Fitbit, Inc. (FIT) CEO James Park on Q2 2018 Results - Earnings Call Transcript

Fitbit, Inc. (NYSE:FIT) Q2 2018 Earnings Conference Call August 1, 2018 5:00 PM ET

Executives

Tom Hudson - IR

James Park - CEO, President and Co-Founder

Ron Kisling - CFO

Analysts

Alex Fuhrman - Craig-Hallum

Sherri Scribner - Deutsche Bank

Jeffrey Garro - William Blair

Scott McConnell - D.A. Davidson

Joshua Kehoe - Citi

Joe Wittine - Longbow Research

Ryan Goodman - BofA Merrill Lynch

Yuuji Anderson - Morgan Stanley

Scott Searle - ROTH Capital

Charlie Anderson - Dougherty

Operator

Good day and welcome to the Fitbit Second Quarter 2018 Earnings Call. This call is being recorded. At this time, I would like to turn the conference over to Tom Hudson. Please go ahead, sir.

Tom Hudson

Good afternoon and welcome. Fitbit distributed a press release detailing its quarterly results earlier this afternoon. It's posted on our Web-site 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 Web-site, 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 or in other earnings presentation materials posted on the Investor Relations page of our Web-site.

This conference call will contain forward-looking information, which is subject to risks and uncertainties described in Fitbit's filings with the SEC and in today's press release. Actual results or events may differ materially.

We will begin with a commentary from James and Ron, and we'll then open the call to questions. We are going to limit the call to about an hour, so we apologize in advance if we don't get to all your questions. Let me introduce Fitbit's Chairman and CEO, James Park. James?

James Park

Thank you, Tom. Thank you to everyone participating in today's call. I'm pleased to report that for the sixth quarter in a row we have delivered on our financial commitments and are making progress in our multiyear transition, which include adapting to the changing wearable device market, transforming the business from an episodic-driven model centered around device sales to more non-device recurring revenue, deepening our reach into healthcare, and increasing our agility and optimizing our cost structure.

Revenue for the quarter was $299 million. We saw continued momentum for our mass-appeal smartwatch, Fitbit Versa, which sold out in the quarter. The introduction of Versa strengthened our brand relevancy and highlights the opportunity to regain market share as we progress in the smartwatch category and continue to deliver both hardware and software offerings that consumer finds compelling.

Fitbit sold 2.7 million devices in the second quarter, up sequentially and with the year-over-year rate of decline in devices sold dropping to 20% in the second quarter versus 27% in the first quarter. The success of Versa has improved the Company's positioning with retailers, solidified shelf space for the Fitbit brand, and has provided a halo effect to our other product offerings. Retailers have been looking for a counterbalance to Apple and Versa has delivered it.

In the second quarter, Fitbit Versa outsold all Samsung, Garmin and Fossil smartwatches in North America combined. With the strong consumer receptivity for Versa, demand has outpaced supply, and we have chosen to add an additional production line. Since launch we have also seen a significant uplift in North America POS trend.

We also believe the channel reduction of trackers has run its course and have increased confidence that Q2 will mark the trough in the year-over-year decline in tracker sales. Our confidence in the trough in the decline in tracker sales is driven by clean tracker channel inventory levels, consumer feedback, and our product pipeline.

As we look forward, we believe our improved forecasting and lower risk approach with new product introductions reduces the risk of an imbalance between sell-in and sell-through and gives us confidence in the path ahead.

In the second quarter, 60% of activations came from new users, while 40% came from repeat buyers. Of the repeat buyers, 51% were previously inactive for 90 days or more. The percentage of repeat buyers coming from previously inactive customers has significantly improved from 39% in the second quarter of 2017, demonstrating that our newest devices can reengage inactive customers and bring them back to the Fitbit platform.

We have always emphasized there is no one-size-fits-all when it comes to health and fitness, and we have always provided a choice for consumers across form factor, feature, and price. While smartwatches continue to grow at a rapid pace and present a strong opportunity for future growth, there is still a large community of users who prefer the tracker form factor and who are looking for powerful health and fitness features at a more accessible price.

