Rating: SELL. Current Price: $ Target Price: $ Timeframe: 12 months. Investment Summary. Investment theme #1: Growth will slow down

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1 NYSE: FIT Rating: SELL Current Price: $29.50 Target Price: $12.18 Timeframe: 12 months Investment Summary Fitbit s (FIT) core value proposition is: 1. Being the pioneer in the fitness and activity tracking wearable space. 2. Variety of product offering at various price points 3. Consumer awareness and brand strength The company just went IPO in June 2015 with the increasing market demand of wearable devices. However, we believe that the growth is not sustainable as there is a lack of uniqueness and is subject to price pressure. This growth rate is not sustainable in this intensely competitive market. We initiate this coverage with a SELL rating. Investment theme #1: Growth will slow down Fitbit cannot maintain the triple digit growth rates and we predict that the growth will slow down significantly within the next few years. New entrants in the market and no switching costs on the part of consumers will primarily drive this. Investment theme #2: Margins to reduce Fitbit will have to spend more on R&D for new product innovations. Also SG&A is expected to rise with additional marketing spend and hence margins are expected to reduce. Valuation Our valuation incorporates a 10-year forecast horizon and generates a price target of $12.18 per share, a 58% decline from the current price. A multiples-based valuation provides a range of $12.99 to $ Report date: December 14, 2015 Prepared By: Venkat Venkatasubramanian EWMBA 222: FIA Thursday section Industry Group: Technology Market cap: $6.11 B P/E ratio: week range: $ YTD performance: NYSE: % FIT: -0.61% Venkat Venkatasubramanian 1

2 Business Overview Company Overview Fitbit is a pioneer in the consumer wearables and in the connected health and fitness tracker space. Started in 2007, Fitbit in less than 6 years from the launch of its first device and on the back of less than $70M venture financing, has generated $1B+ in revenues. Fitbit has experienced explosive revenue growth, with a 246% CAGR over the time period, culminating in nearly $750M in sales in Using the Q actual results, demonstrated growth in the average selling price (ASP), and historical holiday quarter sales, we expect Fitbit s full year 2015 revenues to be around $1.7B Growth in the last year and also into 2015 has been driven not solely by the increase in devices sold, but also by improvement in the ASP of Fitbit s devices. ASP growth is likely through the combined effects of both a better unit mix towards Fitbit s higher-priced offerings (its first nonrecalled device sold above $99 MSRP debuted in Q4 2014). Also the company s growth has been profitable, with operating income of $158M in Gross margins averaged above 48% for the last eight quarters and operating margins averaged above 21% over the same time period. This also explains how the company has avoided taking on additional venture capital, financing its operating activities from its own cash flows. A brief summary of the timeline, the important devices that the company has launched and the various financials are shown below. Source: Rock Health Venkat Venkatasubramanian 2

3 Industry Overview While Fitbit s growth has been nothing short of phenomenal it is operating in a very competitive environment. The fitness activity tracking market has become very crowded. As shown in Figure below, the market share is declining already with the onset of newer players such as Xiaomi who are more price competitive compared to Fitbit. The $15 Mi-band offered by Xiaomi has the same features that are offered by the most of the Fitbit watches. WW market share Wearable devices Fitbit Xiaomi Garmin Samsung Jawbone Others 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2014 Q Q Q Q Q Q2 Source: Mobile Health news 1 The other players in the market include, Apple: Apple Watch although may be expensive, it is attractive to customers who want a smartwatch and a fitness tracking device. Samsung: GearFit launched by Samsung is meant to compete with Apple watch and comes with many features in Fitbit Jawbone: Still has a sizable market share and the devices are fairly competitively priced compared to Fitbit Garmin: Has a fitness smartwatch called Vivoactive, Vivofit2 and Vivosmart. Also another established player and is rapidly transitioning into this market from their navigation device market. Other players in this space include Misfit, Under Armor, Pebble all with similar line of products. With more entrants in the high end and (Apple, Microsoft) and low end (Xiaomi) we think that the 3-digit growth rates that Fitbit has been enjoying is not sustainable. This is also exacerbated by the fact that customers can easily switch between different vendors with Fitbit not providing any additional software services on top of the hardware devices that are sold Venkat Venkatasubramanian 3

