iRobot Corp (IRBT) 2008 Q3 法說會逐字稿

Please stand by. We're about to begin. Good day everyone and welcome to the iRobot third quarter 2008 financial results conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Elise Caffrey of iRobot Investor Relations. Please go ahead.

Thank you and good morning. Before I introduce the iRobot management team, I'd like to note that statements made on today's call that are not based on historical information are forward-looking statements and made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. This conference call may contain express or implied forward-looking statements relating to the Company's financial results and operations, demand for the Company's products and services and business conditions.

These statements are neither promises nor guarantees but are subject to a variety of Risks and Uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those contemplated in the forward-looking statements.

In particular the Risks and Uncertainties include those contained in our public filings with the Securities and Exchange Commission. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

Please note that a live audio broadcast of this conference call is available on the Investor Relations page of iRobot's website at www.iRobot.com. An archive version of the broadcast will be available on the same web page shortly.

In addition, a replay of this conference call will be available through Thursday, October 30, and can be accessed by dialing 719-457-0820, access code 8467473.

On today's called iRobot's CEO, Colin Angle will provide a review of the Company's operations and achievements during the third quarter of 2008, and John Leahy, Chief Financial Officer, will review our financial results for the third quarter. Then we'll open the call for questions.

At this point I'll turn the call over to Colin Angle.

Good morning and thank you for joining us. Given the increasing economic headwinds, I am especially excited to report our 17th consecutive quarter of year-over-year revenue growth. When we talked last quarter, we knew there were uncertain times ahead in the consumer sector, but no one predicted the level of turmoil in the markets experienced over the last couple of months.

Both of our businesses continue to execute well, delivering consolidated quarterly results that exceeded expectations-revenue of $92 million, pretax profit of $6.1 million and earnings per share of $0.15. Continuing emphasis on the fundamentals of our business is yielding tangible results. Increased focused on working capital management has improved our operating efficiency and strengthened our financial position. Redemption of our auction rate securities at par value earlier this year greatly improves our liquidity position.

During the quarter we aggressively managed inventory levels, driving an overall reduction in inventory when historically it has increased in this period. To achieve this reduction we developed production plans that run lean, relative to expected demand, and move slower selling Home Robot products through quick moving channels.

The sale of these robots put additional pressure on gross margins in the third quarter and will again in Q4. But we are focused on tightly managing controllable operating expenses. As a result of these actions, we are in a stronger financial position.

We continue to focus on improved liquidity and working capital management, as they are critically important to the Company, in light of current market environment and economic uncertainties.

Our Home Robot division had a very strong third quarter driven by Roomba 500's continued penetration of both domestic and international markets. And our Government and Industrial division we now have captured 100% of Government and Industrial's annual revenue that is contemplated by our full year guidance as a result of orders received for our PackBot robots from the US Military during the quarter.

This captured revenue is in the form of shipped products, services rendered, executed contracts to be performed and product backlog expected to ship this year.

Based on our strong results to date, we are increasing our revenue expectations for the full year. We now anticipate that we will deliver revenue of $310 million to $315 million. We have adjusted our expectations for full year pretax income to reflect the previously disclosed impact of the Nekton Research, LLC acquisition.

Based on an estimated pretax loss of approximately $1 million from Nekton coupled with continuing uncertainty about the retail market, we now expect pretax income to be $4 million to $5 million for the full year. Pretax income excluding Nekton remains consistent with our prior guidance and we have adjusted the high end of the range to reflect market uncertainty. EPS for the full year is expected to be $0.08 to $0.10, which also reflects a change in our tax rate.

Now let's look at the results in more detail. iRobot's 45% year-over-year growth was driven by our Home Robot division, which was up more than 56% from last year. In the third quarter we saw strong demand from our retail partners both domestically and abroad. We continue to experience growth in International revenues, in Q3 more than double those of a year ago, comprising approximately 26% of total Home Robot revenue in the quarter.

This year-over-year growth is especially impressive because we started shipping the new Roomba 500 series in the third quarter of 2007.

On the Domestic front, Roomba unit sell-through in the quarter was up year-over-year more than 30%. Our retailers are pleased with customer demand for our product in the third quarter despite overall weakness in the retail sector.

