Fitbit: Taking The Leap Of Faith

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About: Fitbit, Inc. (FIT), Includes: AAPL
by: The Happy Fund
Summary

Fitbit's share price has collapsed close to 90% from its peak levels in 2015, leaving investors badly bruised.

Late to consider the transition to smartwatch and spending big to keep pace with a changing market, the company fell rapidly out of favour.

But this was not the end for the once-beloved fitness-tracker, which ranks comfortable as the second best selling smartwatch worldwide in 2018.

Poised to grow 20-25% p.a. in the next 3 years, the wearables industry's huge opportunity has become Fitbit's home turf once again, with healthcare finding strong momentum.

At the current share price levels, the company's rejuvenated prospects and solid balance sheet seem heavily undervalued. The stock is a buy from here.

Investment thesis

Fitbit Inc.'s (NYSE:FIT) mission statement is to make everyone in the world healthier. Unfortunately, the one thing it's not making any healthier so far are the investments from its shareholders. Indeed, Fitbit's share price has dramatically collapsed since its 2015 highs, leaving investors bruised as much as 85% down. And over the past 12 months, it's been range-trading around $5 to $7. So, is it time to give up? Not in my view, the best is yet to come.

Fitbit ranks amongst the world's top smart wearable devices brands, in a market poised to grow by almost 30% p.a. in the next 3 years, to over $73 billion in sales revenue worldwide. Also, the company has made a late yet remarkable entrance in the smartwatch market and is on track to deliver CEO James Park's vision of the most integrated health and fitness smartwatch. At a price of c. $6.5 a share, Fitbit is a very attractive opportunity to not only capture a great brand, with strong potential and a solid balance sheet, but also take direct exposure to the mega-trend behind wearable digital technologies and healthcare.

Of course, this is unlikely to be plain sailing. Competition in this market is very high, with Goliath players like Apple (NASDAQ:AAPL), whilst the turnaround for Fitbit is far from being guaranteed. A lot relies on the Versa's success, the impact of future macro-economic developments on consumer demand, and of course, Fitbit's ability to monetise its B2B health solutions. For now, I see great potential, look forward to the next earnings release, and rate the stock a Buy, particularly at levels below $6 share.

The fall of the rising star

Fitbit has been around since 2007, when co-founders James Park and Eric Friedman joined forces to develop sensors and wireless technology that would change the experiences to fitness and health.

Fitbit launched its first device in 2009, the simply-called Fitbit, which clipped onto the user's clothing and used an internal motion detector to track movement, sleep and calorie burn during both the day and night. Since then, the company has sold 84 million devices (Source: Fitbit Q3 Earnings Presentation) and offers a line of products that spans smartwatches, fitness trackers for all ages (a very unique feature), as well as other products, including a smart scale.

Figure 1: Fitbit product line

Fitbit product line Source: Fitbit.com. As of February 8th, 2019.

Fitbit is undoubtedly recognised as a global leader in the wearables market. Based the International Data Corporation's (IDC) wearables tracker, Fitbit regularly took the third or second position in the quarterly ranking of shipment volume and market share in 2018. In particular, IDC highlights Fitbit's latest devices, including the Versa, Charge 3, and the Ace (i.e. the Fitbit for kids), which helped the company considerably slow its decline compared to previous quarters. Of course, though the year-on-year (y-o-y) sales are down for Fitbit, even by a "small" 3.1% year-on-year rate in Q3 2018, it still compares to +54.0% for Apple in the same period. (See Table 1 below for more details)

Table 1: Top 5 Wearable Companies by Shipment Volume, Market Share, and Year-Over-Year Growth, Q3 2018 (shipments in millions)

op 5 Wearable Companies by Shipment Volume, Market Share, and Year-Over-Year Growth, Q3 2018 (shipments in millions) Source: IDC. As of December 2018.

But the success of the Versa has allowed Fitbit to once again become the second largest smartwatch vendor global - a trend that is likely to continue in the near term according to the IDC. This will certainly help Fitbit deliver healthier growth and positive earnings for the second time in 2018.

However, if Versa plays a significant role in Fitbit's return to profit and brighter prospects, there is a more important (strategic) product that it recently released: the Fitbit Inspire. This new device, derived in two versions (Inspire and Inspire HR), is Fitbit's first business-to-business product. As such, it is only be available through Fitbit Health Solutions partners like health plan providers, employers, and other wellness groups. In an interview to CNBC, CEO James Park said that Fitbit now has 6.8 million patients, employee and health plan members signed up for wellness programs that incorporate Fitbit devices. In addition, according to the firm's Q3 2018 earnings presentation, Fitbit Health Solutions revenue grew 26% y-o-y.

