iRobot - Earnings Call - Q2 2020

Transcript

Operator (participant)

Good day, everyone, and welcome to the iRobot second quarter 2020 financial results conference call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Andrew Kramer of iRobot Investor Relations. Please go ahead.

Andrew Kramer (VP of Investor Relations)

Thank you, Operator, and good morning, everybody. Joining me on today's call are iRobot Chairman and CEO Colin Angle and Executive Vice President and CFO Julie Zeiler. Before I set the agenda for today's call, I would like to note that statements made on today's call that are not based on historical information are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties and involve many factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information on these risks and uncertainties can be found in our public filing with the Securities and Exchange Commission. iRobot undertakes no obligation to update or revise these forward-looking statements, whether as a result of new information or circumstances.

Related to our financial disclosures during this conference call, we will reference certain non-GAAP financial measures as defined by SEC Regulation G, including non-GAAP gross profit, non-GAAP operating expenses, non-GAAP operating income, non-GAAP income tax expense, non-GAAP net income, and non-GAAP net income per share. We believe that our non-GAAP financial results help provide additional transparency into iRobot's underlying operating performance and potential. Our definitions of these non-GAAP financial measures and reconciliations of each of these non-GAAP financial measures to the most directly comparable GAAP measure are provided in the financial tables at the end of the second quarter 2020 financial results press release we issued yesterday, which is available on our website at www.irobot.com and is provided at the end of these prepared remarks.

Also, unless stated otherwise, the second quarter 2020 financial metrics discussed on today's conference call will be on a non-GAAP basis only, and all comparisons are with the second quarter of 2019. In terms of the agenda for today's call, Colin will briefly review the company's second quarter results, discuss current market conditions and key highlights, and share his perspective on our outlook. Julie will detail our financial results for the second quarter and share additional insights about our plans going forward. Colin will wrap up our prepared remarks with some final observations. Then we'll open the call for questions. At this point, I'll turn the call over to Colin Angle.

Colin Angle (CEO)

Good morning, and thank you for joining us. We entered the second quarter focused on navigating major challenges primarily associated with the COVID-19 global pandemic. We've been largely successful thus far thanks to strong market demand and the commitment, focus, and resiliency of our global team. As a result, we delivered stronger than expected Q2 results and continued advancing key elements of our strategy. In terms of our performance, we reported Q2 revenue of $280 million, which was 8% higher than Q2 2019 and well ahead of our target entering the quarter. Our revenue exceeded our mid-June update due to unanticipated additional orders in the last two weeks of the quarter. We posted a Q2 operating profit of $41 million, which benefited from higher revenue, a notable improvement in our gross margin, and disciplined expense management. This translated into Q2 EPS of $1.06.

In terms of our Q2 top-line performance, the breakpoints that we saw emerging in late March continued to strengthen as maintaining a clean home has taken on greater prominence during the pandemic. Revenue in each major geography exceeded our April expectations, with the U.S. and Japan growing 13% and 43% respectively, which more than offset a 14% decline in EMEA. With stay-at-home mandates limiting traditional in-store retail activity for much of the quarter, we adjusted our go-to-market strategy and promotional campaigns to support e-commerce, which includes our website and app, pure-play online retailers like Amazon.com, and the websites of our traditional retail partners. Overall, we estimate that our e-commerce-related revenue grew by approximately 50% in Q2 and represented over 70% of total quarterly revenue.

Our direct-to-consumer business thrived in Q2, growing nearly 160%, even as we are only just starting to implement initiatives aimed at enhancing the buying experience on iRobot.com and on our app, and building stronger ties with our customers. As we detailed on last quarter's call, the global pandemic has created operational challenges which have impacted all parts of our business. Fluctuating demand signals and the steps taken in China and Malaysia to limit COVID-19 spread continue to test the agility of our operations and manufacturing supply chain partners. While consumer spending has declined in a vast array of goods and services, it has been resilient for robot vacuum cleaners. We saw sell-through momentum build globally over the past several months, which underpins the notable improvement in Q2 orders.

During the second quarter, we made important progress executing on key elements of our strategy, and I'll weave in aspects of our Q2 performance that help illustrate this. Differentiating our floor cleaning robots by providing consumers with an exceptional experience is a critical aspect of our strategy that guides our development roadmaps and supports our investments in AI, home understanding, and computer vision technologies. In particular, our premium robots, namely the Roomba i7 and s9 series and the Braava jet m6, combine top-notch cleaning efficacy with compelling digital features that leverage autonomy and thoughtful intelligence to better adapt to and support our customers' lifestyles. These products are resonating in the marketplace, which is reflected in a growing list of impressive awards and favorable reviews and strong consumer demand. In Q2, revenue from premium robots priced at $500 and up grew by 43% and represented nearly 60% of total revenue.

The success of these products also underscores why Roomba models occupy nine out of the 10 best-selling RVC spots in the U.S., seven out of 10 in Europe, and eight out of 10 in Japan. Moving forward, we expect to introduce new AI-driven capabilities and digital features that enhance performance and further elevate the cleaning experience. These innovations will give customers more control over where, when, and how our robots clean, support new smart home advances, and offer new insights into our robot performance and mission status. We're also looking forward to the launch of a new Roomba later this year. This project has progressed on schedule, even with a substantial majority of our R&D teams working from home. We're also accelerating investments aimed at building enduring relationships with consumers worldwide. We've continued to make excellent progress on this front.

