When Fitbit (NYSE:FIT) released revised guidance about a month ago, they let investors and the market know that 2016's Q4 earnings would be much lower than originally projected. Last week, its reported fourth-quarter earnings have proved that guidance right.

On this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and contributor Evan Niu go over the most important numbers from Fitbit's earnings report, and the main reasons behind the sudden drop in performance. They also discuss how the company might recover from this drop, where it seems to be looking to grow into in the future, a few things investors should keep in mind when thinking about buying into this company, and more.

A full transcript follows the video. 

 

This podcast was recorded on Feb. 24, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Feb. 24, and we're talking tech and Fitbit's latest earnings release. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior tech specialist Evan Niu. Evan, how's it going?

Evan Niu: Good! I'm ready for the weekend. It's been a long week.

Lewis: Yeah. I think everyone could use a little break. It seems like Fitbit could definitely use a little bit of a break after releasing quarterly numbers that were, frankly, pretty rough for them.

Niu: Yeah. I don't think there were any big surprises. Even though it was a pretty bad quarter, the market didn't react much because they issued preliminary guidance at the end of January that warned everyone how bad it would be, and it was pretty much right in line with expectations.

Lewis: Yeah. The company's top line came in at $574 million, which is down 19% year over year. That was well within the revised guidance they offered of $572 [million] to $580 million. But that revised guidance was walked back from original expectations of $725 [million] to $750 million. So, it was a big adjustment that took place in the market. If you look back to late January or early February, that's where we saw the high teens, nearing 20%, sell off in the stock. There was no immediate reaction despite the disappointing results. If you're looking for some of the other big numbers from the quarter, gross margins was one of the big surprises. That came in at 22.4%. Usually, we tend to see that up somewhere in the high 40% range.

Niu: Right. That's a function of a bunch of these one-time charges that they took. Again, they warned about that stuff. They had a big writedown for tooling equipment. They also had to increase return reserves because channel inventory. They had to increase warranty reserves. All three of those items are added to cost to get sold. Then, on the flip side, they also had a bunch of pricing promotions because they had to start discounting stuff to get stuff moving. And that item comes as a reduction of revenue. So, you have all these charges, one of them pushes down revenue and the other three push up cost to get sold. So, it really pinches their margins. And, like you mentioned, it came in at about 22% on a GAAP basis. Typically they're around 49%. In fact, if you back out all these items, they would have had about 49%, which is pretty comparable to what they normally have. Since one of these items affects revenue, it also affects your average selling price calculation. They came in at around $85. It would have been $95 without these charges. Which, again, is pretty comparable to what they normally have. But the fact is that these charges were mostly because they really overestimated demand, they really filled their channels, and these devices were not selling.

Lewis: Yeah. I think it was easy to get caught up in high expectations looking at the growth trajectory that this company was on. In 2015, this company posted 150% year over year revenue growth. So, for them to even slow down somewhere into the double digits, you would think it's fairly reasonable. Looking at the full-year results here, revenue came in at $2.17 billion, which was up from $1.86 billion in 2015. But that's only a 16% hike. You're seeing a lot of the effects of them overestimating demand. We can get into why. But, it certainly weighed on financial results, particularly in the holiday quarter, which is typically when we see a lot of these consumer device companies doing a ton of their business.

Niu: Yeah, exactly. They were very up front, they owned it. They admitted that they were really caught off guard by how weak demand was, and they over-forecast it, and they were a little too ambitious with their own expectations, internally. They fell short of their own expectations. They had to own it.

Lewis: Yeah. I think one of the things I do really appreciate is they signaled this to the market ahead of results. Issuing preliminary results, particularly for a really important quarter like the calendar Q4, it was great to give people a heads-up of what to expect. There wasn't as much of a shock to the system when they issued their results later on in the month. I think something else, and I think the ultimate cause of a lot of this stuff, this quote from management in the commentary, "The saturation of the Innovative and early adopter segments of the market was basically the cause." That's what they're seeing as the revised growth rate and really what pushed results down for them.

