Fitbit (FIT) has been most successful at selling pure fitness trackers. That's a challenging business because lower-end devices offer step tracking and other functionality, which puts pricing pressure on the company.

Now, with Fitbit pushing into the smartwatch market, the company is bumping up against Apple (AAPL -0.60%), but it's expanding its revenue possibilities. On this episode of Industry Focus: Tech, Dylan Lewis is joined by Motley Fool contributing writer Daniel Kline to break down how Fitbit makes most of its money and how that may change in the future. They also examine its prospects outside of selling hardware and why its smartwatch is such an important part of that strategy.

A full transcript follows the video.

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This video was recorded on Dec. 1, 2017.

Dylan Lewis: Another very hot product and one that is on a lot of people's wish lists this holiday season, the Fitbit Ionic.

Dan 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 (MSFT 0.45%), 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.