We ended Q2 with approximately 6.9 million connected customers who've opted in to our digital communications. With this metric, which encompasses all iRobot product owners who have opted in to receive in-app messaging or email or both, we're 13% from Q1. We believe that tightly embedding Roomba and Braava into the lives of their owners will further increase customer loyalty and make it more likely that the next robot they buy will be one of ours. Nurturing the lifetime value of our customers is another strategic priority. This multi-year initiative is focused on optimizing our marketing campaigns, enhancing iRobot.com and our Home App, and providing our customers with greater flexibility in how they purchase our robots and accessories, including potential new subscription-like services.

Over the coming quarters, we plan to launch new pilots that can help us gauge consumer interest in potential new service offerings and inform our efforts to build recurring revenue streams in 2021. Improving our gross margin continues to represent an important element in our plan to deliver sustainable, profitable growth. Our success at the end of April in receiving a temporary exclusion from the Section 301 List 3 tariffs that applied to Roomba was a step in the right direction. The exclusion and related benefit contributed to our strong Q2 gross margin. With that said, the exclusion will expire next month unless it is extended. We expect to learn whether an extension will be granted soon, although the recent public testimony of the USTR leadership indicates that any extension granted at this point would only apply until the end of 2020.

To reduce our China exposure and help combat 25% tariffs that will return either next month or on January 1, 2021, we remain focused on manufacturing diversification. As noted last quarter, COVID-19 has disrupted our manufacturing expansion in Malaysia. Given these delays, we expect to incur higher than optimal production costs in Malaysia during 2021. These costs are only moderately improved next year versus the cost of manufacturing with 25% tariffs in China because of the time it takes to qualify a second contract manufacturer, add new lines, and ramp volume. The reinstatement of tariffs and a higher 2021 Malaysia premium are looming as a material headwind to our gross margin in 2021.

As a reminder, $38 million in tariff costs were a three percentage point headwind to our 2019 gross margin as tariffs increased to 25% midway through the year, and nearly all of the volume came directly from China. Depending on the growth assumptions for our U.S. revenue this year and next, our 2021 gross margin could face a similar contraction. We believe that by the end of 2021, we will be manufacturing broadly and at scale in Malaysia, which will enable us to reduce our production costs in that country, thereby supporting an efficient, geographically diversified supply chain decoupled from U.S.-China trade policy. As we look ahead, we move into the second half of our year with improved momentum. Sell-through growth in units has strengthened in each of our major geographies due largely to healthy demand for our premium robots.

In the U.S., we've seen our year-to-date sell-through growth rate more than double since our Q1 conference call. Robust online growth and the gradual reopening of brick-and-mortar retail stores in various countries has accelerated EMEA sell-through growth into low double-digit territory, while Japan has returned to positive sell-through growth thanks to a strong early summer campaign. At the same time, inventory levels with retailers are relatively low. As a result, we are incrementally more optimistic about our second half revenue prospects than we were in mid-June when we shared our business update. We now anticipate full year 2020 revenue to be relatively flat to slightly higher than 2019's $1.214 billion, as we expect solid revenue growth during the second half of 2020. With that said, there is significant uncertainty about second half demand as economic recovery around the world proceeds at different paces.

Government stimulus programs subside, competition remains aggressive, and retailers continue to carefully manage their inventory, all of which limits our visibility to the timing and magnitude of orders. Just as notable, the meaningful improvement in demand that we've seen recently will test our ability to cost-effectively source the raw materials and components as our supply chain remains challenged by COVID-19. From a profitability standpoint, while our first half performance reflects the benefit of our tariff exclusion, our operating profitability will be impacted if the exclusion is not extended through the second half of the year. Nevertheless, we are focused on converting our second half top-line results and prudent spending into solid operating profitability and EPS performance. Julie will provide additional detail about our outlook in just a moment. Clearly, 2020 is shaping up to be a year of unprecedented challenge and resilience.

We are increasingly optimistic that we will exit this year well-positioned to fortify our category leadership, executing on our strategy to drive profitable growth over the long term and reward shareholders for their confidence. At this point, I will turn the call over to Julie. After her remarks, I will return to offer some additional closing thoughts. Julie.

Julie Zeiler (CFO and EVP)

Thanks, Colin. As Andy mentioned earlier, my review of our second quarter financial results, as well as my comments about our outlook, will be done on a non-GAAP basis. So unless stated otherwise, each mention of gross margin, operating expense, operating profit, effective tax rate, and net income per share will mean the corresponding non-GAAP metric. All comparisons are against the second quarter of 2019 unless otherwise noted. Our second quarter 2020 financial performance was driven by substantially better than expected revenue.

Total revenue grew 8% to $280 million, in large part due to strong 43% growth in our premium floor cleaning robots priced at $500 and up. Geographically, all regions outperformed their targets entering the quarter. Revenue grew 13% in the U.S., with international revenue up 3%. Outside of the U.S., 43% growth in Japan and mild expansion in other markets were mostly offset by a 14% decline in EMEA. Roomba represented 90% of our mix, with Braava making up the remainder. Braava revenue grew by 26% as strong growth in the m6 was partially offset by softer orders for other models. One of the key drivers behind the strong growth in e-commerce-related revenue was robust expansion at Amazon, which represented 35% of Q2 revenue.