This leads me to touch on what this "rising star" has built over time: a huge database of validated data from 25 million active users, to help users and businesses better focus on wealth as well as health conditions and outcomes. That sort of data has significant value potential, especially as it is part of the unique and expanding ecosystem of Fitbit compatible apps, as well as one of the world's largest health and fitness social network. In other words, a Fitness version of Facebook (NASDAQ:FB) that has no boundaries. Even a giant like Apple does not have that.

Turning to the firm's financials, most notably its balance sheet, Fitbit is very healthy.

  • no long-term debt, no pension deficit
  • an interest coverage ratio of over 55 times
  • a return to positive free cash flow on Q3 2018, at $47.1 million*
  • a total value of cash and marketable securities of $623.3 billion (which is about 40% of the company's market cap as of February 8th, 2019)

Source: Fitbit Q3 2018 Earnings presentation.(*) This includes a $72 million income tax refund payment received in the three months ended September 29, 2018.

Therefore, why has Fitbit's share price collapsed more than 78% since its IPO level? To give you some perspective, I show in Figure 2 below the price return four relevant competitors in the wearables market. Please note that Xiaomi (OTCPK:XIACF) was not included as the company went public in July 2018, with the share price largely reflecting the deteriorating macro-economic environment (notably the US-China trades negotiations) rather than the company's performance.

Figure 2: Price Returns since Fitbit IPO (18 June 2018)

Chart Data by YCharts

Source: YCharts

There seems to be a striking similarity between Fossil Inc. (NASDAQ:FOSL) and Fitbit. Fossil is an American watch and lifestyle company. Its wearable device business line suffered from the same issues that Fitbit experience - I will come this shortly - but I will not dwell too much on that. This article is on Fitbit.

The drivers behind Fitbit's share price collapse are straightforward. There are 4 main reasons:

  • Rapidly declining growth rates - Fitbit was once a high-growth company, but its sales growth declined dramatically, as new rivals launched cheaper fitness trackers and high-end smartwatches like the Apple added advanced heart rate and exercise tracking features, to watch already packed with innovative features (see Table 3 below showing Fitbit revenue and shipment y-o-y growth rates).

Table 2: Fitbit growth rates for revenue and shipments

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Revenue

(39.8%)

(31.2%)

(0.5%)

(17.1%)

(15.3%)

0.0%

Shipments

(40.4%)

(32.1%)

(16.9%)

(26.7%)

(20.6%)

(3.1%)

Source: Fitbit. As of Q3 2018. Data subject to rounding.

  • Excessive spending (notably in R&D) - Between 2014 and 2016, Fitbit increased its total operating expenses by over 240%, whilst revenues rose by just one 190% in the same period. In addition, a big portion of the operating expenses were driven by R&D, which saw an increase over 150%. If this had resulted in significant revenue growth from sales in the following years, the R&D would have been paid off. But, unfortunately, sales were down 25.5% in 2017 relative to 2016. (Source: Fitbit. SharePad.) Figure 3 below shows the unhealthy evolution of revenue, operating expenses and R&D percentage growth rates, particularly in 2016-2017.

Figure 3: Fitbit revenue, operating expenses, and R&D expense growth rates

Chart Data by YCharts

Source: YCharts, as of February 8th, 2019.

  • A strategic mistake not to enter the smartwatch market when other players like Apple did aggressively. Indeed, while Fitbit sold more than 21 million devices in 2015, taking in sales of $1.9bn - a 150% increase over 2014 - investors and analysts were worried that the company would struggle in the face of intense competition from new entrants to the fitness devices market, particularly the Apple Watch. And indeed, they were right.
  • Consequently, a material and concerning decline in Earnings - Fitbit, earnings per share (EPS), fell from a peak gain of $0.72 in 2015 to a loss of $0.47 the year after. You can see in Figure 4 below how the trailing 12 months EPS decline between 2016 and 2017.

Figure 4: Fitbit 12-month trailing (TTM) EPS Diluted

Chart Data by YCharts

Source: YCharts, as of February 8th, 2019.

Therefore, it would appear that the share price collapse was justified at the time. However, the question is whether it's justified that it remains depressed at today's level, or if market participants have incorrectly considered the renewed growth potential for Fitbit. I vote for the latter, and here is the reason why.

