Daily Email from January 31st, 2017

The following email was sent to Above Avalon members on January 31st, 2017. 

Every story is written from the perspective of Apple. Each daily email contains 2-3 stories and is of comparable length and detail to the following email.


January 31, 2017

This is the exclusive daily email for Above Avalon members.

Access the archive, communicate with other members, and discuss today's stories here. View this email in your browser by clicking here.  

Today's stories: Fitbit Is in Trouble, Apple Watch Momentum Is Building, Deep Dive into Microsoft Surface Sales


Hello everyone,

Today is Apple earnings day. The company will release results at 4:30 pm ET. We will go over the results on Wednesday and Thursday.


Fitbit Is in Trouble

There has always been a feeling in the air surrounding Fitbit that the company was facing long odds. Not only did the company need to continue selling tens of millions of wearables devices per year (not an easy thing to do), but management would need to also figure out what to do about Apple entering its turf.

For a few quarters following the Apple Watch launch, Fitbit seemed to be actually doing OK. Management was seeing success when it came to marketing and branding. Fitbit was even growing its unit sales lead over the first generation Apple Watch. While there were some concerns brewing under the surface, such as worrying user engagement trends, Fitbit seemed to be making a name for itself in the health & fitness wearables market.

The situation changed dramatically with Fitbit's 3Q16 results this past October. (Fitbit's 3Q includes July to September.)

Here's the beginning of the Above Avalon daily update from November 3rd, 2016:

"The largest wearables company in the world has officially hit a brick wall. Fitbit reported very weak 3Q16 earnings yesterday. Management's conference call was one of the worst I have listened to this year. You knew it was going to be bad when CEO James Park kicked off his comments with: we are starting to see some headwinds in the business, including softening in demand.

At the heart of the issue is a company that just doesn't know what is going on in the wearables market."

The holiday quarter was supposed to include the best five week stretch of the year for Fitbit. The company would typically register as much as 40 percent of its annual sales from October to December. However, troubling signs began to appear as early as August and September. Demand for Fitbit products just wasn't materializing as management expected. Fitbit's awful sales guidance for the holiday quarter implied that the company was about to hit a brick wall in terms of growth.

Fitbit pre-announced those bad holiday results yesterday. The initial guidance range, released in October, called for $725M to $750M of revenue. Fitbit now expects to report revenue in the range of $572M to $580M range.

That is what you call a company in free fall. There just isn't any other way to describe it. Fitbit sold just 6.5M devices in 4Q16. To put that number in context:

Fitbit - Unit Sales

  • 3Q15: 4.8M
  • 4Q15: 8.2M
  • 1Q16: 4.8M
  • 2Q16: 5.7M
  • 3Q16: 5.3M
  • 4Q16: 6.5M new data point

Fitbit sold 21% fewer devices in 4Q16 than in 4Q15. More alarming, whereas the 2015 holiday quarter saw a 71% increase in unit sales quarter-over-quarter (i.e. from 3Q15 to 4Q15), Fitbit saw just a 23% increase quarter-over-quarter for the 2016 holiday season. To put these sales numbers more bluntly, consumers turned away from Fitbit in droves. As we will see, there is evidence that even this 6.5M unit sales number is artificially high.

Management's explanation as to what is unfolding is not reassuring. Here's Fitbit CEO James Park:

"Fourth quarter results are expected to be below our prior guidance range; however, we are confident this performance is not reflective of our brand, market-leading platform, and company's long-term potential. While we have experience softer-than-expected holiday demand for trackers in our most mature markets, especially during Black Friday, we have continued to grow rapidly in select markets like EMEA, where we grew 58% during the fourth quarter."

Just a few months ago, management was talking up the incredible opportunity remaining in the U.S. given Fitbit's penetration rate (~40M Fitbit devices vs. 230M smartphone owners). Historically, the U.S. comprised the vast majority of Fitbit sales. The company recently said Asia was becoming a headache. This leaves Europe as Fitbit's last remaining source of growth.