Quarterly revenue from Amazon grew 36% thanks to the lead-up into Q2 events like Mother's Day and Father's Day, as well as from orders to support their second half needs. Our gross margin of 50% was well ahead of our plan due to a combination of higher revenue, favorable product and channel mix shifts, lower than planned write-down charges associated with tariff components, and the timing of other supply chain-related activities. Gross margin was three percentage points higher than Q2 2019, primarily reflecting the benefit of nearly $7 million associated with first quarter tariff costs and no tariff costs in the second quarter versus tariff costs of $5 million in the prior year's second quarter. Our Q2 GAAP gross margin reflected the refund of $47 million in tariff costs that had impacted our P&L since the tariff went into effect in September 2018.

Q2 operating expenses of $99 million decreased by 7% and represented 35% of revenue. During Q2, we completed actions to realign and reprioritize resources across the organization, which helped us lower operating costs while also enabling us to redirect spending into areas critical to long-term success. In particular, our second quarter R&D and G&A costs stayed relatively flat, while sales and marketing expenses declined by $7 million due primarily to shifts in timing of certain campaigns and promotions. Given the state of our accounts receivable, we did not make any meaningful adjustments to our bad debt reserve during the second quarter. Our Q2 operating income was $41 million, or 14% of revenue. Our Q2 2020 effective tax rate was nearly 24%, which was lower than we expected primarily due to the changes in pre-tax profits and the tax-related impact of the tariff refund. Our net income per share was $1.06.

We ended Q2 with $242 million in cash and investments, a decline of $21 million from Q1 levels. The decline primarily reflects changes in working capital and our capital spending activity. Q2 DSOs were 42 days versus 32 one year ago, which primarily reflects the timing of orders and shipments during the latter half of the quarter. Q2 ending inventory was $133 million, or 86 days, compared with $192 million, or 127 days, at the same time last year. The decline in inventory reflects the combination of the removal of tariff-related costs and stronger-than-expected demand throughout the quarter. In terms of inventory at our retailers, as Colin noted, we ended the quarter in good shape overall, having made solid progress to reduce excess entry-level inventory. As Colin noted earlier, our view into our 2020 performance has continued to improve.

With that said, we remain cautious about our near-term outlook due to a number of factors that are beyond our control and difficult to forecast, including the sustainability of recent sell-through trends, prospective consumer spending activity, competitor actions, and whether we receive an extension to our tariff exclusion. As a result, we aren't yet able to offer explicit financial targets like we have done previously. However, we'd like to share as much color as possible to help manage expectations around our 2020 outlook. Starting with revenue, a little over a month ago, we issued our business update and reiterated our view that we expected an annual revenue decline. We now believe that our 2020 revenue will range from relatively unchanged to potentially low single-digit growth over 2019 revenue of $1.214 billion. For further context, our first half revenue was down 5%.

Our current full year expectation implies second half revenue growth in the mid-single-digit range on a percentage change basis. Geographically, we expect solid growth in the U.S. and Japan, with a modest second half improvement in EMEA. We currently anticipate a stronger third quarter revenue growth rate than in the fourth quarter. With that said, forecasting the revenue mix between the third and fourth quarters is challenging in any given year, and it is inherently more difficult to assess now given current market conditions. In terms of gross margin expectations, as Colin said, we don't know whether an extension to our tariff exclusion will be granted. While we are hopeful, the vast majority of Section 301 extension requests have been denied thus far.

Whereas our first half gross margin was 46%, we expect second half gross margin on both a GAAP and non-GAAP basis to be in the 39%-40% range. That is slightly above our original full year 2020 target and assumes the reinstatement of the 25% tariff next month. This would imply a full year gross margin in the low 40% range. We expect our third quarter gross margin to be better than our second half average as we benefit from inventory not subject to Section 301 tariffs and execute various Q4 holiday promotions consistent with historical practices. Looking closer into our operating costs, we currently anticipate a modest increase in 2020 operating expenses due to certain costs that have shifted from the first half of the year, and we invest in working media to drive top-line growth.

With that said, certain costs are subject to change based on revenue and overall market conditions. We anticipate Q3 operating expenses will be moderately higher compared to Q2 levels, followed by an uplift in Q4 consistent with historical trends as we invest in advertising and marketing campaigns for the December holidays. We are targeting 2020 income from operations to be in the mid-single digits as a percentage of revenue. We anticipate a higher third quarter operating profit margin than in the fourth quarter. Ultimately, our full year operating income performance will reflect how our second half unfolds from a revenue and tariff perspective. As we execute on a wide range of supply chain, go-to-market, R&D, and other programs and projects to successfully close out 2020, those efforts will provide the clarity required to set our targets for 2021 and beyond.

In terms of other notable modeling assumptions for 2020, our improved profit profile in both the U.S. and abroad will help produce an effective tax rate in the high teens, which is actually in line with our plans at the start of the year. We anticipate a diluted share count of more than 28 million shares. As it relates to our cash position going forward, I would like to note that we recently started to receive cash payments associated with our tariff refunds from the U.S. government. We anticipate receiving the $57 million in tariff-related refunds owed to us over the next 12 months, with over 40% of that expected within the next two quarters. I should note that the timing of these refunds is at the discretion of U.S. Customs. We plan to continue working closely with our retailers globally to understand and support their needs.

