Fitbit (FIT) will report its Q3 2016 results after the closing bell on November 2nd and too much anticipation as both bulls and bears have dug their heels in with extreme sentiment. Going into the company’s last quarterly release, shares closed the day around $13.30 and after beating on both the top and bottom line, shares rose to a peak of $17 post Q2 2016 results. However, and as anticipated, the share price has retraced and given up most all gains from the prior reporting period as of the close of trading on October 28th.  

Analysts’ estimates are calling for the wearable maker to report $506.93mm in revenues on  $.19 a share. This represents roughly 24% revenue growth and an earnings decline of $.05 a share from the same period a year ago. Earnings are expected to decline, in part, due to increased production, distribution gains and higher A&P spending from new product introduction. 

Valuing a One-Product Category Co. 

What has held shares of FIT down since reporting beats in each previous reporting period has been the nature of the business model which generally has found to deliver single-digit to low-teen multiples, even during periods of growth.  Fitbit is a one-product category manufacturer with no recurring revenues of consequence. With less than 1% of revenues coming from subscription services at such a mature stage in the company’s business cycle, it is unlikely that the company will ever scale this segment of its business. Most Fitbit and other wearable users have come to understand they don’t need to pay for a premium workout program and mobile workout applications have not proven to be practical. 

Without a recurring revenue business model, typically these hardware business models grow to the extent that distribution growth is available. As Fitbit matures, the company gains distribution and pulls forward sales growth that inhibits future sales. This is evidenced in the company’s revenue results over the last several years and forward-looking estimates. Please see the revenue chart below that recognizes how quickly Fitbit’s revenue growth is decelerating.

In 2015, Fitbit grew revenues 92%, but in 2016 the company is only expected to grow revenues roughly 40 percent. While 40% revenue growth is a great expectation and end-result, in 2017 the company is only expected to grow revenues some 16 percent (revised lower from 17%). Having said that, with each successive quarterly achievement in distribution gains, it becomes increasingly unlikely that Fitbit will achieve 16% revenue growth in 2017. It is important for investors to understand and accept that almost 2/3rd of Fitbit’s revenue growth comes directly from distribution gains/sell-in and expanded retail linear footage/shelf space. The actual sell-through of its core products is quite slow as wearables are non-essential goods and the majority of Fitbit’s products are bought as gifts, as evidenced by the company’s reporting of sales. More than 40% of Fitbit products are bought during holiday periods. Fitbit’s expansion objective was one of the main reasons the company issued an IPO, the capital raised through the IPO has helped the company with expansion efforts in 2016. The linear footage gains at existing retailers has been incremental in the company’s revenue growth this year.  More importantly, this was expected as most one-product category companies follow the same playbook. See photograph below:

In 2014, SodaStream (SODA) expanded its footprint at Wal-Mart (WMT) from 4 feet of retail space to 24 feet (a full aisle).  Unfortunately for SodaStream, the expanded retail space captured did not result in greater sales and eventually Wal-Mart discontinued SodaStream’s retail space at some 2,000 locations. While the additional sell-in proved meaningful for SodaStream, investors did not benefit as the sell-through was not to be had and as shares of SODA depreciated through 2014.

Referring back to the revenue chart, investors should also understand that until Fitbit reaches revenue equilibrium and saturates the global marketplace with its devices, an acquisition of the company is extremely unlikely and unprecedented for this particular business model. Essentially, any would-be acquirer would want to know the true demand for the product along with profitability post-market saturation.

Fitbit carries with it all the characteristics of a hardware consumer package good company. While the company is not GoPro (GPRO) or Skullcandy, the business model is identical. Fitbit does have a higher addressable market than does GoPro based on units sold since product introduction, but nonetheless, as it is with all hardware providers, revenue growth is only achievable during expansion periods where distribution gains can be had by the company. It has been the case with this business model throughout history. With this in mind, that is why the revenue growth deceleration has been and is expected to be so steep and until revenue declines are exhibited. Furthermore, that is why the short participation is so extreme with these hardware business models. Shorts understand it is just a matter of “when” revenue and other metric declines are found, not “if”. For that matter, the short interest is a constant and will not decline under 25% of float regardless of upcoming results. No short squeeze will be presented, but rather a repositioning of short interest should higher stock prices be presented. Keep an eye on long-dated option open interest come 2017. 

