Fitbit – maker of eponymous wearable fitness trackers – completed its IPO yesterday evening. With the shares’ trading debut later this morning, the markets are abuzz with excitement.
And why wouldn’t they be? This is the third-largest IPO this year. It’s a tech company, and – something exceedingly rare amongst recent tech IPOs – one that is actually profitable. Plus, just look at this chart:
Source: Fitbit’s IPO filings.
So, will we be buying? Absolutely not.
I have concerns about this business model, sure. But really, this story is one of a company strong-arming the IPO system for the benefit of a few insiders. Fitbit’s ability to drum up positive press is matched only by its reckless disregard for shareholders.
Here’s why we’ll be staying far away from this IPO:
1. Massive insider selling.
Most high-growth companies go public because they have the opportunity to deploy capital at high rates of return, and an IPO is the best way to raise that capital. That’s decidedly not the reason Fitbit is going public. Instead, the company is undertaking its IPO to allow insiders to sell their shares.
This is made clear throughout Fitbit’s IPO filings:
The principal purposes of this offering are to increase our capitalization and financial flexibility, create a public market for our Class A common stock, and enable access to the public equity markets for us and our stockholders.
We currently have no specific plans for the use of the net proceeds that we receive from this offering.
All told, insiders are using the IPO to cash out on about 7.5 million shares of stock, worth about $150 million at the $20 stock price. After years of not being able to sell shares, it’s understandable for insiders to seek some liquidity, but this is a frightening amount of selling. I’m not comfortable putting my money into a stock when the people who know the business best are cashing out en masse.
2. There’s this tiny company called… Apple.
Fitbit devices are valuable only if customers wear them. Rocketing device sales suggest that customers are willing to do so – or at least they hold that belief at the time of purchase. The data suggests many customers quickly lose interest: Although Fitbit has sold over 16 million devices to date, the company reports just 6.7 million “active users,” and that figure is likely inflated (see #5 below).
This isn’t surprising. It’s difficult to change behavior, and asking customers to make a daily decision to don a Fitbit device requires just that.
One the other hand, there’s this little company called Apple (Nasdaq:AAPL) – perhaps you’ve heard of it – whose devices are already part of the daily lives of its customers, and which is already building health-and-fitness functionality for those devices. The 16 million Fitbit devices is just a drop in the bucket compared to the more the 400 million iPhones in use. And that’s not to mention the Apple Watch, which can deliver startling similar functionality to Fitbit devices as well as about a gazillion other functions thanks to the power of the Apple App store. Apple hasn’t yet released Apple Watch sales data, but first-year sales estimates range from 8 million to 40 million watches.
So that unique network effect Fitbit is hyping in its IPO pitch? Not so unique, and certainly not safe from competitors.
3. There’s more competition than you think.
Apple is certainly the most dangerous competitor, but it is by no means the only one. Over 1.6 billion mobile devices run on the Android operating system, creating a huge opportunity Google (Nasdaq:GOOG, Nasdaq:GOOGL) is not ignoring. And don’t forget Samsung, the world’s most popular phone manufacturer.
Aside from the big players who could compete on network size, there are also other wearables manufacturers vying with Fitbit for market share. These include Garmin (Nasdaq:GRMN), a favorite among competitive runners and cyclists, as well as Jawbone, whose new battery lasts up to 10 days, and Misfit, which offers a device at a lower price point than any Fitbit.
4. Dual share classes.
Now we get to the real trouble with this IPO: The dual share class structure.
As part of the initial offering, Fitbit is splitting its shares into Class A and Class B shares. The shares are identical, except that Class B shares command 10 times the voting power as Class A shares. The company, of course, is only selling Class A shares – those with minimal voting rights – and insiders are keeping the Class B shares for themselves. The result is that Fitbit gets to access the public markets without having to actually listen to any pesky shareholders. Insiders will retain 98.3% of voting power.
This would be a red flag for any company (Google actually has a similar structure), but it’s particularly worrisome for Fitbit because of the dynamics of the wearable technology market. There are network effects in having many people use the same device. As discussed above, though Fitbit has the largest network of activity tracker-specific devices, its network pales in comparison to those of general-use smart devices. That makes Fitbit a prime acquisition target for the likes of Apple and Google – or perhaps Samsung or Microsoft (Nasdaq:MSFT). The dual class structure, however, makes such an acquisition nearly impossible – even if its in the best interest of shareholders – without the explicit approval of a few key insiders, whose personal interests may not align with those of shareholders.
5. Completely made-up metrics.
Fitbit is harping on a metric called “active users,” which has ballooned from 0.6 million in 2012 to 9.5 million in the most recent quarter. On the surface, “active users” seems a relevant metric for daily-use device manufacuter, and the concept the metric seems intuitive.
And then you read how Fitbit defines “active users.”
Fitbit considers a user “active” if he has a paying subscription to a Fitbit service or has paired a device to an account or has logged 100 steps or has measured their weight anytime in the past three months. In other words, if I managed to walk a couple blocks with a Fitbit on my wrist or stumble onto my Fitbit scale any morning since March, Fitbit considers me an “active user.” That is, I believe, a bit of a stretch, and I’m not a fan of investing in companies that mislead their investors.
I’m not the only one eyeing this metric dubiously. Fitbit’s lawyers decided it was necessary to cite it as a risk factor in the IPO prospectus, warning potential investors that you should not rely on this metric as an indicator of continual user engagement on our platform. That’s good advice.
6. Still 99% reliant on hardware sales.
The promise of wearable technology businesses is that, once a user buys a device and incorporates it into her life, you can use the data collected to sell high-margin, recurring-revenue services. Fitbit has tried to push out such subscription services – including a digital personal trainer and in-depth personal health analytics – but that effort has yet to yield results.
Less than 1% of sales come from subscription services, with the other 99% driven by device sales. For the time being, Fitbit remains a device manufacturer, and hardware is a tough business typically marked by declining prices and shrinking margins. The wearable fitness market is too young for us to know how the replacement cycle, but we can assume that customers won’t feel compelled to buy a new Fitbit unless it comes with a meaningful improvement in functionality. That puts pressure on Fitbit to innovate rapidly and continuously to generate new sales.
That’s Not All…
The red flags we’ve covered are the most poignant, but even they are not exhaustive. There’s also massive pending dilution as insiders exercise about 50 million options, most of which at $2.13 strike prices against a $20 stock. And there’s the 175 million shares insiders will be allowed to sell starting 181 days after the IPO. And the fact that a single supplier – manufacturing outsourcer Flextronics (Nasdaq:FLEX) – produces nearly all of Fitbit’s devices.
It’s Not All Bad…
Look, Fitbit isn’t a bad company or even a poorly run one.
The business serves customers and society well, and its products generally
receive positive reviews. Management has thus far managed to deftly navigate a tricky market. And unlike many recent tech IPOs, Fitbit is profitable, bringing in $157 million in 2014 operating income at an impressive 21% margin. They’ve managed to secure distribution deals with over 45,000 retail locations and expand overseas, bringing in 25% of last year’s revenue outside the United States.
But this IPO is not structured for investors to win. What the stock will do on its first day is anybody’s guess – those kinds of predictions are gambling, not investing – but over the coming quarters and years, this is not a stock I’d want to own. There are far easier ways to make money in the stock market.
Neither Alex nor Huckleberry own shares of any company mentioned.