Now, let's turn to Government and Industrial robots. We delivered a record of 319 iRobot PackBots in the third quarter for a total of 645 year to date, up 78% over the same period in 2007. We also reached an important production milestone, that of delivering 100 PackBots per month to our armed forces.

On the last calls we discussed our expectation of several large orders of FasTacs, which would initially drive an increase in backlog and then generate revenue in the second half of the year as we delivered against these orders. To date we have received orders totaling $67 million for more than 425 FasTac robots plus spare parts under the $286 million IDIQ contract.

Product backlog was $37 million at the end of Q3. This level increased from $22 million at the end of Q2. Not reflected in this Q3 backlog is a $3.7 million order from NAVC, which was received following the quarter's end.

We also received our first order under the new $200 million IDIQ from the US Army's Program Executive Office for Simulation Training and Instrumentation-that's PEO STRI, on behalf of the Robotic Systems Joint Program Office. This contract replaces a previous $64 million IDIQ. The increased ceiling amount under which multiple types of robots plus spare parts, training and repair services can be ordered over the next five years reflects the military's expectation of increased use of robots over that period.

Our work on the future Combat Systems Program continues to progress on schedule. The FCS team recently passed a major milestone, the FCS SUGV Preliminary Design Review. This was a two-day comprehensive review with representatives from the Office of the Secretary of Defense, Army, Boeing and SCIC. Feedback from the customer was very positive.

Our SUGV Block 1, a commercial off-the-shelf version of SUGV, has been accelerated to be fielded with the first FCS enabled Infantry Brigade Combat teams as publicized by the Army this passed summer. The SUGV Block 1 was featured in the summer--featured this summer by the Army's AETF in the preliminary Limited User Test this summer at Fort Bliss. Numerous SUGV Block 1s were also predominantly featured three weeks ago at AUSA, the Army's largest and most important conference.

During the quarter we achieved two major milestones in the execution of our G&I platform strategy to produce combat proven robots with common software, controls and interfaces. Our military vision pictures unmanned systems all working together in what we call the Robotized Battlespace.

First, we received a long anticipated $3.8 million research and development contract from TARDEC, the US Army Tank Automotive Research Development and Engineering Center, which will result in the delivery of two iRobot Warrior 700 platforms. This funded research will enable us to advance the development of the Warrior platforms to the point of production in Q3 2009.

And second, we acquired Nekton on September 8. Nekton has been instrumental in shaping the underwater marketplace during the past six years by supporting customers such as the Office of Naval Research, Naval Undersea Warfare Command, the Naval Air Systems Command and the US Special Operations Command. We are excited to have the opportunity to acquire a company with such a successful history of innovation and insight in the underwater vehicle space.

Nekton's Unmanned Underwater System Ranger is a general development platform for small UUV capabilities such as multi-vehicle cooperation for search and survey, and the deployment of payloads that deliver mine neutralizing charges.

Weighing less than 20 pounds, Ranger is the current UUV standard for easy launch and recovery. We expect to market the Ranger product beginning in the second half of 2009.

Our Seaglider product, licensed from the University of Washington in June, is attracting significant interest in the oceanographic community. As proliferation of submarines in adversarial hands continues to accelerate, persistent surveillance involving gliders will be an important tool in keeping the world's oceans open for commerce.

Ranger and Seaglider position us well to meet the needs of military and commercial customers in this emerging space. With the Navy establishing a new combatant command for irregular warfare, we believe autonomous underwater vehicles such as those we are developing in Maritime Systems will play an important role in our nation's defense.

Rick Vosburgh, former President and CEO of Nekton, was appointed Executive Director of iRobot's newly established Maritime Systems group.

Looking to the full year, we expect annual revenues to grow 24% to 27% over 2007, or $310 million to $315 million. In Home Robots unit sales through the third quarter were up more than 65% and ASPs increased 9%. In our G&I business we had 100% visibility of our revenue prospects for the full year. Therefore the top line has been--has tracked ahead of our expectations, but there is uncertainty in Home Robots given the retail environment.

As John will discuss in a moment, we expect continuing pressure on gross margins in Q4 as we saw in Q3, and consequently we are not changing our pretax profit expectations other than reflecting the impact of Nekton, the Nekton acquisition, and economic environment.

Our continued focus on working capital management will put us in a stronger position as we exit 2008. To further support our efforts in this area, we have hired a highly skilled executive with 25 years of worldwide supply chain management at Gillette Corporation and New Balance Corporation as Vice President of Operations at our Home Robot division.

