Fitbit (NYSE:FIT) has been paying a big price for being late to the smartwatch game. The company missed the shift in consumer preferences and surrendered its lead in the wearables market to a big shark like Apple, which didn't waste much time in stamping its authority on this still-growing space.

Not surprisingly, Fitbit's device sales fell nearly 27% year over year in the first quarter of fiscal 2018, thanks to the waning demand for its fitness trackers. But a closer look reveals that Fitbit is finally making the jump from focusing on fitness trackers to smartwatches successfully. Its smartwatch sales nearly doubled last quarter, but this is just the beginning as there are some solid reasons why this device category could catalyze the company's long-term growth.

A Fitbit fitness tracker.

Image Source: Fitbit 

Smartwatches are finally taking off for Fitbit

Smartwatches supplied 30% of Fitbit's total revenue last quarter. This is a big deal for the company as it was non-existent in the smartwatch category a year ago, so it has made quick progress in the span of three-odd months and with the help of just two new products.

Fitbit's flagship Ionic smartwatch went on sale in October of last year, then came the budget-friendly Versa that started selling just last month. So the company's smartwatch sales were solely driven by the pricier Ionic last quarter, putting rest to speculation that it wasn't selling enough to kick-start the company's smartwatch ambitions.

The addition of the wallet-friendly Fitbit Versa, which is priced at $200, should drive stronger sales going forward. Fitbit management claims that the Versa experienced strong pre-orders and the best initial sell-through rates in the company's history, setting the company up for a solid smartwatch revenue mix.

This is great news for Fitbit as its higher-priced smartwatches are driving up the company's average selling prices (ASP). The company's ASP increased 16% from the prior-year period to $112 in the most-recent quarter. Fitbit expects to maintain this pricing level in the current quarter as well, which will be a notable improvement over the prior-year period's ASP of $100 when it wasn't selling any smartwatches.

But there are no quick gains here

Ideally, an increase in the ASP should have positively impacted Fitbit's margins, but that's not going to be the case, at least in the short run. In fact, the company expects increasing smartwatch sales to create downward pressure on its gross margins.

This is because Fitbit still relies on fitness trackers for the majority of its revenue. The increase in smartwatch sales will hurt sales of premium fitness trackers such as the Charge 2, which currently retails for around $150 at full price. Fitbit is witnessing product cannibalization that's forcing it to sell its existing fitness trackers at a discount to clear the retail channel so that it can replenish those pipelines with smartwatches.

But investors with a long-term horizon should be willing to overlook this painful transition phase as Fitbit is just warming up to seize a bigger opportunity.

Why smartwatches could supercharge Fitbit

Fitbit users started losing interest in the company's products as it failed to jump on to the smartwatch bandwagon, as was evident from its declining percentage of active users.

Year

2014

2015

2016

2017

Active users (in millions)

6.7

16.9

23.2

25.4

Registered users (in millions)

11

29

50.2

NA

Devices sold (in millions)

10.9

21.4

22.3

15.3

Active users as a percentage of registered users

61%

58%

46%

NA

Data Source: Fitbit annual reports, NA = Not Available

According to Fitbit, "registered device user metric tracks the number of users who have historically either paid for a Fitbit Premium or FitStar subscription or paired a tracker or Aria scale to a Fitbit account." Meanwhile, active users are those who have used the company's offerings at least once over the past three months.

The decline in the active user percentage over the past few years was a clear indication that customers weren't finding Fitbit's offerings to be useful. But Fitbit's foray into smartwatches is bringing back estranged users.

As it turns out, 38% of Fitbit's device activations last quarter came from repeat users, which means the Ionic smartwatch encouraged at least some existing users to upgrade. More importantly, nearly half of these repeat users weren't using Fitbit's services for a period of 90 days or more. Fitbit sold 2.2 million devices last quarter, and using this number, we can estimate that there were at least 400,000 users who had stopped using the company's devices but have now been brought back into the fold.

Fitbit has stopped reporting its registered user base, but the 2016 figure of 50 million gives us a rough idea about the size of its ecosystem. We know the company had roughly 25 million active users at the end of 2017, so that means Fitbit still has a sizable number of dormant users that it can try to lure back with the help of two smartwatches that cater to different price points.

If even 20% of its inactive users buy smartwatches, Fitbit could see a massive boost in sales from this device category, and that doesn't even count new entrants into the company's ecosystem yet.

Today's pain will be tomorrow's gain

Fitbit has set the wheels of a turnaround in motion, and it has been quick to do so with only a couple of products. Of course, the transition will be painful and the company's finances may not be pretty as it matches consumers' preferences for smartwatches over fitness trackers. But it's important to remember that smartwatch sales are expected to double in the next five years, increasing their share of the wearable devices market from 21% in 2016 to 51% in 2022.

Fitness trackers, meanwhile, are a dying breed as they are just one of the many features of a smartwatch. This is why Fitbit's move into smartwatches should reap rewards in the long run, provided it manages to shift its existing user base onto its new offerings.

Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple and Fitbit. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.