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Fitbit pre-earnings wrap-up and article -4

02:02 23-Oct-17


Both the app developer and I have now finished reviewing the current state Fitbit's developer tools.  There's final feedback from the primary user, as well, and I've run some numbers (all non per-share values are in millions.)  There are still a lot of moving parts and variability, but it's time for best guesses.  The executive summary remains that Fitbit should be headed for a big quarterly beat or two, based on low expectations, but the business is probably set to fade from there.  Here are my numbers and reasoning:

Base Case: Fitbit's core competencies and market


 devices sold revenue avg dev price gross margin gross profit dev+SG&A expense EBITDA shares EBITDA /share GAAP EPS non-GAAP EPS
3Q16 5.3 504 95.09 48.3% 243.4 196.2 47.3 222.4 0.21 0.11 0.19
4Q16 6.5 574 88.31 22.4% 128.6 311.9 −183.3 224.4 −0.82 −0.65 −0.56
1Q17 3 298.9 99.63 40.0% 119.6 209.7 −90.1 226.5 −0.40 −0.27 −0.15
2Q17 3.4 353 103.82 43.0% 151.8 212.7 −60.9 230.3 −0.26 −0.25 −0.08
3Q17






233

−0.04
IonicFY17 4 1200 300.00 40.0% 480.0 350 130 236 0.55 0.55 0.55
FlyerFY17 1.32 171.6 130.00 48.0% 82.4
82.4 236 0.35 0.35 0.35
4Q17









−0.03
FY17 11.72 2023.5 172.65 42.8% 833.7 772.332 61.4 236 0.26 0.37986 0.60
StBFO 18.22 2597.5 142.56 38.7% 962.3 1084.19 −121.9 236 −0.52 −0.2701 0.04

This represents my best guess on where numbers might come in based on the all the data I've presented so far.  The Ionic and Flyer FY17 rows represent the combination of 3Q17 and 4Q17.  I don't really care what the split between the third and fourth quarters winds up being, and I don't think the market will either.  On the other hand, I do care about EBITDA and GAAP numbers, whereas the market is likely to focus on non-GAAP.  Unlike with other companies I follow, I simply don't think Fitbit management has earned that sort of trust, as it finally transitions from a first-mover advantage on cheap devices, to a competitive and pricier market.  Moreover, I care about the product cycle throughout the transition, rather than the full-year numbers that the market is likely to focus on.  Thus, in the bottom line, StBFO stands for "Since the Bottom Fell Out", in 4Q16.  I think this measure is important because it represents a financial cycle that Fitbit will probably have to repeat.

Another point to note is that I'm guessing that about one third of Ionic buyers will add the Flyer headphones to their purchase, and that the Flyer will be higher margin.  Assuming that management continues to report number of devices sold, we should be able to estimate the split from the revenue.  Of course, if the ratio is higher that will be better for Fitbit, but I think this statement from the primary tester,

I don't want my watch to become my phone.
speaks to Fitbit's activity-tracking corporate and sales DNA.  In fact, she's turned off pretty much all of the messaging notifications, and just about every review out there indicates that those who want a general purpose smart-watch have clearly better options already available.

My Base Case also guesstimates that Fitbit will have some trouble up-selling its existing user base to a more expensive device.  Many find the older wristbands indispensable as a motivational tool, but the main improvement of the Ionic is better sensors, and thus data; it's questionable how motivational better data actually is.  If Fitbit's community goes stale and it gets even the whiff of being a fad, that spells real trouble.  I've checked anecdotally with a group of legacy device users who used to compare step counts, to see who might be upgrading, but the response I got from the ringleader was, "I don't know.  I haven't worn my Fitbit in months."

