With the holidays rolling in, new gadgets from companies like Microsoft (MSFT 0.45%) and Nintendo are more popular than ever with consumers. In this week's episode of Industry Focus: Tech, analysts Dylan Lewis and Dan Kline explain what products like the Nintendo Switch and the Fitbit (FIT) Ionis really mean for the companies that make them and how they fit into their business strategy.
Find out how the Switch is revitalizing Nintendo, even though the company makes very little (maybe even negative) margin on the console itself, how the Fitbit Ionis is different from the Apple (AAPL -0.60%) Watch, what Fitbit has to do to make it in an increasingly tough smartwatch market, what the new line of Xboxes will mean for Microsoft's bottom line, and more.
A full transcript follows the video.
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This video was recorded on Dec. 1, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, December 1st, and we're talking hot holiday tech gifts. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's jack of all trades, Dan Kline. Dan, what's going on?
Dan Kline: Hey, Dylan! How are you?
Lewis: Doing all right. Now that it's officially December 1st, I think we can start talking holiday stuff. I know that some folks over on the CG show already got into the spirit.
Kline: It's very bizarre having it be December when, as you know, I live in West Palm Beach, so it's 82 degrees, yet somehow, it's almost Christmas.
Lewis: I'll say, even here in Washington D.C., it has been pretty mild. I'm not really feeling the December chill yet, so it's a little tough to get into the spirit of the season. We're going to try today, on the show, talking about some gift ideas. Before we get too far into some of this consumer tech stuff though, Dan, you have a teenage son. What is the hot item for him this year?
Kline: Mostly he's into telling me I'm wrong. He's 13, so that's kind of the age.
Lewis: You can't really package that.
Kline: He wants Star Wars Battlefront 2. He played, I would say, Battlefront was a good three months of endless gameplay, so he's excited about that. And he's getting an Amazon Echo Dot, mostly because I'm tired of him talking to mine. It's going to be a tech heavy Christmas in my house, how about you?
Lewis: I take it that your son doesn't listen to the show, given that you just said what you're going to be giving him for Christmas. [laughs]
Kline: [laughs] I'm not sure my son knows what I do for a living. He did once tell his classmates that I work for The Monthly Fool.
Lewis: [laughs] Well, in some senses that's right, with our stock newsletter service. I have some snowboarding stuff on my wish list, I got into it last season thanks to a friend forcing me to get on the mountain, and I really liked it. So, I'm really looking forward to hopefully getting a couple of accessories for that. Man behind the glass, Austin Morgan, what's on your holiday wish list?
Austin Morgan: First of all, Dan Kline, Battlefield 2, I'm hearing it's a no-go, don't buy.
Morgan: Yeah. It sounds like you have to pay to be good at the game.
Kline: Yeah, that's one of my big complaints about a lot of these games. One of the things I saw in Battlefront 2 is that you can't be Darth Vader if you don't spend extra money. Darth Vader is a pretty core character in Star Wars.
Morgan: It sounds like you have to put in almost 200 hours to unlock Darth Vader -- or, My Heroes. Maybe not Darth Vader, but the heroes. Which is crazy.
Kline: Well, for a 13-year-old on Christmas break, that could happen.
Morgan: That's true, that's very true. My Christmas wish list is slightly different than it usually is. Usually I'm getting a new GoPro or a stabilizer for a GoPro. But, this year, I just went to the Government Expo, and now my wish list is full of video gear that I can't afford. [laughs]
Lewis: So, Austin wants slightly different things than most people.
Morgan: A set of lights, maybe a new tripod so I can work that freelance.
Kline: I'm just glad you went last. You totally could have shamed us with saying how you were donating your holiday to charity or something that makes us look terrible.
Lewis: I'm going to bring this tangent around to what we're talking about today, and actually that Battlefront conversation was kind of a good queue up, because some of the things we're talking about are going to be relevant to the gaming space. One of the really big things on a lot of people's lists, and seeing the circulars being sent around by Best Buy, Target, things like that, is the Nintendo Switch. Dan, do you want to talk a little bit about this product and why so many people are interested in it?
