Alarming Trends for Wearables

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Wearables were an exciting new frontier a few years ago, but as time goes on, enthusiasm is dying out and pure-play companies like Fitbit (NYSE: FIT) are struggling.

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In this episode of Industry Focus: Tech, host Dylan Lewis and senior tech specialist Evan Niu look at some industrywide trends with data from Strategy Analytics to see where the wearables industry is heading as of this most recent quarter. Find out what some of the biggest headwinds facing Fitbit are today and how companies like Apple (NASDAQ: AAPL) are facing them with much less risk, where the wearable industry might go in the next five to 10 years, how Fitbit might possibly recover from here, and more.

A full transcript follows the video.

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This video was recorded on Aug. 18, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, August 18, and we're going to do a little rundown on the wearables space. I'm your host, Dylan Lewis, and joining me on the phone to talk tech is fool.com senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: Not too much.

Lewis: A little bit of a hiccup today. We were planning on Skyping you in as we normally do, but ran into some issues because we lost some power at Fool HQ yesterday, and having some troubles with our computer. I hope the quality comes through OK. A little wrinkle in having you on the phone, but happy to have you here.

Niu: Happy to be here.

Lewis: Evan, we're talking wearables. You're an Apple Watch owner, right?

Niu: I am. I have one of the first-generation ones, and it's pretty underwhelming. [laughs] 

Lewis: [laughs] What do you find that you actually wind up using it for? I'm not someone who has a wearable device, because I just haven't really seen the use case for it.

Niu: I use it to tell the time. [laughs] That's probably the No. 1 thing. Having a little bit of extra information available is kind of useful, like the weather, or all the other little things that you can have displayed on the watch face. But it's definitely not critical. It's not something I'm like, "Oh, wow, I need that now."

Lewis: You have some cool tie ins with what you can do with your car, right, because you are a Tesla owner?

Niu: Right. There's a third-party app that I can use to control my car, which is a Tesla, which is kind of cool. So, I can actually use my Watch to unlock my car, to start keyless driving. But, again, it's kind of cool, it's a novelty, but most of the time I just have the key in my pocket, so it's like, what's the point? There's all these fringe use cases. And for me, I'm not super active with fitness type stuff. Of course, I would like to be more active. Everybody wants to be healthier. But ultimately, like most people, I'm not as active as I ideally would like to be. Of course, that's a big push for wearables, it's the most obvious use case right now. But I don't think that's been enough to spur mainstream adoption. I'm sure we'll get more into that later.

Lewis: Yeah, I'm certainly part of that demographic of people who are fairly active and don't see the need for it. Man behind the glass subbing in for Austin Morgan today, Dan Boyd, is also someone who's pretty active, but you don't have a smartwatch either, or a fitness tracker?

Dan Boyd: I do not, no.

Lewis: And is that because you just don't see the use for it?

Boyd: That and, I don't wear a watch or any jewelry or any stuff like that. When I go to the gym, I record everything in a binder with paper and pen, because while I'm maybe not that old, I act the part.

Lewis: I like the idea of you looking kind of studious with a trapper keeper and a pen.

Boyd: Yeah, my Lisa Frank binder with pink unicorns on it.

Lewis: [laughs] The technicolor unicorns, yes. That's a deep pull. Nice job with the Lisa Frank reference.

Boyd: Thank you very much.

Lewis: That's going to be lost on a lot of listeners, but anyone who grew up in the late eighties and nineties probably gets that one.

Boyd: I hope so.

Lewis: I think, Dan, you and I are part of the problem for the wearables market. A lot of people who are active are not really engaging all that much with these devices. To give you an idea of what's going on in that space, we're going to talk a little bit about some data from Strategy Analytics. They had some recent updates on what happened in Q2 in the wearable shipments space. Looks like shipments came in around 21.6 million units, that's up from 20 million units a year ago. That's 8% growth. But that's really not all that big, considering the market isn't really all that old, huh, Evan?

Niu: Yeah. This is a market that's only been around for maybe two to three years. To see it hitting the speed bump that we've been seeing over the past year is a little disconcerting. It definitely doesn't encourage investors in the space or companies that are trying to offer these products. If you look at, on the Android side, Android Wear came up before Apple Watch. Of course, naturally, those devices are made by third-party manufacturers, and a lot of them are jumping ship and bailing, or just aren't updating the products because they're not really selling well. It's a pretty stark contrast compared to the smartphone world, where Android is by far the most dominant platform. The OEMs are not really putting a lot of effort into this space.