Software Development is the Real Long-term Problem

Recall that my original thesis was that Fitbit's debt-free acquisition of the Pebble and other platforms would enable it to design a better all-purpose smart-watch.  I still believe it has managed to do so in terms of hardware, but unfortunately, that is only half the picture.  The fitness instructor uses the watch for teaching classes, but she would like more functionality, such as that provided by the app built by the software tester.  He started out by being very interested in bringing his code to a single platform that would interface with both Android and iOS.  That enthusiasm faded quickly, though, once he took an in-depth look at the state of the tool set. 

Over the past few weeks, Fitbit has begun throwing up documentation on its APIs, but whereas Pebble allowed local development using familiar tools, Fitbit is trying to foist its own cloud-based IDE (integrated development environment) on programmers, which creates an unnecessary learning/familiarization curve.  It also has no emulator or testing environment to speak of, and the juxtaposition of needing a watch in-hand to storing and evolving one's code off-site is bizarre, to say the least.  Furthermore, Pebble allowed development using the C language, but Fitbit is offering only Javascript for the Ionic.  Javascript popularity has exploded with the web, but it is a very different animal, especially for writing code on devices with limited processing capabilities. 

Although our programmer has published multiple apps and done lots of Javascript coding, he declined even take a shot at porting the project to Fitbit.  As a programmer myself, I can't say that I blame him.  None of us needs extra time-consuming steps, and it took almost two hours for Fitbit to even send an email verification for my account.  I think there is a very good chance that Fitbit's software ecosystem will never be competitive with the likes of Android or iOS, and I don't just mean in terms of number of applications available.  The environment simply creates too many hoops for new developers to jump through and it does not look like it will ever offer the flexibility and power that would enable truly talented programmers to create the next killer app.  That's a shame, because with the best sensors on the market, Fitbit has the opportunity to build its lead on a valuable health-centric data set.  However, with the legacy data being relatively low quality, a diminishing user and developer base would quickly make that a moot point.  There's plenty of evidence that both Apple and Alphabet are ready to focus much bigger budgets on a much broader approach to building such a knowledge base.

The Silver Lining and Conclusion

None of this means that Fitbit is irrevocably doomed.  Tweaking the base case above shows that it needs to sell only about 4.5M Ionics to erase the past year's losses, on a GAAP basis, or 4.9M for EBITDA.  That's not too far off from the guesses I've made, and if the company manages to sell a higher percentage of Flyers with the watch, those hurdles drop further.  I could easily imagine the unrealistically negative press campaign that we saw over the summer flipping positive in the wake of non-GAAP beats.

Fitbit should have some macro tailwinds as well.  Income bifurcation means more high-end spending, and JC Penney re-branding its jewelry department with a focus on smart-watches is the latest sign that the segment is going mainstream.  Note, however, that the press release lists Samsung, LG and Garmin as the top brands.  Fitbit is not even mentioned, and the Ionic is near the top end of the $155 to $349 price range, despite sub-par software and messaging.  In the end, though, the fitness instructor/model chose to keep her Ionic rather than put the purchase price toward other uses.  The reasoning seems to be that it is shiny and does what it was meant to well enough, even though she has fitness related wish-list items that it will probably never fulfill.  Such semi-novelty decisions could help Fitbit to transition its user base over the remainder of the year.  Feature and use case comparisons (read to the end, if you read it at all) probably will not.

Looking a bit deeper, the problems I've highlighted are important, but not permanently built into the device.  Software is more fluid than hardware.  Both that and brand image are things that Fitbit could fix up over the months to come.  I'll be listening for indications that management recognizes the urgency of doing so, but the opposite seems to be the case.  I hope I'm wrong, and if so, quantified projections for improving the software environment, as well as near-term sales numbers will be needed to change my long-term outlook.  Of course, sales are most important, but if we wind up with middling sales projections and no positive surprises on the software, I'll be inclined to take a contrarian view to any earnings positivity, using it as an exit point.  I would also like to publish an article, to call out some of the increasingly unbalanced financial coverage that I've been seeing, either before or after the next earnings report.  I'll heavily factor any subscriber feedback that I get into the timing of such an article.