Kline: I bought a Nintendo Switch right when it came out. It involves a lot of waiting in line, a lot of jumping onto websites. Basically, I'll call it a casual gaming console. It builds upon the original Nintendo Wii, and it's very interactive. Some of the games involve movement. I have a game called Arms where you actually move your arms to box, that's the game. It's more family friendly. It's a little bit cheaper for a new console at $299, which we'll talk about a little bit later. But it's really something that's meant to be for more casual game players. My wife might play Mario Kart. She's not going to play Battlefront 2.
Lewis: And it's a little bit more of a hybrid device. It blends the categories between consoles and handheld gaming.
Kline: That's the really cool part. It's actually a tablet. If you want to play on your TV, you can sit it in a little cradle and it comes up on your TV. And if, mid-game, you want to switch and move with it, you just grab it, slide the little controller things into the side, and it becomes a really cool tablet gaming experience, pretty much seamless.
Lewis: You mentioned that price of $299. One of the things we wanted to do with today's show is look at, this is a popular device, what does it actually mean for the company that sells it and their financials. Earlier this year, this tech firm, Fomalhaut Techno Solutions, did a teardown of the Nintendo Switch, and they ballpark that the build costs roughly $257. That leaves them some margin to grab, but not a ton.
Kline: Except most of them are being sold through retailers, and while there's very little retail markup, they have to be making something to cover their handlings. My guess is, Nintendo sells the device at a loss. But, what's very important on the Switch, and this will come up again and again with other consoles, is that when you get the Switch, you really only have what you need for limited gameplay. You pretty much need to buy a second controller, the two controllers that come with it are mini controllers and they slide into something to make a full controller. So, really, you're looking at another $100 worth of accessories. I bought a carrying case, I bought some additional memory. Those items do have margin. And I would say the vast majority of people, even before they buy a game, and it does not come with a game, do have to buy some additional accessories that are probably at somewhere between 30-50% margin, given retail traditions.
Lewis: And looking at what that mean specifically for Nintendo, you go back over the past six months, the Switch segment produced 65% of the company's revenue and led Nintendo to produce 165% year over year growth for the first six months of 2017. That's incredible!
Kline: And what's more important about it is, it's great to sell all these consoles, but if they're selling them and people are just setting them aside, which I think is going to be the case with some other one-off technology, but they're really building a user base. And this is going to be a viable platform for 10 years, maybe even 15 years. It's very adaptable, you can have new software, and because it's not meant to be cutting edge in terms of graphic capability, it's not that important if it feels a bit dated. You can still buy Wii games at GameStop, it's really just ending its life cycle. So, this kind of revitalized Nintendo's business in terms of a platform to sell software off of.
Lewis: Granted, I cited that very gaudy growth rate, they were coming off of a period where they had really disappointing sales of previous devices. So, in some ways, they were going up against some really easy comps. But, something that was pretty encouraging for me in looking at Nintendo's results is, they also post units as one of their main measurements, so they give you the idea of how many units of the Switch they're selling, but they also talk about the number of software titles they're selling per device, and it works out to about five games for every Switch they've sold. So, that's a testament to how much people enjoy using the device and are buying things to use on it.
Kline: And they've made it really easy. Obviously, there's an online marketplace for every game console. But in addition to being able to buy the top-tier $60 Switch titles, there's also a library of older Nintendo titles. If you want to buy Street Fighter from, I'm going to guess the year, 1994, maybe it's $6.99 and you can get two or three days of play out of that. So, while they haven't turned on all the social features that could eventually be enabled in the game, they kind of made it so that you can make your major purchases when you're excited about, my son really wanted Splatoon, that came out and it was worth $60, but if it's a rainy day and we're just looking for something to play, there's much lower price games that you could download at home relatively easily.
Lewis: And one more point on their financials where I think that has borne out, you look over at what they were doing in the first half of 2016, they posted operating losses of around $50 million. And there's some adjustments there because they report in a different currency. Fast forward to the first six months of 2017, they posted operating income of $350 million. A lot of that is on the back of these software sales because they're higher margin.
Kline: It's been an absolute game-changer for them. Nintendo was at the point that, while they had some of the handheld market, they were teasing, if this didn't work, they would have to just license their content, their intellectual property, to other platforms. And there's certainly a market for Super Mario and Zelda and all their other top-tier content. But the second you start doing, you become one step removed from the sale, so there's margin to be paid out elsewhere. This really insulates their business and protects their IP for a long time to come.
