Fitbit's Stellar Holiday Tarnished By Missteps - My Thoughts On FIT

| About: Fitbit, Inc. (FIT)

Summary

Fitbit did exceedingly well in its holiday quarter, beating forecasts for product sales, revenues, margins and earnings per share by far.

But the company left a lasting sour taste with its disappointing guidance for Q1 2016, where it will miss analysts' top and bottom line estimates by far.

Management showed its weakness by not better managing its operational planning and progress if possible, or otherwise by not better conveying the situation to analysts and investors ahead of time.

Also the company has advised of heavy investment spending this year, and its full-year guidance, while in line with expectations, is either very conservative or concerning as a result.

Fitbit impresses with its progress in healthcare wearable technology, and its valuation is deeply discounted. FIT must strengthen its image with investors, but short covering could lift it near-term.

Fitbit (NYSE: FIT) almost filled in all my checks for a perfect earnings report that could have been a catalyst for a short squeeze and sharp upside rise Tuesday. However, its stellar holiday quarter goes to waste due to surprising quarterly guidance that diverged significantly from analysts' expectations. While it all works out by year-end to conservative full-year figures that meet analysts' annual estimates, it raises uncertainty and is evidence of an unseasoned management team.

Unfortunately, the company misses an opportunity to force a vibrant short squeeze to fuel restoration of shareholder value to stakeholders deserving of it. Still, the deeply discounted on a PEG basis, oversold stock with a heavy short interest could still see a healthy upside rise by week's end or even day's end Tuesday, as current market dynamics have been serving deeply oversold stocks. Over the longer term, it'll take a quarter or two for the company to refashion its image with investors. It's important to note that there is hope; Facebook (NYSE: FB) also had missteps in its early post-IPO days, and it managed to recover nicely. The company has potential, but it cannot afford to miss a beat when competing against Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT).

In a comment to my earnings preview for Fitbit, I laid out how a perfect earnings report might look. Here's how the company fared against my checklist:

  1. Report an EPS beat of 10 cents ahead of the analysts' consensus for $0.25 and at the whisper number of $0.35. Check! And spot on the EPS figure.
  2. Report revenues atop the high end of the analysts' range of forecasts. Check!
  3. Talk about work toward extensions of healthcare uses and progress with healthcare providers and insurers, with my eye on diabetes. Check!
  4. Provide guidance that exceeds analysts' estimates. Unfortunately left unchecked.

Before I even get to the quarter, I want to cover what drove the stock down after hours and what may impede progress on Tuesday morning, since that is what you really want and need to know about. The company failed in two ways with its guidance Monday night. First, it failed by not planning and/or executing its operations to avoid a first quarter disappointment, if it was avoidable. The company's first global product launch and its shift to production of new exciting products are going to impact revenues, expenses, margins and the bottom line in the first quarter. Revenues will be impacted because of the timing of the launch, which is likely to lead reorders to be pushed out to the second quarter. Expenses will be higher on a high level of marketing and selling expenditures that will near fourth quarter levels (heavy holiday levels) to support the new products globally. Expenses will also be impacted by expansion of manufacturing efforts to meet rising global demand for its products and its expanded lines of products, along with increased workforce to manage growth and a conversion to SAP. And margins will be squeezed as a result, with the bottom line EPS guidance for $0.00 to $0.02, versus the analysts' consensus estimate for $0.24. It was quite unfortunate to see that, given the company's stellar performance in the holiday period. The stock immediately sank after hours and was down roughly 15% to $14 by about 8:00 PM ET.

Here's how the company should have mitigated this issue and avoided the pain we're feeling this evening, myself included with my modest long stake. First, it should have planned and/or executed its new product development in a manner that would not have impeded first quarter revenue because of the reorder impact. But if that was impossible, it should have come forward publicly to the analyst and investor community ahead of the earnings report, with notation of how the second quarter would likely benefit from the reorders and how the full year global effort should lead to inline results for the year, conservatively speaking. If they had done that, analysts could have worked in the lopsided quarterly guidance ahead of this earnings report and the company could have had a clean day. Also, perhaps it needs to level out its expansion spending, or be consistent about timing year-over-year, so as to not see roller coaster ride like quarters.

It's possible the company could use a more involved investor relations director to help it better manage its message. You need someone who understands market value creation and protection like I do. You never want to surprise investors on your big earnings report day, when all eyes are focused on you, especially if there's a large group of investors betting on your demise. That's how you feed the short monster. So you make sure analysts are in tune with you as best you can, and within legal limits. And when you under-promise in order to over-deliver, you don't lower the bar so much that you raise concerns and uncertainty about your growth prospects and market share defense against intensifying competition. I feel like the company's forecasts for the full year is too low considering what it has accomplished this year, and it raises concerns about potentially excessive investment spending for an intensifying competitive environment and uncertain future. Anyway, after setting a respectable but still low bar, you beat those analysts' forecasts on all counts. That's how you make the message work for you and satisfy your capital providers on the equity side.

