Q1 Beat / Brighter Outlook for the Rest of the Year

Report Highlights

• Zepp remains focused on adding new AI features through ongoing R&D. Subsequent to Q1, Zepp launched two new products: an upgraded smartwatch, and a new smart ring designed for users who prefer not to wear a watch while sleeping, but still want 24/7 health tracking. The new smartwatch is already available on Amazon (NASDAQ: AMZN), with an average rating of 4.2 stars from 3,700+ reviews in the U.S. These ratings are on par with those of Apple and Samsung watches, despite the latter two having a significantly higher number of reviews. 
• Based on consensus estimates, global smartwatch shipments are forecasted to surge by 5%-10% in 2024, driven by  increasing health awareness, technological advancements, and the rising popularity of wearables.
• At the end of Q1, working capital, and investments, net of long-term debt, totalled RMB1.93B (US$266M) vs Zepp’s MCAP of US$50M, implying that the shares are trading well below liquid assets. 
• We are raising our near-term EBITDA/EPS forecasts, and anticipate EBITDA turning positive this year. 

Price Performance (1-year)

*See important disclosures at the bottom of this report rating and risk definitions. All figures in US$ unless otherwise specified.

Unit Sales & Other Key Metrics

In Q1-2024, shipments were down 66% YoY to 1.2M units, 12% lower than our estimate

Source: FRC / Company

 Self-branded unit shipments fell 60% YoY, amid no new product launches, and Zepp halting production of several low-margin products 

This strategic move paid off as gross profit for self-branded units increased by 33% YoY, despite a 36% YoY decrease in revenue 

Source: FRC / Company

Revenue was down 55% YoY, missing our estimate by 7%, due to lower unit sales, partially offset by higher than expected average product pricing

In line with industry standards, Zepp retains 70% of the retail prices 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. 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.

The average price of self-branded units was up 61% YoY, driven by the introduction of new products, and  terminating production of low-margin items

Source: Company, FRC

As a result, gross margins were up 21 pp to 37%, beating our estimate by 2 pp

Gross margins on self-branded units spiked 21 pp to 40%, exceeding the sector average of 24%, and  progressing towards Apple's 45%. Zepp spent 27% of revenue on sales/marketing expenses, while Apple typically spends <5%

Operating expenses were down 14% YoY, and in line with our estimate. EBITDA and EPS remained negative, but improved despite lower revenue, due to higher gross margins

Working capital, and investments, net of long-term debt was RMB1.93B (US$266M) vs the current MCAP of just US$50M, implying that ZEPP is trading well below liquid assets 

Sector Outlook

Zepp’s products (Amazfit) accounted for 2.8% of global smartwatch shipments in 2023

Source: FRC / IDC / Statista

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

FRC Projections and Valuation 

As Q1 gross margins were higher than expected, we are raising our EBITDA and EPS estimates; we now anticipate EBITDA turning positive this year 

As a result, our DCF valuation increased from $3.55 to $3.78/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 -0.08x forward revenue (previously -0.04x) vs the sector average of 2.24x (previously 2.02x)

Applying 2.24x to our 2024 revenue forecast for Zepp, we arrived at a comparables valuation of US$6.61/share  (previously US$6.36/share)

We are reiterating our BUY rating, and adjusting our fair value estimate from US$4.96 to US$5.19/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 believe the market has yet to recognize that shares are trading below liquid assets, and that EBITDA could turn positive this year.

Risks

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

• Competition and innovation
• Supply chain vulnerabilities
• Reliance on third-party manufacturers
• Revenue dependency on Xiaomi has been declining, though there is still some reliance at this point
• Officers, directors, and principal shareholders hold 95% of total voting power
• Need to always allocate substantial budgets for marketing
• 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.

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