Lewis: Yeah. I will say, I think the quarterly results can be a little lumpy looking at this space in particular, just because when you have various product launches, that's going to skew the results. I think, looking on a yearly basis can be more helpful, and we'll do that once 2017 data is available. I think last year, depending on what data source you look at, shipments were up about 20%. Again, not crazy growth given how young this market is. I think one of the most helpful ways to look at this, though, and the reason I find these data releases so interesting is, it gives us a rundown of the big players in the space, and who's eating up market share and who's getting a bigger pie of the wearables space. We also have a rundown here of the top players. No. 1 is a name that maybe some people don't know, the Chinese manufacturer Xiaomi. According to Strategy Analytics, they clocked in at 17% of unit shipments for Q2, followed by Fitbit at just under 16% and Apple at 13%. They lump everything else in the category into Other, which winds up being about 55% of the market. I think some people, some Fools in particular, who have been following Fitbit for some time, are a little concerned to see them fall to the No. 2 spot.

Niu: Yeah, Fitbit has been having a really tough time. They've long really banked entirely on the U.S. market, and has pretty much always been historically fitness trackers. They don't have a smartwatch yet, they're planning to do one later this year. Their guidance suggests it's not going to be released until Q4. For example, Fitbit, U.S. revenue fell by 55% last quarter in the U.S. That's a huge drop, and that's their biggest market, so that's why their total revenue was down something like 40%. They're still very heavily concentrated in the U.S. market, and I think in the U.S., at least, we're seeing people shift away from single-purpose fitness trackers. The people who are open to having some type of wearable device are more likely to get a multi-purpose device like a smartwatch, whereas the interesting dynamic here that we're seeing from Xiaomi is, in China, they're doing quite well, and they're also only doing fitness trackers. But obviously, China is a huge market, so much bigger in absolute terms. The numbers that we're talking about here, a few million units, that's just a drop in the bucket in the grand scheme of the Chinese market. So, Xiaomi is definitely making progress, heading in the right direction, whereas Fitbit is not. It's an interesting dynamic, because they're both basically just doing fitness trackers, but in essentially different markets.

Lewis: And those numbers from Xiaomi are a little loaded, because they do bundle those fitness trackers with some smartphone sales. So, those are not necessarily units that are shipped where people explicitly buy just fitness trackers, the way someone would buy a Charge HR from Fitbit or an Apple Watch or something like that. So, some of those are bundled sales. But I think your point remains. If you want to look at something that's kind of troubling on Fitbit's side, Q2 2016, they had roughly 29% of the market according to Strategy Analytics. That was 5.7 million units. You look now at this most recent Q2, 3.4 million units, there's --

Niu: Down 40%. That's down 40% year over year. That's pretty big.

Lewis: Yeah. The issue with them, you can lose market share because the pie gets bigger and you maintain your hold of it, whatever your absolute number is. But the problem is, they lost market share because the pie got bigger and they wound up selling less units. Both numbers there were working against them. I think that a lot of people are really hoping with this company, people who have been bulls for quite some time, that what we see later this year with their smartwatch release might help turn the tides.

Niu: I think a big part of it is what I touched on earlier, the whole engagement piece. Everyone wants to be more fit and healthier. Just like every New Year's, gym memberships spike, and then they kind of drop off in February. Everyone wants to, but ultimately isn't really as committed to it as they would like to be. And you can see this play in their numbers. Fitbit, they only disclose their user base numbers once a year in their 10-Ks, so this isn't something they disclose quarterly, which would be helpful, because then you could see more granular trends. For example, at the end of 2016, they had 50 million registered users, but only 23 million of those were active. So, less than half of their user base is active. The data supports the notion that a lot of people buy these things, use them maybe for a month or two, and then kind of abandon them and they end up collecting dust in their drawer, which obviously doesn't help your business if your business is built on hardware sales. Ideally, you want to get recurring sales and upgrades and things like that, and no one upgrades devices they don't use, obviously.

Lewis: Especially as they're trying to become more of a platform company. They're trying to do more than just hardware, they're trying to get more involved in the software side, because businesses can become much more scalable and much more high-margin that way. But if you have trouble maintaining an active user base, those efforts are largely going to flounder.

Niu: Right. They bought Fitstar a few years back, which has the subscription-based fitness courses and online stuff. They've been trying to grow that, and it's still basically immaterial in terms of revenue and all. It's like a rounding error still. So, yeah, they're definitely trying to grow their subscription-based services, but really having a hard time there. On the other side of it is, on the smartwatch that's coming out, they do want to turn that into more an app platform. They're not really calling it an App Store quite yet, but they did buy Pebble specifically to be able to support third-party applications with this new product that's coming out. I think, the understanding is that right now, there will be a handful of third-party apps available at launch. They're calling it a gallery, not a store. But whatever you want to call it, it's just going to be a handful of third-party apps, and presumably they'll expand from there. You can also expect that maybe there will be some payment type features since they bought Coin for their NFC payment technology, which would just compete with Apple since Apple already has NFC payments on its Watch. So, they definitely want to move upmarket into that full-feature smartwatch territory. But that's going to be a pretty tall order to fill, considering who they're up against.