Fitbit Evolution in Question

With all that being said, many investors continue to believe that Fitbit can evolve into something greater. Mind you, the same was said about GoPro becoming a media company to support its millions of YouTube connections and viewers. Unfortunately, this never came to pass to the degree that when the company’s hardware sales did exhibit declines, revenue from its subscription and service-based business were unable to offset these declines. That problem also exists for Fitbit. The so-called “highly valuable” data that Fitbit users generate is of little value to most industries given the nature of the technology and inability to monetize the data from ancillary product offerings. In fact, the user data is so specific to the individual (health & wellness stats) that selling an ancillary product to that user is nearly impossible. The data is only unique in application or purpose and therefore is rendered with little usefulness to other vendors and providers of goods, including insurers.

As far as monetizing the data for the healthcare industry, again, Fitbit will and has found limitations for such usage. The data has limited application beyond remote cardiac patient monitoring. But even so, for the data to be used in mobile cardio telemetry (MCT) device applications, such data would need to clear FDA benchmarks and achieve a Level II classification, at least. The worst part of the assumptions regarding the data or Fitbit becoming a medical device provider is that this particular industry is a quarter the size of the consumer goods industry that has found Fitbit some $2.5bn in revenues. If we look solely at the MCT industry, it is worth less than $1bn in revenues and with 5 competing companies already in the market fighting for these revenues. Most investors either don’t realize these factoids or care not to look deeper into it. The only industry where Fitbit’s clinical data can find direct monetization presently would be the MCT/remote patient monitoring healthcare industry given the nature of Fitbit’s devices. BioTelemetry (BEAT) is the “largest” player in this industry. Even with all the data that BioTelemetry collects and all the FDA cleared devices the company sells into the healthcare market, the company is only expected to achieve $210mm in 2016. This is the difference between headline assumptions from would-be financial bloggers and the media and hard analytics and/or comparative analysis. A comprehensive analysis that includes Fitbit participating in the healthcare industry going forward alongside a DCF modeling of the revenues from such participation still exhibits Fitbit with sales declines beyond 2017. This of course is with recognition to the existing business model.  In short, if you were an investor relying on greater monetization of the user data and/or clinical applications, it would behoove you to better understand the implications. 

Fitbit’s CEO has gone on record as stating the company is transitioning to a digital health platform/Company. Unfortunately, this evidences at least one aspect of the bear thesis. The bear thesis surrounds the eventuality and inevitability of saturating the market with Fitbit products and post saturation exhibiting declining sales along with waning profitability. With Fitbit’s CEO already stating the business model is undergoing a transformation of sorts, it signals that market saturation is close-at-hand and the company needs to adjust its business. 

Fitbit’s and Category Market Share

Fitbit makes a great product and sells millions of units annually. This is without question. The company garners some 85%+ market share of the wearables category.  As such, competition is of little concern for institutional investors. Regardless of the participation in the wearables industry even by Apple (AAPL), Fitbit continues to dominate the industry. Fitbit has found the perfect balance of price, form and functionality with its devices and is effectively eliminating competition. But another factor eliminating competition is the size of the wearables market itself. Simply put, because competitors such as Jawbone and Microsoft (MSFT) have discontinued participating in the industry, this is not necessarily a boon for Fitbit. What many vendors are coming to find is that the total addressable market (TAM) for wearables isn’t as big as originally assumed by analysts or data trackers like IDC. It’s for this reason that most every quarter, IDC has reduced its 2020 estimates for total wearable units shipped.  In fact, if one takes the recently reduced quarterly estimate reduction for 2020 and compounds it out to 2020, the number of units shipped in 2016 will be almost the same in 2020. This is a serious eye-opener for industry participants who are already struggling to gain market share in the industry. At the end of the day, a vendor needs to make a long-term decision and as such some are not finding the growth to be what was proposed only a few quarters ago. The smartwatch sub-category is also evidencing the problems with assumed growth for the wearables category as a whole. 

Fitbit’s biggest competition is Fitbit. For investors, this means that Fitbit is competing with both lofty expectations and its own past performance. Savvy investors understand this premise and care mostly for the company’s outlook, not even the most recently ended period’s results even though come Wednesday that will be the topic of focus. While most investors expect Fitbit will meet or beat revenue and earnings estimates, the company’s guidance will be of key importance. Coming into 2016, analysts did not model for Fitbit to expand its product line to include two new devices that would be distributed in such a condensed period of time. It was the unanticipated business operation that surprised most analysts and investors, forcing profit expectations to be curtailed. This was the fault of analysts and investors who should have understood Fitbit’s business model better and modeled for new product introduction, the costs and the revenues associated with such operations. Ultimately, it was poor business modeling that found shares of FIT depreciating in value since January. Most every consumer packaged goods company is forced to reinvent its product line on an annual basis to keep consumers interested or to drive greater utility for the products.

