Fitbit's (FIT) CEO James Park on Q2 2016 Results - Earnings Call Transcript

| About: Fitbit, Inc. (FIT)

Fitbit, Inc. (NYSE:FIT)

Q2 2016 Earnings Conference Call

August 02, 2016 17:00 ET

Executives

Brad Samson - IR

James Park - Chairman & CEO

Bill Zerella - CFO

Analysts

Tavis McCourt - Raymond James & Associates

Stan Kovler - Citigroup

Jerry Lehue - Morgan Stanley

Nat Schindler - Bank of America Merrill Lynch

Joe Wittine - Longbow Research

Betty Chen - Mizuho Securities

Robert Peck - SunTrust Robinson Humphrey

Ross Sandler - Deutsche Bank

Erinn Murphy - Piper Jaffray

Charlie Anderson - Dougherty & Company

Jim Duffy - Stifel Nicolaus

Mike Delello - Leerink Partners

Operator

Welcome to the Fitbit Second Quarter 2016 Earnings Call. At this time like to turn the conference over to Mr. Brent Sampson. Please go ahead, sir.

Brad Samson

Good afternoon and welcome. Fitbit distributed a press release detailing its quarterly results earlier this afternoon. It's posted on our website earlier this afternoon. It's posted on our website at www. Fitbit.com and also available from normal financial news sources. This conference call is being webcast live on the Investor Relations page of our website where a replay will be archived.

On this call, all financial measures are presented on a non-GAAP basis except for revenue which is a GAAP measure. A reconciliation of GAAP to non-GAAP financial measures is provided in our posted earnings release. This conference call will contain forward-looking information which is subject to risks and uncertainties described in Fitbit's filings with the Securities and Exchange Commission and in today's press release. Actual results or events may differ materially. We will begin with commentary from James and Bill and will then open the call to questions. We're going to limit the call to about an hour, so we apologize in advance if we don't get to all questions. Let me introduce Fitbit's Chairman and CEO, James Park. James.

James Park

Thanks, Brad. Good afternoon, everyone. I'm excited to report another quarter that demonstrated Fitbit's continued growth and positive impact on health and fitness for consumers around the world. The latest industry reports by IDC showed that Fitbit continues to be the leader in the worldwide wearable market by units as of the end of Q1. U.S. unit and dollar growth accelerated over Q1 despite an unusually strong Q2 of last year that benefited the full availability of charge HR and we demonstrated continued growth into an expanding long term international market opportunity.

In addition, given consumer response to Fitbit Blaze and Alta so far this year, the early positive response from retailers seeing the new products we have for the fall are increasing brand strength and distribution footprint, the network effects from our large active user community and the continuing R&D investments we're making to integrate more deeply into the healthcare ecosystem which will make our devices an essential part of people's lives, I'm confident in the Company's future for the rest of this year and beyond. In fact, I'm so confident that I will not sell any stock until the end of the year. Joining me in that commitment are co-founder and CEO, Eric Friedman and CFO, Bill Zerella.

We continue to beat the wearables category we helped create and see substantial runway ahead. We continued to have the leading unit market share in the U.S. for connected activity trackers. In fact charge HR and Alta were our two most activity trackers sold in Q2. Earlier this year we expanded our addressable market opportunity with the Fitbit Blaze which has done incredibly well. The number of Fitbit Blaze devices sold alone was a close second to IDC's estimate for the Apple watch in the second quarter. It is exciting to be leading in such a large, expanding category with IDC predicting a 20% compounded annual growth rate expecting more than 200 million wearable devices shipping in 2020. An opportunity of this size will naturally attract a great deal of competition.

There is a misconception that an increasing number of competitors in a crowded marketplace have created a significant headwind for us with new marketing bids large and being called out with some concern. However, it's not the number of competitors that is important, but their impact on the market. The reality is that most of these entrants have not altered the competitive dynamics of our industry.

That may come as a surprise to casual observers, but the simple answer is, this is not a simple market to succeed in for a number of reasons. First, one needs to intimately understand the market and what consumers want. Our nine-year history has led to successful new products, including two so far this year, confirms that we have a hard-earned and deep understanding of what consumers want in a health and fitness device. During that time, we have sold more than 48.7 million devices and, in the process, established a brand that is both loved and trusted by millions of users around the world, becoming the brand of choice for consumers seeking a fitness wearable device.

Consumers love our devices which is reflected by ratings in places such as Amazon, but the device is only one part of the consumer's experience. Significant effort is required to continually improve the interactive experience for Fitbit users in our apps which is reflected in the fact that our apps are currently top-ranked in their categories at top App stores. The robust social experience with Fitbit app is another key part of our success and has created a competitive moat supported by the network effect of our large active user community. We believe people are more likely to buy a Fitbit over a competitor because their friends and family are more likely to be already participating in the Fitbit social experience and we believe people are less likely to leave to a competitor due to similar dynamics.

Our advantage in broad global distribution awareness and consumer awareness has required significant and consistent investment over a long period of time. To get retail presence requires giving retailers good margins and compelling merchandising support including displays in which we're investing substantially. In the same vein, the strength to the Fitbit brand driven by our significant investments in marketing activities and advertising has driven our success in product such as Blaze and Alta and the overall growth of our business in key countries across the world.