Fitbit decided to take a number of financial steps to shore up its business:

  1. Write down tooling equipment and component inventory by $68M. Code: Weak customer demand caught Fitbit off guard. The environment has deteriorated to such a degree that Fitbit needed to reassess some of its asset values.
  2. Increase rebates and channel pricing promotions by $37M. Code: Fitbit had to slash pricing in order to move product that wasn't selling. It looks like Fitbit's 6.5M unit sales for the holiday quarter was artificially high due to channel stuffing. Sell-through demand for Fitbit products was probably less than 6M devices. That's a nearly 30% decline in demand year-over-year.
  3. Increase return reserves by $41M due to greater channel inventory. Code: The product that Fitbit was able to sell with discounts and promotions will likely face elevated returns.
  4. Increase warranty reserves for legacy products by $17M. Code: People are having quality issues with older Fitbit devices.

As for 2017 guidance, management is looking for $1.5B to $1.7B of revenue. A few things jump out at me. Fitbit management has zero credibility on Wall Street. It's surprising that Fitbit is even bothering with guidance. The company misread near-term demand for its products by nearly 25 percent. How can Fitbit be in a position to estimate demand 12 months out? The second takeaway is that the guidance Fitbit did provide is downright awful. Fitbit reported $2.2 billion of revenue in 2016. Management is forecasting its business to decline 30 percent in 2017.

Three months ago, Fitbit said it expected to have $900M to $950M of cash right about now. A few Above Avalon members were quick to throw skepticism at such a claim. That skepticism proved correct. Fitbit actually had $700M of cash at the end of December.

In order to shore up its liquidity, Fitbit is looking to cut its annual operating expenses by 20% to $850M. Since sales & marketing and R&D make up the vast majority of Fitbit's operating expenses, those budgets are likely going to get slashed. Fitbit is also letting go of 110 employees (6% of its workforce). Unfortunately, history has shown that management teams in Fitbit's position often underestimate the degree of required downsizing.

Fitbit needs to downsize in response to declining sales. If we assume management was initially expecting sales growth in 2017, the company's new guidance implies that the company will likely have $400M less in gross profit to work with. (This is my estimate obtained by taking management's new 2017 revenue guidance, subtracting it from a hypothetical situation where Fitbit was able to grow revenue in 2017, and then applying a 50% margin to the difference.) This is money that would have funded marketing, R&D, and M&A (a form of employee acquisition).

The company appears to be afraid of a widespread brain drain as it wants shareholders to approve "a program under which certain employees may relinquish out-of-the-money options at the time of the exchange in return for a fewer number of restricted stock units."

Fitbit shares traded down 16% yesterday to $6. The company is now valued at $1.3B or 1.9x cash. The company's cash total is going to be a moving target going forward. For context, Apple is trading at 5.4x net cash. It seems like Fitbit is trading with some M&A premium. However, it's not clear who will want to step in as an acquirer at this point.

The most worrying thing for Fitbit is that its largest risks are beginning to materialize. Fitbit has some top engineering talent when it comes to wrist wearables. It is going to become that much harder for Fitbit to retain this talent. In addition, Fitbit's future was built on the premise that it would be able to release new products that customers wanted. If the company is forced to slash its R&D budget due to declining sales, how will the company compete with Apple? I'm not sure there is a genuine answer.


Apple Watch Momentum Is Building

It is impossible to talk about Fitbit without focusing on Apple Watch. Judging by public statements, Fitbit management is still in complete denial when it comes to the impact Apple Watch is having on its business.

Here's Park in Fitbit's press release from yesterday:

"As the overall wearable category leader, we exited the year with an engaged community of over 23.2 million active users, making us uniquely positioned to be the partner of choice for the healthcare ecosystem, which is a key component of our long-term strategy."