For example, we sold 50% more Alta HR devices in the U.S. during the 2018 Amazon Prime Day than the prior year. In addition, our Charge franchise has sold over 35 million devices and Charge 2 continues to be our best-selling tracker with over 15 million sold nearly two years after it launched.

Industry analysts often hear that trackers will continue to be an important part of wearable categories overall. According to IDC, [indiscernible] trackers are expected to reach 46 million units in 2018 compared to 43 million smartwatches globally. We see an opportunity to reinvigorate the category through innovation to successfully serve the needs of this large consumer segment.

Fitbit Ace, our recently introduced kids device is a great example. With this product, we are introducing a wearable to a younger demographic while making fitness fun and helping families connect and build healthy habits together. In addition, we continue to invest in the social and software features. We believe our active community of users provides a barrier to commoditization and a unique value proposition. 56% of our active users viewed the Feed in the second quarter. Our recently introduced female health tracking feature has also been well-received with more than 2.9 million sign-ups.

We know that wearable devices can help people get healthier. The question now is how these devices will continue to evolve and what role they will play in healthcare. We have been working to lay the foundation for growth into the healthcare channel by strengthening our relationships with key players in the healthcare ecosystem, building out our direct sales team, adding capabilities like the human coach platform, and collaborating with developers to create health-focused apps and [indiscernible].

The strength of our consumer offering and our ability to engage people and drive behavior change directly supports our healthcare efforts. We see ongoing evidence that healthcare use cases continue to grow and evolve. Some examples include payors embracing wearables and providing financial incentives to motivate behavior change, condition management, pinnacle research, or connecting patients and care teams. I'm proud to say that as of today Fitbit Health Solutions has the ability to provide solutions to over 100 health plans across the U.S., including Blue Cross Blue Shield and Humana.

In terms of clinical research, we continue to help researchers pioneer new ways to use their devices to drive better health outcomes. In a new study, researchers from Cedars Sinai Medical Center and Johns Hopkins University found that a Fitbit device successfully gathered real-time objective data on patients with cancer helping clinicians predict outcomes.

We are also expanding the work we are doing with the University of Michigan's Intern Health Study which this year will follow 2,000 new doctors better understand how intense and changing work schedules contribute to a resident's mental health.

When it comes to health, we want to leverage the investments we are making across both our consumer and Health Solutions business. As such, we are focused on chronic condition areas that have corollaries on the consumer side, diabetes and weight management, heart health and fitness, sleep apnea and sleep quality, mental health and stress. Our ultimate goal is to help providers, health plans, and clinical researchers better support their patients outside the walls of the clinical environment and help our users better understand their overall health and wellness.

We often receive testimonials from our customers telling us, all their Fitbit devices either raise awareness about a potential medical issue or change their lives by changing their behaviors. These examples include a young mother of three who identified that she had a serious condition called postural orthostatic tachycardia syndrome or how a teenage girl discovered she was suffering from supraventricular tachycardia, a defect that causes a faster than normal heart rate due to an error in electrical impulses. It is these type of testimonials that give us confidence that we have the building blocks to create a device and software offering.

We also introduced a number of key health apps in Q2 that brings important health information like blood glucose numbers to the list, helping to bridge the gap between consumer and healthcare. As part of this program, we introduced new health partner apps and clock faces including Walgreens, OneDrop and Limeade. Built using Fitbit software development kit, the apps and clock faces will give Fitbit smartwatch users new options to improve wellness and help manage conditions like diabetes. Wearable devices are easy to use, unobtrusive, and motivating, while the benefits of increased activity and health awareness come with virtually no side effects.

Finally, before turning the call to Ron to discuss our financials in more detail, I wanted to discuss our operating efficiency. We continue to be on track to reduce operating cost 7%, but have made a conscious choice to pull forward cost and increase our media and advertising spend to support the launch of Versa. As I mentioned earlier, Versa success strengthens channel partner relationships and we believe provides momentum into the back half of the year. Also we continue to make progress transitioning our data infrastructure to Google's cloud where we expect cost savings to begin in 2019.

