Investors have a right to be perplexed by the market's reaction to the third-quarter earnings report from iRobot (IRBT -3.55%). There was certainly nothing wrong in the numbers and near-term guidance. revenue rose a whopping 43% in the quarter on a year-over-year basis, and management now expects year-over-year revenue to increase by 12% to 13%. Meanwhile, earnings per share (EPS) of $2.58 were ahead of estimates, as was the full-year 2020 guidance for EPS of $3.43 to $3.53.
So, with all this good news, why did the stock sell off by double digits?
All about 2021
As the subheading suggests, it's likely that the market was left unimpressed by management's commentary on 2021. Before getting into the details, it's worth noting that iRobot's management didn't give any detailed color on the outlook for 2021 or 2022. As such, the market's dismal reaction is more about the commentary than any specific guidance.
In a nutshell, 2021 is expected to be a year of margin headwinds, and of company investments in order to demonstrate the potency of its business strategy. The question for investors is whether they believe in the latter and are willing to hold the stock through the earnings headwinds brewing in 2021. Here are both sides of the story.
The bearish view
The bearish argument mostly realtes to margin headwinds in 2021 and also skepticism over the consumer discretionary company's ability to maintain margin in the face of pricing competition from rivals. In addition, iRobot is increasingly becoming reliant on its premium products -- over 60% of its revenue in the quarter came from products priced at $500 and above. There are question marks about how sustainable that will be and about its ability to build a moat around its products by engaging consumers with its intelligent technology.
Starting with the headwinds, it's no secret that the trade war with China and the associated trade tariffs have caused cost issues for iRobot. Indeed, CEO Colin Angle outlined that the company is set to suffer from the reinstatement of tariffs on products made in China, and management's plans to shift production to Malaysia have received a setback.
Quoting from Angle on the earnings call, "COVID pandemic has delayed our original plans to get to Malaysia by the end of this year, and instead pushed our transition of manufacturing well into 2021." Moreover, "It's going to be late in the year, and largely 2022" before the increased tariff costs (coming in January 2021) are reduced in their impact by the shift to producing in Malaysia rather than China.
Turning to the business strategy, management argues that it's going to encourage customer loyalty to its increasingly premium-priced products by introducing digital technologies like its iRobot genius home intelligence platform. It's a system designed to enable users to have greater control over the timing, location, and mode of cleaning done by the robot.
The skeptical view sees such developments as offering little resiliency to the threat of pricing competition from rivals. In addition, investors are going to have to deal with a year of uncertainty on margin in 2021 as management invests in order to develop new technologies.
The bullish view
Despite the things noted above, there is an argument that the future still looks good:
- Irrespective of potential pricing competition, the relatively low penetration rate of robotic vacuum cleaners (RVC) -- only 24% in 2019 -- means there's strong growth potential for all RVC manufacturers.
- The strong growth of iRobot's premium products: Sales of products priced at $500 or more were up 86% on a year-over-year basis in the third quarter, which is evidence that customers are already willing to pay a premium for iRobot's technology.
- Despite growing competition, iRobot retains a 52% global market share and remains the market leader by a big distance over its nearest competitor, which has just 14%.
And finally, the key bullish argument is a recognition that 2021 is going to be difficult due to tariffs, but it's just one year, and meanwhile the company is building a pathway to long-term growth.
What it means to investors
All told, investors can think of 2021 as a year when their belief in iRobot's long-term strategy and ability to maintain pricing power and underlying margin will be tested. An early sneak peek into the matter will come from the company's fourth-quarter 2020 earnings -- a quarter in which iRobot is making substantive marketing and advertising investments.
As such, management expects a gross margin performance in the low 40% range and year-over-year sales growth of 12% to 15%. These are numbers to look out for before you make an investment decision on a stock that's going to face a lot of headwinds in 2021.