Lewis: And they've been billing this upcoming product release, this smartwatch release, as something that consumers haven't seen before. And frankly, I'm a little bit skeptical that they can deliver something like that when you consider who they're competing against.

Niu: Yeah. They're like, "No one's ever seen this stuff in a smartwatch." And it's like, actually, this is what everyone is doing. [laughs] They're like, "No one's done fitness first." It's like, actually, that's exactly what companies do. It is a little weird. They do have a lot riding on this thing, because I think investors are very wary, they're very cognizant of the shifting landscape that people are transitioning to. Not only is overall wearable adoption still pretty low, but the people who are willing to adopt it are shifting toward smartwatches. It's going to be a tough battle for them. I don't have a lot of confidence. And plus, if you do actually look at the leaked renderings of this smartwatch that's coming out, it does not look good. [laughs] Purely aesthetics, I know it's a personal preference, but in my opinion, it does not look good.

Lewis: If it's something that they're able to pull off, though, that would give them entrance into what I think is roughly a $10 billion smartwatch category. So I can understand why there's a lot of enthusiasm behind it. But I do worry about them being able to outclass Apple in this space, in the design and consumer perception side of things. And then, I worry about them being able to build out what is really seen as a valuable whatever you call it, app inventory or developer based offering for users. Because, you think about the installed base that Apple has, and the cross compatibility with their Watch offering and some of the stuff with the iPhone or some of their other devices, that's a lot more compelling if you're a developer and you have limited resources than going over to more of a niche ecosystem with Fitbit.

Niu: Exactly. I think it's really, at this point, going to boil down to execution. Fitbit is in kind of a tough spot. They don't really have much of a choice. They got big on these fitness trackers, and as soon as the market started to shift, they don't really have much of a choice but to kind of try to shift with it. But their ability to do so, they're a small company. They don't have a ton of resources. And they're going up against Xiaomi and Apple, more Apple probably, because Apple is in the U.S. How do you compete with a company that's, in a single quarter, Apple's net income is six times the size of Fitbit's entire market cap. It's just hard to keep up. And they have such a wide developer base. So yeah, I think it's going to come down to execution. I don't think they have much of a choice but to make this move. So, I understand where they're coming from, but I also don't think they have a very good shot at it.

Lewis: To turn things to Apple for a second, you look at where they stand in market share for wearables as of the most recent quarter. They're in third place, and that's my shipment volumes. But if you think about this market by dollar value, without question they are the No. 1 player because they have the premium pricing. And I think that's what makes this market so appealing to Fitbit.

Niu: Right, that's absolutely true, too. Right now, Fitbit's average selling prices are right around $100. I believe Apple Watch ASPs are probably in the neighborhood of $500. It's anyone's guess, because they don't disclose any real numbers for these things. They did say that sales were up 50% last quarter, and if you look at the Strategy Analytics numbers that we were talking about a minute ago, they estimated units at 2.8 million, which would be up 55%, which goes in line with Apple's vague commentary. Even Apple is having trouble getting the mainstream consumer to adopt it. And Apple has been focusing very heavily on fitness. So, if even Apple is kind of having a hard time catalyzing adoption, why would Fitbit do a better job?

Lewis: No, I think that's a great point. You think about the amount of resources that they have available, and it's just kind of baffling. Earlier, I touched on the idea that there's some lumpiness with unit shipments because of the release calendar for the products. Fitbit has something likely coming out at the end of Q3, Q4. Apple will also probably have something coming out later this year, right?

Niu: Right. All the rumors suggest that Apple Watch Series 3, which is presumably what it will be called, will probably have more or less the same form factor that they've been using. Maybe it's slightly modified. I know that battery life is a big concern. If you want to put a bigger battery in, that makes the device a little bigger. They might add LTE connectivity, which is kind of questionable, because that's not the killer thing that people have been clamoring for, like, "Oh, if only my Watch had cell connection!" Then, there's a question of, you have to pay for another data plan, piggyback on your existing plan? No one is going to want to pay another $10 a month on top for a cell data plan on the Watch that they don't really use that often. It's really hard to justify. It's hard to see that being a feature that really does it. In my opinion, I don't think smartwatches as a category have a killer mainstream appeal. I don't consider the fitness stuff enough for the mainstream. Again, everyone wants to, but ultimately people aren't as committed to it. I think that whole industry is still trying to find, what is the one use case that's going to unlock mainstream adoption? I don't think it's fitness, I don't think it's having LTE connection. I don't know what it is, obviously, and I'm not nearly as clever as Apple with trying to think about this stuff. But I think that's the open problem that the entire wearables market is running into right now. 

