Description

While we question the long-term viability of current margins in the robot vacuum market, we focus on near-term industry dynamics which present a meaningful opportunity on the short side.

Executive Summary

iRobot created the market for robot vacuum cleaners and has defended its dominant market share against competitors over the past few years. We believe iRobot is more susceptible today than at any point prior as innovation in vacuums has likely reached its peak. Competition will shift from innovation to branding and value which we expect to impair iRobot’s margins over time.

In the short term, we believe the Company’s ability to meet guidance and sell side expectations for FY 2019 is at risk.

Competitors are copying Roomba’s features and selling comparable products at significantly lower prices. Shark recently announced the Shark IQ Robot Vacuum R100 which will sell for $399.99 while iRobot’s comparable i7 has a list price of $799.99. We expect the R100 vacuum to come to market in the U.S. at the end of September endangering iRobot’s largest selling season and potentially already bloated inventories into 2020. 

iRobot produces substantially all its product in China and is currently seeking to diversify its supply chain. iRobot increased their product prices in response to tariffs; however, it appears that the Company is already walking back these increases with discounts and promotions. These discounts are likely a response to competitors who continue to maintain or cut prices to gain market share. 

How we think this plays out:

• Revenue disappoints short term
  • Short term disappointment comes from increased competition and incorrect assumptions embedded in guidance.
• Margins compress
  • Near-term margins are pressured as iRobot continues to increase discounts on their products above what was guided in the Q2 earnings call.
• Guidance cut (again)
  • Given elevated competition, we expect iRobot to cut its FY 2019 guidance again when they announce Q3 earnings. The recently announced increase in tariffs almost guarantees a cut in guidance unless there is a positive development in trade negotiations.

Narrative

Company Background

iRobot was founded by Colin Angle, an MIT grad, to create robots for military applications in 1990. Over time, the Company found a consumer application in robot vacuums which resulted in the creation of the Roomba. Today, iRobot is solely focused on consumer applications after it disposed of its military division in 2016. 

iRobot’s primary product remains the Roomba (robot vacuum) but is working to develop a market for the Brava (robot mop), which it began selling in 2012, and is beta testing the Terra (robot lawn mower) in the U.S. with a small rollout in Germany. 

Market Share

The main point of our short thesis is predicated on U.S. weakness in the near-term and increasing global competition in the long term. Shark has created a viable contender in the U.S. and continues to implement its copycat innovation strategy combined with significantly lower prices. Their success is evidenced with double digit market share in North America which is a first for any competitor since 2014.

Why now?

iRobot is down ~50% from its April 2019 highs where it was trading for 42x NTM P/E. Today the stock trades for ~24x NTM P/E. While the valuation has certainly compressed, we see a deteriorating fundamental backdrop driven by increased competition combined with a lack of innovation to support a continued decline in the equity value of IRBT.

• Short Term Revenue Pressures
  • s9 appears to be a flop and has little to differentiate it from the i7 — aside from price and a 4x increase in suck (we mean suction power).
    • The average Amazon rating for robot vacuums in the top 50 best sellers is 4.25
    • Note the discounts across most models. 
    • 
  • Price Elasticity
    • Simply put, iRobot has finally pushed too far on pricing and consumers are not paying up for innovation. 
    • Some bulls might point to increases in iRobot’s Gross ASP over the past years indicating the consumer has the ability and desire to pay more for Roombas. However, Roomba’s allowances for returns and incentives have been steadily increasing — indicating higher promotional spend (primary driver) and poor product quality (secondary driver).
      • Allowances are measured as (Gross Selling Price less (consumer revenue divided by units shipped)) divided by Gross Selling Price. This methodology isn’t perfect as accessory revenue is captured in consumer revenue. However, the inclusion of accessories in consumer revenue tightens the spread as it increases ASP’s per unit shipped. Thus, the discounting trend is likely worse than presented below. 
      • 
    • The Company touted its success on Prime Day with sales up 90% year-over-year at prices it claims are pre-tariff levels. This information also tells us that the consumer is making their purchasing decision more so on price rather than features.
      • https://www.businessinsider.com/best-roomba-vacuum-deals-amazon-prime-day
        • Prime Day offerings
          • 671 – List price $350 – Prime Day price $290
          • 690 – List price $375 – Prime Day price $230
          • 891 – List price $450 – Prime Day price $300
          • 980 – List price $900 – Prime Day price $550
            