The problem for Park is that the Apple Watch ecosystem will likely surpass 23M active users in a few months. It is also becoming likely that Apple will soon earn the "overall wearable category leader" title from Fitbit as well.

However, if judging by actions, Fitbit management is very aware of the threat Apple Watch poses to Fitbit's long-term viability. Fitbit is running as fast as it can into the smartwatch market.

Here's more from Park:

"We believe we are uniquely positioned to succeed in delivering what consumers are looking for in a smartwatch: stylish, well-designed devices that combine the right general purpose functionality with a focus on health and fitness."

Park is describing Apple Watch.

In less than 12 hours, we will get some data as to how Apple Watch performed over the holidays. My estimate is that Apple sold 5.4M Apple Watches during the holiday period. This would be a very strong number for Apple. However, simply comparing Apple Watch to Fitbit sales may hide one of the more important developments in the wrist wearables space.

Apple Watch may be seeing success in pushing the wearables market in a new direction. Instead of splinting into dedicated health & fitness trackers and smartwatches, the entire market appears to be moving towards smartwatches. This is why it is so strange that Park is quick to say that Fitbit is running towards smartwatches but has never commented that Apple Watch is impacting Fitbit. The simple fact that Fitbit is being forced into smartwatches tells us that Fitbit is merely leading Apple Watch, and that is not a position you want to be in.


Deep Dive into Microsoft Surface Sales

One of the more interesting questions facing Apple's Mac business has been whether a portion of the Mac user base would flee to an alternative platform. This transition could be linked to a few reasons, including frustration with Apple's update schedule for the Mac and/or excitement surrounding new hardware from competitors.

Recall Microsoft's recent claim of seeing a record number of people switching from Mac to Surface. The company provides up to $650 off Surface Book or Surface Pro to users who trade in a MacBook Pro or MacBook Air.

Late last week, we received the latest sales data for Microsoft's Surface products as part of Microsoft's earnings release.

Microsoft Surface Revenue

  • 2Q15: $1,077M
  • 3Q15: $715M
  • 4Q15: $888M
  • 1Q16: $672M
  • 2Q16: $1,350M
  • 3Q16: $1,110M
  • 4Q16: $965M
  • 1Q17: $926M
  • 2Q17: $1,320M new data point
  • Sum: $11.711B

Microsoft reported $1.32B of Surface revenue over the holiday quarter. While unit sales are not disclosed, we can back into an estimate of around 1M to 1.2M devices sold based on average selling price.

Nearly every report focused on Microsoft's earnings positioned $1.3B of Surface revenue as a resounding success, especially since results didn't include much from new product categories.

My stance on Microsoft Surface has been consistent. While it may very well be serving its purpose as a way to motivate Windows OEMs, Surface sales do not match the narrative found in the tech press. Consumers are not embracing Microsoft Surface in droves. According to Microsoft, commercial demand for Surface was up 25%. Since overall Surface revenue was down year-over-year, this would seem to imply that consumer demand was also down year-over-year. This is odd since Microsoft had said that November was the best month yet for consumer Surface sales.

We have niche hardware that is seeing some adoption success in enterprise. Will wider availability of the $2,999 Microsoft Surface Studio change this narrative in 2017? It's doubtful.

This isn't to suggest that Apple should ignore Surface. There are some who think Surface is a slow, gradual movement that will take years to eventually reach a $10B revenue per year run rate. There may be a case to make for such a development. However, this is not what is being pushed in the press. Instead, it's labeled as a genuine Surface vs. Mac battle among consumers. Microsoft has been happy to build up that battle in recent months. However, sales numbers don't lie. If it's a Surface vs. Mac battle among consumers, the Mac is doing fine.


Each daily email is approximately 2,000 words and contains 2-3 stories (10-12 stories/week). 

Story topics include:

  • Strategy and business analysis
  • Financial modeling and estimates
  • Perspective and observations on current news events, competitors, earnings, and keynotes

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