Finally, I believe Fitbit's pace of innovation is a key competitive advantage demonstrated by our history and recent new products. The additional investments we have made so far this year in our R&D team we believe will result in a further acceleration of our innovation. As an additional proof point on innovation, I want to highlight Blaze and Alta's continuing success which together including related accessories comprised 54% of Q2 2016 revenue and increase sequentially of 50% from Q1. During this time, Fitbit Blaze and Alta have achieved strong rankings on Amazon in the U.S. and together have earned nearly 7,000 reviews which is significant given the short time in market with both products rated four stars are better.

With all the activations of Alta and Blaze in the second quarter, approximately two-thirds were by new customers and the other one-third were by people who own or previously owned another Fitbit device. Similar to last quarter, approximately one-fifth of those repeat purchasers were reactivations having been inactive for 90 days or more. This demonstrates that our business is both sustainable and growing attracting new customers while successfully trading existing users up to new devices.

We have additional new products to come this year. The positive response we have received from retailers who have had the chance to preview these new products under NDA in recent weeks strengthens our confidence in our guidance for the year. Fitbit will have more new products for consumers to choose from for this year's holiday season than we've ever had before.

Following the accelerated investment strategy we announced for 2016, R&D headcount increased in Q2 although not as quickly as planned. We're focused on hiring the right people and are doing so in a disciplined way. As a result, some additional R&D hiring will continue in the second half of this year.

We expect this larger team will allow us to deliver an even greater expansion of features and functionality both on our devices as well as in the Fitbit app in 2017, strengthening our competitive position and driving consumers' perception of Fitbit's value and difference at every price point. In addition, we believe this R&D sets us up well to be more deeply integrated into the healthcare ecosystem and to be an essential part of people's lives.

Turning to sales, distribution and marketing, we sold 5.7 million devices in the second quarter up 27% year-over-year, our second-highest quarter ever, second only to last holiday season. This growth is all the more remarkable given the ramp of Fitbit Charge HR that made the second quarter of 2015 unusually strong. Revenue in the second quarter was up 46% year over year reflecting the strength of our new products. Total revenue was up 48% for the first half of 2016 compared to the first half of 2015.

Overall we're pleased with the customer uptake of accessories for our new products. For example, you may have noticed the introduction of a gun-metal color frame for Blaze in Q2 that proved to be popular. Together Blaze and Alta accessories have added roughly $3 average revenue per device in the quarter.

In North America, U.S. devices sold were up 20% in Q2 2016 year over year while revenue was up 42% and showed sequential acceleration from Q1 2016. We continue to be comfortable with our store count in the U.S. and Canada and are predominantly focused on driving more volume to these outlets with our retail partners. First-half 2016 revenue for the U.S. was up 30%.

As we projected on the last quarter call, we're now in progress and rolling out new modular display materials which will represent a significant investment that Bill will later discuss. This was accompanied by shelf space expansion in most of our North American retail outlets. A little further expansion is anticipated in certain retailers in the fall for additional accessories. We experienced a solid Mother's Day and Father's Day. We saw no meaningful impact from the U.S. sporting goods retailer bankruptcies primarily because these were not our highest volume outlets.

In EMEA, devices sold were up 100% year over year reflecting continued progress in several key European markets. Driven by the same demand for new products, revenue growth was higher second quarter and increased 144% for the first half 2016 with the first-half 2015. Like North America, our EMEA region is focused on driving more through the doors we have in Europe today with leading retail partners.

Long term, we believe there remain opportunities to expand store count. Fitbit and our app are available in English, French, German, Spanish and Italian for the European market. The first-half European story has been about continuing to refine expanded visibility and resonance with the Fitbit brand in the region. We have invested more localized marketing, PR and advertising which is reflected in the first-half 2016 growth. Blaze and Alta helped deliver strong Q2 first half in EMEA. The point of sales update and expansion is still underway and we expect it will be completed for the holiday season. Second quarter marketing highlights for the region include integration with Let's Dance, Germany's version of Dancing With the Stars, sponsoring the B2RUN winning series for an estimated 180,000 participants across 17 events from May to September and APAC promotion on 17 million bottles of sports drink, Lucozade, in the UK.

Impacts, devices sold and revenue were impacted by several factors. One of our primary retailers in Australia, Dick Smith, progressively shut down its business closing nearly 370 stores. In addition, this was driven by a reduction of channel inventory. Despite the impact of these challenges, first-half 2016 units in APAC were still up 11% while first-half revenue was up 29%.

With better management of Australia and with the anticipation of a continued ramp up in a number of countries, we expect our APAC region to return to growth in Q4 2016. In many I went to Alibaba's headquarters in Hangzhou, China, the launch of our relationship and Fitbit's super-brand, FT Mall. This launch exceeded our expectations, delivering tremendous visibility across traditional social channels including more than 100 million impressions and approximately 1.3 million unique visitors to Tmall.

In China, for all retail sales, online sales make up a higher percentage of the total than they do in the U.S. which gives us some additional optimism about the future of this relationship. In the weeks before the events, we launched the Chinese, Korean and Japanese versions of Blaze and Alta in their respective markets. Localization is an important step in our development of international markets and we believe these new localizations will help accelerate both dissertation partnerships and sales in those three markets. Beyond Super-brand day, other regional marketing highlights included EMEA Blaze and Alta fashion show launch in Tokyo, with our celebrity ambassadors and launch events in Singapore, Hong Kong and Korea.

