Apple, Fitbit, Spotify, Oh My!

Apple (AAPL -0.81%) posted seemingly strong results, but the market was disappointed in changes to its reporting and guidance. Ditto for Spotify (SPOT -1.51%), which made some changes to its expected subscriber counts for 2018 and sold off after its report. But Fitbit (FIT) made a statement with the success of its smartwatch segment, and its shares soared.

Should Apple and Spotify investors be worried? And Does Fitbit belong on your watchlist? Check out this episode of Industry Focus: Tech, in which host Dylan Lewis and Fool.com contributor Evan Niu dive into these topics and more.

A full transcript follows the video.

This video was recorded on Nov. 2, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, November 2nd, and we're talking tech earnings. I'm your host, Dylan Lewis. I'm joined on Skype by senior tech specialist, Evan Niu. Evan, how was your Halloween? 

Evan Niu: It was good! The kids had a good time. 

Lewis: You've got two young kids. What were the costumes this year? What did they get into?

Niu: They did Batman and Harley Quinn.

Lewis: Alright! And did you and your wife dress up? Or did you just take the kids around? 

Niu: My wife is into dressing up. I am not because I'm not fun like that.

Lewis: [laughs] You can't even make concessions with the kids?! I wound up doing two costumes this year. I had a Harry Potter murder mystery that I did last weekend with some friends, and then, I was the Morty to my girlfriend's Rick of Rick and Morty over the weekend. I went from having a nice, big beard to shaving it, because to be a 14-year-old boy for Halloween, you cannot have a beard. But it sounds like we both had a pretty good time. I hope your kids had plenty of candy loot. It's probably driving you a little crazy. 

Niu: Oh yeah, of course. 

Lewis: We're going to be talking about our treat, Evan, and that is financial reports and some fresh earnings takes on some companies that we love to cover. We have big earnings releases from Fitbit, Spotify and Apple. We're going to do our best to hit all three and not get too, too long-winded. I know we can do that sometimes when we talk Apple. 

Why don't we kick things off with Fitbit? This is a company that has desperately needed some good news, and it seems like they finally got it with this new report. 

Niu: It was a pretty strong release, in my opinion. Revenue was up to about $393 million, which beat its own forecasts as well as analyst expectations. The big news here is that they became profitable again. They've been losing money for about two years as people have been shifting away from these basic fitness trackers toward more full-featured smartwatches. The big challenge has always been, can they transition from trackers to smartwatches successfully? And, of course, they still sell trackers. Those are really popular in the Middle East, Africa, and some of those emerging markets. But in the U.S., it's really all about smartwatches these days. They were able to post adjusted net income of $10 million, or $0.04 per share. Getting back in the black.

Lewis: Worth noting that on, on a GAAP basis, they did lose money. We have to emphasize that adjusted income there. Exploring that outperformance a little bit, it seems like the company is seeing success with the smartwatch line. That was really the big, looming question for them. With the more simplified fitness trackers out there, and that market being a little bit tougher with some competitors like Xiaomi in the mix, can they go to the smartwatch market and make a big splash? It seems like the answer is yes.

Niu: Right, especially after their first smartwatch, the Ionic, flopped. That thing did not sell well. It didn't look that appealing from a mainstream perspective. They considered more of a niche performance type positioning, whereas the Versa is very clearly resonating much better with consumers. If you remember, they spent years acquiring different little companies to help them build their smartwatch strategy. And now, we're seeing the results of that. They sold about 3.5 million devices during the quarter. Average selling prices were up a little bit to $108 as the product mix continues to shift toward smartwatches, which are now about half of revenue. I do think they're making some really impressive progress here.

Lewis: You look at the overall market share, a year ago, they had 0% market share in smartwatches. Flash forward to now, they are one of the major players, they're in second place in this market. Not only are the financial results looking good, but in the competitive landscape, they are not only holding their own but taking market share from other players.

Niu: Exactly. Since Ionic launched in Q4 of last year, a year ago, they really didn't have anything. Now, we fast forward to today. Android Wear OS, which used to be Android Wear, has done so terribly. No one is really buying those devices. Alphabet really failed on execution in terms of getting into wearables. I think that's given Fitbit this opportunity to step up and fill that need, provide some type of alternative to Apple Watch. Apple Watch is still the dominant smartwatch in the world right now, but people want competition, people want alternatives, and Fitbit is really offering something else.