1. The smartwatch issue: Fitbit's Versa is now a leading reference in the sector, with better growth prospects

Fitbit was slow (wrongly) in addressing rapidly changing consumer preferences from fitness wearables to smartwatches. But make no mistake, Fitbit has fixed the issue and fixed it with great "panache". The company went from virtually from zero smartwatch shipment to over 1.5 million units sold, with its Versa reaching the 1 million mark in less than two months after it went on sale in April 2018. (Source: Fitbit).

According to Counterpoint Research (see Figure 5 below), Fitbit smartwatch shipments soared in Q3 2018, closing in the gap with market leader Apple, and being a 10 percentage points increase in its global shipment market share, to 16%.

Figure 5: Global smartwatch shipments market share (Q3 2017 vs. Q3 2018)

Global Smartwatch Shipments market share by in Q3 2017 vs. Q3 2018

Source: Counterpoint Technology Market Research, December 2018.

According to statistics portal Statista, global smartwatch shipments are forecast to grow from 43.5 million in 2018 to 89.1 million in 2022 (see Figure 6 below). That's a growth rate in excess of 20% p.a. Currently, the Versa is selling at a discounted price of $170 (happy Valentine!), whilst its standard price is about $200. Let's assume Fitbit is able to maintain both the $200 pricing point from 2019 to 2022 and its 16% of global smartwatch shipments. This would represent a total revenue of $8.9b in 4 years and a 2022 revenue of $2.85b for the smartwatch segment alone! To put it into context, Fitbit's 2018 total expected revenue stands at about $1.5b.

Figure 6: Global smartwatch shipments forecast from 2018 to 2022 (in millions)

Global smartwatch shipments growth Source: Statista, January 2019

Of course, Fitbit has a lot to do to retain its leading place in the sector, especially as the competitive environment is fierce in the smartwatch markets. Low barriers to entry, short product life-cycles and very sensitive to consumer changing behaviours and preferences. But Fitbit has an edge here:

  • an ecosystem of apps, data and social connections (one of the largest)
  • a 25 million active users base that should look to upgrade with Fitbit
  • a rapidly growing Health Solutions for business and corporate

2. The expense issue: management has implemented effective controls, reducing costs by 17% in Q3-2018

Fitbit's big mistake in its early days was to have spent substantial amounts of cash, not to pay for the cost of goods sold, but to sustain an interest in what was clearly a rapidly slowing business: the fitness tracker. It's a little bit like when a country borrows tons of money in hope that it will stimulate growth (and allow it to pay back debt). That only works when growth materialises itself. In the case of Fitbit, not only did growth fade away, it also turned into declines, and all the R&D spending was somewhat wasted.

What's the situation now? As shown in Figure 7 below, Fitbit has significantly rein in its operating expenses.

Figure 7: Fitbit total annual operating expenses (in $ million)

Source: SharePad. As of 8th February 2019.

According to Fitbit's Q3 earnings release, the company seems to be managing its cost base much more efficiently. As illustrated below in Figure 8, the largest reductions came from Sales & Marketing (S&M) as well as General & Administrative (G&A) expenses. What do I like here?

  1. R&D is least the reduced item (-8%), largely from a reduction in consulting costs. As such, Fitbit continues to invest in innovation (look at the Versa results) but more "surgically" - R&D well spent!
  2. Part of the reduction in S&M comes from better quality products requiring lower customer spend. To me, this means Fitbit has more satisfied customers.
  3. Better management of G&A, even though the 42% reduction is exaggerated by the Q3-17 bankruptcy of Wynit. Excluding this, the cost reduction would have still been substantial, at -24%.

Figure 8: Non-GAAP Operating Expenses Details (Q3-2018)

Fitbit Opex Details Source: Fitbit

In addition, capital expenditures (Capex) have also been under tighter control, representing 3% of total revenue in Q3-18, down from 5.4% in Q4-2017. Of course, the danger is that the company does not spend enough in Capex for the business. Is this the case for Fitbit? No. An easy way of assessing this is to look at the company's Capex to Depreciation ratio (See Figure 9 below). As a rule of thumb, a capex ratio that is higher than 100% suggests the company is investing in more assets (it's good), whilst a ratio below 100% may represent under-investment (it's bad). Please mind that a ratio of less than 100% could be driven by over-stated depreciation (prudent approach). It's not the case for Fitbit.

Figure 9: Capex to Depreciation Ratio

Chart Data by YCharts

Finally, whilst Capex is just 3% of revenue in Q3 and expected to be about 4% for the year, it's worth noting that they are still relatively high relative to the company's operating cash flow, at 138.8% in 2017 and most likely still above 100% for 2018, given the expected total annual Capex of $64.7 million for the year.