I want to wrap up this part of my discussion with a couple thoughts about demand and our growth opportunity. We believe that smartphone penetration provides a reasonable point of comparison for addressable opportunities in different markets as we believe a significant portion of smartphone users can become Fitbit users over time. I think it's worth highlighting some of the numbers that quantify both the size and expected duration of our market opportunity.

This year, there are expected to be more than 2 billion smartphones in use around the world. And for the end of the second quarter 2016, Fitbit has shipped a lifetime total of 35.6 million Fitbits in the U.S. which represent only 15% of the approximately 230 million smartphones here. In our five primary European countries, UK, Germany, France, Italy and Spain, we have sold roughly 5 million Fitbits in those countries against a total potential market of approximately 200 million smartphones today.

In our five primary Asia-Pacific countries, Australia, India, China, Japan and Korea, we have sold roughly 4 million Fitbits to date against a total potential market opportunity of 1.1 billion smartphones. At the pace at which we can develop these markets, we expect to have tremendous long term opportunity and will continue to evolve and expand our products and experiences to engage consumers with their health.

I'd like to wrap up with a few comments on the progress around corporate wellness and digital health. While today this is a relatively small part of our total revenue, Fitbit's success as a consumer brand is helping to drive our longer term vision and evolution into a leading digital health company. In early June, we hosted the Fitbit Captivate Summit in San Francisco, our national conference for health and wellness professionals that drew 200 executives. This event gives us a chance to build our leadership position in wellness and to showcase a number of our successful customers. We expect that Captivate's ongoing impact will continue our momentum in Corporate wellness.

We have also seen some truly exciting momentum in our work with the clinical research community. Researchers are actively working to incorporate wearables in their studies and Fitbit has emerged as the wearable brand of choice for a number of leading research institutions. Over the last four years, Fitbit and our partner Fitbase, have worked to help researchers overcome some of the key challenges in the way research is conducted by helping them continuously and objectively measure physical activity, engage patients in new ways and enable just-in-time adaptive interventions in over 200 studies with leading institutions such as Johns Hopkins University, Northwestern Medicine, the University of Texas MD Anderson Cancer Center and the University of California at San Francisco.

The studies looked at things like how to better predict recovery or time for patients undergoing spine surgery by monitoring physical activity using Fitbit trackers, testing the impact of improved physical fitness on patients awaiting liver transplants or even helping to move the precision medical movement forward by helping create health interventions that our adaptive and individualized versus static and generalized. These studies are an important validation of our ability to engage consumers in the healthcare setting while providing powerful data and information in the research community.

Lastly, you may have seen our news yesterday that we've hired Adam Pellegrini as our Vice President of digital health. Adam comes from Walgreens where he was their VP of Digital Health and will be responsible for leading Fitbit's vision, strategies and programs to further drive the Company's integration into healthcare systems around the world.

These milestones are incredibly important as we build the foundation to integrate more deeply into the healthcare ecosystem and hopefully underscores both our vision and commitment that's deepening the impact we can have on health outcomes around the world. We're well on our way to start making Fitbit an even more essential part of people's lives. Let me now turn the call over to Bill for some financial highlights. Bill.

Bill Zerella

Thank you James and to all of you joining us today. My prepared remarks will be focused on a financial overview of the second quarter of 2016 as well as our related business trends. I will then provide our guidance for the third quarter and the full year of 2016. The second quarter marks another quarter of outstanding results in which we exceeded our previous guidance demonstrating the strength of our business model and the success of new products and the Fitbit brand, the significant growth opportunities ahead and our ability to manage the business to meet financial objectives.

Q2 2016 revenue of $586.5 million was above the high-end of our guidance range representing a 46% increase year over year from $400.4 million in the second quarter of 2015. This is a significant result because of the timing of the availability of Charge HR fulfilling built-up demand of Q2 of last year which made last year's quarter unusually strong. This also reflected continued strength of Blaze and Alta our new products which we first introduced in Q1 2016.

Geographically, we saw acceleration in growth in the United States, our largest market accounting for 76% of our Q2 2016 revenue compared to 78% in Q2 2015 and up sequentially from 70% in Q1 2016. Looking at international regions, our total revenue outside the United States grew 61% to $141.3 million in the second quarter 2016 compared to $87.7 million in Q2 2015. With 17% of Q2 total revenue coming from EMEA, 2% from Asia PAC and 5% from the Americas excluding the U.S.

We're very excited by the progress we're seeing in markets around the world demonstrating we believe that there is tremendous multiyear runway both internationally and in the U.S. Second quarter 2016 revenue from the United States grew 42% year over year while revenue from EMEA grew 150%. Asia-Pac was down 54% which was expected. As James mentioned this was driven by a reduction in channel inventory and the closure of one of our largest retailers in Australia, Dick Smith. Americas excluding the United States grew 63% year over year.