Before turning the call over to John, I'd like to comment on Helen Greiner's changing role at iRobot. As you know, Helen and I along with Rodney Brooks founded the company in 1990. Helen, as Chairman of the Board, has worked tirelessly to help the company grow as a robot industry and science education evangelist. She has decided to pursue other interests and opportunities within the robot industry, including her work with the Robotics Technology Consortium, Massachusetts Robotic Cluster and various boards on which she serves.

Helen will remain a non-employee member of the Board of Directors of the Company and we look forward to her continuing contributions in that capacity. I appreciate the Board's support as I assume the added role of Chairman of iRobot.

I will now turn the call over to John for a review of our financial results.

Thanks Colin and good morning everyone. Our financial performance for the third quarter exceeded expectations at both the top and bottom line. Revenue grew 45% over the third quarter of last year to $92 million driven by Home Robot division revenue, which was up 56% year-over-year. Revenue for the quarter included approximately $600,000 from our acquisition of Nekton on September 8.

Pretax profit in the third quarter was $6.1 million compared with a pretax loss of $1.4 million a year ago. Earnings per share were $0.15 for the third quarter compared with a $0.06 loss per share last year. Higher revenue and operating expense leverage drove this significant year-over-year favorability.

EPS in Q3 included a $0.01 loss per share from the Nekton acquisition, as anticipated, largely due to a write-off of in-process R&D and amortization. A change in our year to date tax rate improved EPS by $0.01 in the quarter.

Looking first at Home Robots, year-over-year unit shipments increased 55% resulting in revenue of $54 million in the third quarter, compared with revenue of $34 million last year. We expected revenue for the division to be higher than last year due to the Roomba 500 production ramp in the third quarter of 2007. However, our revenue was fueled by greater than expected growth in the International market, which totaled $14 million or 26% of revenue in Q3 compared with $6 million or 18% last year.

In the G&I division, total revenue grew 31% to $39 million. This increase was driven by fulfillment of several large orders for the PackBot with FasTac Kits. Contract revenue increased slightly from a year ago and we now have the long expected funding for Warrior development, which will help boost contract revenue in Q4.

G&I product revenue was $34 million in the third quarter compared to $24 million a year ago. We shipped 319 robots during the quarter, 279 of which were FasTacs. Product life cycle revenue or PLR was approximately $6 million or 18% of G&I product revenue compared with 11% of product revenue in Q2.

At the beginning of the year our customers were focused on ordering robots for the field. In the third quarter we received multiple orders for spares in part due to the end of the government's fiscal year.

For the total Company, gross margin for the third quarter was 31.3% of sales, down slightly from 31.5% last year. Home Robot gross margin increased 2.4 percentage points while G&I gross margin decreased 2.4 points.

The improvement in Home Robot margins was driven by product mix. Revenue in Q3 2008 was primarily from the sale of Roomba 500s while a year ago we were transitioning the product line from Roomba 400s to 500s. The higher Roomba 500 gross margins coupled with product transition costs in the third quarter a year ago drove the gross margin improvement.

G&I margins were negatively impacted by lower product life cycle revenue and shipments of lower margin FasTacs versus higher margin MTRS units last year.

In the third quarter we continue to aggressively manage operating expenses, which were $23 million or 25% of revenue compared with $22 million or 35% of revenue a year ago. Operating costs this year included the write-off in-process R&D for Nekton. The 10 percentage point improvement reflects our increasing scalability and our focus on expense management.

On our last call we estimated a full year tax rate of 43.9%. We now expect the full year rate to be 48.8% largely due to our updated pretax income outlook. Because we are in a year to date loss position, we booked a 36.5% rate in Q3 as a true up. The increased full year tax rate negatively impacts EPS by $0.01 for the year.

Operating cash flow for the quarter was essentially break-even, comparing favorably with a negative operating cash flow of $19 million a year ago. The significant improvement this year is a result of our focus on inventory management. We expect to see strong operating cash flow in Q4 and to report positive cash flow for the full year.

EBITDA for the third quarter excluding stock compensation expense of $1.8 million was $9.6 million compared with $0.5 million a year ago. EBITDA margin was 10.4%. This non-GAAP metric is an important measure of our operating profitability and we will now be reporting EBITDA each quarter.

