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Fitbit – Buy The Over-Reaction – Fitbit, Inc. (NYSE:FIT)

Investors might ask, “Why bother with Fitbit?”, (NYSE:FIT), after the string of operational disappointments in 2016 and the seemingly unstoppable underperformance in the stock price? The company has gone ex-growth, opex costs have exploded and it’s starting to eat into its cash nest. Should it go the same way as GoPro (GRPO) or Blackberry (NASDAQ:BBRY) after their sales peaked? Maybe, BUT, at least it acknowledged its past errors, it has a very strong brand and it still enjoys over $600M in net cash. And slow growth is not necessarily a bad omen, if it is handed properly.

We think that there is a chance that the company can redress itself (and the last 2 quarters showed some signs of improvements) and we feel the stock has a very good risk/reward profile here. The downside is limited by the value of its net cash and intellectual property (provided the cash drain won’t last longer than a few quarters), while the upside is more than 100% in case of a successful launch of its smartphone and/or a potential takeover.

This article intends to:

1) highlight some of the most important trends emerging from the latest quarterly results;

2) compare Fitbit with some (in)famous companies that have gone the same route in the past.

Comments to the latest quarterly results

Overall results have been relatively positive for the past two quarters, especially after the horrible revision to Q4/16 numbers and the re-set of the company guidance for 2017 and 2018. Sales have been declining but slightly less than feared, with EMEA being the sweet spot (up 10% from a year earlier) but USA still showing weakness, both because of saturation and the strong competition from Apple products.

Despite weakness in revenue and profits, we noticed 2 positive developments that suggest that the bottom might be behind us: the company retains some pricing power (ASP on the rise and growing contribution of high margin products and services, see graph below) and it is effectively managing its inventory, entering the next quarter with a leaner channel (more below).

Fitbit had a very rough end of 2016, with capex, hiring and inventory all rising to unsustainable levels and sales stalling or dropping. It resulted in operational disruption and a necessary inventory write-down. It looks like the recent quarters have witnessed a more disciplined approach, and the company is approaching the launch of its new smartwatch (hopefully before Q4/17) with lower inventories and receivables; an indication that future sales should be higher quality and that there will less discounts to clear unsold inventory. In the next graphs we see:

Days Sales in Inventory = 91.25 * Inventory / Quarterly COGS

Days Sales Outstanding = 91.25 * Account Receivables / Quarterly Revenue

Finally, we should recognize the effort the organization is making to trim-down to the new reality of lower sales. Albeit not yet enough to return to profitability, the measures taken have allowed a reduction of around 170 headcounts, slightly more than 10% of the total.

Comparison with companies who underwent a similar growth decline

We selected a number of companies that experienced a sharp drop in sales, moving from strong growth to decline in the space of few quarters. The IT sector is especially prone to these dynamics, given the disruption brought by rapid innovation. In this study, which is not exhaustive nor conclusive, I have included companies of different sizes but linked by being a one-time of the pioneer in their fields, with some significant exposure to the consumer: the same conditions applying to Fitbit today.

The closest example is probably GoPro, a mono-product company that has known great hype and growth and a sudden stop (2015). But in the past Motorola (2006), Hewlett Packard (NYSE:HPQ) (2011), Blackberry (2011) and TomTom have met a similar same fate. More recent examples are Groupon (although it managed the decline considerably better) and Twitter (2016). The rest of the article tries to compare the operating results of those companies in the quarters following their top revenue quarter, with a particular emphasis on 3 quarters after (Fitbit revenue peaked 3 quarters ago, in Q3/2016 at $2.3B) as well as a longer timeframe. The goal is to learn a lesson from the past, as well as determine if the market has punished too severely (or not) Fitbit, given where it stands today in terms of profitability and financial health.

Clearly it is a static analysis that does not attempt to time or evaluate new products, not yet in the market and whose consumer acceptance is impossible to forecast. The long-term faith of Fitbit is linked to the release of a competitive smartwatch later in the fall but future optionality would be magnified by a potential gap in current valuations.

