Fitbit's Layoffs Don't Go Far Enough

By Timothy Green Markets Fool.com

Image source: Fitbit.

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The worst-case scenario is playing out for fitness wearables company Fitbit (NYSE: FIT). Fitbit reported dismal preliminary results earlier this week, effectively killing the growth story. Sales during the holiday quarter are now expected to fall nearly 20% year over year, well short of the company's previous guidance calling for slight growth. A big net loss during what should have been Fitbit's most profitable quarter ends the company's streak of profitability.

Fitbit is taking a $68 million charge related to tooling equipment and component inventory, a $37 million revenue reduction related to increased rebates and pricing promotions, a $41 million charge related to increased return reserves, and a $17 million charge related to warranty reserves for legacy products. The company will fall well short of its gross margin guidance thanks in part to these items.

That's not even the worst news. Fitbit expects to produce revenue between $1.5 billion and $1.7 billion in 2017, a drop of 26% at the midpoint compared to its expected 2016 revenue, and 14% below revenue from 2015. Fitbit expects to post a loss this year along with negative free cash flow, even after its planned $200 million operating expense reduction.

Part of Fitbit's plan to cut costs is the elimination of 110 jobs, roughly 6% of its workforce. But with the company's headcount severely bloated, this doesn't go nearly far enough.

A sharp reversal

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Fitbit has spent the past couple of years rapidly expanding its headcount in an effort to both keep up with its growth and bring new products to market quickly. The company had just 469 employees at the end of 2014, a number that soared to 1,627 by the end of the third quarter of 2016.

Data source: Fitbit.

Fitbit stated in its most recent quarterly filing in October that "we expect headcount growth to continue for the foreseeable future." With holiday sales coming in far worse than the company predicted, Fitbit is now doing the exact opposite. The company was vastly overconfident, and investors are now dealing with the aftermath.

The 6% cut in the headcount planned for 2017 doesn't go far enough. Based on the most recent headcount number, which would be lower than the current headcount if Fitbit added employees during the fourth quarter, the headcount will drop to about 1,530 when the layoffs are complete. That's still 39% higher than the headcount at the end of 2015, despite expected revenue this year being substantially lower.

Fitbit CEO James Park is convinced that all of this is just a temporary setback. "To address this reduction in growth and what we believe is a temporary slowdown and transition period, we are taking clear steps to reduce operating costs," Park said in the press release announcing the preliminary results.

What's Fitbit's plan to return to growth? "Looking forward, we believeFitbitis in a unique position to stimulate new areas of demand by leveraging the data we collect to deliver a more personalized experience while developing upgraded versions of existing products and launching additional products to expand into new categories."

In other words, exactly the same thing the company attempted to do in 2016. Fitbit launched two brand-new products (Alta and Blaze) last year, as well as upgraded versions of the Charge and the Flex. None of that helped prevent a disastrous holiday season.

With the market for fitness wearables in the U.S. appearing to be saturated, Fitbit can no longer bank on millions of new customers each year. The Charge 2 and Flex 2 needed to drive substantial upgrades from existing users. But reports of high levels of inventory in January, and now confirmation that the holidays were far weaker than expected, suggest that they failed to do so.

Even after the planned layoffs, Fitbit's costs will be based on a much higher level of revenue than the company can deliver. Fitbit needs a big hit this year, something compelling and innovative. Anything short of that will lead to more layoffs down the road.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Fitbit. The Motley Fool has a disclosure policy.