Fitbit Q4 2015 Results Beg For Solving The Attrition Growth Rate

| About: Fitbit, Inc. (FIT)

Summary

Attrition rate keeps climbing.

2-year attrition rate needs further consideration with regards to usefulness and business life cycle.

Health and wellness and corporates unlikely to be long-term solutions to growing profitability.

Well, so much for the widely hoped upon short squeeze for Fitbit (NYSE:FIT) shareholders. As forecasted by analysts, investors and commentators, Fitbit had a tremendously strong Q4 2015 with results beating the average analyst estimate on the top and bottom line. Once again, this was actually the expectation and when the expectation is as such, the guidance had better be equally fitting in beating the expectations.

Fitbit reported its fourth-quarter earnings rose to $64.2 million, or 26 cents a share, from $39.2 million, or 19 cents a share, a year ago. On an adjusted basis, the San Francisco company would have earned 35 cents a share. Revenue nearly doubled to $711.6 million from $370.2 million. Analysts surveyed by FactSet had projected earnings of 25 cents a share on revenue of $649 million. Now let's look at some of the metric and operational breakdowns from the Q4 and FY15 period as noted below. And there is a lot of "good" in the metrics, but they do bear some greater analysis and consideration.

Fourth Quarter 2015 Financial Highlights

  1. Sold 8.2 million connected health and fitness devices
  2. Q415 revenue increased 92% year-over-year; adjusted EBITDA increased 66%
  3. U.S. comprised 75% of Q4 revenue; EMEA 12%, APAC 8%, and Other Americas 5%
  4. U.S. revenue grew 100% year-over-year; EMEA 191%, APAC 6%, and Other Americas 77%
  5. Newer products, Fitbit Charge, Fitbit Charge HR and Fitbit Surge, comprised 79% of revenue
  6. Q4 non-GAAP gross margin adjusted for foreign currency exchange rate impact was 50.0%
  7. Non-GAAP operating expenses comprised 32.2% of revenue in Q415, compared to 25.9% in Q414 and 28.6% in Q315

Full-Year 2015 Financial Highlights

  1. Sold 21.4 million connected health and fitness devices
  2. FY15 revenue increased 149% year-over-year; adjusted EBITDA increased 104%
  3. U.S. comprised 74% of FY15 revenue; EMEA 11%, APAC 10%, and Other Americas 5%
  4. U.S. revenue grew 146% year-over-year; EMEA 244%, APAC 110%, and Other Americas 139%
  5. Cash, cash equivalents and marketable securities totaled $664.5 million at December 31, 2015, compared to $195.6 million at December 31, 2014 and $575.5 million at September 30, 2015

Fourth Quarter 2015 and Recent Fitbit Operational Highlights

  1. Active users grew 152% to 16.9 million at year-end 2015 from 6.7 million at year-end 2014
  2. Added 18.0 million new registered device users in 2015, of which 13.0 million, 72%, were active users at year-end; Total year-end 2015 registered device users was 29.0 million
  3. Introduced Fitbit Blaze and Fitbit Alta. Fitbit Blaze won 18 top-pick awards at CES
  4. Pre-order volume for Alta and Blaze exceeded internal forecasts; Blaze was already ranked 2nd last week in Amazon's best selling smartwatches over $100
  5. Introduced SmartTrack automatic exercise tracking
  6. New partnerships with Public School, Westin and Thermos
  7. R&D headcount grew to 624 at year-end 2015, comprising 57% of the company's employees
  8. Added 1,000 Fitbit Wellness enterprise customers in 2015

With such great results and such superficially strong metric performance, it is of no surprise that shares of FIT are not performing well in the after hours trading session. And furthermore, it is only in part to the relatively underwhelming Q1 2016 guidance that would see the company's margins come under pressure and only support earnings of $0.00-$.02 per share versus estimates of $.23 a share. The company forecast for Q1 revenues also came in shy of expectations at $420M-$440M versus street consensus of $484.6 million.

Superficially strong metric performance is what I stated right? What no single analyst has recognized in their reporting to clients thus far is the retention issues that are ever present and expanding against Fitbit's likely favor. But what is even worse is not just the current rate of attrition for Fitbit connected devices but rather the more identifiable 2-year attrition recognition. So it is one thing to understand the total active users added in 2015, but when added to the active user base established through 2014, we have a serious issue to recognize with regards to the usefulness of health & fitness trackers. Let's take a deeper look that really isn't that deep at all, but will definitively not be discussed without my presentation. Guaranteed!