Accordingly, DSOs may stay elevated above historical levels over the coming quarters. At the same time, we continue to prioritize inventory flexibility to ensure we can mobilize quickly to accommodate shifts in demand over the coming months. We anticipate a peak in DII in Q3 before a potential return to more normalized levels. In summary, we've seen our business build steady momentum over the past three months. As a result, we move forward with improved confidence that our second half 2020 revenue will grow meaningfully over first half levels. We plan to stay focused on converting our second half revenue expansion and prudent spending into solid operating profitability and EPS performance. With that said, we remain cautious given the relatively fragile state of the global macroeconomic environment.

We remain committed to managing the business in ways designed to enable us to emerge from these difficult market conditions as a stronger company. At this point, I'll now turn the call back to Colin for his closing thoughts.

Colin Angle (CEO)

Thank you, Julie. As our robot moves forward, we remain excited about the long-term potential of our business. We are seeing that our strategy to differentiate the cleaning experience is helping support the continued shift in our product mix toward our premium products as we accelerate investments to leverage our growing base of more than six million connected customers. As we look to finish 2020 with a strong second half performance, we are advancing our planning processes for 2021 and beyond.

Finally, I think it's timely to close my commentary by noting that iRobot's success over the past 30 years has been fueled by hiring the best and the brightest in our industry, talented individuals who bring a unique set of skills, experiences, and passion to our company, along with diverse perspectives, beliefs, and backgrounds. We are continuing to support and develop diversity within our global workforce. These efforts extend well beyond the CEO Action for Diversity and Inclusion pledge that I signed last month. It's reflected in our hiring practices, training programs, and continued efforts to extend our STEM-based educational resources, curriculum, and Root programming robots to students in underserved communities. Strengthening diversity and inclusion within our global workforce will remain important to us as we work together to invent a future that seamlessly fits the unique, personal, and diverse needs of our global consumer base.

Last month, we updated our website with a new corporate social responsibility section that details our efforts to advance racial, ethnic, and gender diversity and inclusion, along with a range of relevant, timely information about our people, products, production, and philanthropy. That concludes our comments. Operator, we will take questions now.

Operator (participant)

Thank you. Ladies and gentlemen, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. We ask that you please limit yourself to one question and one follow-up. Please stand by while the Q&A roster compiles. Our first question comes from Mike Latimore with Northland Capital Markets. Your line is open.

Mike Latimore (Analyst)

Great. Thanks very much. Yeah. Just on the, I guess, on the tariff topic, I guess you'll hear August 6th whether you get a further exemption.

I guess, is the thought that there's really no opportunity to get an exemption in 2021 at this point, or is it just too early to tell?

Colin Angle (CEO)

Secretary Lighthizer testified in front of Congress where he made quite explicit that exemptions that would be granted would expire at the end of the year. So that is the public testimony that is the most current and explicit guidance that we have been given. So we are continuing to push with all energy to drive the diversification of our manufacturing base, which unfortunately has been one of the impacts of COVID-19 we haven't been able to remediate and overcome because there's travel bans in place sending people into Malaysia, which has created a delay.

But we do see the ability to get that work back on track, and we do believe that by the end of 2021, we'll be in a situation where we are effectively geographically diversified and U.S.-China trade policy does not substantially impact our business anymore. So we're working it.

Mike Latimore (Analyst)

Got it. Okay. Great. And then obviously, the online sales have been great. Do the type of products that are sold online skew more towards the high end than average, or is the mix online sort of similar to the normal retail outlet?

Colin Angle (CEO)

Well, it's interesting. The conventional wisdom says that e-commerce tends to skew down in premium. We have seen a very material shift up in the sales that we're seeing.

iRobot.com has always skewed favorably toward the premium, but in general, when you look at online as a whole, you can go online and you can look for value products, so the evidence that we've seen in Q2 has been a very clear shift up in mix, which sort of bucks these traditional online trends, and so we're very pleased with that, and definitely I've seen a real appreciation for the capabilities that we're delivering in our premium products, so I think that's a true shift because it even goes against some traditional wisdom on what online can deliver, so we're very excited about that.

Mike Latimore (Analyst)

Thanks. Great quarter.

Colin Angle (CEO)

Thank you.

Mike Latimore (Analyst)

Our next question comes from John Babcock with Bank of America Merrill Lynch. Your line is open.

John Babcock (Managing Director)

Good morning, and thanks for taking my questions.

I guess just quickly on the premium products in your mix this quarter, what drove that in your mind? I mean, did the promotions that occurred during the quarter happen to contribute to that? And then also, what are your expectations on how that mix might contribute to the second half here?

Colin Angle (CEO)

So we've seen our customers shift in their expectations of products since 2018 from, I'm speaking sort of at the highest level, from a skepticism—is this vacuuming robot thing real?—to an impatience that our robots can't do more. And the idea that they don't want the robots to be more autonomous. They want to have better control over the experience, what the robots clean, where they go, and how they operate, and how they can direct the robot to do what they want.

And our premium robots with the directed room cleaning features augmented by the docking, the Auto-Evac functionality, I think has really resonated strongly with our customers. And given the importance of keeping one's home clean and having the robots work around the lives of people at home, I think it's. I think these are just extremely valuable features that we have rolled out in our premium products and have driven demand. So at the end of the day, the intelligence of the robot is starting to play bigger and bigger in differentiation.

John Babcock (Managing Director)

Okay. And so for that, can I extrapolate into the second half basically that there should be some benefit to mix from the premium products?

Colin Angle (CEO)

I think that the predictability of the world right now is challenging.