Having studied Fitbit’s business model and performing analysis on the company since 2013, on January 4th I released my first publication warning investors about the TAM for Fitbit and the importance of TAM with regards to the business model. In the article titled “Fitbit's Total Addressable Market Hype May Leave Investors With Disappointment” I discussed the nature of Fitbit’s business model. Shares were trading above $30 at this time and as the company has grown its revenues through 2016, shares have tumbled to a low around $11 a share. The article mentioned was clicked more than 100,000 times since publication and on the day it was released found on Google at number 4 using keyword Fitbit. 

Competition, Apple Watch Series 2, heart rate tracking reliability, Jawbone litigation, class action lawsuit related to marketing practices of HR application, digital health, FDA, clinical trials, social sharing,… this is all white noise and it is unfortunate that there is so much white noise out there. I would go so far as to suggest that even the analysts covering Fitbit are offering a good deal of white noise. Some are too bullish, like Goldman Sachs and Oppenheimer and some are too bearish. Most every analyst or data-tracking agency is reiterating notes offered months ago. Be it Pacific Crest or Cleveland Research, both have been bearish on Fitbit since the IPO. Cleveland Research downgraded Fitbit and warned of market saturation back in June.  Again the company reiterated the same warning in October even as Fitbit reported strong Q2 results. The point is that Cleveland Research is not misleading or even wrong in their assertion, but Fitbit results won’t bear out market saturation metric performance likely until 2017 and as all the market saturation elicits lowered orders from retail partners. None of these white noise variables are worth even $100mm to Fitbit: None will make, transform or break Fitbit.  It’s simply a matter of making a call to early or too late. 

Robust Product Cycle Gives Way To 2017

After meeting with CEO James Park at the CES show in January, what I walked away with was a better understanding that timelines for investor returns would need to be curtailed. While I’m sure that Mr. Park did not intend to offer such a sentiment, as a research analyst I went into the meeting with questions that would deliver an understanding of the business model and what it portends as an investment thesis. The company, like most companies achieving strong demand from retailers during an expansion phase, is spending beyond its recognition of long-term revenue generation. Coupled with the trend in sell-through of Fitbit devices, 2017 will be a challenging year for Fitbit and its investors who remain bullish on the long-term outlook of the company.  As we look toward the final quarter of 2016, the product cycle remains robust for Fitbit as the company launched its flagship Charge 2 device during the Q3 2016 period. I would be less optimistic about the Flex 2 launch seeing how well the Alta has performed and users decision to opt for a digital display on wearable devices. It will be the job of Fitbit management to monitor inventory of Flex 2 and maintain accurate supply/demand balance.

Mr. Park is not to blame for the stock’s seemingly underperformance. The Fitbit team has done exactly as they had been expected to do, grow revenues and dominate a category. The earnings expectations lay in the hands of the analyst community and unfortunately the analyst community was found lacking in this regard. But even so, savvy investors can look at like business models and the current FIT valuation and find the share price relatively cheap at less than 12 times FY17 earnings expectations. 

One product category businesses are not rendered long-term investments as proven by history. They are often utilized as trading instruments and in order to trade them profitably, investors need to have an understanding of the product cycle and maturity of the business operation. Given the revenue growth deceleration of greater than 50% YOYOY and the expected continuation of this trend, investors have been cautious with shares of FIT or avoided the company altogether. Again, this has been exhibited by all like company shares in the past, even those with recurring revenues like Keurig Green Mountain and SodaStream (SODA). GoPro and Skullcandy, both one-product hardware companies, also had the same share price pressure post the IPO period. As it pertains to Fitbit, presently both the maturity of the business operation and the product cycle align for stronger stock performance in the final months of the year and as such shares are expected to increase in value barring macro-influence.

On Wednesday when Fitbit reports Q3 2016 results, here is what investors should look for:

1. User base growth
2. Revenue regional breakdown (U.S. should still account for 75% of total revs)
3. Warranty Reserve rate
4. Inventory build
5. Gross margins
6. Average selling price
7. Individual device results if offered
8. NPD Data highlights if any
9. Market Share statistics
10. Guidance