At the end of the third quarter we had cash and investments totaling $27 million compared with $30 million at the end of June. Included in the Q3 balance were $16.2 million of auction rate securities, or ARS. On October 6 the ARS were redeemed at par. We received the full $16 million and have used the proceeds to pay off the $5.5 million credit line balance outstanding at quarter end.

Our cash balance was also impacted by the $10 million consideration plus closing costs of the Nekton acquisition.

During the quarter we also favorably amended the terms of our $50 million credit facility with Bank of America, which gives us increased borrowing flexibility under the agreement.

Day sales outstanding were 48 days, up from 36 at the end of the second quarter but down from 54 last year. You should expect our accounts receivable for the remainder of the year to increase somewhat as our retailers continue stocking for the holiday season.

We are seeing tangible results from our focus on improved inventory management. At the end of the quarter inventory was $42.6 million, down from $43.3 million at the end of the second quarter, counter to seasonal trends. Inventory was down $1.1 million or 3% versus Q3 last year, despite revenue growth of 45% year-over-year.

Inventory turns were approximately six times versus four times last year. As Colin mentioned, this improvement was driven by a two-pronged approach of more aggressively managing production builds and a concerted effort to push slower moving SKUs through our sales channels. We expect a significant decrease in inventory in Q4 as well.

The Nekton integration is on track and the business outlook is consistent with our expectations. Q4 revenue is expected to be $600,000 to $800,000 with a pretax loss of $500,000 to $600,000 for Nekton or a loss per share of $0.02 due to Nekton. We estimate we will have a pretax loss for the full year from Nekton of approximately $1 million.

To summarize, the third quarter was stronger than expected in a tough environment, indicating the attractiveness of our products and our business model. And we will continue to aggressively manage our operating margins, working capital and cash flow.

Now I'd like to turn the call back to Colin.

Thank you John. In conclusion we exceeded expectations at both the top and bottom lines and while there's a great deal of uncertainty about the economy for the rest of the year, we expect to deliver full year revenue of $310 million to $315 million, pretax income of $4 million to $5 million and EPS of $0.08 to $0.10.

We'll now open the call to questions.

Thank you. (OPERATOR INSTRUCTIONS) We'll take our first question from Paul Coster with JPMorgan.

Thanks. Good morning. Colin, I hate to do this to you but '08 is already history I think for most investors but what about '9? Can you give us any early thoughts about either of your segments moving into the New Year?

We're not commenting on '09 guidance at this point. We're all concerned about the economy and how that'll impact us but as you see we've held up pretty well so far this year.

Do you have pretty good visibility into the G&I business going into '09 at this point?

I think that as we look at FCS with administration change and so forth, it is difficult to say definitive things about how it's looking. But the demand for robots is continuing to help transform our military. It is still strong and we just can't comment exactly on the mix between FasTacs and SUGVs and that whole transition between robots going to the infantry at this point.

Okay. John, a couple of quick questions. The tax rate for '09 and you mentioned EBITDA is an important metric for you. Does that mean you'll be issuing guidance on an EBITDA basis and are you expecting to sort of be sustainably EBITDA profitable at some point in the near future?

Paul, in terms of EBITDA I do see EBITDA as an important metric for us going forward and so that would form part of our guidance going forward. I can't say right now whether we will be consistently EBITDA positive, meaning quarter in-quarter out in the near to mid term. But clearly that is an objective of ours to get there at some point.

Maybe that will be welcome. Any FX benefit you can talk of this quarter, any hedging on the go forward basis given how big that's becoming now? Is the International business becoming part of your revenue? And any comments on nickel pricing and hedging there as well, please?

Really nothing meaningful in terms of FOREX at this point, Paul, since although we do have European sales starting to become more meaningful, the domestic business still really shadows offshore, so nothing meaningful in terms of FOREX hedging.

Nickel continues to decline. I think it's down to something like $10,000 or $12,000 a ton from a peak of $55,000. We are in the midst of our negotiations right now for pricing for next year with our contract manufacturers. So nothing to report except clearly the improvement in nickel will benefit us and help in those negotiations.

And my last question, is the Warrior contract to R&D revenue that you've won? Over what kind of timeline should we recognize it and can you remind us how much that was again?