I'm also excited to announce that we have hired a new leader for our engineering organization, Koby Avital. Koby joins us from Priceline.com where he was a Chief Technology Officer. As Executive Vice President of Engineering, Koby will focus on hardware, software, and firmware engineering. Eric Friedman will maintain his role as CTO focusing on data security and advanced research.

With that, let me turn the call over to Ron to discuss the quarter in more detail. Ron?

Ron Kisling

Thanks James. My prepared remarks will be focused on a financial overview of the second quarter result. I will then provide our guidance for the third quarter of 2018. Before I go through the details, I would like to remind investors that all financial references are to non-GAAP measures, except for revenue, unless I specify otherwise, and all financial comparisons are on a year-over-year basis unless otherwise specified.

Fitbit sold 2.7 million devices and generated $299 million of revenue in the quarter, down 15%. The 15% decline in revenue resulted from a 20% decline in devices sold, partially offset by an average selling price increase of 6% to $106 per device. The average price of trackers sold declined year-over-year, driven primarily by a mix of fewer Blaze units rather than competitive dynamics.

Versa sales at an average selling price higher than Blaze more than made up for the tracker delta. However, with Versa contributing the vast majority of smartwatch sales in the quarter, having a sales price less than Fitbit Ionic, smartwatch ASPs declined from the prior quarter.

Accessory and other revenue added an additional $5.23 per device sold. Accessory revenue was negatively impacted by fewer units sold while non-device paid revenue grew 34% but remains immaterial to overall results.

U.S. revenue represented 61% of total revenue or $182 million, declining 8% in the quarter. International revenue declined 24% to $117 million but growth varied significantly between regions. APAC revenue advanced 66% to $35 million while EMEA revenue declined 39% to $66 million, driven by higher promotional activity and weakness in the U.K. market. The U.K. market has lagged in its transition to smartwatches and thus was disproportionately exposed to contraction in the tracker market. We expect a reversal of this trend in Q3 and a return to growth. Americas, excluding the U.S., declined 35% to $16 million.

As James indicated, broadly speaking, retail channel inventory is relatively clean with some Versa demand unable to be fulfilled given supply constraints and tracker inventory now in line with expected consumer demand. Our direct consumer business, Fitbit.com, represented 14% of revenue and declined 9% to $43 million.

Gross margin declined 210 basis points to 40.9%. Decline was expected, driven by the growing mix of smartwatch revenue, partially offset by lower warranty cost and lower customer support contact rates. Operating expenses increased 1% to $194 million. Research and development cost increased 6% to $72 million. Despite an objective to lower operating costs, we are maintaining our investment in innovation to transform the business. Our goal is to drive efficiency in our device business, while investing in software services and Fitbit Health Solutions.

Sales and marketing costs were flat year-over-year at $96 million. We increased investment with higher media spend to support the launch of Versa but benefited from the improved quality of our devices. As [DPTM] [ph] has improved, case volume has shrunk, leading to lower customer support spend. In addition, we spent less on point of purchase displays.

General and administrative expenses were $25 million. In addition, we have reduced our real estate footprint in San Francisco. This suddenly lowers our operating expense run rate but removes approximately $81 million in lease obligations from our future commitment. Operating loss was $71 million with other income up $4 million. We recorded a tax benefit of $12 million, resulting in a net loss per share of $0.22 in the quarter.

Cash flow from operations was a negative $67 million and capital expenditures in the quarter were $16 million, resulting in a free cash flow loss of $83 million, better than our expected free cash flow loss of $85 million. We ended the quarter with $580 million in cash and short-term investments and no debt. In addition, on July 3 we received a $72 million tax refund payment from the IRS. We expect to receive approximately $8 million in additional tax refund payment but the timing is uncertain.

Now let me turn to address our guidance. We expect third quarter results to benefit from the lessening in year-over-year decline of tracker revenue and continued growth of our smartwatch franchise. We expect revenue to decline approximately 3% on a year-over-year basis to a range of $370 million to $390 million, and roughly flat gross margins to the second quarter.