The company might gracefully shrink as TomTom did, expand profitability (Groupon) or reach near-death as Motorola in 2007 and Blackberry in 2012. And as always, we are on the market to trade stocks, not companies: despite a dire situation, if the market over-reacted on the downside, there might be a buying opportunity.

Among this peer group, Fitbit has experienced the fastest build up in revenues and so far one of the steepest sales declines; only GoPro dropped faster but recovered after 4 quarters:

There is no clear trend in sales after the peak. GoPro sales dropped by 40% in just 4 quarters while Groupon remained fairly stable at -10% for more than 1.5 years and it looks set to recover further. HP, probably helped by its sizable enterprise business managed to limit revenue losses but the decline, albeit modest, persisted for more than 3 years. The real problem was faced by Blackberry and Motorola, whose revenues kept on disappearing, reaching a whopping -77% and -53% respectively (but partly because of divestments). In this respect Fitbit is clearly among the worst performers. Has the company been punished accordingly? The following graph offers some indication:

No other company has seen the stock price being bashed more for an equivalent drop in revenues 10 months after peak. And remember that Fitbit shares at the end of Sept/16 were nowhere close to the top (trading at around $15, way below the IPO price at $20 or the $51 reached in 2015). Fitbit traded 65% lower, similar to GoPro despite revenue falling “just” 25% for the former and 32% for the latter. A close comparable, TomTom dropped only 29% on 20% lower sales and despite a much more challenged balance sheet (more on that later).

Fitbit has been amongst the companies entering the revenue slowdown phase with the healthiest balance sheet (net cash position equal to 20% of its market cap) and thanks to the deferred recognition of cash flow, has been able to navigate the first 3 quarters with an impressive improvement (now the cash portion equals 50% of its market cap, with no debt). Only GoPro had a similar behavior while all the others have been burning cash at a faster pace than the retreat in their market capitalization.

Another reason to be optimistic is the gross margin profile, already the highest entering this critical period and falling to a still respectable 37%. Again this is very much in line with what happened at GoPro and Blackberry. It is critical to determine how likely Fitbit will go the way of Motorola, TomTom and HP, companies that were able to boost their margin in the second year (except Blackberry).

To conclude, what can we learn from this brief history of past failures?

First of all, there is not a single path to revenue shrinkage and consequently no stock punishment looks the same. Markets can be more or less forgiving, especially with regards to the breadth of the product offering (i.e.: single-product stocks suffering more than conglomerate like HP). What is puzzling is that the speed of the sales drop does not seem to be correlated to the corresponding stock performance.

Secondly, that Fitbit (rightly or wrongly) has been the most heavily penalized, despite its strong net cash position, insider ownership and resilient margins.

Summing up all of that, we think that the reaction to Fitbit disappointing growth in the past several quarters has been too harsh. It has created a valuation gap that might represent a buying opportunity. The company sits on almost $3/share of net cash (50% of its market cap) and it looks set to slow the rate of cash burn (as per the last 2 publications). The better operational control and the drop in inventories suggest that Fitbit might be on the path towards a decent-margin, slow-growth company, not necessarily a bad outcome.

Next to that there are the usual source of upside catalysts:

– the new smartwatch (but don’t bet the house on that, it might backfire!);

– digital health as a growing market;

– the accumulation of a lot of data that might be monetized;

– potential to gain traction in the corporate wellness segment;

– expansion of its potential market (smartphones and not only fitness trackers) that brought challenges (competition with Apple mainly!) but also opportunities to increase the average selling price and (hopefully) future margins.

– the disappearance of 2 competitors (Pebble and Jawbone), testament of a difficult environment but also a sign that pricing pressure might ease.

– the possibility of a takeover, either from the founders (remember that they still own around 12% of the company and sold some of their shares at $20 and $29) or from a bigger IT/Pharma company who might want to own its data and user-base.

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.

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