Should Investors Be Concerned About Fitbit, Inc.'s Soaring Inventory?

Image source: Fitbit.

Inventory management is as much art as it is science. Have too much, and you risk a writedown or impairment charge if it goes unsold. Have too little, and you risk not meeting demand and leaving money on the table. Getting it just right is much easier said than done. That said, Fitbit (FIT) just reported a precipitous rise in inventory levels at the end of the third quarter. Should investors be concerned?

If you build it, will they buy?
At the end of 2014, Fitbit had $115.1 million in inventories on the balance sheet. By the end of the third quarter, this figure has soared to $276.1 million.

FIT Inventories (Quarterly) data by YCharts

This total is predominantly finished goods as well, with very little being allocated to components.

Source: 10-Q. Figures may not sum because of rounding.

The natural fear is that Fitbit could be building too much inventory and sell-through may not be strong enough to clear out all those fitness trackers. Fortunately for investors, this doesn't seem to be what's happening. The company is mostly just preparing for the busy holiday shopping season. This is in addition to Fitbit's continued expansion into international markets, which also requires some inventory build.

Sales have been steadily rising, after all, and Fitbit hopes that consumers will be stuffing stockings with the Charge, Charge HR, or Surge. CFO Bill Zerella confirmed that the "vast majority" of current inventory consists of these three newest products, which now comprise nearly 80% of revenue. Fitbit expects revenue in the fourth quarter to be in the range of $620 million to $650 million, representing 72% growth from last year at the midpoint.

Getting ready for the holidays
On the conference call, investor-relations exec Brad Samson pointed out that a year ago, Fitbit was actually supply constrained heading into the holiday quarter so inventory levels were depressed. Fitbit has consciously chosen to boost production capacity and build inventory levels to meet order shipments, which it did starting in October, as it fills its distribution channels.

Fitbit is also walking a fine line with inventory because it has hinted at new products in 2016. If Fitbit is unable to ramp down its inventory levels in time for potential new products next year, it will probably need to discount the older models and take an impairment charge in the process.

Samson said Fitbit constantly analyzes demand forecasts and its supply-chain ramp so that it can dynamically make adjustments as needed based on when new products are expected to hit the market.

The Apple curveball
Perhaps the biggest unknown for Fitbit heading into the holiday shopping season will be how Apple's (AAPL -2.19%) new Watch will perform. Apple Watch launched earlier this year, so Q4 2015 will be the first holiday quarter for Apple's first wearable device. While Apple refuses to share results around this new product category, Strategy Analytics estimates that Apple sold 4.5 million units in the third quarter -- a stone's throw away from the 4.8 million devices that Fitbit sold in the third quarter.

If Apple Watch takes a bite out of Fitbit demand, the inventory risk becomes even greater.