Fitbit (NYSE: FIT) has been a controversial stock given both the well-known implosion of another "personal device" company which is GoPro (NASDAQ:GPRO) and the appearance of a huge amount of potential competitors ranging from watch companies, other "personal electronics" companies (Garmin, Jawbone, etc.) and broadly focused consumer electronics companies (Apple, Samsung, Xiaomi).
The company released its second quarter earnings today and then held what I thought was a very interesting conference call. There were a lot of general comments on the call that, while not intended to be a comment on any specific competitor or issue, suggest that the company's strengths and sustainable position is not fully understood or appreciated. In my comments below I will go over some of the areas which I believe are notable.
Goal oriented versus fun oriented
I believe the GoPro comparison is completely inapplicable as I view GoPro devices as mainly being for "fun" (although there is some commercial use of their products) and more susceptible to declining interest as consumers migrate to different activities. I view the portfolio of FitBit products, although also a completely discretionary purchase similar to a GoPro device, as having a much more dedicated user base that is goal oriented. You might think that the pursuit of "fun" sounds more interesting than the pursuit of "goals" but when the goal is personal health and fitness, then that creates a much more sustainable category.
Comments on the Fitbit Q2 conference call confirms the more sustainable base of goal oriented users with an anecdotal story of what they are seeing in "reactivations." The "stickiness" of Fitbit devices in terms of active users also has been a controversial topic cited by those who are negative about the company but James Park, Fitbit's CEO, had an interesting comment that fitness activities run in cycles.
He described that Fitbit wearers have lots of different goals ranging across weight loss activities, interim fitness goals, and more specific objectives such as preparing for competitive events. He described that the company now feels very familiar with the cycle of such activities and understands that usage will ebb, resume and flow again.
He also described that the company's strength in having the broadest portfolio of fitness trackers was ideally suited for the broad range of possible goals across customers interested in fitness tracking capabilities. Another significant difference between Fitbit and GoPro is that Fitbit's price points are a lot lower along with a range of products that are a lot more accessible depending on a customer's fitness goals versus GoPro's products that I believe are actually a lot more narrow for various personal activity "documentation" objectives.
Direct Competition to Fitbit
Since fitness trackers are worn on wrists, various watch companies have introduced devices with basic functions that appear to be competitors in the overall category but I believe such companies are not really taken seriously by the "goal" oriented consumers that Fitbit describes as their targeted customers. There also are other sports related product companies that have introduced one or two activity trackers as "extensions" to their overall product lines at lower price points but I also do not believe that such products are seriously regarded by the goal oriented users of Fitbit's products.
Two viable competitors to Fitbit are Jawbone and Garmin but both have a somewhat different market focus and a more limited product range than Fitbit. Jawbone is generally at somewhat lower price points and has four products versus Fitbit with seven products. Garmin is at higher price points and with more of an integrated product focus with more features but I believe that is actually a different market segment than the main focus of Fitbit's products. Fitbit and Jawbone also are involved in a horrendous food fight of lawsuits and counter lawsuits (Fitbit's Jawbone related legal fees this year will probably approach $50 million, which I do not view positively) which they probably should just find a way to settle and let themselves compete directly in the marketplace instead of in the courtroom.
More broadly focused consumer electronics companies such as Apple, Samsung (OTC:SSNLF) and Xiaomi are competitors to one extent or another in various segments of the "health" and "fitness tracking" segments but none of them have the product breadth or focus of Fitbit. One interesting data item on the Q2 conference call is that Fitbit claims that unit sales of their high end watch/fitness tracker (the Blaze, which has a $199 price point) were almost as many as the Apple Watch during the recent quarter.
Supporting Fitbit's ongoing positioning in its market versus competitors is a very large Research and Development budget which should exceed $325 million in 2016. This spending supports both a continuing technology leadership position versus competitors as well as a very strong new product pipeline. Fitbit commented on the call that multiple new products will be introduced between late in Q3 and prior to the holiday season in Q4. From overall comments on the call, Fitbit's revenue guidance for the remainder of 2016 suggests that roughly half of the projected Q4 revenues of between $900 million and $950 million (a 26 percent to 33 percent projected increase over Q4 2015) is planned to come from the new products that will be introduced.
Concerning ongoing new product development, I felt that I heard suggestions that future product releases will be on a more consistent schedule that will also help with overall financial planning and earnings visibility for the company. One of the negative perceptions of the company is that financial results have little visibility quarter to quarter and also that a huge amount of each year's results are in Q4 and that is a somewhat risky profile for investors. If the company is successful with a more consistently planned product introduction schedule then that could mitigate a currently perceived risk factor.
