Short Seller vs. iRobot: Can the Stock Be Too High for Its Own Good?

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On this segment of Industry Focus: Consumer Goods, Vincent Shen is joined by Fool.com contributor Danny Vena as they look at iRobot (NASDAQ: IRBT) and the bearish report from a firm called Spruce Point Capital Management.

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The latter is known for its calls to short companies, but its mixed record has us considering our own outlook for the consumer robotics company.

A full transcript follows the video.

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This video was recorded on Aug. 29, 2017.

Vincent Shen: Let's get specifically into this example with iRobot. What are the law firms here investigating then? What are they bringing up exactly? Because there has to be some basis for their investigations, no?

Danny Vena: That's true. What has happened is, there's a research report that was issued by a short selling company called Spruce Point Capital Management. Now, that company is headed by a guy by the name of Ben Axler. And actually, that's the only person that works for the firm as far as we know. He made his name by uncovering fraudulent Chinese reverse mergers, which is essentially a Chinese company that wants to enter the U.S. stock market. What they'll do is buy up a shell company in the U.S., and then do a reverse merger so they can basically cheat their way onto the stock market. So he made his name finding those types of situations and exposing those fraudulent companies. 

Since then, once he's gotten beyond that, it's a little more difficult to continue in that vein. You're only going to find that many companies for a certain amount of time. So what happened thereafter is, he started issuing short reports on companies for a number of different reasons. In the case of iRobot, he said there were several points, the first being that the stock performance -- the stock is up some 150% over the last year, and he said those gains are a result of the supply chain being restocked from the company divesting its military robot division, and also an acquisition of a Japanese distributor. Now, there's not necessarily a problem with any of those things, and what he says is the stock has run too far, too fast and there's going to be a reversion to the mean, they're not going to be able to keep up with those, that once it comes time for them to report earnings in the future, it's going to be difficult to meet those comps, and as a result of that, the stock is going to fall.

Shen: Yeah. It seems odd to me, what you mentioned in terms of this basis for some of these investigations in this report. This is an issue that will come up for plenty of stocks on the market. Things like hype do play into some of these bullish runs we see for these companies. And, overall, iRobot is followed quite closely here at The Fool, and some of the things that you mentioned, I understand the risk of having potentially flown too high, but there's nothing fraudulent here so far that we can see.

Vena: That's right. They didn't make any type of accusations, they merely said that because of these issues, he also pointed out that competition from SharkNinja, which is a competing vacuum company, they could potentially release a product to compete with the iRobot. SharkNinja released a product that competed and stole market share from the Dyson vacuum people. Also said that companies that have acquired their related party distributors have oftentimes run into issues that weren't apparent when they made the decision to do that. So they're saying there's potential for these types of problems. Not necessarily saying that there is any issue, but that there could be.

Shen: Sure. And I understand that you have some background here for Spruce Point Capital, in terms of some other instances where they've written reports and tried to leverage some of the market response in that. Could you share that with the listeners?

Vena: I'd be happy to. Let me first start by saying, anybody who wants to, all this information is publicly available. I went to Spruce Point Capital's website, I looked at the number of companies that they have written short reports on going back about two years. I eliminated the ones that were done most recently just because, whatever their thesis was hasn't had a chance to play out yet. So I want to look at my figures here for a second. Over the last two years, eliminating the reports from the last six months, the stock performance for the companies that were the subject of these reports, four of the 10 did significantly better than the market, three of them had single-digit percentage price moves either up or down, meaning they were essentially unchanged or even with the market, and three of them were down significantly. So what that shows is, out of these 10 reports that I've reviewed, Spruce Point Capital was right about 30% of the time. And if you take all 10 of those companies and compare the performance from the time they issued the report to the current day, and you compare that to the S&P 500 over the same time frame, the differences in total is less than 2% overall.

Shen: So not really that much there, as the reports and the legal response would seem to indicate.

Vena: Right. So it's one of those things that shareholders have to be able to and ready to deal with. These things happen, there are some companies that will be the target of these types of short sellers. And how they work is, they'll do a report, they wait until the stock runs up or until there's an issue, and then they will release this research report after they've sold the stocks short. Then, the stock will fall and they'll cover that short and pocket all the money.

Shen: Sure. That's really helpful background, and I think it's a very good reminder in this instance to be wary of this kind of research. When it comes down to it, even some of the most well-known investors that we follow and really respect here at The Motley Fool, think, even a Warren Buffett, will have their own reasons for calling out companies, good or bad, so you have to keep their motivations in mind and make sure you perform your own due diligence before you take any kind of action. I know, Danny, that you've done some additional research for iRobot specifically in this case. Really quick, what is your take? They make these consumer-focused robots, what's your take on the company's outlook?

Vena: I'm an accountant by trade, so I prefer to think in terms of metrics. If you look at, for instance, the recent sales on Amazon Prime Day, they doubled year over year from the prior Amazon Prime Day. In their most recent quarter, revenue was up 45% year over year. They beat guidance for both top and bottom line for the year, and the stock jumped to an all-time high. So that's probably part of what made it a target. What's exciting about the company is that their robot, the Roomba, the most recent model uses something called spatial awareness, which basically gives the robot the ability to determine where it is in a confined space. Now, what they're doing is using this technology to map the room that the Roomba is in, and from that, they're pursuing an entry into the smart home market. Now, the smart home market was $10 billion in 2016, and it's projected to increase about 60% this year alone. So it's a hot market, and they're looking to get into that market. What they're doing is asking Roomba owners if they will opt into the program to basically map their home, and they're using that information to hopefully help consumers better move into the smart home products that are out there.

Shen: Yeah. With that information, the idea is, it could help homeowners, and also the creators of smart home technology, get the most out of the experience and convenience that smart home tech can offer. And management at iRobot is really focused on this. Keep in mind, this is a consumer products company in terms of what they sell and how they generate the revenue. But they hold dozens of patents, they spend $100 million every year on research and development, so they're very focused on the tech behind this. I think that is ultimately, with some of the smart home and the mapping and the opportunities to branch out of that, the main thing to watch for this company going forward.

Danny Vena owns shares of Amazon. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and iRobot. The Motley Fool has a disclosure policy.