iRobot Stock Downgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

iRobot (NASDAQ: IRBT) recently released a bang-up earnings report.

For the first time in history, the maker of Roomba robotic vacuums and Braava robotic mops raked in $1 billion in sales in a single quarter. The company beat expectations for Q4 sales and earnings, and announced new guidance well ahead of what Wall Street was looking for.

Now, Canaccord Genuity is downgrading it.

Five dice labeled buy and sell on top of LCD screen showing stock charts and numbers
Five dice labeled buy and sell on top of LCD screen showing stock charts and numbers

Image source: Getty Images.

Canaccord was for iRobot before it was against it

Mind you, this is not because the Canadian investment banker hates iRobot. The opposite would be more accurate.

Late last year, when much of Wall Street was still worried that iRobot would miss earnings because tariffs on vacuums produced in China would hinder sales in the U.S., or hurt margins -- or both -- Canaccord stepped up to recommend buying iRobot stock, which it believed would outperform the market and rise as high as $115 a share. Three months later, however, iRobot shares have already soared past that price target (they're selling for about $118 today), prompting Canaccord to observe that they're starting to look a little pricey.

As reported on TheFly.com, Canaccord is cutting the stock to hold and tweaking its price target ever so slightly -- from $115 down to $114.

Earnings gave Roomba wings

This hardly seems fair, given how well iRobot performed last quarter.

In what CEO Colin Angle described as "a phenomenal finish to 2018," iRobot reported 24% sales growth in its robots, thanks in part to the company's decision to "absorb" the effects of President Trump's 10% tariff on robots imported from China -- keeping its prices low enough to attract buyers in the crucial holiday sales season. Despite these tariffs, iRobot managed to report an operating profit margin of "nearly 10%," with the result that per-share profits soared 450% to $0.88 (for the quarter) and 73% to $3.07 (for the year).

Furthermore, the company issued new guidance for fiscal 2019, predicting it will book just under $1.3 billion in sales this year (about 18% more than last year) with earnings of $3 to $3.25 per share.

Is $3 a share good enough? How about $3.25?

And yet, if you crunch the numbers, even hitting the top of that guidance might come as a letdown to iRobot shareholders. Given the $3.07 that the company earned in 2018, $3.25 in per-share profit would work out to less than 6% growth. This means that profits will grow less than one-third as fast as sales this year, presumably due to a big decline in profit margins, which will not please investors one bit.

There's also the stock's valuation to consider. iRobot today trades for 37.5 times trailing earnings -- and an only slightly less extreme 36.4 times projected 2019 earnings.

What's more, S&P Global Market Intelligence data show that iRobot's cash flow has been declining for two years in a row (yes, despite growing "earnings"). As a result, its valuation looks even more extreme when considering its cash profits. With cash flow falling, and rising capital spending, iRobot dropped below $40 million in free cash flow last year -- down 63% from its $105 million cash haul in 2016. Valued on its cash profits, iRobot now sells for a very rich 84 times free cash flow.

Even with most analysts in agreement that iRobot can recover from this year's growth slump to increase profits at a more respectable 20% annually over the next five years, 84 times FCF seems like an optimistic valuation.

The upshot for investors

Granted, it's possible iRobot will surprise us, and grow earnings faster than 20%. The company has already announced a new Terra lawnmower to help goose sales growth, and promised to introduce several new products "midyear." Still, it's uncertain how much of this promised product innovation is already baked into analyst estimates for iRobot's earnings growth. In Canaccord Genuity's view, all this uncertainty adds up to a very good reason to take profits today, and back away from iRobot until its valuation looks a bit less stretched.

I agree.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends iRobot. The Motley Fool has a disclosure policy.