As a percentage of revenue, we expect Q3 operating costs to trend materially lower. We expect free cash flow of approximately negative $30 million in Q3 and net income per share between a $0.02 loss and a $0.01 profit. Our tax rate will vary on our ability to achieve profitability and the geography of income. We expect tax to shift from a benefit to an expense of approximately 2% on a basic share count of approximately 247 million shares. Stock-based compensation is expected to be approximately $26 million.

We are reiterating our full year 2018 guidance. We have increased confidence that Q2 marked the trough in the year-over-year decline in tracker sales and anticipate continued strength in smartwatch growth. Similar to Q3, we anticipate gross margins to be roughly flat to Q2 at approximately 41%. The device mix shift will also benefit average selling price on a year-over-year basis but will not offset the decline in tracker devices sold and as such we are forecasting an overall year-over-year decline in devices sold.

Relative to Q2, average selling price is expected to be roughly flat. We expect to continue to grow our Fitbit Health Solutions business and increase our premium subscribers but this growth will be relatively immaterial to our wearable device revenue. The net result is that we are maintaining our revenue expectations of approximately $1.5 billion.

We are on track to reduce operating expenses by approximately $60 million from 2017 level to $740 million, consistent with our previously stated commitment. Our intent is to continue to drive efficiencies into the business and redeploy capital to growing our software services, Fitbit Health Solutions, and the international sales footprint.

Given the strength of demand for Versa, we have increased our capital expenditure cost to increase production capacity and now anticipate CapEx to increase as a percent of revenue to 5% from the previously forecasted 4% level. We expect this spend to negatively impact free cash flow. As such, we are revising our fiscal 2018 free cash flow guidance to a loss of approximately $20 million from breakeven.

Moving to taxes, we are forecasting fiscal 2018 tax of approximately 25% but anticipate the tax rate to fluctuate substantially depending on the geographic distribution of our earnings. With respect to liquidity, given the shifting demand patterns and continued investment to transform our business from an episodic one to more durable sources of revenue, our primary focus in 2018 is to adapt the changing wearable device market while creating the foundation to grow Fitbit Health Solutions and software services in 2019 and beyond.

Our balance sheet remains robust with $580 million in cash and marketable securities as of the end of Q2. In addition, as I noted earlier, we received $72 million in a tax refund in early July. We will continue to augment organic investment with targeted M&A. Similar to the acquisition of Twine Health, we expect M&A to continue to play an important role at Fitbit and are targeting businesses that will help transform our business toward digital health and recurring revenue.

Before turning the call over to the operator, I wanted to take a minute to discuss the tariff situation. Fitbit utilizes contract manufacturers located in China to produce its devices. These devices, with the exception of our scale and headphone, are included in the tariff code identified by the U.S. trade representative's recent proposal. As such, a 10% tariff, if implemented, would apply to the build of material cost on goods imported into the U.S. We are navigating a number of different paths to reduce or eliminate the impact of the tariff.

It is important to note that it is unclear if the tariff will ultimately go into effect if wearable devices can qualify for exemption or how much, if any, of the potential increase in cost can be mitigated. Thus, our full-year guidance excludes the potential impact. We support open markets and free trade where everyone plays by the rules.

With that, let me turn the call back to the operator to answer questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Alex Fuhrman with Craig-Hallum.

Alex Fuhrman

Congratulations on the huge success of the Versa. I wanted to ask about where do you kind of envision the role for the legacy wearable trackers in your portfolio over the next couple of years. It's encouraging to hear that it sounds like you're continuing to think that Q2 was the trough in terms of the negative growth rate. Can you give us a little bit of a sense of where that optimism comes from? I imagine some of that comes from the fact that the inventory in the channel appears to be pretty clean. But going forward, on a more sustainable basis, can you give us a sense of where you see the role of the trackers in your portfolio? And specifically, I'd be interested to hear where you envision the distribution of these products. I think you mentioned that the success of the Versa really helped strengthen the relationship with some of your channel partners. What are the channel partners most interested in carrying? Do you envision them likely carrying the legacy products over time or do you see them more carrying the newer products and then selling more the legacy devices on Fitbit.com? Just curious how we should expect to see that process unfold over the next couple of years.

