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iRobot Corporation (IRBT) had a blow-out Q3-20, reporting better-than-expected revenue growth of 43% despite Prime Day moving from July to October this year. Although Q4-20 expectations are filled with cautious optimism, as is the case with many retail companies, guidance figures point to the company reporting sustained growth in Q4-20 and a strong finish to FY-20 overall.

Thesis: Based on the execution of iRobot’s growth map in DTC ahead of product expansion, there is ample room for prolonged growth at the top as profitability metrics remain fairly stable. While there is definitely a medium-term upside based on current performance metrics, the real upside comes from the strong customer engagement ecosystem that the company is building out. It is this ecosystem that will deliver strong growth well into the future.

Q3-20 Review

Stellar numbers were reported all-round at the Q3 earnings call. Revenue grew in strong double digits, as we saw, with the U.S. market reporting 75% revenue growth, followed by EMEA at 22% and Japan at 12%, all over the prior period. Of significance is the fact that online sales now make up 60% of overall revenues, having grown by 70% between Q3-19 and Q3-20. Roomba sales accounted for nearly 90% of the mix, while the Braava line was driven by M6 sales and grew by 38% overall.

On the profitability front, gross margin was positively impacted by forex and the channel mix shift to e-commerce, as well as other one-time events like the timing of supply chain activities and, of course, higher revenues. The company reported a 48% non-GAAP gross profit rate. Operating expenses were up 18% due to short-term incentive compensation and additional investments toward DTC and revenue growth support. The company now expects to report an operating profit margin of 9% for FY-20, with a low single-digit margin projected for Q4-20.

The company reported non-GAAP earnings of $2.58, which beat analyst estimates by $1.58 for a 159% surprise and marks over 20 consecutive quarters of beating earnings estimates.

Despite beating estimates on EPS as well as revenue (by $98.5 million), the stock declined by about 15% after the earnings release. A plausible reason for the decline is that the stock witnessed a strong +25% surge ahead of Q3-20 earnings and, as a result, a significant portion of investors will have booked their profits at that level.

A further decline was seen after Pfizer (PFE) reported that an external panel of experts found that the vaccine candidate developed by itself and BioNTech was “more than 90 percent effective in preventing the disease among trial volunteers who had no evidence of prior coronavirus infection.” While the broader market rallied on the positive news on November 9, iRobot stock took a dive once again, the assumption being that the market sees a ‘returning to work’ trend as a negative indicator for iRobot products. I believe that’s highly unsubstantiated at this point. We’re not going to be seeing the vaccine come out for at least a few months, and even then the initial run will only be about 20 to 30 million units, per Pfizer. It’s going to be at least another year before everyone is vaccinated and even longer before the fear of COVID-19 is wiped out from the collective public memory.

At this point, there are some signs of the stock recovering, and the promising political climate ahead bodes well for the company that has been struggling to show a price return ever since List 3 was implemented, as seen in the price chart below.

Source: Seeking Alpha

For now, the company is under an exclusion period that began in April 2020 and will run through December 31, 2020, and expects the $25.4 million in pending refunds (from a total of $60.3 million) to be received over the next three quarters, “at the discretion of U.S. Customs.” The expansion of the Malaysian production facility to meet supply needs at scale will only be completed the end of 2021, which means FY21 could once again see the reinstatement of the 25% tariff under Section 301 List 3. This will “dampen our gross profit in 2021” per the company’s 10-Q filing for the third quarter of fiscal year 2020.

One of the main reasons the company was able to post strong gross margins for the first nine months of 2020 was that the refunds received until September 26, 2020, were recognized as a benefit to cost of goods sold – or cost of product revenue, to use the company’s preferred terminology.

Although another $25.4 million is yet to be received and recorded under the same line item, it may not provide a significant boost to gross margin moving forward, hence the lower guidance for Q4-20 and warning for FY-21.

Q4 Expectations and Key Considerations for the Future

The company has guided quite narrowly for Q4-20 and FY-20 revenues. It expects Q4 revenues in the range of $480 to $490 million for a growth rate of between 12% and 15% over the prior period. That puts FY-20 revenue guidance at $1.365 billion to $1.375 billion, representing 12% to 13% growth. Although this is better than what the company hoped to achieve at the start of the year, the market isn’t showing the kind of enthusiasm you’d expect.