It's $3.8 million and it's a multiyear contract so we'll be beginning to see favorable impact from that contract in Q4 of this year and that'll extend through next year and perhaps a bit beyond.

Okay. Thanks very much.

You bet.

We'll go next to Alex Hamilton with Jesup & Lamont.

Hi. Good morning. How are you? Two questions. One, I've heard and not to take away from anything, I've heard vast improvement in terms of progress made in terms of liquidity. Can you talk just strategically about how you guys are viewing margin improvements going forward?

And then my last question is related to inventory. Obviously you worked that down. Can you talk about the nature of that inventory work-down?

Sure. Let me start with the first one and John will jump in. With respect to margins, the two sides of our business are approaching profitability improvement in different fashions. On the Home Robots side we see significant opportunity for product gross margin improvement as we look at what goes into the bill of materials, as we become more and more sophisticated in managing our costs, and as we come out with new higher value products over time.

Okay.

So there is substantial opportunity on that front. On the Government Industrial side we have been developing a tier one team to allow us to operate on a very large scale and to a real degree have been adding competencies, which has increased our indirect costs on the Government side. And as the revenue associated with Company possessing those competencies continues to build we can more fully absorb those costs. And we again see opportunities for real improvement in operating margin through scale on the Government side.

So we have mechanisms on both sides that we are aggressively pursuing and believe strongly that they will have the desired effect.

Thanks Colin.

In terms of the inventory question, I guess I would frame it in terms of this is an overall effort to better drive operating cash flow and therefore working capital. And this is something we've been working very aggressively with over the last several months.

Were they all Roomba 500s or are they older SKUs?

So what we've done specifically in terms of inventory is really a couple of things. One is driving towards leaner and more tightly scheduling of production and therefore not having the sort of inventory build that we've experienced before.

And we started to see the impact of that in Q3 despite the seasonal trend, expect that we will see a very meaningful impact in Q4 in terms of reduction in inventory and therefore improved operating cash flow.

During the quarter, as Colin mentioned in his remarks, we also were pushing harder in making sure that we moved older or slower moving SKUs. And so those were older versions of Roomba and older versions of Scooba that we pushed through. I expect that that will continue through Q4 but it might not be of that magnitude that we had in Q3.

And then just lastly, can you provide a little more color on the tax rate and what the increase is?

Yes. So it's a bit frustrating for us as I'm sure it is for all of you to try to keep track of what's going on with the rate. The rate that, the adjustment that we made again this quarter with an expectation of a full year rate of 48.8%, it's largely due to the fact that we've lowered the pretax outlook largely because of the impact of Nekton, and while at the same time we have permanent difference items which stay in tact and stay fully taxable. And those are things for us largely it's stock compensation expense.

So if your pretax income shrinks, those permanent items serve to inflate the rate. And so we booked in Q3 a true up to get the year to date rate to 48.8% and then we expect in Q4 to be booking 48.8% once again.

Okay. Thank you.

We'll go next to Jim Ricchiuti with Needham & Company.

Thank you and good morning. I was wondering if you could give us a sense as to how the retail sell-through tracked as the quarter progressed and maybe thus far in October. Here's what I'm trying to get a sense is to at what extent your retailers have grown more cautious and how much more cautious in recent weeks just given the economic environment.

Sure. As I said in the call, sell through and our performance in Q3 was very, very strong. But we certainly have seen some drop off and weakening in retail sales thus far through the fourth quarter and our guidance reflects our best guess of how that weakening will continue and where we'll end up at the end of the quarter. But there is substantial uncertainty.

Depending on who you listen to, predictions run from bad to dire and we're trying to make sure that we treat our inventory position and treat our expectation as to Q4 performance appropriately.

So that is the biggest area of current uncertainty in our business and we're doing our best to appropriately manage that risk.

Colin, if we look at the International business, to what extent is that caution coming through in that portion of the business, which has grown very rapidly the last couple of quarters. Are you seeing the same kind of conservatism?

I think that the difference between our Domestic and International performance represents the fact that internationally we are very early in the adoption of Roombas and so that the--our market penetration is so small that despite the worsening economic environment, we've seen less--we still continue to grow sales because we're moving off such a small base. But it is doubtless that in a different economic environment we would see even more improvements internationally.

So we're taking that conservatively and trying to set modest expectations for what's going to happen in the fourth quarter and going forward internationally as well.