What is Fitbit's total active user base as they recently reported? Active users grew 152% to 16.9mm active users from 6.7mm users in 2014. Sweeeeeettttt, right? So what's the "prob Bob"? Well, and I'm glad you didn't ask, but I'm able to recognize the totality of the metric dissemination. What did Fitbit state were the total new active users in 2015? Yes, the total new active users in 2015 were 13mm. That's right, a completely round number and they are certain of it despite the tenths of percentage points they offer in other disseminated metrics (Believable, does it matter?) Do you see the problem in the dynamics of the metrics yet? Let's perform the math if not.

If total active users in 2014 were 6.7mm and you added 13mm new active users in 2015 one can perform the simple math to surmise a total active user base that equates to 19.7mm active users. But Fitbit said total active users as of 2015 only equated to 16.9 million.

Y1 6.7mm

+ Y2 13mm

__________

19.7MM

-16.9mm

________

2.8mm

Based on the undeniable mathematical equation noted above, the attrition rate in year 2 of Fitbit product usage, the attrition rate is roughly 42% and again identifies the perceived usefulness of the product by its users. "Houston, we have a 2-year attrition rate that now has to be considered more deeply; Houston, we have a problem with our investment thesis". Based on Fitbit's reporting and not Seth Golden's, but rather Fitbit's, in year two of Fitbit usage wearable devices the attrition rate remains elevated and beyond the normal of what should be perceived as a useful product. Essentially, people purchase the product under its intended usage, but the benefits are less attractive than either assumed or recognizable by the user. So after using the product for a year or so, those users decide to attrition from the system. This is the broader evidence I desired to see with regards to the notion of gadget introduction and early adopters. This is the deeper analysis that I would suggest investors or would-be investors consider as it points to what will likely occur to the company in the future. Cell phones, microwaves and at an even lesser technology driven level, counter-top grills never had this level of attrition and that is the identifiable differentiator in determining long-term forecasts for a product and company. Essentially, at the heart of the Fitbit business model is the constant fight or struggle to sell more product to new retailers and new distributors with the attrition rate approaching 50% year-over-year and in an increasing fashion. Again, as reported through Fitbit's metrics.

Fitbit is touting the technology driven health advantages to consumers and corporations as being a drivers for future growth and I laud the company's efforts. Fitbit will undoubtedly garner growth in the interim through the deployment of its products into the various sales channels, but nonetheless, the total addressable market for long-term users is at least 50% less than what the company is disseminating as determined by the attrition rate. Can Fitbit convince customers to purchase their product, certainly, but using the product long-term is verifiably beyond their current capabilities and not within the assumed total addressable market assumptions. While the company has suggested friends of users will also add to growth, they make no mention of the impact from attritioned users. Apparently attritioned users have no friends and furthermore why would Fitbit executives suggest the impact from attritioned users to the investment community? It's really up to you, the investor to dive deeper and consider metrics more broadly to establish a greater investment thesis.

In an attempt to warn investors previously, I discussed my inability to care for Fitbit's corporate sales strategy. The commercial marketplace is less than a 1/3 the size of the consumer market. It's consumer driven or it's not an investment for this guy. The ability for this commercial sector of business to drive the business model with increasing profitability long-term is very limited if not impossible. With the business sector currently garnering less than 10% of total sales for Fitbit, this expressed sentiment is further evidenced and proven factual in its representation. One could very easily add up all the corporate accounts in the developed world available for distribution of Fitbit products and they would not equate to half of the total consumer channel sales in North America and Asia-Pacific. I didn't even get to European consumer sales channels; that's how miniscule the corporate sales channel is when compared to the consumer sales channels. And don't get me started on how small the health & wellness category is with regards to total retail sales. I've discussed this as a point of greater analysis and understanding of how to position the potential of Fitbit within the consumer trends.

I can certainly appreciate what Fitbit is doing so far as addressing health & wellness. I don't think anybody could say assisting consumers through packaged technology with their health concerns is a disadvantage. The problem with Fitbit is not an issue of health & wellness it is an issue of usefulness of products. Yes, many millions will purchase and be retained as active users, but the totality of the business model for investing must be considered using both potential retention of active users and attrition of users. They go hand-in-hand in recognizing when and where growth will begin to decline and for every single product ever introduced to the marketplace, sales always find a way to decline over time. So within that consideration it is always a numbers game. When will Fitbit saturate its global distribution and when will those sell-through numbers, which are always less than the initial sell-in, not be able to offset lesser sell-in once markets are saturated? Fitbit still has a decent runway based on my expert knowledge of available global distribution. Thus far, the firm has garnered roughly 50,000 global storefronts/doors. There still remains another 50% upside to this number, give or take a few thousand depending on regional sales channel infrastructure. I'm of the opinion that Fitbit will maximize this potential distribution network over the next 12-18 months. I propose this forecast in part because of the company's total net sales increase YOY, which can only be achieved through advancing the distribution network and initial pipeline builds. Curtailing such distribution growth would dramatically negate the company's ability to continue to grow. The sell-through rate simply isn't strong enough. That is the proverbial "interim" investors should consider in their investing strategies; a forecast for distribution saturation. So let's take a look at the company's forward-looking guidance.

