What can you say about Fitbit’s (FIT) executive team other than “Wow”? After lowering FY16 guidance upon missing Q3 revenues, the situation continued to deteriorate for Fitbit as demand for its fitness trackers continued to fall.  In Q3 2016, Fitbit lowered revenue expectations from a growth rate of 38% to just 25% growth. But on January 30, 2016 Fitbit announced yet another disappointment by releasing preliminary Q4 2016 results as follows: 

Fitbit expects to report 6.5 million devices sold and revenue for the fourth quarter of 2016 to be in the range of $572 million to $580 million, compared to the company’s previously announced guidance range of $725 million to $750 million. For the full-year 2016, Fitbit expects annual revenue growth to be approximately 17% from the previous forecasted growth of 25% to 26%. Non-GAAP diluted net loss per share for the fourth quarter is expected to be in the range of ($0.51) to ($0.56) compared to the previously announced guidance range of non-GAAP diluted net income per share of $0.14 to $0.18. The non-GAAP effective tax rate is expected to be materially higher than prior guidance. For the full-year 2016, Fitbit expects to earn approximately $32 million in non-GAAP free cash flow and have approximately $700 million in cash and cash equivalents.

Whether one looks at revenues or earnings, the picture is pretty bleak regarding 4^th quarter results. How the company missed by such a wide margin begs to question the leadership in position. I wouldn’t suggest that the CEO or CFO were asleep at the wheel, but rather never steering the ship in the first place. In order to miss guidance to this degree an organization has to have a divergence in communication between account executives and the chief operating officers of the company. For example; whoever has been handling the account for the likes of a Best Buy (BBY) or Wal-Mart (WMT) should have had a clear vision regarding sales and orders to the retailers and communicating this information to the C-suite so as to ensure capacity utilization is inline with a decrease in demand. That clearly did not and is not happening at Fitbit. There are several examples akin to the one mentioned that I could outline and have ample experience with identifying, but the results show that senior executives were not managing the business along the lines of decreasing demand. It is for this apparent and negligent reason the company has also offered additional information regarding its 4^th quarter performance as well as expectations for 2017.

The company expects non-GAAP fourth quarter gross margin to be materially below its previously issued 46% guidance due to excess inventory and other related charges as follows:

• One-time write-downs of tooling equipment and component inventory of approximately $68 million.
• Increased rebates and channel pricing promotions of approximately $37 million, which is recorded as a reduction in revenue.
• Increased return reserves of approximately $41 million due to greater channel inventory.
• Increased warranty reserves for legacy products of approximately $17 million.

For the full year 2017, Fitbit is providing some targeted financial metrics as the company transitions its business to the next stage of growth. The company expects a challenging year over year comparison in the first half of 2017 given that new product introductions represented 52% of revenue in the first half of 2016. In addition, the company enters 2017 with a higher operating expense run rate than the first half of 2016, and channel inventory levels that are higher than previously anticipated. The company expects stabilization in financial performance in the second half of 2017. Considering these factors, the company is providing the following guidance:

• Preliminary 2017 revenue guidance of $1.5 billion to $1.7 billion.
• Preliminary non-GAAP basic net loss per share of ($0.22) to ($0.44) per basic share.
• Preliminary non-GAAP free cash flow guidance of approximately negative $50 to $100 million.
• Long-term non-GAAP gross margin of approximately 45% versus previous 50% target.

Furthermore, the CEO and CTO are reducing their salary to $1. While I’m sure that is a warranted action to take for these executives, it is of no consolation to the investor community. And at this point, the go-forward strategy for Fitbit has been left very much in question given the glaring failures that have besieged the company since its IPO in late 2015. 

Fitbit is no different than any other 1-trick product category, hardware provider before them. They have a nifty and useful gadget like its peers SodaStream (SODA), Skullcandy, Keurig Green Mountain and GoPro (GPRO). They also have a very high attrition rate like that of the aforementioned SodaStream. The business model is quite simple for these businesses and the mantra is always the same; expand distribution, expand distribution, expand distribution. The job of a gadget vendor is always to gain more and more distribution to reach more and more potential consumes around the world. But at some point, you run out of room to expand; there is no place left to expand. Essentially, this operation comes to an end and your gadget has saturated the marketplace. All these business models work the same way and grow and grow and grow through the expansion phase of its business cycle. But what happens once market saturation sets in is the inevitable decline. Even more simply put, these gadgets sell far more slowly from the retailer to the consumer than the previous growth would have one assume.