Niu: Yeah. There's certainly a niche group of really active fitness users where that's just part of their lifestyle. And that's a good market for them. But they need to break into the mainstream. Everyone wants to get healthier, and most people, even after they make that decision, they kind of let it go. How many times have you said you were going to start going to the gym, or whatever, and then two months later you give up? It's a common thing. Think about the New Year's spike in gym memberships. Every New Year, people are like, "My New Year's resolution is that I'm going to get healthy," and then by February they give up. So it's certainly a characteristic of the market that it's hard to keep people engaged in terms of their health, but that's this company's whole point. So, it's an uphill battle in some ways, just by nature of the way that people are.

Lewis: And one of the benefits that we get from looking at their full-year results is they disclose user base information when they do the full-year reporting. I think they just disclosed they have roughly 23 million active users, and 50 million registered devices. Do you want to touch on how that trends compared to previous years?

Niu: Yeah. They give this number every year. I like to look at what proportion is active of their total registered base. Right now, like you mentioned, if we have 23 million active users and about 50 million registered devices, that's under half of the devices that are being active, it's like 45%. Over the past three years, this number is usually around 60%. 2013 through 2015, it's about 60% plus or minus a couple percentage points. That's a pretty big drop in terms of engagement. Fitbit has said before that they don't want you to look at that ratio as the engagement proxy, because they argue that some people go inactive but then they reactivate and become active again, and it tends to be bumpy so don't look too deeply at it. But at the same time, I still think there's value in looking at this metric as a proxy for engagement, even if it's maybe not perfect. I think there are still important things to note. I was looking through the numbers a bit more carefully, too. One thing they mentioned that stood out to me was 26% of activations in 2016 came from repeat customers. Of those, 20% were reactivated. If we go back to that 26% of activations, last year, there were a total of about 21 million activated devices, if you just look at how many more devices were registered throughout the year. If they're saying that 26% of that is from repeat customers, then the other three-quarters is new customers. That's about 5.5 million repeats, almost 16 million new customers. Yet total active users -- which includes repeat and new -- only increased by around 6.3 million. So, you have all these new customers coming in, almost 16 million who bought a new Fitbit last year. But your total active users only increased by 6 million. So, there's a big disconnect there with how many people are buying them and how many are still using them at year end. And I think that's a pretty troubling disconnect, a big discrepancy.

Lewis: And I think those numbers really speak to the idea of, there is a dedicated group of consumers that, the Fitbit products meet their needs very well. These are people who want metrics on their workouts, their heart rate, the number of steps to taking a day. And their products are perfect for that. That seems to be more of a niche group than a large addressable market as, perhaps, originally predicted. When you see that that's the group which is really driving a lot of those engagement numbers, you have to think that, maybe the ceiling is a little bit lower than we thought for what the total addressable market is here, and really, the long-term growth prospects on the consumer side of the business for them.

Niu: Yeah. I totally agree. I think we've talked about this with other companies before. It depends on what your growth expectations are. You can build a great business around this niche group of people that's really active, and you can count on them to start subscribing to the services that Fitbit wants to start selling, like Fitstar. You can count on them to upgrade more regularly. But there's a lot of people that are fickle about their health, who are like, "Oh, I'm going to try this Fitbit out," and maybe they give up on it. And yeah, Fitbit gets that sale, and maybe they'll keep trying to appeal to that customer. But if they just temper down their expectations, there are a lot of people who are going to try and are just not going to stick with it. If you just bake that into your expectations, and adjust your business strategy accordingly, versus trying to spend all this money to keep trying to win back all these customers if they're resistant to actually committing to improving their health with these devices, then there's not really a whole lot you can do. It's a tough dynamic to overcome.

