2023-05-16 05:01:48 ET
Summary
- At the end of March, I recommended avoiding or shorting IRBT shares despite the potential tie-up with Amazon.
- Shares have since plunged another 20%+, underperforming the market, and the arb spread now offers an incredible 80% upside.
- While not ready to make an outright bullish call, I am upgrading IRBT shares to HOLD.
Despite my preference for (and broader experience with) long trades, I issued on Seeking Alpha a SELL recommendation for iRobot ( IRBT ) shares at the end of March. Personally, the investment case looked like a potential example of what Howard Marks described as first and second-level thinking in his famed "The most important thing" investing book. The arb opportunity (first-level thinking) was there for everyone to see. Last August, Amazon ( AMZN ) offered $61 to take IRBT private, and the arb spread represented an attractive 30% discount to the buyout price. However, the second-level thinking screamed caution to me. By analyzing how such a discount fared in relation to the probabilities of a deal going through and the risks in case IRBT should continue as a standalone business, I concluded that the risk/reward proposition was skewed to the downside.
Quantifying the scenarios, I considered the chances of problems with regulatory authorities and IRBT earnings power, then warned that a 50% chance to get a 40% reward ($43 to $61) was not worth the equally possible risk of a 50%+ freefall ($43.1 to $20). Moreover, in the meantime, shorts were circling the stock, with a high short interest on IRBT shares that suggested the Street was also looking at this with a lot of skepticism. Fast forward to these days, and IRBT shares have plummeted another 20% further towards $34, underperforming the market by 25%. With such background, I have decided to follow up on my original call to understand the reasons for the drop and whether the time has finally come to switch sides on this trade.
No significant changes in the M&A outlook
Last month, IRBT shares fell in sympathy with Activision ( ATVI ) on the news that the UK's antitrust regulator was moving to block Microsoft's ( MSFT ) planned purchase of the videogame maker. The information should not come as an overly big surprise to readers. I have already outlined in my original article how the scrutiny of FAANG's M&A deals has considerably increased in recent months. Even if, on the one hand, regulators have taken a more confrontational approach towards FAANG's acquisitions, on the other hand, the blocking of the MSFT/ATVI tie-up has no practical consequences for IRBT or AMZN.
Regarding the IRBT deal specifically, only a little has changed since March, but what has happened is in line with expectations. The UK's CMA has launched an inquiry into the merger last month. The move was to be expected and again shows how regulators are just not letting these deals go through lightly anymore. The European Union should be the next antitrust authority to open an official investigation. Even if an official inquiry does not necessarily lead to a block of the merger, I continue to see how claims could emerge about the potential misuse of the data collected by the robots. Alternatively, arguments could be raised about alleged anti-competitive practices vs. other vacuum cleaner vendors by misusing AMZN marketplace's collected data.
In the comments to my last article, I was grilled by bulls about how unsubstantial the EU/UK claims might be. However, the truth is that it does not matter whether I think the antitrust claims are not substantial. My only interest is determining how antitrust authorities will act based on whether they believe their arguments are correct. Warning signs are flashing that they could act against the deal or, at the very least, conduct a detailed investigation. My feeling is that such formal inquiries could go either way, so I am reiterating my 50% chance that regulators will eventually move to block the merger. But even by leaning towards thinking that the deal can go through, it will still take a lot of time. The initial outside date for the merger is August 4 th , 2023, but the contract could be extended for up to 24 months after that so that the deal's final closing date ends up somewhere in H1 2025. That's a lot of time to sit and wait on either side of the trade.
Deteriorating results
Another point raised in my previous article was that analysts still largely underestimated how ugly IRBT results could get over the next quarters. I warned investors in March that IRBT was potentially facing a ($9) loss per share for FY23 compared to an unreasonably bullish consensus projecting a ($3.8) EPS loss. Then, on May 9 th , iRobot 1Q23 results came out:
And now, the Street Consensus is finally revising their FY earnings projections downwards, ending up way more aligned with my March expectations. While Main Street had to readjust their predictions, nothing has changed for my original model already presented in the previous article:
And Value For All
I still see IRBT returning to profit by FY25 and earning approximately $70M in operating income by 2025 and about $52.5 million in net income ($1.9 EPS) with a 25% tax rate. The above expectations reveal the true potential earnings power of the company regardless of the merger. If the deal falls apart, they should act as a valuation floor for iRobot.
Considered an effective tax rate of 24% and a cash conversion of 80%, that would leave us with approximately $42M normalized Free Cash Flow. By multiplying FCF for a fair multiple of 15x, I am still valuing IRBT at roughly $600 million or $20 per share. The number represents a current downside risk of 40%, still relatively high but for sure much better than the 55% risk I saw in March.
Putting it all together
Quantifying the above scenarios again based on the current IRBT share price, the potential upside has increased from 40% to 80%. I have rarely seen arb spreads so large, and it is evident that, even if risks remain high, the reward now seems enticing enough to get big fishes interested. I am not suggesting this will happen, but as Warren Buffett took a stance in ATVI after the MSFT merger deal was announced and an unusually wide arb spread was available, somebody could decide the same kind of trade is worth the risk for IRBT. On the other hand, the downside risk has decreased, in my view, from 55% to 40%. While IRBT is not profitable, it remains an interesting business with appealing products. iRobot holds valuable know-how in the consumer robotics space, and I have little doubt management can successfully maneuver through the rough economic conjuncture. Based on the more favorable risk/reward proposition, I am backing off my negative view and upgrading IRBT to HOLD. While I am not convinced enough to flip towards a bullish call (a 50% chance of a 40% downside still leaves me somewhat uncomfortable), I now see the increased attractiveness of taking the long side of the trade.
For further details see:
iRobot: Merger Risks-Reward Balancing, Taking Profits (Rating Upgrade)