James Park

So, we continue to be excited about the tracker category and we expect trackers to be an important part of our portfolio for many years ahead, and the reason for that is several. One, there is no one-size-fits-all in the wearables category. There's a lot of nuance in consumer preference and choice between form factor, feature set, and price, and there's actually a large community of users based on our market research who still prefer trackers and actually specifically trackers and not smartwatches, and it's a good thing that we lead that category. So, we're going to continue to invest and innovate in trackers, and I'm pretty excited about our product pipeline in that category.

And to give you some context, we've had a huge franchise since we've launched original tracker, 35 million devices for Charge, 15 million in Charge 2 since launching two years ago. So, it's going to continue to be important. Not only that, we're taking opportunities to increase where trackers can be sold. One is the kids demographic. Fitbit Ace continues to get positive momentum and reception. And then healthcare is going to be a big channel for us for trackers. The healthcare channel is more price sensitive and a tracker lineup is perfect for distribution into our health plans.

For retailers, because we feel pretty strongly that the year-over-year decline in trackers has hit a trough, they're going to continue to carry the tracker lineup along with smartwatches.

Alex Fuhrman

Great. Thanks James. That's really helpful. And then if I could just add one follow-up, it seems like you have a very strong and growing community of users that are really engaging with the app using the Feed. Is there any discernible difference in behavior from those core engaged users that are using the Feed? Are they more likely to gravitate towards the smartwatches or the trackers or more likely to purchase on Fitbit.com versus a retailer? Just curious if that subset of users is behaving differently than the other users.

James Park

They do behave differently. Where we see it is actually in terms of retention and engagement. Being involved in the community and being involved with your friends and family on Fitbit helps both of those metrics pretty materially, and where that's going to really manifest itself in terms of our future strategy is, as we roll out more services that are paid and attached to the core product, we obviously want very healthy engagement and retention numbers. And a great statistic for us on the paid premium front is, inclusive of our Twine acquisition, our paid premium services actually grew 34% year-over-year. So, that's a positive trend.

Alex Fuhrman

Great. Thank you very much.

Operator

We'll go now to Sherri Scribner with Deutsche Bank.

Sherri Scribner

I guess just thinking over the next couple of years and the transition in the smartwatch business from trackers, I guess how you're thinking about potential unit growth as we move into 2019 and 2020 as we sort of stabilized some of the declines in the tracker business or at least the smartwatch business has become a bigger piece of the overall business?

Ron Kisling

This is Ron. I think if you look at kind of the mix we saw in Q2 with smartwatches being 55%, so a little over half, I think as you look certainly to the second half of this year and probably into early next year, I would expect that we would still see trackers comprising a significant portion of those sales and that the smartwatches would still be probably in that 50% range, maybe increasing a little bit as part of the mix going forward.

But trackers, as James indicated, there is a large community of users who prefer trackers. I think as you look at the innovation, you're going to see more of a blending of some of the features and form factors between the two. And in addition, particularly in healthcare and in the kids space, you're going to continue to see sort of demand in new products and increased unit sales into healthcare.

James Park

And like I mentioned in my prior comment, we need both of those products to be successful in executing our strategy, and they are a foundational element of I think a huge milestone which is one for us to breakeven in Q3 and actually return to growth and profitability in the second half, which is what we're expecting.

Sherri Scribner

Okay, great. And then thinking about all of the new initiatives you have on the health side with sleep apnea and tracking women's health, I guess I'm trying to – I guess I'm asking, is there a way for you guys to monetize those opportunities beyond just selling a hardware device? Is there some way that you guys have been thinking about where there's some sort of service or there's some sort of other way that you guys can generate some type of recurring revenue stream maybe on top of the hardware sale?

