What Fitbit's Management Doesn't Want Shareholders to Focus On

By Markets Fool.com

Image source: Fitbit.

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Fitbit (NYSE: FIT) is the world's leading tech wearables company, but it faces several challenges that could knock it from the number one spot. Concerns over competition and profitability have caused the company's stock price to decline over 50% in the past year from its 52-week high of $45.25. Let's take a closer look at what investors are concerned about and three things threatening Fitbit's future.

Increased competition

When Fitbit launched in 2007, it grew rapidly thanks to very little competition, but over the past several years established companies such as Apple (NASDAQ: AAPL), Xiaomi, and others launched products that have eroded Fitbit's market share. According to IDC, a global provider of market intelligence, Fitbit's wearables market share decreased from 32.6% in 2015 to 24.5% in the first quarter of 2016. Fitbit remained the top vendor in the category, but Xiaomi, with its 19% market share, and Apple, with 7.5%, aren't far behind. Recently launched products from both brands could continue to challenge Fitbit's future.

Apple's Watch Sport, which is priced at $299 and geared toward athletic users with its anodized aluminum case, could lure cost sensitive customers away from Fitbit.Apple also has the technology and resources to easily launch a lower-priced band device that would directly compete with Fitbit. Xiaomi, the world's 5th largest smartphone maker, launched the Mi Band 2 in June 2016. Although it's only sold in China, it can be easily bought from resellers on Amazon for around $50. Even though it's less than half the price of the Fitbit Alta, it provides similar features including an OLED display, iPhone and Android compatibility, activity tracking and heart rate monitoring.


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Increased litigation

Like most successful tech companies, Fitbit has faced its share of lawsuits over the past several years. It's currently the defendant in three separate suits with Jawbone, Valencell, and a class action suit filed earlier in 2016. Jawbone allegesthat Fitbit stole trade secrets when it hired former Jawbone employees and infringed on several of its patents. Jawbone hasaccused its former employees of stealing at least 335,191 files, which included schematics, manufacturing data, and product launch schedules, when Fitbit first hired them. Jawbone also claimsFitbit used the technology contained in some of the files in its recently launched Alta device. The judge hasn't issued rulings yet, but a judgment against Fitbit could be a major blow to the company.

The Jawbone lawsuit is the most significant to Fitbit, but the suit with Valencell and the class action filed on behalf of customers who purchased the Surge and Charge HR could cause also issues. Valencell, a company that makes biometric sensor technology used in heart-rate monitoring, allegesthat Fitbit and Apple copied its patented PerformTek sensor technology in the Apple Watch and Fitbit's Charge HR and Surge.

The class action lawsuit allegesthat Fitbit's heart-rate monitoring technology isn't as accurate as the company claimed. Funded by the plaintiff's legal team, a California State Polytechnic University study found an average difference of 20 beats per minute between Fitbit's devices and the results of an electrocardiogram. Judges haven't ruled on either of these cases yet.

Like most companies caught up in legal battles, Fitbit hasadamantly rejected the claims in all three lawsuits and plans to defend itself in court. Once judges have issued rulings in the cases, investors should have a better idea of the impact the lawsuits will have on Fitbit's future. Regardless of rulings, legal costs related to the lawsuits negatively affected Fitbit's bottom line in the second quarter. Fitbit had set aside $9.5 million to be used for legal costs last quarter, and expects additional legal costs in upcoming quarters.

Increased warranty reserves

The added legal costs from ongoing litigation aren't the only thing crushing Fitbit's bottom line. In the second quarter of 2016, Fitbit increased its warranty reservesfrom $50 million to $77 million, which caused gross margins to decrease from 47.2% to 42%. The warranty reserves line item is money the company sets aside to cover the estimated costs of repairing and replacing products under warranty. It doesn't include customer service-related costs, which added another $10 million in expenses in the second quarter. According to management, the increased reserves resulted primarily from legacy products and shouldn't need to be increased much in the next several quarters. But I'm concerned that as unit sales continue to increase, this won't be an isolated event and warranty-related costs could lead to decreased gross margins in the future.

As concerns go, rising competition is the biggest threat to Fitbit's core business, but investors should be aware of the potential for legal costs and warranty reserves to eat into the company's profitability.

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Ben Estep owns shares of Fitbit. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Fitbit. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.