Looking at the first-half 2016 in total provides good perspective on Fitbit's progress. U.S. first-half 2016 revenue was up 38% compared to the first-half 2015. EMEA was up 133% and Asia-Pac was up 29%. Our second quarter and first-half 2016 year over year revenue growth was driven by continued strength in the sales of Charge HR which remains our top-selling product augmented by the launch of our new products, Blaze and Alta.

With a full quarter of availability, Blaze and Alta collectively represented 54% of total Q2 2016 revenue including related accessories. Blaze and Alta also drove a 12% increase in our average selling price from $88 a year ago to $99. ASP excludes the sale of accessories which included increases the average revenue per device to just over $103. We believe accessories provide another growth opportunity for us as we introduce new products with accessories elements.

In the second quarter of 2016, the impact of currency FX was nominal. More importantly, based on the hedging activities we have put in place, we do not expect any impact from Brexit on our Q3 results. As a reminder, in my remaining remarks about financial performance and guidance, all financial references are to non-GAAP measures, except for revenue or unless I specify otherwise. Gross margin in the second quarter 2016 was 42% down from 47.2% in the second quarter last year. This was due to an increase in warranty reserves for legacy products. This is not a reflection of any change in the competitive environment or in pricing as supported by ASPs for the quarter which were up year over year and consistent with Q1 2016. It is also not a function of lower margins on our new products.

We expect the additional reserves taken will adequately cover our future warranty liabilities allowing us to return to our normalized margins beginning in the third quarter which I will discuss in guidance. I should also note that we're seeing strong margin trends on our new products which are also benefiting from lower warranty costs due to their inherent design and the improved manufacturing processes we have implemented this year. We expect this trend to also apply to other new products we will be introducing heading into the holidays driving our gross margin trends in the second half 2016.

We exercised strong OpEx management in the second quarter to offset lower gross margins resulting in Q2 2016 non-GAAP operating income of $42.1 million. Our OpEx levels reflect continued investments predominantly in R&D, staffing and marketing expenses. Second quarter operating expense was $204.4 million. Specifically during Q2 2016 we ramped up sales and marketing expenses associated with the global launch of Blaze and Alta.

We consistently see a strong and direct sales impact and ROI associated with building our brand's equity through our advertising campaigns and our see our strong top-line performance as a reflection of that return. Additionally, significant investments were made in new display materials that were rolled out in the U.S. and internationally. That said, based on our expectations for the full-year of 2016, we expect sales and marketing expenses in the well-established Americas region to be close to our target model of 15% of revenue. The higher investment in international markets due to the early stages of development and higher growth potential. We believe this will establish a steady-state run rate for sales and marketing spend in other markets as they reach similar scale and brand awareness.

Additionally, we continued to successfully track more engineering talent to support our future product development plans. We continued to invest in software and fitness tracker device development, through R&D as a key investment for maintaining a rapid pace of innovation that drives our differentiation not only in devices, but also in the other key aspects of the Fitbit platform and users' superior experience with Fitbit.

We also continued to invest in the back-office infrastructure required to support our increasing scale. As mentioned in our last call, we have launched the implementation of SAP which we expect will be our new business system's backbone beginning in 2017. Q2 2016 total headcount increased to 1473 from 1306 at the end of Q1 2016 and 727 in Q2 2015.

The predominant focus continues to be in the groups that increase our capacity for developing new hardware, software and user experiences and in our capacity to drive revenue growth. We expect to continue adding to headcount in these groups in the second half as we enhance our existing products and services, design and develop new products and services and expand internationally. Second quarter 2016 adjusted EBITDA was $48.3 million exceeding our guidance due to the strong top-line growth and cost management. Consistent with our view for the full year, we expect our heightened investments will drive strong year-over-year growth in EBITDA as we get to the second-half 2016.

In Q2 2016, adjusted EBITDA also excluded costs related to the Jawbone litigation. Because we do not believe these costs have a direct correlation to the operations of our business and because of the singular nature of the claims underlying the Jawbone litigation matters. We began excluding costs in the second quarter as these costs significantly increased during the second quarter 2016 and may continue to be material for the remainder of the year. Excluding Jawbone litigation costs, Q2 2016 G&A expense, as a percentage of total revenue, was 3.6% consistent with our target model. Although we did not include the expenses for the Jawbone litigation in our adjusted EBITDA for the first quarter of 2016, these litigation expenses were $9.1 million. Second quarter 2016 net income was $29.5 million resulting in earnings per diluted share of $0.12. Our effective tax rate in Q2 2016 was 31% on a non-GAAP basis and 37% on a GAAP basis. 242 million diluted shares were used to calculate the second quarter of 2016 diluted earnings per share.

Turning to the balance sheet, we ended the second quarter of 2016 with $759.7 million of cash and short term investments and no debt. This is a decrease of $32 million from the end of Q1 2016 primarily as a result of the linearity of collections and timing of payments to vendors. Year-over-year for Q2 2016 cash, cash equivalents and short term investments increased 65%. Accounts receivable at the end of Q2 2016 was $377.5 million an increase from $339.7 million at the end of Q1 2016 with DSOs of 67 days in Q2 2016 compared to 56 in Q1 2016 and 53 a year ago in Q2 2015. DSOs increased in Q2 2016 primarily due to longer payment terms with certain customers in Asia-Pac due to the channel inventory levels previously discussed. Inventory was $190.6 million down sequentially from $212.1 million in Q1 2016. Inventory turns increased to 6.8 in Q2 2016 from 5.2 in Q2 2015 and from 5.6 in Q1 2016. Inventory turns were higher in Q2 2016 due to improved supply-chain management.