From a profitability angle, gross margin is expected in the “low-40% range” for FY-20 and roughly 45% for Q4-20. We’ve already see the operating profit margin expectation of 9% for FY-20. Q4-20 will see a lower operating profit margin as well, due to an increased spending toward marketing and advertising, as well as software. Operating costs are expected to be reported in the range of $190 million to $194 million for Q4-20 and adjusted EPS guidance is $3.43 to $3.53 for FY-20.

iRobot expects to finish the year on a strong note despite worries that economic depression would affect the ability of consumers to purchase expensive home appliances. To the contrary, iRobot saw a significant boost in the premium segment:

“Quarterly revenue from premium robots, which are priced at $500 and up, grew by 86% and represented over 60% of our Q3 revenue.”

That’s double the growth rate seen in Q2-20, when the company reported a “43% increase in premium robot (list price of $500 or higher) revenue.”

Part of what’s driving this growth in the premium segment is the fact that the company actively drives higher levels of customer engagement through its software and other digital investments. The best example of that is the Genius Home Intelligence platform, which allows for a granular level of customization. User can specify cleaning routines, get Keep Out Zone recommendations, and so on. Another example of its proactive approach to customer engagement is the 7.8 million consumers that have opted into the company’s digital communication channels, which is a 45% increase on a YTD basis.

Another growth driver is DTC or direct to consumer, sales of which were up 155% in Q3 over the prior period and have reached $35 million. It’s admittedly small compared to overall revenues but the growth rate is certainly something to watch in the future. The DTC segment is further supported by new initiatives like Roomba Restore for refurbished Roomba units. During Q4, the company has also been testing various other services to enhance its DTC reach, and these are expected to be refined and rolled out in 2021.

Moving forward, the company is holding off on go-to-market plans for Terra, the robotic lawn mower. Part of the strategic reasoning behind that decision appears to be the company’s increased focus on engaging directly with customers. In the long run, this will create a strong delivery channel for future products, but it also means investing now in marketing and supply chain capabilities to broaden and deepen its reach within target segments.

I am of the opinion that this is a particularly astute move on the part of the company. Rather than growing heavy on the product side and continuing to rely on third-party distribution channels, it is building out the ecosystem that it will need to fulfill the needs of a larger user base that it can reach, engage with, and sell to directly. Genius is very much a part of that ecosystem, as is every other DTC initiative and investment that’s being executed or made now.

A good analogy would be the way Tesla (TSLA) built out its supercharger network well before it had sold enough cars to fully utilize that network. It’s a strategy that underscores the long-term vision of iRobot, and that should be a solid positive signal for any potential IRBT investor.

Investor’s Angle

Potential investors should not forget that IRBT continues to be a highly shorted stock. Although it’s been coming down since the 60% short interest high set in February 2020, it’s still relatively high at around 38%, as of this writing. As such, such a stock normally represents a risky proposition for investors.

That said, however, the current growth momentum coupled with the company’s vision for DTC and customer engagement indicates a strong long-term upside if you’re willing to ride the volatility that comes with the current economic climate.

iRobot has shown that it can keep growing its revenues despite economic downturns, and I don’t see that trend being disrupted in the foreseeable future. That’s validated by analysts’ price targets for IRBT, which range from a relatively conservative median price target of $81.14 for a 12% upside from analysts on MarketBeat to a median point of $96.5 for a 33% upside by analysts on WSJ.

While the short interest is definitely something to be concerned about, long-term investors can be confident that the strong fundamentals will eventually overcome any worries about the stock staying at depressed levels. We’re already seeing short interest and short volume ratios steadily coming down this month.

Source: Fintel.io

The road ahead for growth is very long considering that iRobot is operating in a segment that brings AI to practical applications, and the DTC ecosystem that the company is building out right now could lead practically anywhere – from robotic lawn mowers in the short term to robotic house-sitters, dog-walkers, house-painters, landscapers, and so many other home-based use cases in the future. Investing in iRobot is like getting in on the ground floor of a massive high-rise that will keep adding floors as the elevator ascends. Definitely a company to watch even if you’re not investing now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.