So I think that we are hopeful that this mix shift based on the fundamental appreciation of these advanced features will continue. So as I say, we're increasingly confident that the back half of the year is going to show growth over prior year and leading us to be able to, on this call, start to lean forward as to what we think the full year is going to look like, showing a recovery from the first half where we were down over prior year in total to being flat to slightly up for the full year. So the trends are good, and certainly the mix shift is an important driver of that improved performance.

John Babcock (Managing Director)

Yeah. That's helpful. And then next on Malaysia, I mean, how are you thinking about the ramp-up of volume there?

And then also you said that production costs would be moderately lower than the cost of manufacturing with 25% tariffs in China. And so I was wondering if you might be able to add some color on what you mean by moderately.

Colin Angle (CEO)

I'll give a little color and then Julie will jump in. Getting the type of pricing that we've enjoyed in China may never be fully possible in Malaysia, but we certainly can get closer as volumes ramp. We were able to move our lower-end products over to Malaysia with one line toward the end of last year, and that's ramped up and will represent sort of 20%-25% of volume headed to North America this year.

We think that in 2021, the challenge is getting our premium robots in manufacture at the volumes that we need to get the premiums down to a level that is consistent or at least in the same ballpark with China manufacturing costs. And so that's going to take the better part of 2021 to get to. Julie.

Julie Zeiler (CFO and EVP)

And I guess the other thing I would say is obviously that is slower than where we originally began our strategy. We are constrained, as Colin noted, in our ability to get our engineers in and out of those key manufacturing partners to really work that line transfer. And so as a result, the heading through 2021, and we haven't finished our planning yet, but through 2021, we do expect to see that there will be a higher than we had anticipated cost premium associated with that volume.

John Babcock (Managing Director)

Okay.

So there's really no way to kind of quantify what you meant by moderately then at this point?

Colin Angle (CEO)

Unfortunately, it really depends on the ramp rate. And right now, we're crossing our fingers that in August, the travel policies in Malaysia will change and we can actually send people into Malaysia. This is a temporary speed bump problem, but it's not a one-month speed bump problem because of the complexity of building these factories and scaling up production. So it is a temporary challenge that we will overcome, and we're doing everything we can to be ready to jump as soon as the doors open. But there's so many things beyond our control. I mean, if we can get it done faster, it's going to be less impactful.

But if we're held out as a country and really have to do most of the work starting in Q4, it's going to take us a while to get to that at-scale manufacturing volume and thus be less than satisfying answer to your question. But it's really, there's a lot of wait and see. But to be clear, this is a temporary speed bump, and we do have plans, partnerships, and implementation activities underway, which will get us out from under this by the end of next year.

John Babcock (Managing Director)

All right. That's great. And then just last question, which hopefully is quick before I turn it over. I was just wondering if you can provide some clarity on how much insight you have into demand for the third quarter.

And then also, what color can you provide on Amazon Prime Day, realizing obviously there are limitations there, but just wanted to see what you might be able to say?

Julie Zeiler (CFO and EVP)

Yeah. So I'll jump, and then I'll let Colin add on. I think what gives us improved confidence in the color that we've provided for the back half of the year is really anchored back to the sell-through trends that we're seeing. So we've seen meaningful improvement in our sell-through trends, as Colin iterated, across all of our regions. And we believe that coupled with relatively low inventory should result in revenue that we think is meaningfully better in the second half of the year. As it relates to Amazon Prime Day, I think we need to defer to kind of the public statements and news reports around the timing of the Amazon Prime Day.

We always have to remind investors that this is an invitation-only event, and while we've been very proud of our inclusion in prior year Prime Day events and supporting its expansion to international markets, Amazon prohibits its suppliers from confirming participation in Prime Day prior to the commencement of the event.

John Babcock (Managing Director)

Okay. Fully understand. Thanks again.

Colin Angle (CEO)

Thank you, John.

Operator (participant)

Our next question comes from James Ricchiuti with Needham & Company. Your line is open.

James Ricchiuti (Managing Director and Analyst)

All right. Thank you. Good morning. Julie, maybe a question for you. I'm wondering if you might be able to just quantify the impact on gross margins of the tariff-related charges in the quarter and also perhaps the impact of the timing of the Malaysia supply chain activities that you alluded to. Is there a way to quantify that?

Julie Zeiler (CFO and EVP)

Sure.

So if I'm talking about in Q2 versus last year, we had roughly, let's call it about a point of impact from tariff-related expenses. And then, Jim, what was your other?

James Ricchiuti (Managing Director and Analyst)

Yeah. I mean, clearly, there's been more of a disruption in Malaysia, and I'm just wondering what the impact of that was, if you could size that.

Julie Zeiler (CFO and EVP)

On the quarter results, I don't know how to do that, Jim. Let me think about that, and maybe we can talk about it further.

James Ricchiuti (Managing Director and Analyst)

Okay. But I think we can also discuss it offline.

Julie Zeiler (CFO and EVP)

Yeah. Okay.

James Ricchiuti (Managing Director and Analyst)

That's fine. The other question is just wanted to pursue a little bit more on the direct-to-consumer business, Colin. I mean, you're seeing a better mix, presumably. There's higher margins in that portion of the business.

I'm wondering more broadly where you might see this part of the business going as a percent of revenues, which I guess was, what, nearly 12% in the quarter?