Moving to guidance, we remain optimistic for the second half of the year. As James mentioned, we expect to enter the holiday season with the most compelling lineup of new products than any previous holiday period. For Q3 we expect revenue of $490 million to $510 million, gross margins of 48% to 49%, EPS of $0.17 to $0.19 and adjusted EBITDA between $70 million and $80 million. Stock-based compensation is expected to be in the range of $26 million to $28 million. Our revenue guidance reflects the impact of seasonality combined with clearing the channel of several legacy products.

While we expect to start refilling the channel in the latter part of Q3 2016 in connection with new products for the holidays, revenue will be dependent on the production ramp coming out of the factory. This guidance also reflects further reductions in channel inventory in Asia-Pac during the quarter before an expected resumption of growth in that region in Q4 2016. I want to emphasize that even with this channel clearing, the midpoint of our guidance reflects a 22% year-over-year increase in revenue and a 58% sequential increase in adjusted EBITDA reflecting the expected improvement in operating leverage beginning in the second half.

Our Q3 2016 gross-margin guidance is driven by the margin profile of both Blaze and Alta and our other new products since they will represent a significant portion of our revenue for the quarter. We will also be closely managing our OpEx level to be consistent with seasonality and therefore expect a significant sequential decrease in marketing spend before we reramp during the holidays.

Moving to the full year, we're maintaining our full-year revenue and EPS guidance ranges of $2.5 billion to $2.6 million and $1.12 to $1.24 in diluted earnings per share. While our expectations for gross margin for the second half 2016 remain unchanged from our previous views, the full-year gross margin will be impacted by the Q2 2016 actual results.

Our full-year adjusted EBITDA guidance also remains unchanged at $430 million to $490 million. Stock-based compensation expense is expected at $92 million to $97 million for the year. Our guidance assumes an effective tax rate of approximately 30% for both the third quarter and for the full-year 2016. And a fully diluted share count of $244 million to $247 million for the third quarter and $244 million to $250 million for the full year. This concludes my prepared remarks. I will now turn the call back over to James. James?

James Park

Thanks, Bill. I want to reiterate that I'm very proud of the continued strong growth in progress we're making as a company. We continue to focus on building the right team and foundation for long term growth and I want to emphasize again how pleased we're to have two very experienced new directors join the Fitbit board. Laura Alber, CEO of Williams-Sonoma and Glenda Flanagan, CFO of Whole Foods Market have many board opportunities. It's a strong endorsement to Fitbit's future opportunities that these two executives have made the decision to join ours.

Operator, we're ready to open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. We'll take our first question from Tavis McCourt with Raymond James.

Tavis McCourt

I have got two of them. First, a clarification on the warranty charge. It looks like from the last quarter, your total warranty balance was about $50 million or so and the chart this quarter was probably somewhere around $40 million. So I just wanted to confirm that that was for legacy products and what happened intra quarter to make it ramp-up that charge this quarter versus previous quarters?

And then secondly, on new products, this year we will see, four new products or so. I am asking the question of how unusual would you expect that in the future based on the product development engine that you've created here? Is that a year that we should view as unusual in terms of new product launches or is that something that you think is sustainable in terms of the level of innovation and refresh cycles on the core products? Thanks.

Bill Zerella

Let me first answer your question on warranties. First, the amount of warranty charges running through the P&L for the quarter are $50 million and that excludes about $10 million of customer service related costs. So about $60 million in total is running through the P&L. The puts the liability at the end of the quarter for warranty claims at $77 million. Warranty is accrued based on the installed base of all products that are within the warranty period. That said, the significant increase in the charges as I mentioned on the call really relate to the legacy products versus our new products. Second question, I will turn it over to James.

James Park

Yes, we'll have the largest number of new products available for Q4 of this year in the Company's history, so that's a very positive sign from us for the holiday quarter. We're pretty excited about that. As for future guidance on new product cadence, that's not something that we can give right now, but all I can say is that, as you've seen this year, we've put a substantial amount of OpEx into R&D; and that is being reflected in a pretty healthy product pipeline for the next few years. What we do want to do at some point out though is have a target of a more predictable cadence of product launches, but that's going to unfold over time.

Operator

Will take our next question from Stanley Kovler with Citi.

Stan Kovler

Also just one clarification and then a question for me. So, the clarification, I just wanted to better understand why this was the quarter to start taking out the legal expenses and obviously it's not something new. Many companies take these expenses out of their non-GAAP. Last quarter, it was already looking like a pretty substantial amount; you quoted, I believe, $9.5 million, so I just wanted to understand that. And then the question around the higher level touch points here is, some of the wearable blogs out there have suggested that you have a couple of products coming out something like a lower-end product, if you will and more of a mid-range product. When can we expect the high-end to get a refresh and is that something to think about as far as if these go? Thank you.

Bill Zerella

It's Bill. I will take the first one and then I'll pass the second one to James. On the legal fees, what happened in Q2 was the costs had gotten to be more and more material. And our expectation for the year is that they can continue to be material to the business and determine at this point that it's not representative of our normal run rate in looking at our G&A spend versus our target model, so we made a decision to pro forma those costs out. That was the reason and we do think that it does make sense to do so similar to other companies as you mentioned.