Lewis: Outside of the financials, looking at some of the user activity, I think there are a lot of really encouraging signs there. A lot of the activations that they're seeing over this quarter are from new users. It seems like engagement with folks that had been users at some point and then fallen off is starting to get revitalized a little bit.

Niu: Right. That's always been a big problem with these basic fitness trackers. It's like when people start going to the gym, then you get kind of lazy, then you just stop going. People would buy these fitness trackers, use them for a couple of months, and then just stop using them. Let's face it, we're all lazy. [laughs] The big challenge for Fitbit has always been, how do we keep these users engaged? How do we motivate them to stay active and improve their lives and health? They're starting to make some progress there. They said that out of the existing users that had bought new Fitbits this quarter, about half of them had previously been inactive. So, they are starting to get more people back on the platform that had previously been dormant.

Lewis: After quarters of declines on the revenue side, the market was very happy to see some revenue growth, even if it was pretty meager. How are you feeling about this company? It's up like 35% since this earnings release. Does anything that you've seen here change your outlook on this business?

Niu: I do think it was a very strong report, and I do think they're making a lot of progress with this turnaround. They had been on the ropes for a while with these fitness trackers. But, at the same time, I don't think they're out of the woods yet. This is going to be a long game. We're talking about smartwatch platforms. Any platform strategy, by default, is a very long-term strategy. So, they're making progress, but they still have to keep going. They're also in consumer hardware. It's notoriously difficult. You have to constantly innovate, constantly put out new products that people like, you have to build your platform, you have to get more app developers on there. There are just so many pieces to do well and maintain over time. And, you're competing against literally the richest company in the world. So, it's going to be tough. That said, I'm impressed that they've been able to do as well as they have over the past couple of years with transitioning to smartwatches that people want to buy.

Lewis: They're guiding for what is essentially a slight decline in revenue next quarter after being basically flat year over year this most recent quarter. It's not like the hardware segment is showing blistering growth. It's a nice return, and it's a show of strength in some key categories for them, but hardware is still this business. It's all of their revenue. That hasn't changed. And I think what makes a hardware company really compelling is if they can create a really viable platform. And I don't see that yet with this company. There's so much potential for it, but unless I start seeing the signs and some money coming in on the software side for them, I'm going to remain a skeptic. I think I can find better places to put my money, honestly. 

Niu: I totally agree with you. They've been talking about this idea of building up the services business for a long time, and they're still trying, and they want to get into corporate wellness programs. But these are still less than 1% of revenue. Again, when it comes to building a platform, you want to get away from relying totally on hardware, and grow your software and services business a little bit. And on that front, they have not made much progress.

Lewis: Why don't we switch gears and talk Spotify? The market was happy with Fitbit's results, not exactly the case for Spotify. We saw a pretty big sell-off after earnings. The company is actually down to lows since they've gone public. This is the lowest we've seen shares.

Niu: Investors weren't too happy with Spotify. I think part of it was their guidance. As far as the results for this quarter goes, revenue came in at about $1.5 billion. Premium subscriptions are continuing to grow. Now they're at about 87 million Premium subscribers. That's by far the biggest premium paid subscriber base in the world in the music streaming industry. We've talked about Tencent before, but Tencent, as we mentioned on other shows, most of their users are free users. They're not actually subscribing. Spotify is by far the market leader here.

They were actually profitable, but that was a one-off occurrence, and actually related to Tencent Music. They had a tax benefit related to a market-to-market adjustment regarding the value of Spotify's stake in Tencent Music. If you remember, they did an equity swap last year. When Tencent Music filed to go public, there was a lot of information in there that basically warranted them making some adjustments. So, that's where their tax benefit came from. That's not a regularly occurring thing. They actually lost less money than they thought on an operating basis, which they considered a negative thing. They said, "We should have lost more money."

Lewis: Right. This is a company that is very much in growth mode. They're expecting to spend a lot of money, particularly on the hiring side, in the R&D element of their business. They were disappointed that they couldn't spend more and bring more people on.

