Warren Buffett is one of the greatest investors of all time but he's not stingy with his knowledge. On the contrary, he wants to be remembered as a teacher. And in 1988, he used his annual letter to shareholders of Berkshire Hathaway to educate investors on something called merger arbitrage.
In short, merger arbitrage happens when a stock trades at a price that is lower than what another company has already agreed to pay in a takeover. The first question that Buffett says investors need to answer in this situation is, "How likely is it that the promised event will indeed occur?"
When shares of autonomous vacuum cleaner company iRobot (IRBT -0.11%) traded below $50 in early 2023, I believed that Amazon's takeover offer of $61 per share was a sure thing. After all, a $1.7 billion acquisition is nothing for a company of Amazon's size. I couldn't imagine any reasonable argument to block it. So, I made iRobot one of the largest positions in my portfolio, expecting a nice return when the deal went through.
Regulators saw it quite differently, and I was consequently quite wrong. It's been a painful 80% drop from my purchase price. And it's been an even more painful 94% drop for anyone who's held since its all-time high.
I'm still contemplating what to do with my position in iRobot -- a company I admired long before Amazon took interest. However, if my investment is going to start bouncing back, the business needs to do two things.
What iRobot needs to do now
To make a robot vacuum, there are material and manufacturing costs. In a nutshell, the difference between the cost of making a vacuum and the price it sells for is iRobot's gross profit. And the gross profit is suffering right now.
For long-term shareholders, this may come as a surprise. After all, iRobot provides more higher-end products than much of the competition. Therefore, one would expect a good gross profit margin. And that used to be the case. However, as the chart below shows, iRobot's gross margin has plunged in the last couple of years.
IRBT Gross Profit Margin data by YCharts
The first thing that iRobot needs to do now is get its gross margin going back in the right direction. Fortunately, there's some good news for investors in this regard.
Manufacturing for iRobot is outsourced and management is already renegotiating terms with its partner. Interim CEO Glen Weinstein said this is "the cornerstone of our gross margin improvement plan."
The second thing that iRobot needs to do now is related to the first thing. The company needs to maintain sales volume without lowering prices -- lowering prices would again hurt its gross margin. But this will be the more challenging issue.
Consider the chart below comparing iRobot with other premium brands such as Yeti, Traeger, and RH. All of these companies try to position themselves toward the high end of the market. However, with pressures on consumer spending, growth for all of these companies has slowed significantly.
YETI Revenue (Quarterly YoY Growth) data by YCharts
In the first quarter of 2024, iRobot's average gross selling price for its robots was $346. This was down 14% year over year. It's noteworthy that management talked about trying to address entry-level devices more, which implies more products at lower price points in the future.
In short, iRobot is generating less revenue right now, in part, because consumers aren't buying robots at higher prices. And management seems intent on giving more options at the lower end of the market. That might help it maintain sales volume. But it will be harder to fix its gross margin issues.
The really good news for investors
There are problems for iRobot to fix to be a good investment from here. The issue now is how much time does the company actually have before it goes out of business?
Surprisingly, I don't believe this option is even on the table. Right now, iRobot has a term loan of almost $170 million, but it has cash and equivalents of $118 million. Moreover, it already has an additional $40 million set aside for paying back part of its loan. That's not a terrible financial position.
Moreover, iRobot's financial guidance implies that it could break even on an operating basis in the second half of this year. In other words, it's not burning cash at an alarming rate, giving it plenty of time to fix its issues.
To be clear, iRobot might not fix the problems -- I'm only saying it has some breathing room. That said, the stock trades at a price-to-sales (P/S) valuation of just 0.3 right now. For comparison, it used to trade at a P/S ratio of at least 1.
Fixing its problems could restore investor confidence and send iRobot stock back up to a normal valuation, which implies around 200% upside.
In closing, however, fixing its problems is far from a sure thing for iRobot, and investors likely shouldn't buy this riskier idea until it's made progress. Even if I personally believe it could get better, I've clearly been wrong about iRobot stock before.