James Park

Yes, on the new product side, we can't give any guidance that ASPs will increase, but what I can say is that pretty much every existing product that we have in market today is undergoing substantial R&D, so you should anticipate some type of refresh for those products in the coming years; but again, I can't give specific guidance as to our new product launch.

Operator

We'll take our next question from Jerry Lehue with Morgan Stanley.

Jerry Lehue

Bill, if we look at the second half non-GAAP OpEx run rate, you clearly kept OpEx in check in the second quarter, so that R&D, that marketing expense that you were planning to do, are you pushing that further out, out of this year or is there some change in strategies or road maps internally to not have that spend show up in the second half of the year?

Bill Zerella

Frankly our views here in terms of OpEx spend for the second half has not changed since the last call. We expect a pretty significant decline in marketing spend in Q3 associated with a low point from seasonality and then it's going to ramp back up in Q4. As we get closer to Q4, we may decide to be opportunistic if we think there's an opportunity to drive more revenue supported by more marketing spend, but we would only do that with the expectation that it would be at least bps neutral if not accretive. We don't finalize all of those marketing plans until we get close to the holidays.

Jerry Lehue

Understood and on the second quarter, another way to ask the question is with the lower OpEx spend than what was originally planned, you guys don't feel that that's delayed any R&D or products or limited you to do less marketing than you would have originally wanted to do?

James Park

This is James. No, absolutely not. We were just incredibly disciplined in our hiring and we're focused on hiring the right people into the Company. And in fact, as I mentioned, the answer to the last question, we have a few new products launching this fall which I'm super excited about and our products pipeline for the next couple of years is pretty full. So I don't believe that there was any impact to our innovation.

Jerry Lehue

Awesome. And then just one clarification, when I look at the guidance in terms of EBITDA margins, does that exclude or include litigation? Is it just excluding for second quarter and forward? Do we factor in that first quarter $9 million plus? Thank you.

Bill Zerella

Sure. Our guidance excludes Jawbone-related legal fees for the rest of the year. All other legal fees related to other corporate matters are obviously still within G&A. So it does exclude them for the second half for Jawbone only.

Operator

We will take our next question from Nat Schindler from Bank of America Merrill Lynch.

Nat Schindler

Can you help me understand a little bit more; I'm sorry I missed some of the prepared remarks around profit and if this is a new baseline or if it's just clearing some channel inventory. And do you think the new products coming out later in the year are going to have similar to historic gross margins or is this where we should be looking from now on?

Bill Zerella

Actually, the lower-than-expected gross margin in Q2 was due to us accruing additional warranty reserves for our legacy products and we believe that probably states the liability to cover future claims; and as a result, our future gross margins and what's baked into our guidance is primarily driven by our new products which by the way, are also experiencing lower warranty costs based on their inherent design and all the things that we've done on the operations side in terms of manufacturing processes for our new products. The Q2 gross margin is not indicative of any new baseline; it is reflective of taking those additional reserves, in conjunction with our accountants, believe we're required.

James Park

To add to that, it is absolutely not a reflection of any change in the competitive environment for pricing as supported by our ASPs for the quarter. Competitively, we're doing incredibly well.

Operator

We'll take our next question from Joe Wittine from Longbow Research.

Joe Wittine

A question on market share. You referenced the IDC data I suppose, at least as of the first quarter. With the new point of sales displays, it's pretty obvious some of your competitors, even some of the bigger ones are being relegated to what I would call less attractive real estate. So I'm curious if you have any early data showing relative share movement where the new displays are in or if it's too early?

James Park

I think it's a little too early. A lot of the displays have just come in or are coming in, but we do expect those displays to have a pretty material impact on our success in Q3 and Q4 and you are correct. We're experiencing incredible success in the channel and we're seeing our competitors being, as you said, relegated to a bit more second-class status.

Joe Wittine

And then James, quickly, it was productive to lay out the relative geographic unit shipments versus smartphone in that fashion. So the question is internationally, in EMEA and APAC, are you viewing the ultimate long term opportunity relative to smartphones as commensurate with your U.S. shares or anything that functionally or culturally perhaps limits you to a more modest share internationally? Thank you.

James Park

Yes, so I think the smartphone penetration percentages that I laid out show an incredible opportunity in EMEA and APAC. I think right now in terms of unit shipments versus the addressable market we're not even close to the U.S. so we have a lot of headroom there and opportunity for growth. I think, I've always said this, I don't believe that there is a cultural barrier to adoption of our devices. It's nearly a matter of consumers in that market being educated about the benefits of our products.

Especially if you look at APAC, the idea of health and wellness across families and friends and people sharing their health statistics is a very powerful concept; so we continue to invest, especially in sales and marketing, in those regions.

Operator

We will take our next question from Betty Chen with Mizuho Securities.

Betty Chen

I was wondering if you could talk a little bit more about maybe the reactivations and also the new customer. What are you learning from why they are reactivating or perhaps why they have been inactive for some time? And then also, in terms of the upgrade cycle, do you have a sense on how long they owned the previous device before they are now upgrading into the Alta or Blaze devices? Thanks.