James Park

Yes, absolutely. We are very focused on building a recurring revenue stream. So that's going to happen on both the consumer side and on the healthcare side. So, on the consumer side we are investing and thinking about creating a membership model for devices and having services that consumers pay for. And then on the healthcare side, the ways that we monetize beyond a device will be, one, selling our services, include diagnostics and coaching on a per member per month basis, or possibly even sharing in some of the cost savings that our products and services deliver. Now I think one of the positive proof points is that our healthcare business actually grew at a double-digit rate in Q2.

Sherri Scribner

Okay, great. And then just quickly, Ron, a clarification, the change in the free cash flow to be down as opposed to flat, does that include the $72 million cash you got from the tax refund or does it not include that? Thank you.

Ron Kisling

Our free cash flow guidance excludes the tax refund of $72 million.

Sherri Scribner

Okay, great. Thank you.

Operator

We'll now take a question from Jeff Garro with William Blair.

Jeffrey Garro

I wanted to ask a little bit more about the [indiscernible] in healthcare and maybe get you guys to talk a little bit more about the [indiscernible] strategy and specifically how you view the health plan channel versus the direct to employer opportunity or maybe any other channel within healthcare?

James Park

So, our two primary go-to-markets for our healthcare business is our employers and health plans, and we're continuously adding to the breadth in both. I think one of the big proof points for us in Q2 was that the number of health plans that we work with now exceed over 100, including Blue Cross Blue Shield and Humana. And one of the things that we're trying to work with all these partners is adding revenue streams beyond the initial device sale. So again, either on a per member per month basis, PMPM, or shared savings, and that's a big focus of the Company.

Jeffrey Garro

Great. That's helpful. And maybe the follow-up, I was hoping to get an update on the Twine acquisition, the integration of that, and how we can get healthcare stakeholders to engage more deeply on the health of their end-users and ability to produce tangible results, like the cost savings that you say you might be able to share and then generate revenue?

James Park

So the Twine acquisition has been going really well. We have gotten positive reception again from our employers and our health plan customers. And just to repeat the stat that I had before, inclusive of Twine, our paid premium or recurring software business model grew 34% year-over-year. So, we feel the integration is going well.

Operator

We'll now go to Scott McConnell of D.A. Davidson.

Scott McConnell

So you talked a little bit about the difficulties in the U.K., but how did growth in EMEA outside of the U.K. look? And maybe can you discuss what exactly the hurdles are in the U.K. with getting users to switch to smartwatches from trackers and how you're addressing these challenges?

Ron Kisling

This is Ron. So, across the EMEA we don't typically breakout each country individually. What I can say is that the decline we saw in Europe was driven primarily by declines in the U.K., which is one of our largest markets in the U.K. And what we saw there is, in the quarter they were impacted by their relatively high exposure to trackers. That was a predominant portion of what they were purchasing. And so, when we saw the reduction in the tracker category, they were disproportionately impacted.

I think the one positive thing that we're seeing is, unlike when Australian and the U.S. went through this category correction, we have this alternative with the smartwatch product that has been well received, and so we expect the decline that we saw in the region to be less and we expect the rebound to be much faster than what we saw in other regions, and as a result, we're expecting to see a return to growth in Q3 in the region.

Operator

Our next question will come from Jim Suva with Citi.

Joshua Kehoe

This is Josh Kehoe on for Jim. What are your expectations for non-wrist worn device sales? For example, your headphones and scale sales, and when should we see that coming maybe at 5% or more percent of revenue?

James Park

I think as we look at those, I think at this juncture those non-wrist sales, we would expect to see those continue to be pretty minimal in terms of our sales, and in the foreseeable future to continue to be in that under 5% level.

Operator

We'll go to our next question with Joe Wittine with Longbow Research.

Joe Wittine

Ionic is going on a year since announcement. By all accounts, the reception has been pretty mixed. So, when you look at that combined with the obvious success of Versa, I'm wondering how your strategy is evolving, if at all, and serving that high-end GPS running market where there's some long-standing intense competition with high-end features? Like I guess, do you think that you are getting the ROI and the resources you're directing to GPS-enabled or could the niche [indiscernible] by the Versa mass-market smartwatch area be enough for Fitbit to carve out more ground?

