Being wrong for the right reasons

Over the Christmas holiday period, many of you would have noticed a bombardment of advertisements for Fitbit (NYSE: FIT). Fitbit produces wearable devices that measure various health parameters such as steps walked, hours slept and even your heart rate. The idea is that such health information, once measured, can be used to better manage health and wellness outcomes. It’s not a bad idea at all, but ultimately, this is a consumer product and its success will depend almost entirely upon user adoption and its sustainability.

This second point is key: sustainability. You see, many consumers are more than happy to try a product, yet the long-term prospects of Fitbit depend on users sticking with the product and continually engaging with it and upgrading to new models in the future. Think of Apple’s iPhone for an example of a first-class consumer device that consumers will continually engage with sustainably into the future.

Fitbit listed on the New York Stock Exchange with much fanfare in June 2015. We are always sceptical of high-growth companies that go public – the timing can often be a reflection of deteriorating growth prospects.

In the most recent quarter prior to listing, Fitbit’s reported revenue growth was +229%YoY. The company had only recently turned an operating profit, so its profit growth was a staggering +286%YoY. This is clearly impressive and growth rates at these levels have an incredibly powerful compounding effect.

But to understand the sustainability of this growth rate, one needed to understand one key parameter: churn. That is, what share of the active user base was giving up on using a Fitbit?

Unfortunately, this number was not explicitly provided. The data that was provided included:

  • Devices sold each quarterly period;
  • Active users at the end of the period, defined as: “a registered Fitbit user who, within the three months prior to the date of measurement, has (a) an active Fitbit Premium or FitStar subscription, (b) paired a health and fitness tracker or Aria scale with his or her Fitbit account, or (c) logged at least 100 steps with a health and fitness tracker or a weight measurement using an Aria scale.”
  • Registered users at the end of the period.

It is also noteworthy that disclosure of the second two parameters above were fairly promptly discontinued intra-year, following the Fitbit’s IPO. Did the company have something to hide?

You see, if we had all the data for each three month period, we would be able to impute an estimated rate of churn. We would do this with the following steps:

  • For each quarter, look at the increase in active users; then
  • Subtract from this the number of devices sold during the quarter. Assuming that anyone who bought a new device becomes a new active user during that quarter, then the remaining number would be the quarterly change in the active user base.
  • We can then use this number to estimate the churn by comparing it to the total number of registered users.

Now, although we are not provided with all the relevant quarterly data, we can probably estimate it reasonably accurately using a regression analysis. Essentially, we take the data points we have and apply a curve of best fit, as shown below. We can then use the equation of this curve to estimate the missing data points we need.

Screen Shot 2016-03-07 at 12.59.47 PM

Given we now have a complete set of data – albeit with some estimates – we can proceed to estimate the annual churn in the Fitbit user base. Shown below, we estimate the churn is around 40% per annum! This is a very large number and calls into question the sustainability of Fitbit’s business model.

Screen Shot 2016-03-07 at 1.00.22 PM

To put this number into context: in order to achieve the 35%YoY revenue growth the market is expecting for 2016, Fitbit would need to grow its devices sold by approximately 75%YoY, assuming constant prices.

Even if Fitbit can keep up the 24%YoY average price inflation that it achieved in the most recent quarter (which hardly seems sustainable longer term), then it would still need to grow devices sold by 51%YoY. This appears optimistic – especially as competition intensifies from the likes of Apple with its new watch that performs many of the same functions as Fitbit.

In short, we believe current market expectations are too high for Fitbit relative to the underlying rate of churn in its active user base. Or said another way, the market is underestimating this rate of churn. Typically, this would be the makings of an attractive short opportunity.

We identified this opportunity prior to the company’s results on February 23. We chose not to invest. The reason we opted against investing was because the company’s free float was too small and short interest was too high. Essentially, many others were already shorting this stock; and we deemed the risk of a short-squeeze as being too high. The cost of borrowing the stock to initiate the short at the time was 20% per annum.

Essentially, we had a good fundamental opportunity but decided against executing the position for risk management reasons. When Fitbit reported its results, the stock price collapsed 21%. From this perspective, we were wrong not to initiate the position. From the perspective of our risk management process, we were absolutely right.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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