James Park

Yes, so I can't go into all the statistics, but generally what we see is that, in health and fitness, people do cycle in and out of when they have a health goal. So if they have a weight-loss goal, they may hit it and then fall off. Or they might be training for a half marathon, hit that goal and fall off. So I think, inevitable in the category, there is going to be some ebb and flow.

So the positive thing for us is that with each new product cycle, especially this last quarter, we have been able to demonstrate the ability to reach back to these inactive users and upgrade them. People are attracted to a lot of the new features and functionality in the hardware and particularly the interactive experience where we're continuing to invest in. This also ties into our strategy of trying to make our devices more useful to people outside of their health and fitness goals; that's why over time we've added more general-purpose functionality such as caller ID, tech certifications, etcetera.

That was a driving reason behind our acquisition of Coin as well. We want to continue to make our devices an indispensable part of people's lives, not only in health and fitness, but since they already have these devices on their wrists, in other parts of their lives as well.

Operator

We will take our next question from Robert Peck with SunTrust.

Robert Peck

Just a couple of quick ones. First of all, James, I was wondering if you could comment a little bit on channel fill by geography. Has there been any changes to sell-through that you've been able to discern? And then, Bill, on APAC, obviously it was impacted by the Dick Smith closure, but you also mentioned some inventory reduction. Can you help us quantify that? And lastly, James, I was wondering if you at high level could talk to us about churn, if you see any discernible uptick or downtick or how has churn been on the platform in general? Thanks so much.

Bill Zerella

We don't get into the level of detail in terms of trying to put out any data in terms of how channel inventory levels are changing by geography. We would say directionally certainly Asia-Pacific was impacted by a reduction in channel inventories, that was offset by some increases elsewhere in the world.

So net-net, at least as far as this data that we have, it doesn't appear to really have had any material impact on our revenue for the quarter. There were a bunch of puts and takes. I think that answers your question in terms of sell-through or channel inventories. I'll turn the other question over to James.

James Park

In terms of churn, the retention engagement numbers are something that we published once a year, but just directionally I don't see anything materially out of line right now; and, more importantly, we're making a lot of R&D investments on the software side and I'm really excited about some of the interactive features that are going to be launching over the course of the next year which I think will even more dramatically improve our engagement numbers.

Operator

We will take our next question from Ross Sandler with Deutsche Bank.

Ross Sandler

I guess I'll start with the new products. Now that Blaze has been out for a quarter and has a more interactive display, how does the engagement and user activity in the Fitbit app for Blaze uses compared to other previous products and what are some of the functions that are being used the most? Any new things you have learned from Blaze that might help with future product development?

The second question is also related to the new products, in terms of revenue, are Blaze and Alta performing in line, better or worse than Charge and Charge HR in their first quarter or two from last year? And, Bill, are the current launches of these two in balance in terms of the supply demand perspective? Are the production levels for Blaze and Alta the constraint or is it fairly balanced? Any color there would be helpful. Thanks.

James Park

We don't break out any specific stats on Blaze, but directionally, I think we've seen is that our newer products, each successive generation of our products sees higher and higher levels of engagement and typically we attribute that to more sensors or new metrics that take advantage of the sensors. With recent products, we've obviously seen more general-purpose functionality have a material impact on engagement rates. So directionally, that's a trend. Our newest products, because of the greater interactivity, the sensors, the data, et cetera do exhibit higher-engagement statistics.

Bill Zerella

Ross, on the question, so first on production levels, we're in great shape in terms of our production capacity for both Blaze and Alta. We have been able to meet consumer demand out there. We have not really experienced any shortages that I am aware of and we're in great shape heading into the holidays for those two products as well. Collectively, I would say that we had some pretty high aspirations for both those products combined and we're tracking really well against those expectations. Both these products are, I would say, we're very pleased with the results so far.

James Park

If you look at Amazon, I think, it is very clear that consumers love these products. It has been a break-out success.

Ross Sandler

Are Blaze and Alta currently available in all the regions or can you give us some color on the geographical outlook for the new products?

James Park

Right now they are available in all regions.

Operator

Will take our next question from Erinn Murphy with Piper Jaffray.

Erinn Murphy

Just a couple of questions for me. First, how should we be thinking about inventory at the end of third quarter and for the new product you have coming in for holiday? And then, are the new product set embedded into your third quarter guidance? That is my first question.

Bill Zerella

Yes, sure. The second question, yes, there is new product revenue baked into our third quarter guidance. As I mentioned, the channel is going to be draining and declining for some of our legacy products and then we will start refilling the channel with these new products and the revenue outcome for the quarter will frankly be primarily dependent upon how much production we can get out of the factory in terms of shipping these into the channel. That frankly ties into what our inventory levels will be.

Directionally we would expect them to potentially be flat. They might be down a little bit. It all depends on how much new product production is in process and sits on the balance sheet versus how much we can get out the door.

Erinn Murphy

And just a question as we head into the holiday season, I think last year you mentioned that black Friday was really the only day that you really helped fund some of the promotional activity out there. Is that still the way we should be thinking about things when we're looking and monitoring promotions into the holiday season or has that directive with how you are working with your retail partners changed?

