Fitbit (NYSE:FIT) was once the world's top wearables maker, but it lost that title to Apple (NASDAQ:AAPL) during the fourth quarter of 2017, according to market intelligence provider IDC, due to rising sales of the Apple Watch. Fitbit then slid to third place behind Xiaomi (NASDAQOTH:XIACY) during the first quarter of 2018.

IDC recently released its second-quarter market share figures, and the results were similar. Fitbit remained in third place, with just 9.5% of the market, compared to 12.8% in the prior-year quarter. During the same period, Apple's share rose from 13% to 17%, as Xiaomi's grew from 13.3% to 15.1%.

Two versions of the Fitbit Versa hanging from strings.

Fitbit Versa. Image source: Fitbit.

Huawei, which ranked fourth, also saw its market share rise from 3.1% to 6.5%. Garmin's share dipped slightly from 5.4% to 5.3%. Fitbit's quarterly shipments dropped from 3.4 million to 2.7 million, making it the only market leader that posted a year-over-year volume decline.

That's bad news for anyone who expected Fitbit, which lost over 80% of its market value over the past three years, to make a comeback. Let's take a closer look at Fitbit's woes to see why the company continues to shrink as its rivals expand.

What happened to Fitbit?

Fitbit was once a high-growth company, but its sales growth decelerated as new rivals launched cheaper fitness trackers. Xiaomi's popular Mi Band devices, for example, offer features similar to Fitbit's Flex devices for less than $30.

Meanwhile, high-end smartwatches like the Apple Watch added advanced heart rate and exercise tracking features, reducing demand for Fitbit's higher-end fitness trackers like the Charge and Alta. Fitbit fought back with smartwatches like the Ionic and Versa, but those late arrivals have their work cut out for them to significantly boost revenue or shipments.

Metric

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

Revenue

(39.8%)

(31.2%)

(0.5%)

(17.1%)

(15.3%)

Shipments

(40.4%)

(32.1%)

(16.9%)

(26.7%)

(20.6%)

 Data source: Fitbit. Columns represent year-over-year growth / (decline).

Fitbit expects its revenue to drop 3% (at the midpoint of its outlook range) for the third quarter of 2018. For the full year, it anticipates a 7% sales decline, compared to a 26% decline in 2017.

Can Fitbit recover?

The good news is that Fitbit's revenue declines are decelerating, so the company might claw back to positive sales growth next year.

The key to that recovery would be its smartwatch business. Fitbit claims that it sold out of the Versa last quarter, and that its smartwatch revenue accounted for 55% of its top line. IDC also reported that the Versa was the second largest smartwatch brand during the quarter, at 1.1 million shipments. A higher mix of smartwatches also boosted Fitbit's average selling price 6% against the prior-year quarter, to $106.

The Ionic and Versa both have access to Fitbit's "App Gallery." If Fitbit can expand its app ecosystem with more paid apps, it could eventually turn the gallery into a new stream of higher-margin software revenue.

Fitbit Versa.

Fitbit Versa. Image source: Fitbit.

That strategy would complement the expansion of Fitbit's digital health ecosystem, which includes its Twine Health unit and a partnership with Alphabet's Google Cloud for Healthcare API. Fitbit also recently added new women's health features to its mobile app, launched the new Ace smartwatch for kids, refreshed its Charge lineup with the Charge 3, and expanded beyond wristwear with the Flyer fitness headphones.

Fitbit believes that growing its overseas revenue could also reverse its fortunes. Fitbit's U.S. revenue, which accounted for 61% of its top line, fell 8% last quarter against the comparable quarter, as its international revenues fell 24%.

Fitbit posted declines across all international regions except the Asia-Pacific region, where revenue jumped 66%. Management believes that revenue in the EMEA (Europe, Middle East, and Africa) region -- which fell 39% during the quarter -- will return to growth during the third quarter.

However, the company's gross margin is still deteriorating. Fitbit's GAAP gross margin fell 240 basis points to 39.8% last quarter, and its non-GAAP gross margin dropped 210 basis points to 40.9%. Net losses also widened significantly by both GAAP and non-GAAP measures, and analysts don't expect the organization to return to profitability anytime soon.

On the bright side, Fitbit expects its full-year gross margin to stay "approximately flat" from the second quarter onward, as its full-year non-GAAP operating expenses decline 7% -- indicating that it doesn't expect to significantly cut prices or boost marketing expenses to stay competitive.

But it's a long way back

Fitbit is making decent progress with the Versa, but Apple is expected to launch the Apple Watch 4 soon. If Fitbit doesn't ramp up its marketing efforts -- which could be tough given its conservative spending strategy -- it could fall further behind Apple and Xiaomi.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A and C shares), 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.