4 Accounting Analysis We did not find anything specific that need to be monitored or appeared suspicious from the financial statements. Q profits soared on higher sales of the fitness-tracking wearable device. But investors should be more skeptical of 2014 performance, when the company reported net income of $132 million compared with a $52 million loss in A closer look at the securities filing for its IPO shows that $103 million of that increase more than half is a result of tax accounting decisions. Also Fitbit seems to emphasis more on adjusted EBITDA in their earnings releases. This does not include costs incurred due to stock options or product recalls. Fitbit spent $107 Million on the Force product recall in Financial Analysis Sales Growth and User engagement While Fitbit has enjoyed a tremendous growth it will be really hard to sustain the triple digit growth rates. For Fitbit to compete against low cost competitors such as Xiaomi it needs to introduce new products faster and also retain existing users. In the S-1 filings, some information is available on the user engagement and churn. It s unclear from the filing how much users actually engage with the Fitbit software platform based upon traditional mobile metrics (daily active users and monthly active users). Presently, this is the largest criticism of wearables that the majority of people abandon the devices after six months. Instead, Fitbit presents its own metric: Paid Active Users (PAUs). A PAU has been defined as a user that in the last three months has done any of the following: had an active Fitbit Premium or FitStar subscription; paired a tracker or scale to their Fitbit account; logged 100 steps; or logged a weight measurement. What we see from the S-1 for the last 3 quarters is that the PAUs are almost only 50% of devices sold. This again points to very low engagement levels and hence customers can effectively switch to other platforms. A lack of long-term engagement and repeat purchasing will matter in the face of a competition in the market. Devices Sold (Millions) Negative PAUs/Churn Change in PAU vs last year Q Venkat Venkatasubramanian 4

5 Operating Margin Will be hard to sustain A comparison of Fitbit and some of the peer groups in terms of the OM% shows that the margins are almost at par or better than Garmin and GoPro while lagging behind Apple s margins. This will be hard to sustain, as the COGS tends to go up with more competition in the market. Gross Margin Will be hard to sustain Fitbit is again in the middle of the pack when we compare the Gross margin compared to peer groups. The margins can decrease with market saturation and arrival of newer low priced competitors. DuPont Analysis ROE and ROA Based on the DuPont analysis the ROE metrics are here compared to Fitbit s peer groups. Over the last 8 quarters, the ROE has been slightly better for FIT compared to GoPro and Garmin while Apple does the best in ROE returns. Venkat Venkatasubramanian 5

6 Asset Turnover Asset turnover ratio for FIT has been steadily declining but still at par or better than its peer groups. Venkat Venkatasubramanian 6

7 Days of inventory Needs improvement Fitbit s days on inventory numbers have been steadily increasing. Apple being the best in the industry with their superior supply chain efficiencies has the lowest inventory. Holding up more inventory for Fitbit can negatively impact the ROA in the long term. Valuation and Forecasting General Parameters Forecast Horizon We used a 10-year forecast horizon. Consumer electronics is a fast changing industry but the wearables space is relatively new and the overall fitness activity tracking device market is growing. The market is expected to reach $33B (including all wearable devices) by 2022, based on the most conservative of analyst estimates. We expect that this market is very much in its infancy and will take a long time to reach steady state. Hence we think a 10-year forecast is reasonable. Cost of Capital The discount rate was fixed at the given rate of 10% based on the required rate of return of our investors. Growth The growth is by far the most important valuation impacting metric for any company. While the overall market is growing, how much of that market share can Fitbit capture is essential to the model. While Fitbit has been growing at greater than 100% in the last 2 years, the competitive forces in the market will result in a significant growth slowdown. We expect the growth rates to Venkat Venkatasubramanian 7

8 exponentially decline to nominal terminal growth rate. We use a terminal growth rate of 4.2% based on the World Bank OECD 2 and IMF estimates 3. The growth rates that we have used for the model compares very well with the consensus Wall Street estimates. We have used an exponential declining model to growth rates. We also differ from consensus in the way there is a short-term growth decline followed by a period of brief recovery in Wall St Consensus Our Forecast Sales Growth 160% 140% 120% 100% 80% 60% 40% 20% 0% Year Profitability Cost of Goods Sold Currently Fitbit has a healthy gross margin trading at around 51% for FY The consensus expectations are for it to remain in the low 50% range. The COGS is a measure of manufacturing efficiencies and Fitbit s ability to source parts at a cheaper price while at the same time making sure that their ASPs stay flat or increase. The average ASPs across all Fitbit product lines increased from $69 in 2011 to $87 in 2015, which means there is a focus on selling higher priced products. With the launch of similar products in the market especially from Chinese manufacturers such as Xiaomi, we expect that there will be ASP pressures which will also result in a lower gross margin. We are modeling a 55% terminal COGS with a linear increase from the low 50% range of where they are now Venkat Venkatasubramanian 8

