Fitbit Q1 16A – Forced hand.

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Fitbit is being forced to spend to stay ahead.

• Fitbit reported good Q1 16A results but cut guidance in order to ramp up spending placing unrealistic expectations of profitability in H2 2016.
• This is particularly worrying as there are clear signs that commoditisation is forcing the company to increase spending, hitting profits.
• Q1 16A revenues / adj-EPS were $505m / $0.10 nicely ahead of consensus at $443m / $0.03 but EPS for the quarter ahead is going to be weak.
• Q2 16E revenues are expected to be $565m-$585m ($575m midpoint) ahead of consensus at $533m but expectations of adj-EPS at $0.08-$0.11 are way below consensus of $0.26.
• Gross margins are slipping as commoditisation creeps in but the real problem is OPEX.
• Fitbit is right in that it needs to spend on R&D and sales and marketing to stay ahead of its rivals, but general and admin expenses (G&A) are a real worry.
• In Q1 15A G&A expenses were $13.0m or 3.9% of sales but in Q1 16A they jumped to $35.7m or 7.1% of sales.
• My threshold for G&A is 5% and this sudden elevation has all the hallmarks of indisciplined expansion.
• This in turn makes me worry about the quality of the investments that the company is making in both R&D and sales and marketing.
• If these investments do not produce results, then commoditisation will accelerate and gross margin will continue to decline hitting the already fragile profitability.
• The good news is that Fitbit knows exactly what it has to do which is to increase the stickiness of its users through the refinement of its embryonic ecosystem.
• This alone puts Fitbit miles ahead of GoPro when it comes to dealing with aggressive competition and slowing and saturated end markets.
• When it comes to an ecosystem the key is the number of users and the degree to which they are engaged with one’s services.
• Fitbit posted some encouraging figures at its 2015 year end results in January with 16.9m active users making up 59% of the registered user base.
• These users were also more engaged with an average of 7.5 connections to other users compared to 4.9 at the end of 2014.
• Unfortunately, Fitbit declined to update these figures leading me to believe that there was nothing particularly good to report.
• This is concerning because if the investments that it is making in R&D and sales and marketing pay off, it is in user numbers and engagement that the results will be first seen.
• Gross margin stabilisation and profits will then follow but it is in the ecosystem where the loyalty and preference will be generated that will give Fitbit pricing power.
• Somewhat inexplicably, Fitbit also raised its adj-EPS guidance for the full year to $1.12 – $1.24 from $1.08-$1.20 meaning that to meet guidance Fitbit needs to generate 83% of its net profit in the last 6 months of the year.
• Given the environment, this looks to be a very tall order and I suspect that there is a heavy cut to full year EPS guidance coming either in June or October.
• My concerns around both the market for its products and its fiscal discipline lead me to believe that Fitbit could realistically generate adjusted EPS of $0.80 for the full year.
• This leaves the company with a 2016E PER of 18.5x which is quite punchy for a company showing little profit growth and at high risk of commoditisation.
• I would be more comfortable between $10-12 a share rather than the $14.90 that it is currently at but if forced to choose I would have this over GoPro.