Niu: Right. It's basically, their operating margin improved. They still lost money on an operating basis, but they said, "We should have lost more. We didn't hire as many people as we wanted to." That's also continuing into the fourth quarter, which is also why they adjusted their guidance. Their financial guidance, they're actually expecting to lose less money than they previously forecasted. Again, they consider that a bad thing. They know they need to be reinvesting very heavily into this business to really keep growing, and profitability will come later.

Lewis: You mentioned the guidance. I think you're right, that's why we're seeing the sell-off today. The reality is, they've gotten bitten by their own optimism. They put out some improved guidance last quarter, looking at their full-year outlook. They revised all that back down to what they were originally expecting at the beginning of the year. It's not that there's a huge reset going on. We're talking about a difference of one million Premium subscribers one way or the other. 

All told, Evan, how are you feeling about Spotify? You are a shareholder.

Niu: I still think it's a good company for the long-term. I still believe in where this company is going. I think this market reaction is an overreaction. It's just minor adjustments to their Premium subscriber outlook. Like you mentioned, it's like a million subscribers one way or the other. That's not the kind of number that's going to make or break this company. Investors selling off the stock, I think, is kind of silly. We're just going back to the guidance they issued earlier this year, which is still strong guidance. They're expecting 93-96 million subscribers at the end of the year. Again, they're by far the biggest paid streaming service out there. 

Lewis: If you're buying into the long-term vision of this company, and you're thinking, "Music streaming is the future. This is one of two companies that are extremely well-positioned to capitalize on it in the U.S. and in Europe, some of the big markets," then one million in one or two quarters shouldn't make a big difference. The addressable market for these types of services is so much bigger than that. The larger opportunity is so much bigger. I wouldn't get too swept up in the individual guidance figures from one quarter to the next if that's the narrative that you're buying here. 

Niu: Exactly. I'm still confident. I'm hanging on. 

Lewis: I think this is also a pretty good lesson in dollar-cost averaging on some positions. We've talked about some recent IPOs, we've done some deep dives. It's really easy to get excited when you first have an opportunity to scoop up shares of a company that you've been following for some time. I think that this movement that we're seeing is very typical, really, for a new issuance. We're still within the first year, first couple of reports, of Spotify as a publicly traded company. I take all this as a reminder to why it's so important to buy into positions over time, to dollar-cost average. There are going to be lumps with companies as they report. The market is going to take their lumps, as well, as we're seeing over the last couple of months. You don't want to have a cost basis that is tied to one particular point in time. You want to benefit from those movements and work down to, ideally, a lower cost basis on your position.

Niu: Especially IPOs. All IPOs are so volatile and risky in the first year or so. The market is trying to figure out, what is this company worth? It takes some time.

Lewis: Our last company today is Apple. This is one of our favorite ones to talk about. Usually, this is the boring quarter for Apple. The stock is down 7% since they reported. What happened?

Niu: [laughs] There's a lot going on here with Apple's earnings. One of the big reasons it's down is that the guidance for the next quarter wasn't too great. We can get to that later. Revenue jumped about 20% to $62.9 billion, which is ahead of the company's own guidance. iPhone unit volumes were about flat at 47 million. But iPhone revenue increased 29% to $37 billion, which is really just more of the same that we've been seeing play out over the past year. Ever since they introduced the $1,000 iPhone X last year, they've been pulling this lever hard on pricing. Pricing is really where all the growth in this business is coming from nowadays. Units are basically flat. The past four quarters, units have been more or less flat, but revenue has been up considerably because they're charging so much for these phones now. 

Lewis: It's kind of incredible that, at a $1 trillion company, and a company that's putting up tens of billions of dollars in revenue, they are still capable of doing 20% growth. Not that we should necessarily expect that going forward, but it's worth emphasizing that a little bit here. Some of that is due to the success of the iPhone segment. Some of that is due to the success of their services segment.

Niu: Services hit a new record at $10 million in revenue for the quarter. A year ago, they had a one-time positive adjustment of $640 million related to a change in an accounting estimate. But if you exclude that one-time item, that basically means they grew 27% this quarter on Services. On a trailing 12-month basis, Services is now a $37 billion business. They've been reiterating this target of $50 billion by 2020. They continue to march, slowly but surely. Every quarter, they're marching closer and closer to that goal. They're right on schedule.