Now to the stellar earnings report that few will give weight to Tuesday except patient deep value prospectors hoping management fine tunes things. Don't get me wrong, running a company efficiently is a difficult task and it's easy for me to Monday morning quarterback. But some companies do a better job of it than others and don't need to fend off short sellers. Hey, even Facebook, today's darling of the market, had a misstep in its early post-IPO days. I was there to recommend Facebook at that time; I'm not ready to do that for Fitbit for the long term yet though. It'll take at least a quarter and possibly two for it to refashion its image with investors. Keep reading, though, because the stock still has a chance for a near-term gain on tangential drivers.

The company exceeded Q4 expectations on all fronts. Fitbit's quarterly revenues grew 92% to $711.6 million. That compared against analysts' consensus expectations for $647.8 million, and it ranked above the highest of 17 estimates for $676 million. To get there, Fitbit sold 8.2 million connected health and fitness devices, marking 55% growth and exceeding the 7.5 million in device sales projected by analysts surveyed by Factset.

Gross margin expanded by almost 300 basis points to 48.8% in Q4, from 45.9% in the prior year quarter on manufacturing efficiencies on greater sales. Non-GAAP gross margin adjusted for currency impact was 50%. Non-GAAP operating expenses comprised 32.2% of revenue this quarter, versus 25.9% last year, as the company expanded supportive sales efforts. The company's footprint expanded significantly into enterprises and across geographies. Some 1,000 Fitness Wellness enterprise customers were added in 2015, where greater margins are attained. It also formed partnerships with a few public schools and sees other organizational opportunities. Even despite its increased sales and marketing spending, net margin expanded by 45 basis points to 12.3%. Adjusted EPS grew 67% in the quarter, year-to-year, to $0.35, which far exceeded analysts' consensus estimate for $0.25.

Other accomplishments included successful market acceptance of the company's newer products, which accounted for 79% of revenue. That would bode well for this year's global new product introductions of the Fitbit Blaze and Alta. Pre-order volume for Alta and Blaze has exceeded internal forecasts, and Blaze was ranked second last week among Amazon's (NASDAQ: AMZN) best selling smart watches priced over $100.

Customer retention seems to be improving thanks to new products and company efforts to improve supportive "friend" growth among users, based on conference call notation. The company added 18 million new registered users in 2015, of which 72% were still active users at year-end. That marks strong improvement and it was a point of focus of the CEO on the call. Total registered users numbered 29 million at year-end, of which 16.9 million (58%) were active users (+152%), so you can see retention is improving. Analysts are looking toward the prospect of monetization of the user base in the future, and that is not priced into the stock yet at all. We'll need to see some evidence first.

The company's quarterly guidance disappointed, as I've noted. Fitbit sees Q1 2016 revenues of $420 to $440 million, versus analysts' consensus forecast for $485 million. Non-GAAP gross margin is seen slipping to 46.5% due to new product launches; expansion efforts; and on lower revenues due to the expected reorder push-out to Q2. EPS is seen in a range of $0.00 to $0.02 a share, versus analysts' consensus estimate of $0.24.

But for the full year, things even out. The company sees full year 2016 revenues managing $2.4 to $2.5 billion on new product introductions and geographic expansion, versus the analysts' consensus forecast for $2.42 billion. Depending on product acceptance versus tougher competition, this could be understated in my view. Gross margin should expand for the full year to a range of 48.5% to 49%, again likely understated and notably better than Q1's guidance. Quoting the release, "Operating margins reflect strategic investments expected in 2016 to further develop Fitbit's Digital Health strategy, expand corporate wellness offerings, support 2017 and 2018 product roadmaps and further build out back-office infrastructure to support increasing scale and global breadth, including migrating business systems to SAP." Full year 2016 EPS is seen ranging from $1.08 to $1.20, versus the analysts' consensus for $1.14. We want to believe the company is understating its potential here, but the warning about investment this year raises some doubt about that.

Given its history of outperforming, if we assume it can earn the top end of its EPS guidance range and the stock opens at $14 on Tuesday, that would give FIT a forward P/E of 11.7X, a discount to the market. Still, that represents just 12% growth over the $1.07 per share earned in 2015. Even assuming that seemingly conservative forecast, the stock would have a forward PEG of about 1.0X, not excessive. If the company can manage the 31% long-term growth analysts forecast for it on average, it's PEG on trailing EPS (to be conservative on P/E) would be 0.4X. The stock should not, therefore, drop further and would appear to be a value at the open Tuesday. Though, given its short interest and the disappointment this quarter, it may take some time for the stock to realize its full value.

That said; CNBC noted Monday that the market has been rewarding beaten-down heavily shorted names of late, as stocks rise more broadly and short sellers cover. Fitbit is one of the most shorted stocks on the market on a percentage of float basis. For this reason and its valuation and longer term opportunity beyond Q1, if the market's recent uptrend can continue well into March as I suspect, then the stock could very well end the week (or even the day) much higher than where it closed on Monday before the earnings report. I think value investors can buy it here for a tradable upside opportunity on any softness Tuesday morning, but beware next quarter's earnings report, as there will be risk again and memories of this week to weigh on the stock ahead of that report. I'm now following this stock closely and will better familiarize myself with it for relative interests and my own purposes, so I invite relative parties to follow my column here at Seeking Alpha.

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.