Any specific countries that have been very strong internationally that you seem to be getting traction a little sooner than expected?

As we've said, as a category International is growing at an exciting clip and it's currently exceeding expectations. This year our progress in Europe has been particularly pleasing as a result of finally getting a distribution strategy right and in place long enough to start harvesting the benefit. And that was a major investment last year and we've been reaping the rewards this year. So that has been wonderfully satisfying to see that play out.

Okay and you may not be prepared to answer this question but I'm just wondering if how we should think about 2009 from the standpoint of new products in the Home Robot business. Obviously you're not going to announce anything but how would you characterize the year in terms of activity and maybe just the timing?

We are a robot company and we continually work on new products. In the Home Robot division you have to frustratingly wait for them to be blessed by us and ready for a real launch, so that it is a continuing priority of iRobot to find, discover, invent, reduce to practice, manufacture and distribute new products, that the strategy is unchanged but I've got nothing to say on that front.

And I might say that in 2009 we are, and currently, particularly focused on making sure that we are right-sized, that we have--our operating expenses are on track to deliver the type of profitability improvements that we have promised.

Okay. John, can you talk at all about OpEx in Q4 just relative to your guidance, any specific guidance that you might be able to provide in terms of R&D, G&A?

Jim, in terms of total OpEx, as I mentioned in the remarks, we've been focused on running tight. I think the Company's did--has done a good job the last few quarters of leveraging our OpEx as revenue has grown. So OpEx was about 25% in Q3 as a percentage of revenue.

I would expect similar sort of leverage and therefore similar sort of OpEx as a percentage of revenue in Q4 as we saw in Q3. I would not want to try to break out the individual line items but suffice to say, as Colin said, we are managing our costs as well as working capital very aggressively and so you should expect to see the results of that in Q4.

Okay. Thank you.

We'll go next to Barbara Coffey with Kaufman Brothers.

Yes, good morning. A couple of questions on the European, or on the International expansion, a lot of that last year, or last quarter was so into the channel. Are there indications that these channel partners are re-upping and ordering in?

And also as credit lines to retailers have gotten tighter, have you ended up seeing a different pattern of ordering from those partners? And as a cousin to that, the website traffic to your own site and strengthen that and changes in that--buying patterns, customer and website?

Okay, the first question was about International inventory and I would say that we've been now in the European markets strongly since Q3-Q4 of 2007 and so that we're in a cycle where it's not so much expansion of retail outlets and channel sale associated with that. We are into the reorders. There are certainly some stocking for the holiday season in Europe but that tends to be less pronounced than in the United States.

And so the type of performance that we have been delivering in Q2 and then again in Q3 needs to be viewed as driven by sell-through to a very great extent, so that I don't feel like we are stacking and have any sort of inventory challenge internationally.

That said, we have--we do have less visibility on that front because we sell products to distributors which then bring them to the ultimate retail partner, so our data is less strong. But we do have anecdotal evidence through continued orders and what we hear back from our distributors, that sell through is very strong.

The buying pattern of the trade question, it is true that retailers open to buy levels are--have been reduced from what we have seen and so that we're--it does create a slightly different pattern of ordering where you have more frequent smaller orders.

And we also saw some orders in Q--pulled into Q3 from Q4 so we're trying to stay ahead of that. I think we're current--we have manufactured, as John has said, a lean set of product so that we don't intend on allowing ourselves to end the year under inventory.

And again, we've been at this for many years and have very tight relationships with our vendors and they give us our plans and the pattern is different but it hasn't shifted much from the perspective of Q4 orders into Q3 beyond what we previously said.

And your third question was on direct. Q4 tends to be our strongest quarter from a direct perspective and like all of our other channels, we are seeing a slowing of orders on direct and have done our best to model that, predict where that's going and then reflect the impact through our guidance that we're providing to you today.

Thank you.

We'll go next to Josephine Millward with Stanford Group.

Hi, good morning. Congratulations on a great quarter.

Thank you.

Colin and John, your guidance implies a pretty significant gross margin improvement in the fourth quarter. I think it's over 35%. Can you address how, specifically how you plan to get there in both of your divisions?

Josephine, I think the implied gross margin, although it's certainly higher than Q3 and our year to date run rate, it's fairly consistent with what we have done in prior year fourth quarters. So Q4, just because of seasonality, our gross margin and our operating margins are the strongest of the year. So I think your observation is right however it's pretty consistent with what we've experienced in the past.