Other interesting comments from the conference call
Another sign that Fitbit is a real company with a sustainable advantage in the market for its devices are favorable consumer ratings. In the highly competitive marketplace at Amazon, consumers apparently love Fitbit's devices as there are over 7,000 reviews and most ratings are at least 4 or higher on Amazon's five point scale. Fitbit's apps also are very highly rated and are top ranked in their categories. The "network capable" features of Fitbit's devices also create a robust social experience resulting in a significant network effect which should drive future usage and upgrade device purchases.
Fitbit also has a very effective and expanding presence in other retail channels through actively working with its retail partners. The company is continually working on improving its product placement with compelling merchandising programs including upgraded and expanded product displays. Such active programs with channel partners is what makes the company feel confident that the Q4 revenue plan is achievable as it commented that its new products are very attractive to retailers.
A sustainable advantage in retail channels is expected to continue as even more improvements are planned for merchandising programs for the rest of this year and into the future. International activities are very active as the company is finding opportunities to expand their Europe, Middle East and Africa (EMEA) store count and is expanding localized marketing and advertising. Other programs internationally are expanding point of sale (POS) updates and continuing to expand in other new geographic areas.
Additional growth initiatives are in developing Corporate Wellness and Digital Health programs with large organizations. Although not yet a significant revenue driver currently, such programs should help Fitbit maintain a market leader perception which should produce higher revenue growth than competitors in the future. Fitbit also mentioned that its devices are used by over 200 research institutions for monitoring participants in various health and activity related studies. Fitbit's commitment to future expansion of these programs was confirmed on August 1 by announcing the hiring of a new Vice President for Digital Health, Adam Pellegrini, whose previous responsibilities were heading the Digital Health market segment for Walgreens Boots Alliance, the very large international drugstore chain.
Overall revenue for the quarter of $587 million both exceeded expectations by around $8 million and was up 46 percent versus Q2 2015. Revenue growth was actually even limited a bit by a large sporting goods retailer in Australia that closed all 370 of their stores during the quarter which limited Asia Pacific (APAC) growth to only 11 percent versus Q2 2015. Sequential unit growth was also very strong with 5.7 million units sold in Q2 versus 4.8 million sold in Q1. The attractiveness and continued acceptance of Fitbit's products was seen in an average selling price increase as the Q2 ASP was $99 versus $88 in Q1.
The potential margin expansion from the additional revenues was offset a lot by a one-time addition to warranty reserves of $50 million for legacy products that are no longer being sold. That additional amount in Cost of Goods Sold resulted in Gross Margins being 42 percent versus 47 percent in Q2 2015. Without the addition to warranty reserves, the Q2 2106 gross margin would have been eight points higher at 50 percent. Other comments made on the call seemed to suggest that the company has learned a lot from previous product warranty issues and is now far more capable in both designing and manufacturing all of its products. A specific comment was that the new products to be introduced in the second half of 2016 will have higher margins due to better designs and manufacturing improvements.
Balance sheet quality and financial strength is top notch as the company has no debt and ended the quarter with $760 million in cash which is an increase of $100 million in just two quarters from year-end 2015. My financial model projects an additional increase in cash to almost $850 million by the end of 2016 even with a very large increase in receivables from the holiday selling season. My financial projections for 2017 forecast another $200 million increase in cash by the end of that year as the company has very attractive cash flow characteristics.
Fitbit is a company that will always generate a lot of different opinions given rapid changes in customer preferences that can happen with consumer electronics and in retail channels. I think the latest earnings report was a significant milestone, however, in further displaying the company's strengths, product positioning, and competitive advantages. The company also seems to have learned a lot from any previous missteps whether they may have been higher than anticipated warranty claims or a less predictable product introduction schedule. At this point, Fitbit is the leader in the fitness tracking device category and appears to have the research and development strength, broad and expanding retail presence, and financial strength to maintain that leadership position.
Valuing the company's future projected earnings is complicated, however, as growth rates will inevitably slow from the high rates of growth that will be seen for the full year this year (which I project to be 36 percent). I'm projecting 18 percent revenue growth in 2017 but with positive operating leverage that should produce a 25 percent earnings gain. That would result in $1.45 of projected earnings in 2017 versus a current stock price of $14. I think even with uncertainties about future rates of growth, which should at least be positive each year, that a fair P/E multiple for the company would be at least 15-times earnings given its overall financial strength. That would result in a target price of $22 which is almost 60 percent higher than the current stock price.
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.
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