Walking, Talking iRobot

High risk. High reward.

That's the name of the game in robotics investing at Motley Fool Rule Breakers. Sometimes we get the reward, as a pick like robotic surgeon Intuitive Surgical (Nasdaq: ISRG  ) racks up a 550% profit. Other times, the risk turns around and bites us on the donkey tail.

That's been the case with brother robot maker iRobot (Nasdaq: IRBT  ) , which, far from galloping, has traipsed backwards nearly 40% since we picked it in our January 2006 issue. But cheer up, Fools, because as of yesterday, iRobot is ... if not running, then at least walking again. And forward, this time.

Nuts and bolts
Reviewing iRobot's earnings report yesterday evening, and seeing that 2007 sales raced ahead 32%, I entertained hopes of using multiple "running" metaphors today. Alas, the farther I read, the more obvious it became that we'll have to settle for walking, because that's pretty much the pace iRobot set.

As it previously advised (twice, actually), iRobot beat expectations in 2007. Helped by beaucoup sales through retail outlets such as Best Buy (NYSE: BBY  ) , Target (NYSE: TGT  ) , and Sears Holdings' (NYSE: SHLD  ) stores, Roomba unit sales boomed last year, rising 24% for the 12 months.

Unfortunately, as quickly as sales grew, gross profit rose a mere 18%, and gross margins contracted to 33%, well below the fiscal 2006 level. Part of the problem was higher costs for components. As for the margin contraction, you can look to the same actors who helped drive sales higher -- the retailers. Given its druthers, iRobot prefers to sell Roombas directly to consumers. Doing so yields better margins than selling through someone else's storefront, and it also offers better information on what the consumers are buying. Unfortunately, perhaps, for iRobot, Roombas proved so popular last year that most buyers rushed right out and bought them off of store shelves -- at lower margins.

Meanwhile, brisk sales failed to dent inventories. According to the release, these more than doubled in comparison with the end of fiscal 2006. Accounts receivable rose 67%. These were not at all the trends I expected to see, and since the earnings release failed to elaborate on them much (and also failed to include a cash flow statement -- tsk, tsk), I tuned in to iRobot's conference call this morning in hopes of getting more color.

iRobot talks the walk
Lucky for me that I did. And lucky for you, too. In just a minute, I'll tell you why. But first, the cash-flow story: Basically, iRobot was surprised by the level of demand for its products in the fourth quarter and, particularly, by the way demand was backloaded toward the end of the quarter. That outcome required extra spending to manufacture Roombas. It also delayed collection of payment on units shipped, which explains why accounts receivable leapt.

And the inventories? Those rose rapidly, yes, but management reassured investors that this increase was both "anticipated" and "required" to support the growth of the business. Selling more robots, and different sorts of them, requires iRobot to keep more spare parts on hand. Broadening markets and selling more robots internationally also requires the company to ramp its inventories. Long story short, this increase was unavoidable. I'd get concerned only if inventories fail to begin leveling off in future quarters.

And speaking of the future
iRobot also used its conference call to elaborate on guidance. Referring to its several contracts to build military robots, iRobot confirmed that it has secured $614 million worth of "indefinite delivery, indefinite quantity" contracts, of which 75% remain to be filled. Some of these revenues, I suspect, will be shared with partners such as Boeing (NYSE: BA  ) and Lockheed Martin (NYSE: LMT  ) . Some, iRobot gets to keep all to itself.

Combined with ramping home robot sales, iRobot projects that it will book more than $300 million in revenue this year, at least a 20% year-over-year rise. Management targets 37% gross margins on these sales (right about where iRobot was in 2006), operating margins of 5%, and "pre-tax net" margins of about 3%. This should all work out to somewhere between $0.18 and $0.23 per share, diluted.

Storm before the calm
And finally, here's the bit that made listening to the call, and reading this column, all worthwhile. As good as next year looks overall, it's going to be a rocky ride getting to the end. Laying out its expectations quarter-by-quarter, iRobot predicts "substantial" revenue growth in the current first fiscal quarter. It's also taking steps to lock in lower component costs, reduce operating costs, and improve product quality to reduce profit-eaters in the form of product returns and warrant costs.

All of the above may make Q1 look pretty good -- but don't be fooled. Q2 will be a bear, in both senses of the word. iRobot warned that not only will a lull in military orders knock Q2 revenue down to its "lowest level" all year, but a peak in internal R&D spending during Q2 will also savage profits.

Foolish takeaway
Long story short, if investors fail to get the message beforehand, you might expect them to buy iRobot on Q1 news, but perhaps overreact and dump the stock when the Q2 numbers break. In the longer term, we're still looking at improved gross margins, economies of scale, and contained operating costs that will yield a decent profit come this time next year. But beware the quarters in between now and then.


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