Lewis: Well, I think that wraps the looking-backwards part of our conversation, Evan. I think we're going to talk a little bit about what growth might look for them down the road, how they might be able to reignite it with both the consumer segments and some other options. But before we get into that discussion and see what might be going on in 2017 for Fitbit, I just wanted to give Fools a little heads up. If you're interested in income investing, we have a brand-new service called Motley Fool Total Income. It incorporates dividend stocks, options, bonds, real estate and more. If you want to check it out, all the details are at totalincomeradio.fool.com.

So, Evan, in addition to some of the growth strategies this company talked about in their earnings release, they also offered up guidance for 2017. It looks like we'll be seeing revenue somewhere in the neighborhood of $1.5 [million] to $1.7 billion, and gross margins returning to what we would reasonably expect, somewhere between 42% to 44%. That top-line number is a 20% dip from what they posted in 2016.

Niu: Yeah, it's getting harder before it's getting easier. Last year, they put up about $2.2 billion, almost. And they're already predicting another decline, a decline is definitely not a good sign in terms of investor sentiment.

Lewis: And I think, when you look at some of the strategies that they're outlining here for the turnaround plan, maybe it's not all that surprising. CEO James Park talked about some of the different things they're going to be pursuing, and one of them was increasing their promotional activity. This is something that we saw a little bit in Q4, and I think we're going to continue to see into 2017 with some of their existing products. They talked about the idea of having more in-store promotions, working with retail partners. And really, the aim of all of that is to clear out the inventory channel. Of course, when they do that, that's something that's going to push down average selling prices on devices.

Niu: Yeah. They really overloaded their channel during the quarter. They're getting these writedowns, they have reserves, they have to start giving discounts to their channel partners. Like you mentioned, it is going to take a couple quarters to clear it out and get channel inventories back in line with a balance. But, it doesn't look too good right now.

Lewis: One of the other things that they're talking about doing is improving efficiencies across the company. We've seen this a little bit already with some reorganizations within the business. They've made some staffing cuts. But one of the other things they talked about was restructuring their accessories business. They moved to this partner and license model instead of the designing and producing accessories in-house approach. That obviously gives them a little bit less control, but it might help them out on the cost side, a little bit.

Niu: Yeah. It's just outsourcing it, more or less. I think that's probably the right move, because they obviously have better things to focus on right now. And yeah, coming back to this idea, they just bet too heavily on growth. You mentioned headcount, their headcount increased by 60% last year. That's why they really need to cut back those operating expenses, and that's also why they laid off about 107 people. But, at the same time, they also did a bunch of acqui-hires. They acquired Pebble and Vector within the past couple of months, and that certainly adds to your headcount, also. But those are much more strategic in nature, because those will help the development of the smartwatch, which they've been talking about. But yeah, they just needed to cut down these costs to really get back in line with more reasonable expectations.

Lewis: Yeah, and you talked about that being a focused decision, too. I think really not having to worry about that stuff allows them to focus on two core things. One of them is, the products that they are offering, and maybe building out some more all-in-one smartwatch-like products, and the other one being other ways for people to be using their products that are beyond the base consumer approach that most people are commonly using them for now. So, we talked about this a little bit in the first half of the show, but they've mentioned that they have captured this innovator group already, people that are early adopters and want fresh gadgets and fresh technology, and the affinity group of people who want fitness trackers. They've talked about the idea of needing to transition to that mid-to-late adopter market, and then meet them with products that are going to be attractive to them. James Park had this quote in the conference call where he said, "Increasing the value proposition of our software beyond just tracking is key to bringing more customers to the Fitbit family and reigniting growth." I don't know about you, Evan, but to me, that sounds like it's going into smartwatches.