Ron Kisling

So I'll just say, Ionic didn't meet our initial expectations, but over the course of its lifetime so far, it is playing a very important role in our portfolio, and it's not something that we would get rid of. So, when we talk about smartwatches being 55% of our revenue, that's a combination of both Ionic and Versa. Ionic is targeting the performance segment of the category really effectively and Versa is targeting the mainstream portion of the category. So, I feel that we still need both of those products in the mix.

Joe Wittine

Great. And then on OpEx, James, you referenced the move to Google's public cloud, which will carry some cost savings, and Ron, you mentioned the office square footage decline. I know you won't quantify 2019 OpEx but can you give us some directional comment on if these initiatives are enough to keep OpEx dollars flat or continually declining next year?

Ron Kisling

I think in general we're looking to drive efficiency and leverage into the business, and I think a number of things, such as the Google Cloud transition, the office space reductions that we did, are very focused at driving efficiencies, particularly into 2019. Driving that efficiency is we're going to continue to invest in software, our Fitbit health services as well as international sales. So I think, we're looking at kind of a balance of those two and we don't have specific guidance for 2019 at this point other than continuing to drive efficiency in the business.

Joe Wittine

Okay. And then finally, you may have answered a little bit of this on the U.K. question earlier, but how do we interpret EMEA returning to growth, because I think in your tracker only days the Company used to view EMEA as lagging the U.S. by a couple of quarters? I think it's an interesting data point and I don't know if it may be an easier comp or a quicker smartwatch adoption in EMEA versus the U.S. today.

James Park

So, as Ron mentioned before, and then as you just mentioned, EMEA does lag the U.S. markets. I think the positive thing is, as it goes through this shift in the wearables market from trackers to smartwatches, we do have a great product and product line-up in both Ionic and Versa to help mitigate that. And while we don't break it out specifically, we are seeing very positive momentum for our smartwatches outside of the U.S., EMEA and APAC. So, that's what's giving us confidence in our statement that we feel that the region is going to return back to growth in Q3.

Joe Wittine

Is EMEA where smartwatches are the largest portion of your unit mix geographically speaking?

James Park

No. The largest portion of our smartwatch unit mix is in the U.S.

Joe Wittine

Got it. Thanks a lot. Good luck.

Operator

We'll go now to Ryan Goodman with Bank of America Merrill Lynch.

Ryan Goodman

I have two. First one, really nice job in the quarter, but I did have a question. So you beat the quarter versus expectations. The outlook was also pretty good, but you reiterated the fiscal year guidance. I'm just curious, this seems to imply more of a conservative posture just on 4Q versus where you would have been a quarter ago. So, first, just any thoughts on that? And then, second question just on the gross margin guidance for the year to hold flat with Q2 levels. Previously that was expected to decline over the course of the year. So, is the implication that smartwatches kind of stabilize at this 55% of revenue level or is there anything else playing a factor there?

Ron Kisling

I think on the guidance, I think a couple of things. Part of it is to de-risk the year in terms of looking at guidance. The majority of our sales still occur in the second half. So, I think it's prudent not to be raising guidance, but we have increased confidence around our revenue guidance of $1.5 billion. And I think particularly given the positive momentum in Q2, it significant reduces our risk around our 2018 commitment.

I think in terms of gross margin, if you kind of go back to beginning of the year, your Q1 margins were higher. Part of that was due to reserve adjustments associated with [indiscernible], and so we did expect that the rest of the year coming after Q1 would be lower. I think based on the gross margin levels that we saw in Q2, right around 41% are where we would expect to be for the rest of the year. So, we expect them now to run flat for the remainder of the year. I think we also saw tracker in Q2 was kind of the trough in terms of their demand, which also impacted margins in the second quarter.

Operator

We'll go next to Yuuji Anderson with Morgan Stanley.

Yuuji Anderson

On the Q3 guide, I appreciate that you mentioned that the Versa had a sell-out in Q2. Is there additional channel stocking activity built into the Q3 guide versus perhaps additional product launch?

