Sonos speaker to play the volume up a little bit, because it's coming to vacuum, but your kid's still in the room? You can just imagine, if it does, indeed, integrate with other devices and sell some of its capabilities, that's a marketplace advantage. That's hard for a competitor who's just manufacturing a device on a price-point to compete with. 

I think the stock long-term looks attractively valued here, especially, it's sold off along with the general tech sector as of this recording a little bit this year. What are your thoughts, Vince?

Shen: I think for a company in this position, you have the market share leader. They're putting up well over 20% top line growth in 2018. Over 15% on the bottom line. The 30 times forward earnings doesn't look quite so pricey to me. I think a long-term investor can generally, not quite shrug off, but not put as much weight on, for example, the near-term hit with the tariffs. That doesn't mean you can't protect your yourself by building out your position over time. Given the strong demand for these new products that they launched, those are going to be big story drivers in the holiday season. Strong sales, maybe weaker profits, but the company is going to work into that with these new features and building up their ASPs. 

You have a company here that's the leader in this young industry. As you said, it's very small, $2.5 billion market cap. Again, I've really been excited to look into this company, get updated on it again. It's a very cool business.

All right, that's all the time we have for today. Thank you, Asit, for joining us!

Sharma: Thanks so much, Vince! It's been a pleasure!

Shen: Thank you, Fools, so much! For Austin, Asit, all the other contributors, I'm signing off from Industry Focus. Thank you for all your support!

People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!