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05/05/2016
Fitbit Q1 16. Forced hand

Fitbit is being forced to spend to stay ahead Fitbit reported good Q1 16 results, but cut guidance in order to ramp up spending and thereby placed unrealistic expectations of profitability in H2 2016. This is particularly worrying as there are clear signs that commoditisation is forcing the company to increase spending, hitting profits.

Q1 16 revenues/adj-EPS were $505m/$0.10 nicely ahead of consensus at $443m/$0.03 but EPS for the quarter ahead is going to be weak. Q2 16 revenues are expected to be $565m-$585m ($575m midpoint) ahead of consensus at $533m, but expectations of adj-EPS at $0.08-$0.11 are way below consensus of $0.26. Gross margins are slipping as commoditisation creeps in, but the real problem is OPEX. Fitbit is right in that it needs to spend on R&D and sales and marketing to stay ahead of its rivals, but general and admin expenses (G&A) are a real worry.

In Q1 15 G&A expenses were $13.0m or 3.9% of sales but in Q1 16 they jumped to $35.7m or 7.1% of sales.
Our threshold for G&A is 5% and this sudden elevation has all the hallmarks of undisciplined expansion. This in turn raises concerns about the quality of the investments that the company is making in both R&D and sales and marketing. If these investments do not produce results, then commoditisation will accelerate and gross margin will continue to decline hitting the already fragile profitability. The good news is that Fitbit knows exactly what it has to do which is to increase the stickiness of its users through the refinement of its embryonic ecosystem. This alone puts Fitbit miles ahead of GoPro when it comes to dealing with aggressive competition and slowing and saturated end markets.

When it comes to an ecosystem the key is the number of users and the degree to which they are engaged with one’s services. Fitbit posted some encouraging figures at its 2015 year end results in January with 16.9m active users making up 59% of the registered user base. These users were also more engaged with an average of 7.5 connections to other users compared to 4.9 at the end of 2014. Unfortunately, Fitbit declined to update these figures leaving the distinct impression that there was nothing particularly good to report.  This is concerning because if the investments that it is making in R&D and sales and marketing pay off, it is in user numbers and engagement that the results will be first seen. Gross margin stabilisation and profits will then follow but it is in the ecosystem where the loyalty and preference will be generated that will give Fitbit pricing power.

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