James Park

Yes, I think in Q3, as we indicated, we were sold out in Q2 on Versa. So, there would be some amount of additional stocking two-fold. One is, as the additional supply comes online, and secondly, as we get toward the late part of the year and we get closer to the holiday season, then we'll continue to add and build inventory back to what we believe is a healthy level in the channel.

Yuuji Anderson

Got it. And then a quick question on Twine and the continued investments in direct sales there, as we model out OpEx, should we be expecting some incremental hires to close out the year? And related to that, how should we think about leverage off of those investments? Thanks so much.

Ron Kisling

This is Ron. First off, in terms of just kind of looking at overall headcount, I think broadly speaking, we're focused less on the level of headcount and driving OpEx efficiency. While we redeploy resources in growth areas of investment, such as health services, Twine, and international. And broadly speaking, as we indicated, we do expect to continue to achieve our $60 million reduction in OpEx versus the prior year. And here are $740 million operating expense commitment for 2018.

Operator

We'll go next to Scott Searle with ROTH Capital.

Scott Searle

Nice quarter, nice outlook. I apologize I'm late to the call, so I apologize again if this was already covered, but in terms of the outlook for the second half of this year, I think you had spoken previously about 50% of the mix coming from smartwatches in the context of 55% in the second quarter. Have your thoughts on that changed at all? And in particular, you had some – I heard the positive commentary talking about trackers and returning more to a growth mode and playing an important role. So, I'm kind of wondering, how you see that sequentially progressing both into the third quarter and fourth quarter with some seasonality but also from a product portfolio standpoint on the smartwatch front? How much do you have to broaden it to start to hit all the different buckets out there? You certainly have high-performance and Versa has been a huge success in terms of the middle market, but other areas such as cellular connectivity and otherwise, where does that fit into the overall thought process for the portfolio?

Ron Kisling

So I'll take the first part of the question in terms of the mix. I think we still expect the smartwatch mix in the second half to be around 50% realm, what we saw in Q2. I think part of that's driven by, as we noted, Q2 will mark the trough in year-over-year declines in tracker. So, we would expect the trackers to improve in the second half over what we saw in Q2. And so, given the improvement in trackers, we expect it to remain basically flat, in line with that 50%.

James Park

And in terms of the overall smartwatch portfolio, we have Versa and Ionic today which target two very different segments of the category, but we do feel there is opportunity to expand the lineup at some point and address additional needs, and we feel that those will be incremental to the overall lineup.

Operator

We'll take our last question from Charlie Anderson of Dougherty.

Charlie Anderson

I wonder on smartwatch gross margins, if you could maybe address sort of the long-term trajectory that you see there, are there opportunities to increase ASP over time, or is it going to be a situation where ASP goes down to broaden up the appeal. But given the cost side, what do you see happening there, that's maybe identifiable to help gross margins there. And then, I've got a follow-up.

James Park

So, on the ASP side, it kind of relates to my prior comment. We're looking at different opportunities and addition opportunities in the smartwatch portfolio. So that's clearly going to affect the ASP. It's a little too early to comment how that's going to be affected, but it most likely will.

Ron Kisling

I think on the cost side, I think there is a couple of things. Certainly as we expand our production, yield improvement will yield some improvement in gross margins. I think at this point we have clear visibility for the remainder of this year, but in terms of them being flat, but I think through yield improvements, product mix, some of the new products that James was talking about I think, there is an opportunity to drive efficiencies there.

Charlie Anderson

Great. Then for my follow-up question, you mentioned with Versa really allowed yourself to be sort of that second brand next to Apple, and I wonder over time do you feel like you use leverage of advertising here and incremental margins on the smartwatch business get better over time, you will need less advertising to support it maybe than we've seen in some prior launches?

James Park

Yes, that's definitely a possibility. I think one of the things that we did in Q2 to support the launch was invest more heavily in sales and marketing, and we do expect that investment in brand awareness to have benefit as we enter the second half of the year. So, I'd say, overall it's a very positive story. The success of Versa creates a positive feedback loop between ourselves, our customers, and the channel, and it's providing an overall halo effect and lifting brand awareness and product strength across the board.

Operator

This concludes today's call. Thank you for your participation. You may now disconnect.