Lewis: All of this is to say, if you see Nintendo Switches flying off the shelves, and you see a lot of reports about really strong Nintendo Switch sales, that's going to bode very well for Nintendo's stock, right?
Kline: Absolutely. This is really strong news for Nintendo's stock and really for the company. Look at everything they're trying to do -- licensing to Universal for theme park rides -- it's all built off this infrastructure of games. And this gives new life. Right now, they're riding Super Mario Odyssey, and I don't know what number Mario title that is, but the X entry in that game, and that's just things they can build off of without having to rely on Apple or Microsoft or whoever else it might be who would distribute it for them.
Lewis: Speaking of Microsoft, Dan, why don't we talk about the Xbox One S and X products?
Kline: Absolutely. I have an Xbox One. The original One. And I have to say, with a 13-year-old who plays a ton of games, with me being a casual game player, I have seen no limitations with this aside from the fact that, sometimes due to the storage capacity, I have to go back and delete things I haven't used in six months. But when you look at the two new players, they're going after really different tiers. The X, and I'm going to say it X like the letter because their X and S sound a lot alike, is $499, and it has 4K, it has all the top-tier processors, it has a terabyte of storage, it's going after top, high-end gamers. People to whom the performance matters for. The S is $189, and I think it's possible at holiday time you might even be able to get a game bundle with that, and that's going after the rest of the market. So, for Microsoft, it's a very smart strategy where they have a niche, high-end product that can really appeal to a certain segment, and then they're lowering the price well below the Nintendo Switch, to give you an example of a very mainstream player that's good enough for nearly everybody else.
Lewis: You mentioned before that the nature of console gaming, it's very hard to make money on the consoles themselves, kind of a razor and blade strategy. We got some confirmation on that. The Xbox team lead, Phil Spencer, did an interview with Business Insider earlier this year. They asked him, at a $500 price point, is Microsoft making any money on the Xbox One X? And he flat-out said no, just because of all the things that need to go into a device like that to power it and give it that incredible graphics processing power. He went on to say the console business is not the money-making part of the business, the money-making part is in selling games.
Kline: Yeah. It's about controlling the living room. Of course, there's the software. There's a lot of margin in a $60 game. There's a lot of margin in Xbox Live subscriptions, which are pretty much required if you want to do the social end of most of these games, which make them a lot more fun but also add hours and hours of gameplay. We keep talking about Star Wars Battlefront, but if you have an Xbox Live subscription, you can talk to other people, you can play multiplayer campaigns, there's just way more than the single player missions when it comes to it. Then, there's also the incremental revenue. They don't break out where any of this comes from, but if you subscribe to Netflix through your Xbox One, Microsoft gets a cut of that. And that goes for the thousands of apps and television shows and renting a movie. So, it's really about having a central place in your living room where they can have a store. And whether that's for software or subscriptions or movies, that's where the revenue comes from.
Lewis: Taking a step back and looking at how this all fits into Microsoft's business itself, for the past 12 months, they have this gaming revenue segment within their personal computing segment, and the gaming revenue has produced $9 billion overall. And in that time, Microsoft has booked over $92 billion in revenue. That is to say, the gaming revenue segment is nice, but it is not what is driving results for Microsoft.
Kline: Except, I think there is an important public relations factor there. My 13-year-old son knows who Microsoft is because of that. And when he comes old enough that he might be making a decision on cloud hosting or a word processor or even a laptop, it's giving him some exposure to Microsoft, and that has to be a good thing.
Lewis: Absolutely, and I think they have this incredibly loyal, die hard bass of gamers that love the Xbox console and have been using it, in some cases, over a decade at this point. So, you want to keep those people happy. It's just to say, if you see really great Xbox sales over the holiday as well, it's not going to have the same effect on Microsoft the company the way that it does with Nintendo and the Switch.
Kline: No. It's almost a branding play for them. You can look and say that it's 10% of revenue, but obviously a lot of that is console sales, which is not profitable. So, for Microsoft, this is really about all the ancillary benefits of driving their brand as much as it is the incremental revenue.
Lewis: And just to understand some of the dynamics within that, it's worth mentioning that last quarter, the growth within the segments was 1% year over year, and 21% growth in the software and services offset declines in hardware. So, that segment is moving more and more toward software sales, but the overall gaming segment itself is not really growing all that much for Microsoft.