The trick with this business model is to understand your total addressable market or (TAM). Unfortunately, most every management team over estimates their TAM. A strong management team that understands its product and the addressable market can align capacity utilization with demand through the expansion cycle so as to express the greatest profits. A weak management team, well, you might have seen what has happened previously to the share prices of SODA, SKUL, GMCR and GPRO. 

In the article titled Fitbit App Download Results Misleading, But Bump To Share Price Warranted, I offered the following to readers and investors: 

“Analysts’ average estimates have come way down for 2017, as I suggested they would months ago.  I had warned investors repeatedly that the company would not be able to achieve the analysts’ modeled 16% revenue growth in 2017.  With Fitbit lowering this year’s forecast, analyst have revisited their 2017 models for revenues and earnings to elicit just 3% revenue growth and earnings roughly 40% lower than in 2016.  Do I have an issue with the analysts’ revised estimates; I certainly do! 

The estimate for revenue growth doesn’t make a lot of sense when juxtaposed to Q4 2016 revenue estimates.  The 4th and 1st quarters of the year are high replenishment quarters after the gift-giving season.  With the average analyst estimate for Q4 2016 revenues modeling just 4.3% growth, how does Fitbit achieve any growth in 2017? 

The global market has proven to be saturated with Fitbit goods, North America especially and where greater than 75% of the company’s revenues are being generated.  North America is likely going to exhibit sales declines in 2017 for which any international growth will not be able to fill the gap from N. America.  Secondly, the ASP will remain under pressure and express lesser profit.  Third and most importantly, any new iterations will be meeting lesser demand via market saturation definitions, thus fewer orders from retail partners as is always the case post-market saturation for hardware products.  This is especially true if those hardware products are non-essential goods.  Lastly, the company is up against a huge iteration cycle come Q2 2017 where they will anniversary the launch of Blaze and Alta.  The Blaze has languished since it launched earlier this year and retailers simply won’t find themselves in the same situation they have found themselves to be in this year with the “smart fitness watch”.

Unfortunately, my forecast for negative growth in 2017 has come to fruition given Fitbit’s preliminary guidance.  Investors should have recognized there were issues surrounding demand during the holiday shopping season and since. The discounts from the holidays had carried into the New Year. Many retailers are still offering discounts and incentives on Fitbit products. Additionally, Fitbit utilized the home shopping channels during the holiday season that helps to boost unit sales, but at a great cost to profits. Fitbit is taking this promotional pricing activity into account with increasing return reserves, warranty reserves as well as rebates and promotions. Simply put, the retailers couldn’t clear inventory during the holidays and they have to offload it whether it goes back to Fitbit as a return to vendor (RTV) credit or the consumer through discounts and promotions.

Next up for Fitbit in 2017 will not be any incremental revenues from their digital health transformation; it’s just not. While the company has touted newly established partnerships with Medtronic (MDT) and United Health (UNH), these partnerships will be slow developing and without any meaningful revenue accumulation. For greater understanding of Fitbit’s journey into an adjacent clinical market such as digital healthcare services I offer readers and investors a great deal of information on the topic in the article titled Fitbit And Medtronic: Headlines Vs. Reality. As I’ve said before, the reason Fitbit hasn’t offered any color around the size of this digital healthcare services market is because the applicable products Fitbit has created offer the company very little in the field of healthcare. Moreover, Fitbit has even greater competition in this industry from some of the top medical health device makers in the industry depicted below. Most every medical device utilized for the healthcare industry has a corresponding diagnostic and software application. Fitbit knows this, but they don’t desire for the average investor to understand it to the degree they shrug off the potential. But again, it’s why they have yet to advance the dialogue with investors and analysts. Maybe they will do so on the Q4 2016 Conference Call.

With shares of Fitbit demolished recently and since its IPO, what is left? In truth and despite the negative sentiment expressed in this article, there is a great deal left for Fitbit and long-term investors. Just as I outlined the similar failures of Fitbit’s peers and their respective stock prices, there is always a rebound. But that rebound doesn’t come quickly and without some additional growing pains, negative growing pains that is. 