Lewis: We were joking about this in the beginning of the show, but even just talking you, me, and Dan, and that's the reality, you are the only one of the three of us who owns one, and you don't really see a huge value prop there. I will put it to our Industry Focus listeners -- I would love to hear about your experience using wearable devices, especially if you have something that we haven't hit on that you regularly use it for. If you are someone who is a hardcore fitness person and finds a huge use case for them, shoot us a note at industryfocus@fool.com. I would love to get some of your perspectives on that. Evan, circling back quickly to what we were talking about with the Apple Watch, I see another challenge here in looking at the calendar, because Fitbit is building up this great smartwatch offering, but if that coincides with when the update to the Apple watch is coming, I think consumers are going to have a tough choice, and it's not a no-brainer to go with whatever Fitbit offers.

Niu: Yeah. There's also a perception problem. When you buy modern tech gadgets, you have high expectations in terms of ongoing support, ongoing content updates, new apps, all this stuff that these bigger platforms have over time. That's a much longer-term game. Fitbit is starting, they're going to jump in, but how well are they going to be able to, like we touched on before, attract developers to the platform, which is a much smaller installed base compared to Apple? How well are they going to be able to push ongoing updates and new features? This isn't just about getting it out there. It's about getting it out there and staying competitive over time and sustaining that position. That's arguably much harder over time than just getting it out there in the first place. And we know that Apple can obviously do that. Apple Watch is a pretty small business for them, so they have that luxury. They're not a pure play. Obviously, iPhone is the big thing, and Apple Watch is a footnote, where is Fitbit is all about wearables. So, if the whole category is suffering, it's going to hurt Fitbit a lot more than it's going to hurt Apple.

Lewis: Yeah. And it may not come as a surprise to listeners to hear that I am not the biggest Fitbit bull. I personally don't really love the idea of owning a pure-play consumer tech wearables company. Consumer tech hardware in general is a very tough business to be in. You see that with GoPro, too. Apple, for them, this is a segment that produces some money, but it's almost inconsequential when you look at their larger business. I think, Evan, you're kind of the same way with Fitbit, right?

Niu: Right. The only thing I'll say about Fitbit is that, I think, specifically just as far as the stock goes, they've gotten so cheap. If they could pull off this smartwatch launch and keep maintaining relevance in that way, I think there is some possible upside, just because the shares are so cheap. They're down to $5. It's really cheap right now. I'm not super optimistic about the smartwatch, but I think there's a lot of pessimism and the expectations are pretty low, the expectations being priced in right now are pretty low. So, I think there is a chance that they could really come out and be able to turn around based on the smartwatch, in which case there could be upside just by virtue of how cheap the stock has become. I mean, purely (unclear 20:50), I don't think they have a great shot. But when things are so pessimistic out there, you can sometimes find opportunities.

Lewis: And that's what'll happen when you have basically three straight quarters of sales declines, the market is going to turn. But I think they're currently trading at just under 1X sales.

Niu: Yeah, they're 0.7X sales. [laughs] That's so cheap, right? And that's the thing. When it's so cheap, it doesn't take a whole lot to get a nice bump out of it if the stock is bottoming out. The next two to three quarters are going to be pretty pivotal, I think, in the Fitbit story.

Lewis: Yeah. Frankly, even with that cheap argument that we just had, I think long-term, I don't love what's going on with the industry. Unless developers and people on the hardware side are able to break out of this more niche category so that more people in the mainstream are interested. I still don't love the five or 10-year prospects for a company like Fitbit. Even if, short-term, there's something that might meaningfully boost sales and the share price to follow, I think this category is not going to be a huge growth one, just thinking about things over the course of a decade.

Niu: I definitely think that's true, especially if you compare it to the expectations of what we all had three to four years ago. There was all this hype around, "Wearables are going to be the next big thing, Apple is jumping in, they're going to get everyone to use this with their Watch," and it just hasn't played out to those initially lofty expectations. I think there's probably some recalibration in terms of what people were expecting from this market, and I think that's a good thing, it's healthy, probably, ultimately.

Lewis: Yeah. I think that covers it for wearables. Once we get the full year data, like I said, it's easier to get an at a glance and control for any of the product release side issues that come with quarter-to-quarter looks. We will definitely do an update then. Anything else before I let you go today, Evan?

Niu: No, I think we're good. 

Lewis: All right. Listeners, that does it for this episode of Industry Focus. If you have any questions for me or Evan, just shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for subbing in behind the glass today. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Dylan Lewis owns shares of Apple and Tesla. Evan Niu, CFA owns shares of Apple and Tesla. The Motley Fool owns shares of and recommends Apple, Fitbit, GoPro, and Tesla. The Motley Fool has the following options: short January 2019 $12 calls on GoPro and long January 2019 $12 puts on GoPro. The Motley Fool has a disclosure policy.