9 Wall St Consensus Our Forecast COGS % of sales 56% 55% 54% 53% 52% 51% 50% Year SG&A expense For many consumer electronics products, the SG&A is an important component in the valuation. Fitbit significantly ramped its efforts in both distribution and marketing in 2014, helping to drive the company s 175% growth in Also Fitbit notes penetrating corporate wellness as one of five growth levers for the business, the S-1 provides no insight into its success in the market beyond a reference to its first 1,000 unit corporate wellness sale, which came all the way back in October It is unclear how many units are being sold through this channel, but the relative depth of the offering (employee onboarding, leaderboards, reporting, analytics) suggests how seriously Fitbit takes competing in this market. What this means is that there is additional marketing and administrative expenses, which will have to be modeled in the forecast. Fitbit notes in its S-1 that creating global brand awareness, global distribution, and corporate wellness as the other primary growth opportunities. All of this means increasing in SG&A expenses. Wall St Consensus Our Forecast SG&A forecast 35% 30% 25% 20% 15% 10% 5% 0% Year Venkat Venkatasubramanian 9

10 Advertising spend reached $71M, and was the primary reason overall sales and marketing expenses grew by more than 300% in 2014 versus This is expected to increase in the coming with additional product launches and with international expansion. The terminal value of 30% SG&A for Fitbit is also inline with some of direct comparable companies such as Garmin, which has been seeing an increase in SG&A expenses since its IPO as shown below. SG&A% Garmin SG&A% of sales 0 Dec '06 Dec '07 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Sep '15 R&D expense Fitbit notes that $233M of the first quarter s revenue was from new products released in the fourth quarter of 2014, or nearly 70% of Q s revenue. This is significant, since Fitbit did not discontinue older products, including the Zip, One, or Flex, and all of the new products launched at higher price points ($129+) than existing products. It speaks to the need for a steady stream of new products, particularly for the holidays (the fourth quarter has represented 44%, on average, of annual revenues the past three years). Because competitors can so quickly commoditize the hardware in this category, it will be important for Fitbit to identify relevant physiological parameters to track for their core markets (everyday, active, and performance in the company s language, respectively targeting general wellness, physical activity, and sports) and successively launch new devices incorporating these sensing features. What this means is Fitbit needs to constantly spend on new products and the current R&D as percentage of sales is likely to increase. We are modeling a 9% terminal R&D spend value. We differ slightly from the street consensus estimates and are using a linear projection upwards. Venkat Venkatasubramanian 10

11 Wall St Consensus Our Forecast 12% 10% R&D forecast 8% 6% 4% 2% 0% Year Again using the comparable of Garmin and how they spend on R&D over time, the 9% spend on R&D is reasonable and perhaps even conservative Garmin R&D% of sales 0 Dec '06 Dec '07 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Sep '15 Effective Tax rate Fitbit has been provisioning less for taxes, but the ETR would mean revert quickly and we have modeled a terminal year tax rate of 38%, which is inline with Wall Street consensus estimates. Venkat Venkatasubramanian 11

12 Wall St Consensus Our Forecast ETR forecast 45% 40% 35% 30% 25% 20% 15% 10% Year The main valuation drivers are Growth rates, SG&A, R&D as percentage of sale, and the COGS margin. Valuation Implementing all of the forecasting assumptions discussed above, the residual income model provides a stock price estimate of $ The implied terminal ROE is 14.3%. Though we expect that Fitbit is a leader in the fitness activity tracking space, its success has opened doors for variety of new competitors. With little to differentiate, the company with the best-cost structure will quickly become the market leader. A summary of the model is shown here Enterprise Value and Multiples Forecasted Value as of Valuation Date 2,523,600 Less Value of Contingent Equity Claims 0 Value Attributable to Common Equity 2,523,600 Common Shares Outstanding at BS Date 207,183 Equivalent Shares at Valuation Date 207,183 Forecast Price/Share $12.18 Venkat Venkatasubramanian 12

13 Sensitivity Analysis To test the model, we tried a few different variables. The first variable to test was the growth rate in itself. The exponential decline can be modeled in a more aggressive way which results in a $8.31 price and a more optimistic way which gives us a $15.19 price for FIT. We choose the approach where growth rates start of at 60% in 2016 and gradually decline to a terminal growth rate of 4.2% Forecast Price for different growth rate curves $15.19 $12.18 $ % 80% 60% 40% 20% 0% Venkat Venkatasubramanian 13