James Park

Yes, I think black Friday is still going to be the predominant place where we do promotions. And, the rest of the year, because of the popularity of our products, we don't really see the need to really use promotions to drive revenue.

Erinn Murphy

Okay, so if we do see other kind of promotional activity, whether it's at a specific retailer or online, our baseline assumption should be that is being funded by the retailer, is that correct?

James Park

Yes. In a lot of cases what we're seeing is that the retailers are competing with each other; so, yes, that is what you're seeing out there if there is significant discount.

Erinn Murphy

And I just have a follow-up for Bill on the SAP launch, can you just comment on the timing of how you are planning to roll that out geographically or just any context for how we should be thinking about the execution of that? Thank you.

Bill Zerella

Yes, so SAP, the target launch date is in the spring of next year. Specifically April 1 is the target date, so that's what we're working towards.

Operator

We will take our next question from Charlie Anderson with Dougherty and Company.

Charlie Anderson

I wondered on the Australia headwind if that was contemplated in the earlier guidance or we're actually doing a little bit better excluding that? And also if you could quantify the impact to Q3 on the top line.

Bill Zerella

So we were not surprised by the need for us to burn down channel inventory in AsiaPac, so that was not a surprise at all. We also knew that Dick Smith was going to be closing stores; so I would just say directionally there was nothing that was a surprise there. I can't give you any specifics on Q3. We don't get to that level of fidelity. All I can say is we have been pretty conservative in terms of projecting further burn down in inventory in Asia-Pacific and that is what we have Incorporated into our guidance.

James Park

I think the key highlight is, excluding Australia, that APAC business grew 98% year over year. That is amazing growth in that region.

Charlie Anderson

And then a follow-up for me. James, since you mentioned it about not selling stock for the rest of the year, I wonder why you made the statement and just maybe your philosophy going forward, maybe beyond this year in terms of your ownership stake? Thanks.

James Park

Look, I think the best way to put it is, looking at our product pipeline and the innovation that we have for the rest of the year, I'm really excited about our prospects and that's driven the decision not to sell stock for the rest of the year and that includes, again, as I mentioned, Eric, cofounder and CTO and Bill as well.

What I can say is, I think we're willing to do anything to ensure that investors have confidence in the Company's future prospects and growth; and our statement to not sell stock is part of that and going forward we will continue to reevaluate whether we need to give that level reassurance.

Operator

We'll take our next question from Jim Duffy with Stifel.

Jim Duffy

I was on the call late, so maybe you addressed this first one. But the growth rates in R&D spend in the quarter moderated meaningfully relative to recent rates. Have you changed your view on the R&D budget for 2016?

James Park

I don't think that reflects an overall change in our philosophy on the importance of R&D to the company. As I mentioned and as an answer to a previous question, I think what that primarily reflects is that we were just very disciplined in our interviewing and hiring process and we're just making sure that we're pretty selective the right people onboard. And the most important thing is that change in R&D spend will not have an impact on future operations.

Jim Duffy

And then a question with respect to expectations for marketing expense in the U.S., has there been any test to the impact to demand from more moderate marketing expense? Or is this uncharted territory as you pull back on that looking forward into the fourth quarter?

Bill Zerella

Yes, Jim, the pullback that we're expecting in marketing spend for Q3 is really to be aligned with seasonality. And again, we're also going to be going through several product transitions as well. So those two factors lead us to conclude that is not the right quarter for us to be expending a lot of marketing dollars and that we should have that dry powder really available for the holidays and get some leverage back into the model in Q3.

And then of course, Q4 is a quarter that we would typically expect a lot of leverage as well. We think that is the right cadence. It is also reflective of the fact, especially in the U.S., that we have a higher level of maturity and brand awareness in the market than we've had in previous years.

Operator

We'll take our next question from Mike Delello with Leerink Partners.

Mike Delello

Just really quickly on the inventory draw down in Australia, I just was to make sure I understand this. It is separate from the retailer shutdown and is it because there was initial overstocking of supply for that market or that product is not selling as well as you initially thought or what's really driving that correction in inventory?

Bill Zerella

This is Bill. There are two separate issues. First was the closure of these Dick Smith stores and the impact that had on our business during the quarter. That is separate and apart from channel inventory levels being too high and this is something we've taken some corrective action on. We have changed some of our management locally in that market on the sales side, so channel inventories were too high based upon shipments in Q1; and, as a result, we're just bringing those inventory levels down over time before we get back to the growth we expect in Q4.

Mike Delello

That is APAC in general or Australia?

Bill Zerella

This is all Australia, but Australia is our biggest market in Asia; therefore, it has a pretty big impact on the overall Asia-Pacific revenues.

Mike Delello

Okay and then just bigger picture, I wanted to get your latest thoughts on sensor technology and where you think it is at this point as far as integrating into new products? Or is that more of a 2017 event where we would expect something like a heart rate sensor type level of a new sensor?

James Park

What I can say is that, an R&D pipeline is pretty full of new technology and, especially as we integrate more deeply into the healthcare ecosystem, there is going to be more demand and requirements for more sophisticated sensors. And definitely, what we have in the works, we're pretty confident we'll be up to that challenge.

Operator

Ladies and gentlemen, that is our final question today. This does conclude today's conference. We appreciate your participation.

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