Colin Angle (CEO)

Yeah. This is a major strategic focus for the company. We started talking about it. We started taking action to harvest and grow the numbers of our customers, which we could reach out to directly. If you recall, at the end of last year, it had grown substantially to around four million. At the end of Q1, that number had reached five million through both continued efforts around our connected products, but also making sure that we had access to and were counting robots that weren't connected but whose customers had opted into app and email communications with us. We were able to grow from that five million to 6.9 million in this quarter.

So we're seeing extremely rapid aggregation and growth in the numbers of customers for which we can uniquely identify, uniquely reach out to them, that we can access directly. And that's a very, very exciting trend. And one of the showstoppers, if you said, "Gee, Colin, what did you say today that's important?" That would probably be top on my list. The COVID-19 impact on our business, as we talked about earlier, provided a tremendous acceleration in customer engagement on online channels, including the 160% growth we saw in the last quarter in our direct business. And so I would say all of that growth happened even prior to rolling out many of our systems improvements that we have been investing in. So we're sitting in a very interesting place where probably the growth in our online business has been accelerated because of COVID.

The investments we're making in better reaching out to our customers is in the process of getting rolled out to the balance of this year and into next year. It's a continuous improvement operation. And we're getting validation that our customers are responding well to experiential improvements in the products, which actually reinforce the benefit in the digital performance of the robot and the intelligence of the robot. So that's the idea that as the robot understands your home better, it can be more directable, as demonstrated by our success in Clean by Room technology. That reinforces this idea that buying a Roomba and having an ongoing relationship with the company is valuable. So there's a lot going on, and hopefully trying to do a decent job of explaining it in just a few seconds that all self-reinforce around growing confidence in our direct strategy. Where could it be?

We hit 12% this quarter. We hope we can maintain momentum and continue to see that grow. Retail will continue to be a very important part of our strategy. But I think that we're just in the early days of what our direct-to-consumer business will look like.

Julie Zeiler (CFO and EVP)

Yeah. And I would just underscore how you ended that, Colin, where we believe, as we think forward, retail is a very important ongoing part of the way that we reach our customers. And our direct-to-consumer efforts are complementary to that very strong strategy.

James Ricchiuti (Managing Director and Analyst)

Got it. That's helpful. Just one final question. I noticed, and maybe it was my imagination, but it seemed like there were more promotions bundling Braava with Roomba. And I'm just wondering how effective that has been because the Braava units were down, but it seems like that's more a reflection of the decline in the lower-end product.

Julie Zeiler (CFO and EVP)

Yeah. I think what you see is, particularly with our more premium products, we see strong and growing interest from our consumer base in the Imprint Link Technology, which allows the Roomba and the Braava, particularly the m6, to work together. So we view that as a very interesting and important way that we're looking at the way our products resonate with our consumers.

Colin Angle (CEO)

And the way that the Braava works with the m6, with the navigation ability, really drives more utilization of that robot as well. So the mix shift that we were seeing broadly definitely included a shift toward the m6 from the lower-end models as well. So I think what you're saying is, in fact, true.

James Ricchiuti (Managing Director and Analyst)

Got it. Thank you. Congrats on the quarter.

Colin Angle (CEO)

Thank you.

Julie Zeiler (CFO and EVP)

Thank you.

Operator (participant)

Our next question comes from Ben Rose with Battle Road Research. Your line is open.

Ben Rose (President)

Yes. Good morning.

I wanted to drill down a little bit in terms of what's happening in Japan and Europe. It looks like there was very strong performance in Japan. Could you speak, Colin, and/or Julie, to some of the factors driving that performance, and after that, we'd like to get your thoughts on what's happening in Europe. Is your confidence stemming from the fact that there are more stores opening now in the back half of the year?

Colin Angle (CEO)

Yep. So happy to jump in on this one. Let's talk about Japan first. Japan has traditionally been our strongest market from the perspective of premium products, and so the rollout of the s9, complementing the prior rollout of the i7, was going to be bigger in Japan, faster than in any of our other markets, and we definitely saw that.

We definitely saw that and benefited from that, and that drove some growth as one. Two, the pandemic-driven growth and interest in RVC, which definitely was a tailwind, added to interest in Japan as well. And retail in Japan was less impacted than in other parts of the world. And so it stayed, I will say, more open than it did elsewhere. And then finally, the government had a points program, a stimulus program to help the economy move. And we definitely benefited from that. So that stimulus program with less travel and other discretionary venues for spending created opportunities to drive growth. So there were a bunch of tailwinds in Japan that offset the clear headwind of reduced store traffic in retail. So put that into the pot, stir well, and you get plus 43% performance in Q2.

EMEA, by contrast, was the region that had the most significant, and I speak in the broadest of generalities because there's a lot of texture country by country. But at a high level, EMEA is the most brick-and-mortar dependent region and was most heavily impacted by stay-at-home orders. And so the COVID headwinds driven by, "I can't get to the product where I'm used to buying the product," were most severe. And then layer on top of that, the maturity of the online services in Europe, again, speaking broadly, were least mature. So that there were situations in Q2 where online e-tailers were preventing us from advertising, offering very much delayed fulfillment schedules where essential products were being prioritized over vacuuming robots.

And so there wasn't the surge capability in online that was ready to go meet the increased demand as we saw and benefited from in, for example, North America. So as Europe has started to reopen retail, some of those headwinds have decreased, and some of the tailwinds we spoke of earlier are certainly there in Europe as well. And we're seeing recovery in that market.

