Revenue Dip, Cost-Cutting Success, Eyeing H2 Recovery

Report Highlights

• Sources indicate that global smartwatch shipments declined by 9% YoY in Q2 amid slower global GDP growth. Additionally, average product pricing fell due to discounts driven by excess supply. Apple (NASDAQ: AAPL), the largest smartwatch maker, reported a 1% YoY decline in unit sales. That said, global smartwatch shipments are forecasted to surge by 5%-10% in 2024 (unchanged consensus estimates), driven by pent-up demand, increasing health awareness,  AI integration, and the rising popularity of wearables.
• In Q2, Zepp maintained its spot as the sixth-largest player in the global smartwatch market by sales, trailing Apple, Garmin (NYSE: GRMN), Samsung (KOSE: A005930), Huawei, and Fitbit (Google/NASDAQ: GOOGL).
• Zepp is forecasting a strong revenue rebound in H2-2024, fueled by a series of product upgrades and new releases, such as the T-Rex 3 outdoor smartwatch, and the Open Wearable Stereo (OWS) earbuds. For Q3, management is anticipating $45-$60M in revenue vs $41M in Q2. 
• At the end of Q2, working capital, and investments, net of long-term debt, totalled $257M vs Zepp’s MCAP of $43M, implying that the shares are trading well below liquid assets. 
• Despite a favorable outlook for H2, we are lowering our 2024 revenue and EPS forecasts due to weaker-than-expected Q2 results. We now expect EBITDA to turn positive next year, rather than this year.

Price Performance (1-year)

Unit Sales & Other Key Metrics

In Q2-2024, shipments were down 66% YoY, to 1.3M units (Q1: down 66% YoY as well), 18% lower than our estimate.  As a result, revenue fell 56% YoY, missing our estimate by 22%

In line with industry standards, Zepp retains 70% of the retail price of its products as revenue, while retailers and distributors keep the remaining 30%.

Zepp does not disclose segmented results:

• Smart wristbands, and watches, constitute 90%+ of revenue. 
• Self-Branded Products - Europe & the Middle East account for 50% of sales, followed by North America (25%), China (10%), and the rest of the world (15%) 
• Xiaomi (SEHK: 1810) Products – China accounts for 70% of sales for this segment. In addition to its own portfolio of products, Zepp manufactures wearables for Xiaomi, the second largest wearables technology company, behind Apple. Xiaomi owns 20% of Zepp’s outstanding shares. Zepp's dependence on Xiaomi has been waning, as evidenced by the declining share of total revenue contributed by Xiaomi.

Self-branded unit shipments fell 36% YoY (Q1: down 60%), amid Zepp halting production of several low-margin products. This strategic move paid off as EBITDA improved by 6% despite a 56% YoY decrease in revenue 

Gross margins were up 18 pp to 40%, beating our estimate by 3 pp. Gross margins on self-branded units spiked 16 pp to 44%, well exceeding the sector average of 24%, and  approaching Apple's 45%

Zepp spent 26% of revenue on sales/marketing expenses, while Apple typically spends <5%. Operating expenses were down 16% YoY, but 9% higher than our estimate

EBITDA remained negative, but improved due to higher gross margins and lower operating expenses

Working capital, and investments, net of long-term debt was $257M vs the current MCAP of just $43M, implying that ZEPP is trading well below liquid assets 

FRC Projections and Valuation 

Zepp’s products (Amazfit) accounted for 2.8% of global smartwatch shipments in 2023. It is estimated that global smartwatch shipments will increase by 9% p.a. in 2024 (Source: Statista)

Historically, Zepp's revenue growth rate has averaged 1.6x the global growth rate. Due to Q2 falling short of expectations, we are substantially reducing our revenue and EPS forecasts

We now anticipate EBITDA will turn positive next year instead of this year

As a result, our DCF valuation decreased from $3.78 to $3.48/share

Comparables Valuation

ZEPP remains the most undervalued stock on our list of comparables. Given the company’s negative enterprise value, its shares are trading at -0.01x forward revenue (previously -0.08x) vs the sector average of 2.23x (previously 2.24x)

Applying 2.23x to our 2024 revenue forecast for Zepp, we arrived at a comparables valuation of $4.87/share (previously $6.61/share)

We are reiterating our BUY rating, and adjusting our fair value estimate from $5.19 to $4.17/share (the average of our DCF and comparables valuations). We maintain our view that Zepp is an attractive acquisition target for larger players like Xiaomi. We look forward to the market reaction to the upcoming product upgrades and new releases. 

Risks

We are assigning a risk rating of 3 (Average)

We believe the company is exposed to the following key risks (not exhaustive):

• Competition and innovation
• Supply chain vulnerabilities
• Reliance on third-party manufacturers
• Officers, directors, and principal shareholders hold 95% of total voting power
• Need to always allocate substantial budgets for marketing
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• ZEPP is trading below $1/share, violating NYSE’s listing standards. The company has until November 2024 to comply or face delisting. To regain compliance, ZEPP is implementing a share buyback program and, if necessary, a reverse stock split.