Kline: It's a 10-year cycle, basically, for a new console. Obviously, in the first few years of that cycle, it's simply people buying the console and transitioning from the previous one. Now that the installed user base for Microsoft is more solid, the people who, when it first came out had to spend $400 for the base model, I believe it was actually more because you had to buy the Kinect with it when it first came out, now those people are spending more of their budget, more of their holiday gifts as we come into Q4, it's going to go into software and other things like streaming subscriptions.
Lewis: Yeah. Dan, we can step away from the gaming space and talk about another very hot product and one that is on a lot of people's wish lists this holiday season, the Fitbit Ionic.
Kline: Absolutely. This is a company that's almost the opposite of the previous two we talked about. Fitbit is a device company. Maybe eventually they'll be a software and services company. There's an angle to that. But, their revenue comes largely from selling everything from low-end fitness devices that track your steps, track your heartbeat, but don't do much beyond that, and in the recent quarter, the company has segued into more of the high-end smartwatch market. Still a fitness-based product, not as broad as the Apple Watch, and not trying to be. Trying to be very strictly about fitness and healthy lifestyle. But, this is absolutely a device company.
Lewis: Yeah. This new product, the Ionic, is their second foray into the smartwatch-ish market, the first one being the Blaze. This new device retails for $300. It has a battery life that should last several days, which I think is a major point of differentiation when you look at some of the other smartwatch competitors out there, namely the Apple Watch.
Kline: The Apple watch battery is a pretty major negative. It's actually the reason I'm not wearing my Apple Watch right now, because you have to charge it every day. And that's drawn me a little bit toward maybe putting a Fitbit -- maybe not even a smartwatch, maybe the mid-level device which has some watch functionality, or, at least, it tells you the time, it has GPS, and it gives you all those fitness-based functions. Because I do track my steps every day. I try to get to 10,000 steps, as you can tell by the phenomenal condition I'm clearly in. Joking a little bit there. I do see some pretty strong upside on the device side. And then -- I think they sold about 3.6 million devices last quarter -- once they have that ingrained people using it, their core community, maybe then they can find some other ways to make a service and software revenue.
Lewis: You mentioned the midrange of their product offering, and that's really where they've seen most of the success. Their best-selling device is the Charge 2, and that's really more of a traditional wearable. It's a fitness tracker, it tracks your steps, and it operates as a traditional watch as well, that remains the company's best-selling device. Like I mentioned, this is their second chance into the smartwatch market. And you look at the dynamics and you look at the business and the way it's currently set up, I think they really need for this to work to build out and get beyond this cycle if needing to continue to put out really great hardware products.
Kline: I worry about the price. They're selling this smartwatch at $299, which is lower than the high-end, the new Apple Watch 3, but not lower, with Apple's trailing strategy of keeping older models available to get that lower-end market. I would have been happier to see all of these prices come down a little bit. I think the key draw on the Fitbit Blaze and the Fitbit Charge is that they're a little bit cheaper. Then, when you go into the new watch, the Ionic, it's not that different, and do I really want something that's kind of good, but the Apple Watch does all this other stuff, I can play Pokémon Go and do all sorts of other things on my Apple Watch that I can't do on the Fitbit product?
Lewis: Yeah. And the reason they're pushing into the smartwatch market, there's a couple. The first one, it seems like there's much more money to be made in that segment, margin-wise. You look down at the low end of the fitness trackers, and when you have companies like Xiaomi selling, was it $15 or $20 rubber band fitness trackers, there's not really much pricing power there. There's not a whole lot you can do to move the market.
Kline: There's also no secondary revenue. If you're selling a full-on smartwatch, even though they're looking at keeping their apps very specific to fitness, one of the things they talked about on their earnings call was their efforts into glucose tracking. So, they can go into very specific segments of health. And maybe you'll pay $1.99 a month to track certain things. Maybe if you have a health condition, you'll pay even more than that to get really precise data that can help you with what medicine you take, how your doctor is looking at your information. With a fitness tracker, you have to then connect it to a computer, and you're divorcing it from the company. So, the ability for there to be a marketplace for Fitbit on a watch, where either they create apps, or third parties create apps and they take a little piece of it, that's their revenue future, and why they need a watch to take off.