Ben Rose (President)

Okay. Great. Sorry. Just a quick follow-up on that, Colin. Is the direct-to-consumer strategy in Europe as applicable as it is in the U.S.? So in other words, enabling the consumer to purchase your products directly from you over the internet, do you think the appetite is as strong there as it is in the United States?

Colin Angle (CEO)

Absolutely. I would say that we're a little bit less mature in Europe, but rapidly closing the gap with North America.

And we believe that our direct strategy is absolutely a global strategy.

Ben Rose (President)

Okay. Okay. Thanks very much.

Colin Angle (CEO)

You bet.

Operator (participant)

Our next question comes from Mark Strouse with J.P. Morgan. Your line is open.

Mark Strouse (Analyst)

Yeah. Good morning. Thank you very much for taking our questions. I wanted to start. There were some media reports about a partnership with Ecovacs that was announced a few months ago. Just curious if you can opine a bit on that, what you're providing to that partnership, what you're getting in return, and how important is it, I guess? Is it more kind of just a putting feelers out there kind of partnership, or could it be potentially something that leads to something more strategic as far as products or geographic expansion, anything like that?

Colin Angle (CEO)

So it's more the former.

I mean, we didn't make a press release about it because it's certainly having conversations with other companies in the industry is something that makes a lot of sense to do. The terms of the deal that we formed with them had two dimensions. One talked about the ability of iRobot to look at certain products that Ecovacs was working on and for possible use outside of China, and in a reciprocal fashion, looked at some of our technology that Ecovacs was interested in potentially using within China, so that it is an agreement that is in an exploratory phase, and I think that how it plays out is still a very significant question as to whether it will be material, but definitely, it's a small industry, and there's only a few players.

And the fact that we're able to communicate and talk about ways that we might work is something that we're open to.

Mark Strouse (Analyst)

Okay. That makes sense. Thanks, Colin. And then, Julie, I want to come back to some earlier questions about gross margins. I know it's really not fair to be asking about 2021, but just the language that you're talking about as far as you mentioned the contraction in 2019, and then you talk about depending on some variables, there could be a similar contraction in 2021. How are we to interpret that? I mean, should we think about that compared to second half 2020 levels? Is that off of 2020 full year levels? Any further color would be very helpful. Thank you.

Julie Zeiler (CFO and EVP)

Sure. And I think that we wanted to make sure that we discussed how we were currently looking at the landscape.

This is not intended to be a discussion on 2021 targets. We have work to do in our overall plans for next year. However, as we look at the uncertainty where we sit today in the timing and duration of a tariff extension and the impact of, as we've been speaking for the last two quarters, the slowdown in our ability to shift our products to Malaysia, we wanted to make sure that we began that discussion.

Colin Angle (CEO)

I would just say the way it's intended to be interpreted is, if all things being equal, meaning that if 2021 was exactly like 2020, there would be a tariff headwind that we wanted to make very clear to all the analysts should be included. Because I think that we had hoped to minimize the impact of any 2021 tariff exposure through more rapid development of our Malaysia strategy.

But the very material slowdown in ramping up of Malaysia because of COVID has precipitated the need to communicate that the tariff/Malaysia premium is going to be a gross margin headwind. So that if you had a model and you didn't include this, it's important that you do. Certainly, there are many other things we've talked about today, which over time are focused on improving our gross margin landscape. Is that helpful?

Operator (participant)

Thank you. Our next question comes from Charlie Anderson with Colliers Securities. Your line is open.

Charlie Anderson (VP and Analyst)

Yeah. Thanks for taking my questions. Congrats on a great quarter. I had a two-parter on back half revenue. First, it sounds like the channel is still fairly lean. So I'm sort of curious, is the assumption that you'll match sell-through and sell-in, or is there a chance that those will be different to any degree?

And then I also wonder. I didn't hear anything in the script about new product. I wonder if there's any new product assumptions in back half. And then I've got a follow-up.

Colin Angle (CEO)

Sure. So there will be a new robot in the back half. So we haven't announced it. I'm not going to tell you what it is today, but exciting new robot coming out. As it relates to inventory levels, we do think that retailers are going to be fairly conservative, continue to be fairly conservative on inventory. And so that if that comes to pass, you'll see sell-through and sell-in roughly tracking each other. Again, it's unlikely that there's going to be a sudden surge in retailer confidence leading to higher inventory levels in the back half. We just don't see that happening right now. But again, a retailer euphoria could create additional demand.

We're just not expecting it.

Charlie Anderson (VP and Analyst)

Okay. Great. And then a question on the potential for subscription services. It sounds like the rest of the year there will be trials going on, and then 2021 is when some of this takes shape. I wonder if you could speak to any trials you're doing currently, if you give any insight. And I wonder if you have any sort of role models in terms of what this may look like. Just any additional color on the subscription opportunities. Thanks.

Colin Angle (CEO)

Sure. Again, not a lot to add other than what we've said before, where in 2019, we had two subscription-like things that we took on, which were both very successful. One was something that felt a little bit like a leasing program in Japan called the iRobot Smart Plan.

It is available today on the iRobot Japan website if you want to get some more detail on that, so that's one of the ongoing tests right now, and I think that what I can say is it was very successful last year. We're not updating that quite yet as part of this call, and then the other thing that you'll see on the iRobot website today is a growing prominence of a financing offer that we launched or we started to highlight before last year, and you can see by the increased prominence of that. It's something that we believe is certainly a type of iRobot customer is very happy to have that option, so I think those are both publicly visible manifestations of Robots-as-a-Service like offering that we're already feeling good about.