3. The competitive advantage: Fitbit's ecosystem and integration to healthcare

Apple enjoys one of the strongest consumer ecosystems on the planet, connecting devices and services that delivers you a seamless (some may challenge that, let's leave it for another day) and unique Apple experience. This obviously serves the firm's smartwatch very well, and it's no surprise that with such a large base of iPhone users (almost 1 billion in use*), the iWatch was going to ship like hot cakes. It's good, but it's not great.

(*) Source: Apple.

As for Fitbit, I see a pretty unique case. At first sight, you'd argue that there is no ecosystem. Fitbit sells smartwatches and fitness trackers, and that's pretty much it. You're not going to buy a Fitbit because you own another product or service from Fitbit that will make your experience unique and more elevated.

That's a very wrong assumption that many have been making, in my view. In fact, Fitbit has 25 million active users and sits on one of the world's largest health and fitness social network, with almost a decade of health data collected from its devices through time - and still counting.

I grabbed the image below from the "Why Fitbit?" section on Fitbit's website (see Figure 10 below).

Figure 10: Fitbit experience

Experience Fitbit Source: Fitbit.

This is in sharp contrast to how many other smartwatch providers present their product: used individually to monitor your self-activity and achieve your own (self-defined) plan/goal. For Fitbit, it has always been about you and the community. Also, Fitbit is the only top brand offering devices across all ages and has targeted a specific women client segment. Since the launch of Versa smartwatch, Fitbit has reported a strong engagement from its new female health tracking feature. As of June 2018, 2.4 million female users had connected to the feature.

Furthermore, Fitbit has a huge competitive advantage from its database of users' health statistics to actually deliver on its fundamental objective of making everyone in the world healthier and to share the benefit in this community. In particular, according to the Forbes magazine, the top 5 technologies that will have the most profound impact on the healthcare industry during 2019 feature Big Data Analysis and Wearables. (See Figure 10 below)

Figure 10: Key Technology To Impact Healthcare in 2019

Key Technology to Impact Healthcare in 2019 Source: Forbes. Frost & Sullivan.

Fitbit has a strong hand to play in 3 out of the top five, including wearables (of course), big data analytics and mHealth.

Over the recent months, it appeared that Fitbit built a program for digital health interventions. The question was on how it would monetise it. Well, wait no more. The company has just launched (very quietly) its first devices to the corporate sector - the Fitbit Inspire. The device has basic features like heart rate, step tracking, and calories burned and now adds hardware to its line of business-to-business products.

In the meantime, Fitbit has signed several partnerships with high-profile plans and payers, including Blue Cross Blue Shield, Humana (NYSE:HUM) and UnitedHealthcare. Here are useful and hopefully convincing facts about this potential:

  • Over 70 of the Fortune 500 have used Fitbit as a part of their corporate wellness programs
  • In Q3 2018, Fitbit launched a platform called Fitbit Care to connect health plans, wearables, employers, health systems and coaching. Humana, the $41 billion health insurance company, selected Fitbit Care as its coaching platform.
  • Earlier this year, Fitbit also announced a partnership agreement with the National Institutes of Health (NIH) to launch an mHealth project to include digital data from wearables in the All of Us research program. Such partnership will enable consumers using Fitbit to synch their accounts with the All of Us program, providing the NIH with real-world and real-time data. Eric Dishman, the program's director, qualified the partnership as the "unprecedented ability to better understand the impact of lifestyle and environment on health outcomes and, ultimately, develop better strategies for keeping people healthy in a very precise, individualised way."
  • Fitbit has partnered with Google's (NASDAQ:GOOGL) (NASDAQ:GOOG) Cloud Healthcare API to help integrate wearables further into the healthcare system, such as by connecting user data with electronic medical records. It is believed that this will make it easier for clinicians and patients to collaborate on care, leading to better health outcomes.
  • Finally, Fitbit Health Solutions' revenues grew by 26% y-o-y in Q3 2018. Even though the business line only represents 10% of the company's revenue, this is the type of growth rates investors will get excited about.

But don't think that Fitbit is alone in this strategy. Apple has also unveiled plans to increase the integration of its wearable tech into healthcare. However, whilst Apple will be fierce competition, it does not have the history and user database that Fitbit can leverage today.