Niu: I think it's both. There's a couple things going on here, I think. They do want to get more into this premium subscription service game, which is why they bought Fitstar in 2016. It's one of those many mobile apps where you subscribe and it gives you workouts, and all these other things. I don't think it's really taken off. They relaunched it, and the reception is pretty good so far, but we're not really seeing a lot of revenue or numbers coming from it. But, I think they're making progress on that front. And then, the other piece of it is the smartwatch idea. They've been really cognizant of the overlap of basic wearable trackers and more full featured smartwatches. And they have a couple products that are watches, but they don't even consider them smartwatches, they consider them, like, a GPS watch, for example. And that was a big part of why they bought Pebble and Vector. But Pebble specifically has a platform that offers third-party apps. It's one of those kinds of platforms that's on top of a platform, so if you have an iOS or Android device, you used to go and download the Pebble app. Inside the Pebble app is an app store. It was never very big, there wasn't a whole lot of stuff in there, but the point is, they had one. So Fitbit wanted to use that as a foundation to build their own third-party platform. It's unclear if they're going to try and do it on their own, or if they're going to try and take the same approach of a platform on top of the platform. But either way, that's definitely a big part of their strategy. They want to expand into creating a third-party ecosystem, which is really when, generally speaking, you see a lot of innovation on top of platforms, is when you really opened up to other developers. They want to get into services, they want to get into software, and really create this smartwatch platform. So, those will be the really big, important things going forward. And also, that would help them diversify a little bit away from hardware, because right now, the whole business is built on hardware sales. With consumer electronics products companies, it's a really fickle market, it's really hard to rely on recurring revenue when you're a hardware-based company.

Lewis: Yeah, it can be a little bit tougher to anticipate what consumer upgrade cycles might look like device to device and how long they'll hold on to them. Additionally, working in software and services offers Fitbit a totally different margin profile. We talked about how they had to do some heavy discounting in order to clear through some inventory, and that's something we're going to continue to see in 2017. That whole product segment won't be subject to the same wild swings and margins, if they're able to build it out to be a meaningful part of the business.

Niu: Right. And definitely, it's scales much better. If they could really get Fitstar off the ground...but that's a really competitive market. There are so many apps out there nowadays that are really geared toward fitness, and they're subscription-based. There's already a lot out there. Fitbit is entering a pretty crowded market. I guess the challenge will be, how do they differentiate themselves in that market? And certainly, they have some advantages because they integrate with the device itself, and they have their other platform that tracks your biometric data and all these other things. But it'll be tough. I think it'll be pretty important to see if they can pull it off.

Lewis: Yeah. Outside of that consumer realm, one of the other things we got some color on in the management commentary following results was the push into some of the health tech initiatives that we saw some of in 2016, and I think the company is going to continue to push. As an example of where this comes into play for the company, last year, they announced a partnership with Medtronic, and basically, that partnership synced up Medtronic's continuous glucose monitors with Fitbit's activity trackers as this integrated solution. The idea was that it helped individuals with type 2 diabetes, to help with their management of that, and give a better diagnostic on general activity, and might have improved outcomes as well. For context, there are tens of millions of individuals with type 2 diabetes in the U.S. alone. That is a very large market. Obviously, these are some very early partnerships. They also have some stuff going on in the insurer space with UnitedHealth. But, in my mind, that is really where some of the big growth opportunities might be for them. And they spent a decent amount of time highlighting that on the conference call.

Niu: Yeah, I think that's definitely another area of opportunity for them. If you can integrate with these other existing health providers, you can really differentiate to a greater degree, and really build up your presence. At the same time, there are these corporate wellness initiatives, which, again, is also very competitive, too, because you have much larger companies like Apple (NASDAQ: AAPL) that have also been working actively to work with corporate wellness programs. Apple has a deal with Aetna, and Fitbit has a deal with UnitedHealth. Both companies are trying to get into this corporate wellness stuff, because companies see that as a way to reduce their healthcare costs over time. So, I think there's definitely an opportunity for both, and that's probably growing enough to where both can succeed without necessarily being a zero-something. The pie is growing so big that there's probably enough to go around, considering how young the wearables market is. I think corporate wellness is really, as an industry, is only now starting to really embrace some of the technology that's being offered out there. I think we're still in the early innings of that.

