Fitbit's (NYSE:FIT) latest quarterly results are proof that the company's smartwatch bet is finally paying off. The wearables specialist delivered its first profitable quarter in two years thanks to a stronger mix of smartwatch sales that led to a slight increase in revenue and a massive improvement in the bottom line.

The company posted an adjusted profit of $10 million, or $0.04 per share, as compared to the prior-year period's loss of $2.8 million. Wall Street was happily surprised at this performance, as analysts were originally looking for a loss of $0.01 a share. (The stock jumped 26% the day after the earnings report.) But the best part is that Fitbit was able to deliver this improvement with the slightest of revenue gains, indicating that the company will enjoy stronger earnings power in the long run as its smartwatch sales increase.

A Fitbit smartwatch.

Image Source: Fitbit

Stepping up in smartwatches

Fitbit's third-quarter results provide a clear indication that the company is covering impressive ground in smartwatches despite being late to the game. Smartwatches now account for nearly half of Fitbit's total sales, while they were contributing only 10% of total revenue just a year ago. What's more, the company notched a 3% increase in the average selling price of each device to $108. That's the primary reason the company was able to post a slight improvement in the top line despite a drop in total devices sold.

The jump in Fitbit's smartwatch sales tells us that it is sinking its teeth into this market despite the presence of bigger and more experienced players such as Apple. In fact, the company now occupies the second spot in smartwatch sales in the U.S., behind Apple. Market research firm Counterpoint Research also shows that Fitbit's global smartwatch share shot up to 16% in the third quarter from just 6% last year, driven by a 348% increase in shipments.

Apple, on the other hand, lost 5 percentage points in market share. This doesn't seem too surprising, as Fitbit already had an established user base that was probably waiting to upgrade to smartwatches from legacy fitness trackers.

As it turns out, 42% of Fitbit's new device activations last quarter came from repeat buyers. But the more important thing to note is that nearly half of those repeat buyers had beeninactive Fitbit users for at least 90 days. Fitbit seems to be bringing a lot of erstwhile users back into its fold with just two smartwatch launches during the course of the past year or so.

This opens up exciting possibilities for Fitbit, as it can still sell upgrades to users within its ecosystem, as well as attract new smartwatch buyers into its fold thanks to the attractive pricing of its devices.

How smartwatches can supercharge Fitbit

Fitbit generated nearly $193 million in smartwatch revenue last quarter, which translates into an annual revenue run rate of $772 million. The company currently has two smartwatch offerings on sale -- the Versa and the Ionic. For a simplistic math exercise, assume that all of Fitbit's smartwatch sales came from the lower-priced Versa that currently retails for $200; leave out any distributor margins and that works out to least 965,000 smartwatches in the quarter. That would be up from an estimated 825,000 smartwatches in the second quarter. That would mean Fitbit is currently clocking an annual smartwatch sales run rate of nearly 3.9 million units. IDC estimates that smartwatch sales will double to more than 94 million units by 2022, with Apple cornering just over a third of this market with 34 million units in annual shipments.

IDC also estimates that global smartwatch shipments will hit 43.5 million units this year. This means that Fitbit's market share at its current shipment run rate that I estimated stands at 9%, and it has room to grow..

The company had more than 25 million active users at the end of 2017. It could move a lot more units once these users move from fitness trackers to smartwatches, or upgrade their existing smartwatch devices to later generations. Meanwhile, Fitbit is also bringing back inactive users, opening up another massive pool of potential customers, as it had more than 50 million registered users at last count. The company has several avenues for growth.

 

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.