5. The valuation case: Access one of the fastest-growing industry at a discounted price but a brand premium

As of February 8th, 2019, Fitbit was trading at around $6.5 a share. Whilst this stands 50% above its all-time-low of $4.33 a share on October 29th, 2018, Fitbit is still an incredibly attractive play on the wearables potential.

As mentioned earlier, the wearables market is poised to grow by c. 25-30% p.a. from 2019 to 2022, reaching almost 90 million devices sold p.a. and a total of $73 billion sales revenue.

Let's look at simple valuation measure from previously mentioned competitors

Table 3: Valuation Metrics

PE (1Y forward) Price to sales Price to NAV Cash & Securities over Market Cap Share Price (Feb. 11th, 2018)
Fitbit - 0.9 1.9 44.5% $6.5
Apple 14.2 3.2 7.6 10.7% $170.6
Garmin (NASDAQ:GRMN) 20.2 4.3 3.5 9.3% $70.3
Fossil (FOSL) 14.9 0.3 1.3 39.5% $15.4

Source: SharePad. As of February 11th, 2019, 2.50 pm BST. Subject to rounding.

Fitbit does not have a PE, given the negative earnings history and forecast, and seems to trade at a significant discount to peers on other measures. To some extent, Fossil may be looking somewhat cheaper on those measures, but, at a PE of 14.9 and with wearable business that is primarily focused on the delivering success through the product fashion, I have little appetite in Fossil.

So, overall, you pay $6.5 a share to:

  • buy an established premium brand with a strategy focused on wearable devices only
  • get exposure to a fast growing industry, with a transformational future (notably for healthcare)

Therefore, using a price-to-sales and price-to-NAV valuation methodology, and considering the industry growth potential in the next 12-24 months, including Fitbit's presence and ability to retain market share, I expect Fitbit's share price to range in the region of $12-15. This represents a potential price return of 85% to 130% from February 8th close price of $6.49.

Risk to the investment thesis:

As with any consumer trend-related products, there are many risks to a player, even a premium established brand, to retain market share and grow efficiently.

In the case of Fitbit, there are three risks that would certainly lead me to reassess my buy rating as well as the timing of any investments in wearables, let alone through Fitbit.

  1. Recession Risk: Digital wearables are still very much tech gadgets. Whilst they are integrating more medical-related features, they do not have the resilience of revenue streams you find in healthcare - at least not for now. The reason is very simple. Can you find alternative way, at a lower cost or through a product you already own, to get what a fitness smartwatch can provide? Yes. As such, whilst this is not my core scenario, a recessionary environment could be painful for Fitbit (alongside the broader wearables industry). Even if Fitbit enjoys a strong balance sheet with no dept, further fall in its revenue streams would most probably lead to negative earnings and additional cost-cutting. In an industry like tech wearables, if you intend to remain at "the top of your game", cost-cutting could hurt your ability to innovate. Fitbit as a solid cash position, but this would literally evaporate in a recession environment. In contrast, Apple's $294 billion cash pile would be a safer option.
  2. Further margin deteriorations: According to Fitbit's Q3 2018 reports, margins have fallen by 510 basis points, to just above 40%. The report seems to indicate this may be temporary from the growing mix of smartwatch revenue and end of life promotions of legacy tracker offerings. I'd be very nervous if margin were to fall below the 40% threshold. This would leave very little space for profit growth, even if sales were to grow more than expected.
  3. Falling out-of-trend: With innovative technologies things move fast. Staying on the wrist-based wearable device, we should remember that we tend to have only two wrists to use, a prefer to keep one free of any wearings. As such, new comers or new technologies that could combine more than what fitness smartwatches (like the Versa) have to offer today could significantly change the future of a company like Fitbit, especially as this is the only market the company is exposed to, for now.

Conclusion

Fitbit has some great potential ahead. Its turnaround strategy is proving to work.

Versa has propelled the firm to the second place of smartwatch providers in 2018 (most likely), whilst the integration of wearable device technology to the healthcare industry is a trend that no better than Fitbit can capitalise on. In additional, Fitbit is the only wearable firm other than Apple that has a genuine ecosystem of users and apps to build on.

Fitbit's current share price seems to totally ignore the potential and still reflects investors' worry around its ability to offer a fashionable competitive product against the likes of Apple, Fossil, and Garmin. Well, Fitbit is much more than that.

Of course, the road will not be a straight fast-line to success, but as Raputzel puts it so rightfully:

Venture outside your comfort zone. The rewards are worth it.

I think it's worth taking an [educated] leap of faith on Fitbit.

Disclosure: I am/we are long FIT, AAPL. 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.