Fitbit (FIT +0.00%) investors have been on a stomach-churning ride ever since the wearable device maker went public in June. In less than two months, the stock soared from its IPO price of $20 past $50. But after Fitbit's second-quarter earnings report revealed a troubling decline in margins, the stock plunged back to the low $30s.
Source: Fitbit.
As a result, bottom-fishing investors might be wondering if Fitbit is now a good contrarian pick. But in my opinion, this high-flying stock could still tumble 40% back to its IPO price due to three simple reasons -- its high valuation, low competitive barriers, and an inevitable decline in margins.
1. Valuations are too high
Fitbit currently trades at 41 times trailing earnings -- a steep premium to the S&P 500's P/E of 20 and the average P/E of 26 for the scientific and technical instruments industry. Its price-to-sales ratio of 5.3 is also much higher than the industry average of 1.8.
One can argue that Fitbit's higher multiples are justified since it respectively grew its revenue and non-GAAP net income 253% and 180% annually last quarter. But on a GAAP basis, which includes stock-based compensation, amortization of intangible assets, and other charges, Fitbit's net income only improved 20%.
Looking ahead, Fitbit still looks expensive, with a forward P/E of 33 compared to the S&P 500's forward P/E of 16.5. As for its long-term future, investors should check its 5-year PEG growth ratio, which tells us how a stock's price compares to its long-term earnings growth forecasts. A PEG ratio under 1 is considered cheap, but Fitbit currently has a PEG ratio of 1.5.
Over the past year, GoPro (GPRO 3.65%) stock rose and fell on a similar path as Fitbit. Both companies posted double and triple-digit top- or bottom-line growth, but both stocks soared to unrealistic valuations. Today, GoPro trades in the low $30s, with a more reasonable forward P/E of 16 and a PEG ratio of 0.56. This means if Fitbit stock follows in GoPro's footsteps to its "fair value," it could be cut in half.
2. Low competitive barriers
In a previous article, I highlighted the similarities between Fitbit and GoPro -- both companies enjoy a first-mover advantage in their respective industries, have strong brand appeal, and use social networking to build their brands. However, GoPro doesn't face any meaningful competitors in the action cam market yet, while Fitbit has already lost ground to cheap fitness trackers and new smartwatches.
Fitbit's global share of the wearables market declined from 30.4% to 24.3% between the second quarters of 2014 and 2015, according to IDC. During that period, Apple's (AAPL 0.17%) share rose from nothing to 19.9%, thanks to the launch of the Apple Watch. Xiaomi, which launched a $15 Fitbit Flex clone called the Mi Band, claimed 17.1% of the market.
Xiaomi's $15 Mi Band. Source: Xiaomi.
Looking ahead, Fitbit could be easily crushed between all-in-one smartwatches like Apple Watch and cheap fitness trackers like the Mi Band. Between 2015 and 2020, Generator Research expects global revenue from basic fitness trackers to fall 77% to $527 million as revenue from smartwatches soars 795% to $154 billion. This means Fitbit will have to launch more smartwatch-like devices, like the Charge HR and Surge, to stay afloat in this crowded market.
3. Margins will fall
As the fitness tracker and smartwatch markets become commoditized, Fitbit must allocate more spending on R&D to produce new products, promote them with higher sales and marketing expenses, and possibly cut prices to stay competitive. This is how much Fitbit's operating expenses rose during the first six months of 2015:
|
Year-Over-Year Increase |
% of Total Revenues | |
|
Research and Development |
153% |
7.2% |
|
Sales and Marketing |
362% |
15.4% |
|
General and Administrative |
72% |
3.7% |
Source: Fitbit 2Q earnings report.
Those soaring expenses caused Fitbit's non-GAAP gross margin to decline annually from 56% to 48%, while GAAP gross margin fell from 48% to 46%. To keep competing against Apple Watch, Mi Band, and other devices, Fitbit's margins could keep shrinking as expenses continue rising.
The key takeaway
On the surface, Fitbit's growth numbers look great, and its long-term plans look ambitious. New smartwatch-like devices, fashionable accessories from Tory Burch, and "corporate wellness" partnerships with companies could expand its appeal beyond fitness enthusiasts. Its premium services, which offer a digital trainer and premium reports with their devices, could also diversify its top line beyond hardware.
But for now, Fitbit's valuations are simply too high, its products have low competitive barriers, and expenses will continue rising. In my opinion, that toxic mix could cause the stock to slide back to its IPO price in the near future.