14 The other important variables that impact the forecast estimates are the COGS, SG&A and the R&D expense. A chart comparing the different price forecast is shown below. As seen below, the COGS and SG&A assumptions seem to have the largest price change. The R&D estimates, which are expected to rise from current levels, also have a significant impact. COGS 52% 54% 55% 56% 58% 60% Price/Share $20.16 $14.84 $12.18 $10.16 $6.13 $4.22 R&D 7% 8% 9% 10% 11% 12% Price/Share $16.21 $14.21 $12.18 $10.17 $8.15 $6.14 SG&A 25% 27% 30% 33% 35% 34% Price/Share $22.25 $18.22 $12.18 $6.14 $2.11 $1.70 Comparable Multiples Analysis We also looked at the performance of FIT and how it compares with some of the peer groups in the consumer electronics industry. Overall based on the 3Q results, the PE, EV/EBITDA, EV/Sales and EV/EBIT numbers are all higher than the median multiple of the peer group. Fitbit has been able to maintain low leverage and hence the debt multiples are better than its peer group. As Fitbit investors are expecting higher growth potential the PE multiple is much higher than the median PE multiple of its peer group. This could also be due to the fact that FIT has a shorter financial history. The choice of comparable companies was a little tricky as Jawbone, Xiaomi don t have publicly available numbers. We also included GoPro here, as we believe that the fundamental nature of the companies is the same. Earnings Price to Price to Price to Enterprise Enterprise Enterprise Company Fiscal Enterprise per Share Earnings Earnings Earnings Value/ Value/ Value/ Name Period Value FY1 Actual FY1 NTM Sales EBIT EBITDA Fitbit A 09/30/2015 5, x 25.52x 2.8x 14.60x 14.20x Apple 09/26/ , x 11.47x 11.36x 2.81x 9.74x 8.34x Garmin 09/26/2015 5, x 15.61x 15.31x 1.97x 9.67x 8.50x Samsung Electronics 06/30/ , x 9.46x 9.13x 0.81x 7.15x 3.81x GoPro A 09/30/2015 2, x 15.58x 14.84x 1.17x 7.85x 7.20x Average 319, x 13.03x 12.66x 1.69x 8.60x 6.96x Median 361, x 13.53x 13.10x 1.57x 8.76x 7.77x FIT Sales (millions) $1,794 Shares Outstanding (millions) EBITDA 373 EPS GAAP 0.96 EBIT 357 Fitbit%Valuation%By%Multiple Sales EBITDA EBIT Earnings Median'Ratio 1.57x 7.77x 8.76x 13.10x EV'Value $2,816 $2,897 $3,129 $2,605 Price/Share $13.60 $13.99 $15.11 $12.58 Using the median multiples, we then attempted to value the share of the FIT. The value estimates are closer to the $12.18 predicted using the actual residual income method. This bolsters our argument that the share has been over valued and has been trading higher because of higher growth premium and that the $12.18 price is a fair value estimate for the share. Venkat Venkatasubramanian 14

15 Conclusion Price Catalysts We initiate a SELL rating on Fitbit. We postulate that the stock has an intrinsic price of $12.18, which represents a 58% discount from the current price of $ The following supports our valuation model: 1) The sales growth that Fitbit has seen in triple digits will be hard to sustain. The increase in the number of similar devices with no unique differentiation will result in declining growth rates. 2) In order to keep ahead of market, Fitbit will have to spend more on R&D. R&D as percentage of sales will increase. Also additional marketing expenses will increase SG&A spend which will result in margin pressures. Risks The risks involved in our price projections are: Possibility that Fitbit launches a completely new set or category of devices targeting the healthcare market. Moves like the hiring of Aaron Rowe 4 shouldn t be overlooked, given his background at both Scanadu 5 and Integrated Plasmonics 6 The possibility that Fitbit itself gets acquired by a larger players in the market such as Samsung or Amazon Potential consolidation in the market (Jawbone, Polar acquisitions) could provide Fitbit with additional opportunities to grow in this space. Our price objective is based on the next 12 months and assumes FIT will underperform on its growth strategy in 2016 in terms of gross and operating margins. Quarterly earnings calls showing this continued underperformance are expected to serve as the primary catalysts for correction, with greater corrections coming later in the 12-month cycle Venkat Venkatasubramanian 15