Lewis: Yeah. And insurers are ultimately looking for as much data as possible when it comes to the population of people that they're providing coverage for. I'm sure that's an appealing option to a lot of those insurers. That's all to say, with the healthcare applications and with what they might be doing on the consumer device side and some improvements in their product line, it seems like there are still some opportunities for Fitbit. This is a beaten-up stock. I know there are a lot of Fools that own it and really like the business and have been following it for a while. Looking at guidance, the company is trading at 1X 2017 sales at this point. We can't do a P/E valuation, we have to do a price-to-sales because the earnings have turned negative, and will, over 2017. But that's a pretty darn cheap business.

Niu: Yeah. That's the thing. I don't think Fitbit has this great business going on. I think they have a pretty solid business, but I don't think it's something where I'm like, "Woah, that looks awesome." I'm pretty neutral overall, I would say, and specifically because it's so cheap, it's hard for me to be bearish, given how cheap the stock is right now. Given the current valuation, the expectations are pretty low. You don't have to really execute that well to meet low expectation. If the stock were higher, like it was a year ago, I would probably be a little bit more bearish. But I'm not bullish, either, because they have a lot of uncertainty, they obviously just had a really terrible quarter, and it's not clear if they're going to really be able to pull off some of these big strategies they're trying to pull off to grow. And they have opportunities that we've talked about. But, yeah, I'm kind of neutral, because they're really cheap, but I don't see a whole lot of upside. There's not even a lot of upside in their own guidance, as you can see. So it's not like they have this huge runway ahead of them, necessarily. But, I'm kind of in the middle.

Lewis: In the past, I've likened them to Garmin, the GPS company, in that early on with Garmin, that seemed like a transformative technology, and it was, and the growth was huge in the first couple years. And then things leveled off, partially because the GPS technology got integrated into smartphones, but they wound up serving a really hyper-focused niche of people that needed performance navigation devices, people that wanted really high-performance smartwatches, people that wanted navigation for more extreme weather and sailing and stuff like that. It's a business that has a core group, and that core group isn't necessarily going anywhere. That is kind of what I see with Fitbit right now, with the caveat that they do have a large opportunity in the health tech space. I think that Fitbit, as it continues to be -- as it looks right now, if it continues to be this company, I don't love the growth prospects. If they're able to make that pivot over to the digital health world and become more of a software services and general platform company that has these health partnerships, then it becomes really interesting. They need to do quite a bit to make that move, though. On my end, I'm not really looking at them until I see some solid evidence that that transition is taking root.

Niu: Yeah, I think it's going to be really tough to transition to smartwatches. Apple is going to be a huge presence in smartwatches specifically. It's going to be so hard for Fitbit to compete against them. We were talking about this before the show. Fitbit's total market cap is, like, $1.5 billion. Apple makes 5X that in a single quarter. So, in terms of resources, you just can't compete. And Apple certainly started off with smartwatches without doing anything like the basic stuff. Now, Fitbit made its name with basic wearables and basic trackers, and now they're trying to move up-market to challenge Apple in the smartwatch market. Not that the smartwatch market is doing very well right now. It kind of stumbled last year. But conceptually, it's going to be really tough to compete with Apple.

Lewis: Yeah. So, ultimately, this might be a business that winds up servicing its core user base for an extended period of time, and doing a very good job at that. There are growth opportunities, but they have to be quite a bit to really make them materialize, and make them into large ramps for this business.

Niu: Right, and they have so many different areas that they have to execute on to really pull this off. The question is, can management actually focus on each of these areas? It's a lot to juggle.

Lewis: Yeah. We will look to future earnings results and see. Thanks for joining us, Evan!

Niu: Thanks for having me!

Lewis: Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or if just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus as well. If you're looking for more of our stuff, subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Fitbit. The Motley Fool owns shares of Medtronic and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends UnitedHealth Group. The Motley Fool has a disclosure policy.