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Explaining iRobot's Inexplicable Stock Plunge

In this segment from the Market Foolery podcast, host Chris Hill and David Kretzmann of Motley Fool Rule Breakers and SuperNova unpack the reasons behind iRobot's (NASDAQ: IRBT) stock tumble in the wake of an apparently excellent third-quarter report and strong guidance.

Its P/E had some high expectations built in -- and part of the problem is that those expectations rely on the Chinese market.

A full transcript follows the video.

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This video was recorded on Oct. 26, 2017.

Chris Hill: iRobot's third-quarter profits -- help me understand this, please. Their third-quarter profits were up big. They raised guidance. They're growing revenue more than 20% year over year, and the stock is down 15% this week. What happened? Help us, America! What happened to iRobot?

David Kretzmann: I'm still trying to figure this out. This is puzzling. I think part of it was a lofty valuation. In contrast to Twitter and Buffalo Wild Wings, which are beaten-down companies, low expectations, iRobot was trading for a P/E multiple of over 40. So the valuation was lofty. Expectations were high. And the company has been getting a lot more attention over the past year or two. Well deserved, but expectations went up as a result.

I think part of the issue here is growing pressure for the company in China, where they've only operated for a couple of years. China still makes up less than 5% of their total revenue. Revenue in China this year will be down 25%-30%. A large part of that is due to increased competition on the lower end of the robot vacuum price spectrum. You're seeing more and more Chinese manufacturers competing with those lower-priced robot vacuums. And you're starting to see some of that trickle into the U.S. as well. You have the SharkNinja -- came out this summer.

Hill: Great name.

Kretzmann: You got a solid name. I don't know it can match the brand power that Roomba has, because iRobot through that Roomba brand really has developed a nice brand following a lot of brand awareness. I don't think that will be easy to match right away.

Anyway, you're seeing some of that price competition trickle over from China into the U.S. Also, looking at the guidance, they raised guidance; they're expecting earnings per share to be between $1.60 and $2.00 for the full 2017 year, but right now their trailing 12 months EPS, earnings per share, is $2.10. So essentially, they're guiding for earnings to drop from where they are due to the fourth quarter.

At the same time, they're guiding for revenue to grow at least 45% in the fourth quarter. But they're also guiding for earnings to take a pretty substantial hit. I'm not entirely sure why that is. It could be R&D, a marketing expense, something else. But when you're guiding for earnings to drop from where they are, that lowers the floor on the stock, so that could be part of it. And that's a double ding for when you already have a higher valuation. So I think that could be part of what the company is dealing with.

But looking longer-term, this is a company that now is entirely focused on the consumer-facing brands. They used to have a military division, which, from a cultural perspective, just didn't work very well. I read an interview with the founder and CEO where he said the military and consumer divisions at iRobot, they're actually competing against each other in a way. From a culture perspective, not a very healthy way to go. But now they're entirely focused on that consumer-facing side. Still less than 10% market penetration in the U.S., which is their biggest market with the Roomba. As connected homes become more of a thing, as people look to automate more cleaning in and around the house. I think Roomba still is in a positive position. But how they compete against these lower price competitors, that'll be a key thing to watch.

Hill: Am I the only one who thinks that a military type of robot vacuum would just be better and stronger and more effective than a regular one?

Kretzmann: Military grade.

Hill: If it's a military-grade vacuum, maybe I'm wrong, but I think that's just going to do a better job of cleaning.

Kretzmann: Maybe. Maybe there was a tie-in there.

Hill: Let's go back to the guidance for one second. I was struck by the range that you mentioned that they laid out, $1.60-$2.00 a share. Put aside for a moment the fact that to hit that range, their earnings would have to drop. Let's just put that aside for a moment. Am I the only one who thinks that's a really wide range? You can't get more specific than that?

Kretzmann: I think they could get more specific. You have to keep in mind that this is a smaller company; they're operating globally. There are a lot of different variables here. Management teams will have different philosophies here. Some will guide down to the penny, and others will leave this large range. Ideally you under-promise and over-deliver with these kinds of results. But in this case, when you only have one more quarter, you think you would have a little bit tighter range than $1.60-$2.00. But, hey, management teams, they choose how they roll.

Chris Hill has no position in any of the stocks mentioned. David Kretzmann owns shares of Buffalo Wild Wings and Twitter. The Motley Fool owns shares of and recommends Buffalo Wild Wings, iRobot, and Twitter. The Motley Fool has a disclosure policy.