So what: Fitbit sank 13.6% after reporting second-quarter 2015 earnings on August 5, and never really recovered as the month wore on. While the company delivered truly impressive revenue growth, investors appeared to be worried over a deterioration in gross margin.
Fitbit improved its revenue by roughly 250%, selling $400.4 million of product versus $113.6 million in the prior-year quarter. However, as several analysts pointed out immediately after the earnings report, the company's gross margin declined by 5 percentage points versus the prior year, from 52% to 47%.
The shrinking in gross margin was accompanied by a surge in research and development spending, which more than quadrupled to $70 million in comparison to Q2 2014.
As a result, despite a ramp-up in revenue of more than 2.5 times against the comparable period, Fitbit's operating income of $80.4 million actually decreased, as a percentage of sales, by 2.7%.
Now what: Why would a 5% drop in gross margin so worry investors that they'd punish the stock in dramatic fashion? Gross margin is derived from sales less product costs, and a good portion of these costs are usually thought to be somewhat controllable by management as opposed to, say, fixed non-production expenses (for example, administrative payroll).
As a company scales its revenue, gross margin theoretically should hold even, and in many cases, improve, as the organization sells more and more goods beyond its breakeven point in a given quarter.
Thus, it can often come as a shock when revenues have improved dramatically but profits actually deteriorate. But in this case, investors may have overreacted just a bit. It's one thing for a young company selling into market demand to bump revenues by, say, 20% or 30%. But at a sales leap of 250%, it's likely that Fitbit was attempting to meet every last bit of demand possible. The company sold a cool 4.5 million devices during the quarter.
With such explosive growth, production and the supply chains that make production possible are often works in progress and not configured for maximum efficiency. Management is projecting that gross margin will remain in the current range of 47%-48% for the rest of the year. It's likely that investments being made in 2015 will lay the groundwork for improved margin next year as Fitbit adjusts its capacity to meet global consumer thirst for its wildly popular devices.
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