Charlie Anderson (VP and Analyst)

Great. Thank you so much.

Colin Angle (CEO)

You bet.

Operator (participant)

Our next question comes from Asiya Merchant with Citigroup. Your line is open.

Asiya Merchant (Analyst)

Hi. Thank you for taking my questions. And congratulations on a great quarter. A couple of questions. One, for the total category, the robotic vacuum category, do you believe you gain share, maintain share? I think some of the sell-through data from POS systems would suggest that perhaps you lost share. Just wanted to clarify that.

Julie Zeiler (CFO and EVP)

Yeah. Thank you. And what I would say is right now, as we are looking at third-party data, it's still fairly early. So what we have in front of us is roughly the first few months of the year where, as I look at the market, I think it was impacted by the overall pandemic. Looking at that in aggregate, I think roughly globally, it's hard to tell. It looks like we were roughly at holding share.

But I think it's a very small percentage of our overall year. So I think we need to wait and see how the second half of the year unfolds.

Asiya Merchant (Analyst)

Okay. That's fair. And then if I can clarify on gross margins, and maybe I just need to get better on math on this, but your Q2 and oh, sorry, first half margins much better than expected. Was there any one-time nature in that? Because even factoring in the kind of tariffs that should see a full quarter impact in the fourth quarter, it seems like your margin degradation in the second half is much heavier than what one would expect with the 25% tariffs going in. So maybe you can walk us through that math. That would be helpful.

And then just as a final follow-up, or related to that question, if there were margin benefits in the reported quarter from direct-to-consumer or premium mix, should we expect those trends to continue? And that's, again, why my question about the margin degradation in this back half. Thank you.

Julie Zeiler (CFO and EVP)

Sure. So as you look at what we said, our first half gross margins are 46%. And then the color that we're providing on the back half of the year of 39%-40%, you can think about that six to seven point drop in margin coming in sort of two places. One is the reinstatement in our color assumption of a tariff at 25%. That's roughly half of that drop. And then the remainder being what we typically see in promotional activity that happens between the first half and the second half of the year.

So our second half tends to, and our holiday period where we have more of our revenue tends to be more promotional. And that's where you can see that walk.

Asiya Merchant (Analyst)

Okay. Thank you. And then the direct-to-consumer trends as well as the shift to premium mix, is that something we anticipate continuing in the back half this year? Or do you think there was something as brick and mortar sort of reopened in the U.S. as well as in EMEA, people start to go more into that, and that would drive some of your promo activities for retailers?

Colin Angle (CEO)

So we definitely think that strength in direct will continue. Whether it represents the same percentage of sales, we are assuming some reduction in that as a percentage of revenue as the promotional activity and some of the events like Black Friday, which can drive tremendous volume, come back.

But 160% growth in Q2 is a very real and exciting trend. I think that at a high level, as retail reopens, you might see a little bit of walking back from the Q2 online percentages. But then as you go forward in time, the question is, how long is it going to take to catch back up to that? And then from a direct perspective, as our efforts to improve our online experience get rolled out, move us beyond where we've seen in Q2. So there's a little bit of uncertainty as to what the retreat from online as the preferred or as the only available way of getting products turns into online as a real growth driver. And so that retail will come back. And that will, in Q3, Q4, probably give us slightly lower online percentages than we're seeing in Q2, as in 2020 and 2021.

Asiya Merchant (Analyst)

Fair enough. And Colin, as you kind of look at it, I know you're not planning for 2020 or guiding for 2021 at this point, but just the secular trends that you see in the domestic robotics space, but offset with some of this COVID-19 impact, it seems to have accelerated a shift to automated cleaning, etc., given lack of cleaning services, etc. Is there some balance there? Are you still seeing the market growing as we look into 2021, 2022 with that mid-teens, mid-to-high-teens kind of rate that one was expecting after normalizing for fiscal 2020?

Colin Angle (CEO)

I think that I'm going to avoid talking about percentages of growth. The category is certainly very vibrant today, and our penetration rates are still extremely low. I think that iRobot, as the premium developer of products, has shown that innovation isn't done.

We are not at a commoditization stage because we're seeing such a strong consumer response to smarter robots, which gives us confidence that we have real runway in front of us to continue to successfully differentiate based on a premium consumer experience. So I think that penetration is still low, opportunity for premium to meaningfully differentiate from entry-level, revitalized to some degree. And iRobot's role of being the leader in the premium area has been enhanced because we're seeing a shift from the lower margin entry-level products to higher-end products, which was something that, as this industry matured, was inevitable to happen. And the fact that we're doing it while maintaining the type of margin and differentiation is exciting to me personally. So the robot vacuuming industry is mainstream at this point. And iRobot's role is becoming increasingly clear, and the opportunities at the top increasingly clear.

Operator (participant)

Thank you.

This concludes the question-and-answer session. I would now like to turn the call back over to Andrew Kramer for closing remarks.

Andrew Kramer (VP of Investor Relations)

Thank you. Thanks, everybody, for joining us. That concludes our second quarter 2020 financial results call. Appreciate everybody's support. We look forward to talking with you over the coming weeks and months. And we'll plan another conference call to discuss our Q3 financial performance later this fall. Thanks again.

Operator (participant)

That concludes the call. Participants may now disconnect.