Lewis: Yeah, that gets them away from being almost entirely dependent on hardware sales, and it also makes their devices a lot more compelling to the people that are using them. If you have this very robust app library, there's a better chance that the products are going to be sticky and that's going to be a part of someone's everyday life.
Kline: Absolutely. We've talked about it with phones before. I know you personally just made a decision to move providers and stick with your old phone for a while longer. The same could be true of fitness devices. It's very hard to make a giant leap forward. I have an Apple Watch, and I can't say it's that much better than my Fitbit from two years ago in terms of its ability to track my fitness. So, I'm probably not going to buy a new Fitbit or Apple Watch every 18 months, or even every three years. So, if you don't develop the secondary revenue sources, then, A, you're not going to make money, and B, this is going to become a device, like so many others in my house that I wear for three months, I put it away, and I never think about it again. So, that's really what Fitbit is fighting, and why they need a watch and a marketplace, is to give you exciting reasons, new stuff it can do to keep the product relevant.
Lewis: Yeah. And the final word with Fitbit here is, the Ionic is not where the company is making most of its money right now. That's with the Charge 2 line, like I mentioned. But long-term, this is the segment that you want to see them be successful with, because it will really bode well for a lot of their software and platform ambitions down the road.
Kline: The Ionic also came out late in the quarter, so Q4 is really the test for it.
Lewis: That's a great point, I kind of forgot about the timing there. Dan, this was a fun show to do. I think we subtly made this point, but I really want to emphasize it -- the exercise we just went through with these companies is a really important one for investors to go through. You can hear about how a product is selling very well, or how a company has exposure to this really big macro trend, and then immediately get carried away creating this growth story for them. But you always need to go back and put within the context of the larger business to see how much it can move the needle for them.
Kline: Absolutely. If you look at the difference between Fitbit, which is entirely driven by device sales, it's some 90% of their revenue, and then you compare it to Microsoft, where if Xbox went away tomorrow it would be two lines in a press conference in terms of its relevance to its overall health as a company. You don't want to get carried away by the sales trends. Xbox and Fitbit, these are forward facing products. They're a lot sexier than cloud computing services. But cloud computing services have very low cost and very high margin. So, when you're looking at Microsoft, that's probably where you need to look, or subscription revenue from Office and things like that. Fitbit, clearly, they need to sell a lot of Fitbits to stay important.
Lewis: Dan, before we wrap up the show, I realize, when we were talking earlier, I never asked you what you wanted for the holidays.
Kline: [laughs] I buy all my own holiday gifts based on the past history of getting gifts and, I guess, yes, my wife probably won't be listening either. I bought myself, as you know, the Star Wars Jedi lightsaber from Lenovo, which I did for a story.
Lewis: That was pretty cool
Kline: I also bought not a One Pot, the one they're selling everywhere, but I bought an eight-in-one cooking device that slow cooks and pressure cooks and it makes risotto and I'm pretty sure it could do my taxes. There will probably be a few other tech gadgets. Is there anything tech coming up in your world for the holidays?
Lewis: I think I'm holding off for now, because I'm anchored to the phone that I currently have as part of the agreement when I switched carriers, so I need to hang out with it for a little while. Otherwise, I probably would have tried to take advantage of some iPhone 10 deals. But, unfortunately, no.
Kline: I bought a 10, but of course, I justified it by the fact that sometimes I do this, and if I didn't have a 10 how could I possibly talk about it on the air?
Lewis: That's the beauty of the work we do, Dan. We get to talk about fun gadget stuff, and we get to justify buying it based on that. [laughs]
Kline: Ohh, if you could only see my house.
Lewis: [laughs] Great. Dan, anything else before I let you go?
Kline: Have a happy holidays! Austin, you too!
Lewis: Yeah. Hopefully we'll talk again before that. But if we don't, happy holidays!
Kline: [laughs] I'll actually see you next week.
Lewis: [laughs] Listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say hey, you can shoot us an email at [email protected], or tweet us @MFIndustryFocus. Specifically related to this show, I would love to know what consumer tech devices are on your holiday wish list, or which ones you're seeing a lot of people buying. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over 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. Shout out to Austin Morgan for all his work behind the glass. For Dan Kline, I'm Dylan Lewis. Thanks for listening and Fool on!