ZEPP - Can Zepp Health Find Its Way Back Up?

2023-07-31 00:11:54 ET

Summary

• Zepp Health has had the most tumultuous two years.
• The share price plummeted 88%, and revenue is down by almost 50%.
• At this point, is ZEPP stock worth investing in?

Zepp Health ( ZEPP ) today is no longer the company it used to be. As Huami, it was heavily reliant on its strategic partner Xiaomi which in 2020 brought close to 70% of revenue. In just a couple of years, this has changed dramatically in favor of Zepp's own brands which now constitute 60% of revenue.

Admittedly, this was not only because Zepp's original products grew well - which they did, in absolute terms, by almost 45% between 2020 and 2021. It was also because Xiaomi's contribution fell as its wearable business hit a rough patch with chip shortages and a sharp reduction in domestic demand in locked down China.

In any case, the strategic shift towards self-branded products has been the right move for Zepp. The biggest upside is the possibility of better profitability. In 2020, the company's original brands achieved a gross margin of almost 30%, twice as much as products sold with Xiaomi would normally make.

The competition, though, has since pushed the margins down - Chinese electronics makers are notorious for keeping costs razor tight - to a more unexceptional 20% in 2022. Operating expenses too went up given a greater burden of building new products and bringing them to market. The overall market slump completed a perfect storm of peril, as Zepp went from a profitable fast-growing outfit to a loss-maker whose sales have halved.

Investors cannot be blamed for losing interest. The massive price decline which began in 2021 has resulted in shares trading just above $1, from the last peak of $11. The big question now is whether there is still value left in Zepp to be considered a growth investment. Three things matter: tech capabilities; market share and moat potential; and the state of the industry.

Technology

Given that healthcare is a growing industry at home and in many foreign markets, Zepp positions itself more as a tech-powered health service provider. Besides the flagship Amazfit line of wearables, the company has released a sleeping app and a hearing solution; there are also plans in the diagnostic space further down the road.

A core strength of Zepp is in-house development of major hardware (chips and sensors) and software components (operating systems and algorithms), which enables it to produce cutting-edge health technology at one of the lowest price points in the industry. This is appreciated especially by younger consumers who, without deep pockets, still want to experience tech-enabled lifestyles. Zepp devices can do it all, for less than $50 a piece.

At the same, the company is moving into more premier consumer segments. With Amazfit watches, it has started targeting niche groups - fitness typically dominated by Garmin and lifestyle typically dominated by Apple and Samsung. Higher-end products carry better margins: in Q1'23 the $100-200 watch category attained a gross margin of 34.6%, well above the median 20% reported for self-branded products in 2022.

Instead of competing with larger companies on brand recognition, Zepp chooses to differentiate based on the latest tech features that it is able to offer at affordable prices. In a way, it is attempting to separate the perception of prestige from tangible technology.

Here is a breakdown of new features Zepp introduced last year:

Source: Annual report

Not only does Zepp keep up with development trends, it also outperforms rivals - including the largest ones - in certain aspects. Listed below are flagship models of major smartwatch brands versus that of Zepp. This is not a comprehensive review, but even the few selected tech features show how well Amazfit performs against all-star competition.

Source: Company websites

In demand

It does look like Zepp's "low price-feature rich" approach is working; the company has sold over 223.7 million units of wearables as of end-2022. More than 326 million registered users have downloaded the mobile app, and 36 million of them are active monthly.

Source: Annual report and Seeking Alpha

Source: Annual report and Statista

The company's struggle in 2022 was largely due to China's zero-tolerance policy towards Covid-19 and the ensuing supply chain challenges. Generally, it was a down period for the entire global market, as shipments of wearable devices decreased for the first time. Asia , typically the fastest growing region, recorded its lowest ever increment of just 1.8%, due to supply chain shortages. The growth rates are predicted to recover this year to a modest 2.4% worldwide and to a more exciting 15% across Asia (ex. Japan).

On China

The Chinese economic recovery is progressing but has slowed down since the end of Covid controls. In Q2, the growth rate was 6.3% year-on-year; but on a quarterly basis, it came to a mere 0.8%. Still, the government - which labeled this recovery "tortuous" - believes it could hit the targeted 5% this year.

There have been only tentative attempts to speed up growth. The central bank has committed to rate cuts, however small. The government, meanwhile, is directing stimulus towards investment; the troubled real estate sector is included. This has already boosted confidence in the Chinese stock market which has risen led by gains in technology and property.

Local industry

Because China is still the global capital of wearables, R&D and manufacturing wise (although India has become a serious challenger), the competition is intense. For a long time, top spots have been occupied by Xiaomi, Huawei and Apple, in various orders. But there are many more contenders including home-grown companies like OPPO and BBK Electronics (which rounded out the top five sometime last year), Andon Health, Lifesense and Fenda Technology. ZEPP though remains the only Chinese smart wearable company listed in the US.

Long way back up

Three factors might help Zepp bounce back:

1. The company already has a large base of budget users who are familiar with the value Zepp offers: cheap but feature-rich wearables. Selling to this existing base will be many times cheaper than spending on new customer acquisition. And low sales figures in 2021-2022 could mean that many users are due for an upgrade.

2. With total cessation of pandemic restrictions, supply chain problems will ease which should improve operations. New features are being added continuously (like the recent integration of ChatGPT ), giving people reasons to upgrade. Test offerings at higher price points (such as Amazfit Falcon ) are expanding the potential for self-branded products.

3. The company is getting more efficient in marketing efforts. R&D and customer acquisition costs are on a downward trend against 2020, the company's best year in terms of sales. This suggests that Amazfit as a brand is becoming more recognizable. Because self-branded products saw a smaller decline in 2022 compared to Mi Band, they could make a better recovery as the market picks up.

Valuation

On the face of it, the stock looks like a bargain, relative to both historical numbers and peers. Price/Sales declined from 0.72 in 2020 to 0.15 in 2022, and the industry average is near 3. The share price has fallen more than sales have which normally signifies a discount opportunity.

Assuming a tolerance level for Price/Sales to be 0.36 (since revenues dropped by almost half), the company's fair price should be around $3.5. The only available analyst forecast for the next 12-months is $3.35.

Source: Seeking Alpha

Conclusion

The valuation is attractive on its own but concern over the company's immediate prospects dampens enthusiasm. If Q1 is any indication, a further decline is possible: Mi Band 8 is still limited to China , and smartwatch shipments have slumped. It may be prudent hence to take time to see how the rest of the year plays out. Keep an eye out for the growth trajectory of self-branded products and a return to profitability, of course.

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