Turning to guidance, we expect 2016 revenue in the range of $2.4 billion to $2.5 billion driven by new product introductions and geographic expansion, with gross margins ranging from 48.5% to 49% driven by the margin profile of our new products as well as our accessory strategy. With this in mind we expect 2016 EBITDA ranging from $400 million to $480 million and EPS ranging from $1.08 to $1.20.

Also the timing of shipment into our sales channels will result in the majority of reorders especially for Alta in Q2. Lastly we expect to incur additional manufacturing cost in Q1 to maximize production of our new products to meet expected demand, which will impact gross margins.

With those dynamics in mind, for the first quarter of 2016, we estimate revenue in the range of $420 million to $440 million. Non-GAAP gross margin is expected to be approximately 46.5%. We expect this to result in non-GAAP diluted net income per share in the range of $0.00 to $0.02.

Unfortunately, investors did not view the FY16 and Q1 2016 guidance favorably. Nonetheless, I would be of the opinion that fears will subside as the company has generally taken a conservative approach to guidance, affording the firm the opportunity to beat guidance and expectations. Having said that, this also identifies the company's ignorance regarding shareholder sentiment and the lack of "clout" the company has established with the investment community. In my opinion, the company made a typical mistake that inexperienced management teams often make when deciding how to issue guidance. While the CEO has built a strong business to date, he is appearing to be less of an outlier for excellence and more of run of the mill, prototypical leader. Strategic business development is desired and found wanting on many levels presently that don't include near term results and the share price performs is supportive of such sentiment. But to reiterate, I do believe investor fears will subside and shares of FIT could move higher in the interim.

In a previous article I offered investors a Preview of things to come for Fitbit. I did this, in part, through dissemination of real-time sales data and orders for Fitbit products. In kind, I will elevate the conversation surrounding Fitbit's guidance for Q1 2016 that I believe to be somewhat disingenuous on the part of Fitbit. The company has claimed that a good, if not majority, portion of its Q1 guidance that failed to achieve the consensus of analysts' estimates will be due to new product launches. What the company failed to disclose is that it is also due to product discontinuation. Some of these sku reductions from retailers are not of Fitbit's doing, but of their retail partners. See, what Fitbit has sold into the retail channel are different colors and sizes of wearables. But over time, retailers identify that some of these colors and/or sizes simply don't sell. They wind up being discounted and/or discontinued in short order and in favor of newer product or different product. This is the first layer of the sell-in issues that Fitbit will encounter as it laps YOY sales in certain regions, mainly the United States. That is also one of the main reasons the company has to offer new iterations of products year-after-year-after-year. Being that the sell-through is not as strong as sell-in, the company has to constantly issue new product in hopes the retailers will continue to distribute. Go-Pro (NASDAQ:GPRO) failed to meet this operational feat and as such was punished mightily by investors. Eventually, Fitbit is likely to succumb to what all vendors evidence; it's just a matter of when. Fitbit has an excellent balance sheet presently and ended 2015 with $664.5 million of cash and short-term investments and no debt. This is an increase of $89 million from the end of Q3, 2015 and included net proceeds of $84 million as a result of our follow on offering in November 2015. The company is spending a great deal of money on R&D as well as A&P and at some point I would suspect hoping to increase their retention rate. Even with the company adding additional features and applications for its technology, the attrition rate is accelerating as identified in the total numbers sold in the last two years juxtaposed with the total number of active users. Analysts don't seem too concerned with total registered devices if the company hasn't been able to monetize that activity either.

Television commercials and various forms of multi-media advertising will aim to support the upcoming global launches of the Blaze and Alta devices and I would hope to see a short-term lift from this dedicated advertisements and promotions. When the company suggests they receive a strong ROI from its marketing, based on the metric performance, that ROI is likely stronger from a distribution gain standpoint than a consumer usage standpoint…and for the interim that is good enough for metric performance, but not so much for shareholder perception. Bottom line seems to be that investors, in the majority, understand where the Fitbit story is heading as all analytics point in the same direction as the stock performance to date. As a caveat, the interim may prove to provide some severely underwater shareholders with some degree of relief. I certainly hope so for Mr. Keith's sake.

Disclosure: I am/we are long FIT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This will be my 3rd trade in Fitbit seeking short term gains from depressed levels with respect to near term performance results.