  • Recent growth drivers
    • i7 and i7+ were launched in Q3 2018 domestically and subsequently launched in Q1 2019 internationally. 
      • Domestic growth will partially lap i7 in Q3 this year and fully lap it in Q4.
      • This timing lines up poorly for IRBT as Shark launches its i7 copycat, the Shark IQ Robot Vacuum R100 which we expect to hit the US markets in late September. The marketed ASP for R100 is $400 versus the i7 list price of $800. Note: iRobot is currently discounting their i7’s by $100 and selling them for $700.
    • International growth driven by i7
      • Comments from the Q2 CC
        • EMEA grew 18% y/o/y in Q2 primarily driven by enthusiasm for i7 and i7+
        • Japan grew by more than 25% driven by the i7 and i7+ and the e5
        • New products, which include i7 and i7+ in international markets are on track with our target of 15% of total 2019 revenue.
        • Guide included increased promotions year-over-year primarily attributable to EMEA.
    • Competition internationally is increasing, resulting in lower international gross margins as iRobot discounts products to remain competitive.
      • Competition is coming from Roborock and Ecovacs (both Chinese companies)
      • Q2 2019 IRBT – 10-Q, Th 08.01.19 3:08 PM http://snt.io/qjF5xmS8d The decrease in gross margin is primarily related to increased pricing and promotional activity in our international markets, most notably EMEA, as well as the increased tariffs on our Roomba products imported to the United States from China.
      • iRobot’s main weakness in international markets is driven by a lack of brand awareness which invites increasing competition and enables consumers to freely switch between brands. 
        • Google Trends – Look at search trends for “vacuum”, “vacuum cleaner”, “Roomba”, and “Robot Vacuum” by country as a proxy for Roomba’s brand awareness. Some markets such as Spain and Italy in EMEA carry higher brand awareness but are under attack by competitors drafting off of iRobot’s investments in advertising 
  • What did management bake into guidance when they announced Q2?
    • Q2 conference call — “We expect other players in the marketplace in North America will also raise their prices. The other players either operate on very, very thin margins or also are structures where premium margins -- premium healthy margins are critical to their business model, so in either case for the company absorb a 25% increase in COGS without impacting their price and market twice. So this will be across-the-board.”
    • Based off our analysis of Amazon best-selling robot vacuums, we believe prices have not increased and, in some cases, have decreased. We used Keepa to view historical prices. The screen shot below is an example using the 4th best-selling robot vacuum, an Ecovacs DEEBOT 500, as an example. The price as of August is comparable to Prime Day pricing. As a reminder, iRobot called out Prime Day pricing as a driver of sales for themselves and it is likely a headwind to sales as eat the tariff and hold or cut prices.
      •  
    • iRobot likely responded to competitor’s pricing decisions by cutting prices on 8/18 across multiple models. 
      •  
    • Seasonality plays a role in pricing and historically Q3 has had the lowest ASPs in 3 of the past 5 years. Q4 is more mixed without a clear trend. The price cuts in August could be the result of seasonal factors however our analysis of prices using Keepa do not indicate that it is likely.
      • First, based off our review of Keepa historical prices – cuts typically occur in September rather than August. Indicating the recent cut in prices across models is more related to competition than seasonality. If nothing else an early cut to prices is a clear negative. 
      • Second, the hike in prices across competitors that management expected and referenced in their Q2 conference call did not occur evidenced by our review of the top 50 best-selling Vacuum robots. 
      • Below is a table to demonstrate seasonality in ASP’s
      • 
        

• Short-Term Margin Pressures
  • Looking at the last point above on pricing, we expect Roomba to discount more heavily than they already have been in the past to keep unit volumes up which will negatively impact margins. We expect gross margins to miss guidance. 
    • Price cuts will have a meaningful impact on gross margins and require the company to cut operating expenses to meet guidance. These decisions would help short term profitability but would be long term negative as it would limit the capital available for driving future innovation. 
    • We estimate the incremental 5% tariff will likely reduce Q4 domestic gross margins by ~140 bps or ~75 bps to consolidated gross margins.

Valuation

Some might find it troubling that we do not highlight a price target or discuss valuation for this pitch outside of a reference to IRBT’s ~24x NTM P/E. It is our experience that any company set to cut guidance two quarters in a row as a result of increasing competition/regulatory headwinds will see their share price decline. We agree whole heartedly that IRBT was a better short at 42x NTM P/E early this year but that does not mean it is not a good short today at ~24x NTM P/E given the recent developments and risk that the denominator is inflated in NTM estimates.

Risks

• Short Interest is relatively high at ~33% of float and days to cover is ~7
• iRobot is seeking a waiver to exempt robot vacuums from tariffs. The process has already begun but any update is expected to be well into 2020 if it occurs. 
• Some trade deal is reached.

Catalyst

• Miss Revenue
• Miss GM%
• Cut Guidance