Fitbit: A Look Into Deteriorating Financials

| About: Fitbit, Inc. (FIT)

Summary

Horrendous sales and profitability over the past two quarters have caused Fitbit's clean balance sheet to lose some of its strength.

Management's liberal spending on selling/marketing, R&D, and capex means that the near-term free cash flow picture is likely to be ugly.

Avoid purchasing shares.

Fitbit (NYSE:FIT) caught my attention when I noticed that the stock was down nearly 70% from its 52-week high and nearly 90% from its all-time high in 2015. When I looked and saw that the company was also debt free, trading at just north of book value, and was cash-flow positive in 2016, I decided to do some more in-depth analysis of Fitbit's financials to see if there looked to be an opportunity.

FIT Chart

FIT data by YCharts

Qualitative Summary

Looking at the body of work on Seeking Alpha, other contributors have provided a lot of coverage on the qualitative story of Fitbit, so I thought it would be more useful to focus on analysis of the company's financial statements and their future prospects. However, it is necessary to at least provide a backdrop. Fitbit produces numerous varieties of health and fitness tracking devices. As the industry leader in wearables, they enjoyed enormous growth from 2013 to 2015. However, declining popularity of their devices and increased availability of substitutes, like Garmin's fitness trackers and the fitness capabilities of the Apple Watch, led to a major company downturn in 2016. Fitbit was predicting a revolution in wearables that would change the climate of the entire health care sector, and up to this point those expectations have been overhyped.

Past Two Quarters: Massive Decline in Revenue and Profitability

In Q1 2017 and Q4 2016, Fitbit posted some extremely poor year-over-year numbers, switching from profits to losses on an operating basis for both periods:

(numbers in millions)

Q4 2015

Q4 2016

Growth

Revenue

$712

$574

-19%

Gross Margin

$348

$127

-64%

Operating Income

$111

($185)

N/A

Q1 2016

Q1 2017

Growth

Revenue

$505

$299

-41%

Gross Margin

$234

$118

-50%

Operating Income

$19

($91)

N/A

There were no big one-time expenses. The huge declines in profitability were the result of a combination of higher R&D expenditure and relatively higher operating costs:

Expense as % of Revenue

Q4 2015

Q4 2016

R&D

8%

15%

Sales and Marketing

22%

32%

General and Administrative

5%

7%

Expense as % of Revenue

Q1 2016

Q1 2017

R&D

14%

29%

Sales and Marketing

21%

30%

General and Administrative

7%

10%

G&A expense saw a relatively small increase, and nearly doubling R&D spending is a choice that management has made in an attempt to develop new products that can drive future sales. The big concern is the spike in sales and marketing expenses - Fitbit has been forced to spend a lot more in order to sell product. This likely indicates that they are feeling increased pressure from competition.

The bleeding is projected to continue, as management issued FY 2017 guidance of revenue between $1.5-1.7 billion, which would be roughly a 20-30% decline from 2016.

Cash Flows and Pressure on the Balance Sheet

Despite of net losses in $146 million and $60 million in Q4 2016 and Q1 2017, respectively, Fitbit had positive operating cash flow in both quarters: $69 million in Q4 2016 and $49 million in Q1 2017. However, these positive numbers were reliant on balance sheet maneuvers that cannot be repeated sustainably:

Q4 2016

Change in Accounts Payable

+$59 million

Change in Accrued Liabilities

+$170 million

Q1 2017

Change in Accounts Receivable

-$283 million

Change in Inventory

-$23 million

Drawing down current assets and building up current liabilities can raise cash temporarily, and was doable for Fitbit considering their sizable amount of working capital, but they cannot do that every quarter. Without these large working capital decreases, the company could have had negative operating cash flow as bad as -$150 to 200 million in both quarters. This is very concerning - the company's cash balance is strong at $732 million for now, but sooner or later sustained losses would force Fitbit to dip into that number.

For now, the damage is being done on the balance sheet, not to cash, but to other current assets. Looking at the past several 10-Qs for Fitbit, I compiled the following data on the company's net current assets (current assets minus all liabilities) per share in each quarter.

Net Current Assets (millions)

Shares (millions)

NCA/Share

Growth

Q3 2015

$ 697

207

$ 3.37

Q4 2015

$ 817

215

$ 3.80

12.8%

Q1 2016

$ 838

216

$ 3.88

2.0%

Q2 2016

$ 832

219

$ 3.80

-2.0%

Q3 2016

$ 862

222

$ 3.88

1.9%

Q4 2016

$ 659

226

$ 2.92

-24.7%

Q1 2017

$ 607

227

$ 2.68

-8.2%

Fitbit's balance sheet, one of its greatest strengths, has taken large hits in the past couple quarters. The decline in net current assets, particularly the nearly 25% drop in Q4 2016, indicates that significant value is being destroyed. The NCA/share metric could be considered an absolute floor for Fitbit's stock, as if the stock fell below that point the company could likely liquidate and have enough left to pay shareholders more than the market price per share. The past two quarters have dipped into that margin of safety and investors should be feeling considerably less comfortable.

With 2017 projected to be another ugly financial year for Fitbit in terms of sales and earnings, investors should expect either continued weakening of net current assets or (more likely) a drawdown in cash. And with management spending liberally on selling/marketing, R&D, and capex (over doubled to $79 million in 2016 compared to 2015), the free cash flow picture appears very grim for Fitbit in the near future.

Positive Factors

Despite their overall struggle, Fitbit does have a couple of things going for them. First of all, with $732 million in cash and zero debt, they still have time to turn the company around. Even in a worst-case scenario, it would likely take them at least a year to start to seriously wear down that cash balance.

At the heart of the company's turnaround potential is Fitbit's increased R&D expenditure:

R&D Spending (millions)

Q2 2015

$ 30

Q3 2015

$ 43

Q4 2015

$ 54

Q1 2016

$ 72

Q2 2016

$ 80

Q3 2016

$ 83

Q4 2016

$ 85

Q1 2017

$ 88

The bull case on Fitbit relies on these precious dollars going to good use and leading to the next great products that can drive sales and profits.

The other optimistic scenario for Fitbit is that with a clean balance sheet and a valuable collection of data, the company could be an attractive acquisition candidate. Other firms would find Fitbit's leadership in the health and fitness wearables business and their collection of over 50 million registered users highly intriguing, perhaps enough so to pay a sizable premium over current market price.

Conclusions

While Fitbit may have the potential to turn the business around with their significant R&D spending, the company was not the opportunity I was hoping to find. Management appears readily willing to use the cash they have on sales, R&D, capex - whatever it takes to drive sales and grow the company. Unfortunately, this means that the company will be almost certainly be free cash flow negative in 2017 and perhaps in further years as well if profitability fails to rebound. Fitbit's net current assets will likely continue to drop and the strong financial base that the company had enjoyed will continue to weaken. As a value investor seeking to buy businesses based upon the value of their future cash flows, I do not see a compelling enough picture to buy. If you are optimistic about the company's R&D spending and want to buy, make sure you do so with the knowledge that Fitbit's financials are deteriorating.

I also believe a short at these levels is quite risky, particularly because of Fitbit's potential to be acquired at a premium. Additionally, the net current assets of $2.68/share (while declining) still provide support to the share price, and investors are well aware that Fitbit has over $700 million in cash. This likely limits the short-term downside potential of the company. For my risk tolerance and investment philosophy, I do not recommend either long or short positions in Fitbit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , Diversified Electronics
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here