Lewis: The story with this quarter for me is, past results were great, but we're going to see some major shifts in how this company reports. I think that really signals some major changes with what the company expects from some of their product lines. The financial reporting that we've gotten used to for Apple is going to be almost unrecognizable soon.

Niu: Right. They made some very big announcements that are going to be really important for investors, in terms of how they do their financial reporting starting in the new fiscal year. They just closed their fiscal year, so we're starting fiscal 2019. The big one is that they're no longer going to report unit sales, which is going to be very controversial, because that's always been one of the most-watched metrics with Apple. They're also going to start breaking things down and separating between Products and Services. They're going to give more granular detail around the cost of revenue for Products and Services. You'll get a much better sense of the margin profile for Services vs. Products. With their emphasis on Services over the past couple of years, which is much more profitable, I think that's a good thing. But, of course, it's a bad thing that you're going to lose the unit data. 

They've been trying to shift this focus in the narrative away from hardware to services for two or three years now. This is the culmination. They're just getting rid of the units altogether. They can't get clearer than that. They've been subtly saying, "Hey, stop paying attention to units." And now, they're like, "You can't pay attention to units anymore." You're not getting a choice anymore.

Lewis: And you've spent so many quarters and so many years putting together these very excellent Apple charts that track ASPs, what's going on unit sales. Evan, all those beautiful charts are going to be rendered obsolete! It's such a shame!

In some ways, we get some more transparency. In some ways, we get less transparency. For my money, given what a big part of the business the iPhone segment is, I would like to know the workings there and understand what's going on on the unit side, what's going on on the pricing side. Obviously, my opinion doesn't matter much, because they've already decided to make this decision. We just have to take some solace in the fact that we'll have a better feel for what's going on on the Services side.

Also, looking forward, we hinted at this before, the guidance that they gave for next quarter is going to be a big deceleration from that 20% growth that we just saw. 

Niu: At the midpoint, guidance is about $91 billion. That's about 3% growth off of a year ago when they did $88 billion. This is kind of like we talked about before -- you have such a huge business, you're running into the law of large numbers. It's really hard to put up double-digit growth rates off such a humongous revenue base. There's some speculation, are they going to guide to a $100 billion quarter? That would have been mind-boggling. I mean, not that that was expected. Analysts were at about $93 billion. So, they do have to hit the high end of their guidance to meet analyst expectations. It's certainly possible, they've done that on multiple occasions on the December quarter, which is their busiest quarter. It's kind of silly that people are disappointed with it. They're going to be selling a billion dollars' worth of stuff every day. How are you disappointed with that?

Lewis: That's nothing to sneeze at. With the sell-off, Apple is actually dangerously close to falling below that $1 trillion mark that they were the first company to hit. Evan, we've talked about Apple a lot. We have both owned the stock for quite some time. I think the crazy growth days for this company are over. If you're a new investor, this is not your older cousin's Apple that's going to be doubling every two years. What are you doing with your Apple shares? How are you thinking about this business?

Niu: I'm not doing anything with it. I've always been a long-term shareholder with Apple. I've never had any temptations to sell it or anything like that. Even if the growth isn't really there anymore, it's also worth remembering, this buyback program that they have is so massive. Even if their top line isn't growing a lot, your earnings per share are going to be growing quite a bit. That will help drive the valuation of the shares and keep them cheap, which can actually help translate into more share gains. Not that they're going to double from here. [laughs] But, the buyback program, they bought back over $60 billion worth of stock this year so far. Ever since tax reform, they've bought back $20 billion a quarter over the past three quarters. That's not going away anytime soon. That's going to help keep that bottom line EPS number strong for years to come.

Lewis: Yeah. They've been really excellent to their shareholders, in terms of capital returns. That's not going to change. That's one thing I think we can continue to bank on, so long as that cash hoard is nice and big, and so long as the Services segment and the iPhone segment continue to post pretty solid results. I can think we can rest assured that that's going to be the case. 

Niu: This stock is so cheap. I've always considered it a very safe stock. They're trading at a discount to the market, something like 13X earnings. This stock is so cheap. It's not going to tank or anything. It's a pretty reliable play there. 

Lewis: Let's wrap up there, Evan. Thanks for hopping on the show! Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch all the videos from this podcast over on our YouTube channel. 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 Austin Morgan for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!