The bottoming effect of this 1-trick product category, hardware business model is painful as sales decline, drawing profits down with sales. There is literally no way Fitbit can grow its metrics in 2017, no matter what new product they launch inline with its category offerings. Retailers order product based on demand and with wearable product demand falling, orders will be fewer YOY.  What makes the situation for Fitbit in 2017 even more difficult is they are coming off a year in which they launched two new wearable products with excessive sales volume.  Fitbit recognizes the first half of the year’s sales guidance sentiment due to the 2016 product launch for Blaze and Alta. The comps for the first half of 2016 are simply to high and with demand falling orders/sales will fall in Q1 and Q2 of 2017. Even as Fitbit suggests the comps are somewhat easier in the back half of 2017, sales will likely fall for each quarter of 2017. But these declines will serve to establish a baseline for true demand going forward. True demand, which is from the retailer to the consumer is a critical understanding for Fitbit and investors going forward.  Additionally, this 12-month period will allow Fitbit to streamline operations and align capacity with true demand. These operations in tandem with metrics bottoming will lay the foundation for a return to normalization in 2018, that is if Fitbit can execute this cyclical operation from its business model and business cycle.  All of its peers have experienced the same cyclicality in their business models and emerged with improved metric and stock performance. So let’s talk Fitbit and the likelihood of the company being acquired.

There’s a 10% chance! That was simple, frank and historically accurate. Hardware-centric companies with no recurring revenues don’t generally get acquired. The one’s that do, and it is very few, only become acquired after a period whereby sales have bottomed, cash flow from operations has normalized and the company has streamlined. Skullcandy was acquired in 2015 for roughly $199mm with the company generating almost $300mm in sales. Most hardware-centric companies don’t get any premium to sales unless they have recurring revenues to go along with the hardware. Keurig Green Mountain being acquired for almost $14bn with sales around $5bn in 2015 demonstrates this perfectly as Keurig’s K-cups were a continuous revenue stream past the purchase of a Keurig brewer. In short, it is extremely unlikely that Fitbit will be acquired without greater understanding of what the free cash flow looks like from true demand of its products that is not inflated by distribution gains. 

Having said that, the Fitbit brand is quite sound and as the category shows declining sales and demand YOY, retailers will consolidate their product offering in stores around just a couple of brands.  Some of the lesser brands will drop off while others are acquired or eliminated from the marketplace altogether. Again, this has happened for most of these hardware-centric business models throughout history and evidenced in retail outlets. SodaStream battled through the competitive threats from Cuisinart, Primo Water (PRMW) and Keurig Kold to emerge as the sole brand in the home carbonation category. GoPro experienced the same cyclicality and category consolidation as well. Fitbit’s brand and product reputation in the category are undeniable and evidenced in most retail outlets. When the competitive fears surrounding Fitbit’s market share erode over the next 12 months, the share price will also benefit from this normalization. But what will benefit the share price more aptly will be the bottoming of metrics in 2017, the restructuring of the business to meet end-user demand and better execution from the executive team. FIT shares could achieve a lesser valuation as metrics bottom through 2017, but for long-term investors whom are willing to ride out this business cycle with Fitbit, 2018 and beyond can be very rewarding. SODA shareholders have found this to be accurate with shares bottoming in 2015 around $11 and since rising to above $44 a share with even minor metric improvements YOY. Furthermore, when one looks at the book values of SODA or GPRO it is extremely difficult to rationalize the low valuation offered to FIT shares presently. One more thing, with the bottoming of metric results through 2017 by Fitbit, it doesn’t even mean they have to return to prior sales peak performance. SodaStream has yet to do so with it’s sales peaking in 2013 above $500mm. The company has yet to achieve that feat 2 years later and with the share price expressing that SODA dominates its category regardless of sales performance. GoPro’s share price performance through 2016 has also demonstrated a bottoming effect, even as the company continues to struggle mightily. This is the benefit of being a leader in your product category and being able to whether the storm that comes from market saturation. Go into the downturn as the leader and emerge as the leader. Can you do that Mr. Park, after all, investors are paying you that dollar?