And so I don't think I would add anything more than that because we expect that both divisions will perform like we've seen at Q4 in prior years.

Maybe you can walk us through your assumption in terms of percentage of direct sales for Home Robots because that in the past has been a real booster for your gross margins, right?

Certainly the direct does improve gross margins. So does, if you look at our historicals, our Q4s, is our largest quarter and our gross margins improved measurably as the top line increased. But if you look through the assumptions, John, on the direct --

Josephine, in the last year our direct in--as a percentage of revenue in HRD was about 18% in the fourth quarter. And on a year to date basis, it's running at about 18% this year. And so we would expect that we would see similar percentage of revenue in direct as we did last year.

The caveat though is we've seen some of the same earnings releases that you have, for example, with Amazon that are indicating expected softness in Q4 and so we're tuned into that like everybody else.

Right, right.

And we're somewhat wary of the impact that the economy will have on direct and so we're being cautious with our plans and the investment we're making on the direct side.

On that note, given the weakening economic environment, can you give us more color on what drove such strong demand for Home Robot in case we--and whether you expect these trends to continue?

The good news is this is a new area and the negatives of the economy are offset by the rapid increase in demand and desire for our Home Robot products. So this is not a mature industry by any stretch of imagination. And there's a great cadre of people around the world who don't yet believe that vacuuming robots work and as they learn this, are very desirous of this product.

So it's not a question of steady state and the economy is the primary driver of demand. What we're seeing is people becoming, continuing to become very exciting about this emerging new category of product. And as they come to believe and see this as being very reasonably priced, they go out and buy this stuff.

Now no doubt that is negatively impacted by the economy but as we talk to our retailers often we hear that we're the good news story in the otherwise very challenging category that they're trying to manage.

Colin, can you talk about the launch of your new products targeting pet owners and small business? How's that going?

The Roomba for pets and the Roomba Pro have been doing very, very strong, in fact they are combined the largest selling SKUs on our website. Again, that helps with ASPs, it helps and it validates our theories that we can put more features into a home vacuuming product and even if it commands a premium price, effectively sell them through our website. So that's a very, very good news story and it's going to encourage us to try more things.

Great. Finally, can you just give us an update on the ocean glider bid, if you expect to hear any time soon?

We submitted the bid two months late as the--as NAVC kept delaying things so originally mid-September was the award--the specified date for award but if you run that two month delay through that original September date, you end up in November.

We really don't have any information. We recently asked and were told nothing.

On that note, do you expect undersea vehicles to be a revenue contributor next year?

We do believe that it will be a revenue contributor as we--of about $6 million to $8 million on the top line but we don't believe it to be an earnings contributor. We saw a small loss in '08 and '09 as--due to the Nekton acquisition and disclosed that previously.

Okay. So the $6 million to $8 million is just from Nekton. You're not --

Yes, that would be --

--into consideration any new potential from the ocean glider.

Were we to--yes, that is x-ocean glider revenue. That does not assume the LBS contract.

Thank you very much.

You bet. So this will be the last question?

Yes. We'll go to Jim Ricchiuti with Needham & Company.

Okay.

Thanks. Just a final question. It just has to do with the product life cycle revenue in the G&I business. You guys obviously have some pretty good history now in terms of the robots that you've put into the field and I'm wondering if you can give us a sense as to after what point in time does the regular maintenance requirements really begin to pick up for these robots as they're in the field?

I think that what we've said is in the past that over time we hope that the product revenue coming into G&I will have about a 20% component of this recurring PLR revenue as an overall percentage. And we've exceeded that some quarters. We've been under it some quarters. This quarter around 18%, we were very close to it. And our install base continues to grow and we see opportunities through partnering and through our AWARE software and our developers [confidences] of continuing to advance this concept of platform--as iRobot platforms as a generic multi-use strategy for the government.

And so I think that we are in the ballpark where we believe we can be long term. And we see that our ability to sustain that 20% figure could become easier over time.

Okay. Thank you.

You bet. So thank you. That concludes our third quarter earnings call. We appreciate your continued support and look forward to talking with you again following our fourth quarter.

Thank you ladies and gentlemen. Once again that does conclude today's conference. We thank you for your participation and you may now disconnect.