Fossil (NASDAQ:FOSL) recently agreed to buy fitness tracker maker Misfit for $260 million. Misfit, which was founded four years ago, competes directly against Fitbit (NYSE:FIT) with a wide range of fitness trackers costing anywhere from $20 to $250. Buying Misfit will help Fossil diversify away from its core watch business and into the growing wearables market. IDC expects worldwide wearable shipments to rise from 76.1 million units this year to 173.4 million units in 2019.

Misfit isn't Fossil's only play on the wearables market. This holiday season, it will launch two connected bracelets, a connected watch, and an Android Wear smartwatch under its "Fossil Q" brand. Let's take a closer look at Fossil's wearables strategy, and how it could threaten Fitbit's long-term growth.

Three of Fossil's "Q" wearables. Source: Fossil.

Looking back at Fossil's woes
Shares of Fossil have plunged more than 70% since the beginning of the year due to disappointing sales of its namesake and licensed watches. Last quarter, revenue slid 14% annually to $771.3 million, missing estimates by $23 million. Decent growth at its namesake and Skagen brands wasn't enough to offset declines in its licensed portfolio, which caused total watch revenue to fall 17%. The strong dollar exacerbated that pain -- excluding currency impacts, total and watch revenues would have respectively fallen 8% and 11%.

Revenue from Fossil smaller leathers and jewelry businesses both posted single-digit declines, but both units grew on a constant currency basis. Fossil's revenues also fell by the double-digits across all three main geographic regions as net income declined 45% to $57.5 million.

Fossil faces stiff competition in the heavily saturated mid-range watch market as consumer interest in smartwatches rises. Earlier this year, NPD analyst Fred Levin told Bloomberg that sales of all sub-$1,000 watches were vulnerable to the rise of smartwatches.

Why Fossil needs Misfit
Fossil hopes that expanding into the wearables market can get its sales growth back on track. However, that growth could impact its bottom line growth. During last quarter's conference call, CFO Dennis Secor warned that "downward pressure on gross margins" will occur as wearables become a larger part of Fossil's product mix. But over the long term, Secor expects economies of scale to kick in and "restore sequential earnings growth."

In addition to selling Misfit's existing wearables, Fossil plans to integrate Misfit's health-tracking technology into traditional-looking watches. These connected devices might appeal to consumers who like activity tracking features but dislike the "geek factor" of wearing a full-color screen on their wrists. These wearables could also carve out a niche between the crowded smartwatch market and the low-end fitness tracker one.

Misfit's Shine 2 (L) and Speedo Shine (R). Image source: Misfit.

These changes won't happen overnight. It's unclear how much revenue Misfit generates, and its market share isn't significant enough to be listed by IDC. By comparison, Fitbit, Apple (NASDAQ:AAPL), and Xiaomi respectively controlled 24%, 20%, and 17% of the worldwide wearables market during the second quarter.

Why Fitbit should be worried
While Fitbit remains the market leader, its market share actually fell over six percentage points since the second quarter of 2014, due to arrival of Apple Watch and Xiaomi's $15 Mi Band. Fitbit's gross margin has also been declining on a year-over-year basis, due to new products being sold at slightly lower margins.

Last quarter, Fitbit claimed that 79% of its revenue was generated by the Charge, Charge HR, and Surge -- which all offer more "watch-like" features than its flagship Flex fitness tracker. While Fitbit is trying to carve out a niche "sports performance" wearables category with these devices, there's no guarantee that the market won't be cannibalized by the Apple Watch, Android Wear devices, and Fossil's Q devices.

Fitbit investors should watch Fossil
Misfit wasn't a major threat to Fitbit on its own, but Fossil's financial backing could be game changing. Fossil's operating expenses of $342 million last quarter were already much higher than Fitbit's comparable expenses of $129 million.

Considering how highly Fossil values the wearables market, it will likely boost spending on R&D and marketing to challenge Fitbit and other wearable rivals. After Fossil enhances its licensed brands with Misfit technology, Fitbit could face a huge number of new competitors in connected watches. Those new competitors could cause Fitbit's market share to decline even further in the future.