Fitbit – Boredom bites.

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User indifference likely to drive further estimate cuts in 2017.

  • Fitbit issued a horrible profit warning as users appear to be becoming bored with fitness tracking despite Fitbit’s efforts to drive engagement through the ecosystem.
  • Q4 16A revenues / Adj.EPS will be $572m – $580m / LOSS$0.51 – LOSS$0.56 compared to previous guidance of $725m – $750m / $0.14 – $0.18.
  • The new revenue estimate is 22% below where the company thought demand would be in Q4 16 and 27% below the consensus estimate of $736m.
  • The company also took the knife to its 2017 estimates with revenues / Adj-EPS of $1.5bn – $1.7bn / LOSS$0.22 – LOSS$0.44 compared with consensus at $2.38bn / $0.43.
  • The company blamed market softness for the shortfall and promised a recovery in H2 2017 but only because the year over year comparisons are much easier given the awful H2 2016 the company has had.
  • I think that Fitbit has three major problems:
    • First: It’s sensors are not accurate enough to be of any use beyond recreational health.
    • I believe that all health trackers suffer from this problem and until these devices are far more accurate, they will all have difficulty in expanding into the huge opportunity represented by health monitoring.
    • Phillips makes some bold claims in this area but I have yet to see hard evidence that its products are meaningfully more accurate than anyone else’s.
    • Second: The issue with wearables being a solution looking for a problem (see here) appears to be getting worse.
    • This is because the health tracking that these devices offer is simply not good enough and hence many devices end up gathering dust in a drawer after a couple of months.
    • Fitbit does far better than most but with only 23.2m active users of its devices, there are still a large number of devices out there that are no longer on the wrists of users.
    • Furthermore, from an ecosystem perspective, Fitbit is still miles adrift of the 100m active users that RFM estimates are needed for an ecosystem to hit critical mass.
    • Third: Fitbit is being eroded from both ends with Apple Watch at the top of the market and cheap Chinese health trackers at the bottom.
    • This issue is exacerbated by the fact that Fitbit has offered no real innovation in health tracking for some considerable time which has meant that the cheaper Chinese versions are just as good in terms of generating raw data.
    • If Fitbit was able to reliably track calorie consumption, blood pressure or blood sugar, then this would give it something with which to fight back against commoditisation, but of this there is no sign.
  • On top of the warning, Fitbit has also pledged to cut $200m of OPEX in 2017 with way less than 10% of this coming from headcount.
  • This means that certain aspects of sales and marketing and some research and development projects are also going to be cut.
  • This will make it even harder for Fitbit to come up with a winning innovation with which to restore its gross margins.
  • Consequently, the outlook for Fitbit in 2017 looks very difficult and I suspect that it may be taking the knife to its estimates yet again in 2017.
  • Just like GoPro, Fitbit remains one to be assiduously avoided in 2017 as both have further to fall leaving them open for acquisition (see here).

Fitbit and GoPro – Horrific Halloween

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I see acquisition as the endgame for both players. 

  • GoPro and Fitbit have both been hit again by the simple fact that their products are commoditising and that they have been late to generate user stickiness through the ecosystem.
  • Fitbit reported Q3 16A revenues / adj-EPS of $504m / $0.19 compared to estimates of $508m / $0.19.
  • However, guidance for the critical Q4 holiday season missed estimates by 25% with Q4 16E revenues / adj-EPS of $725m – $750m / $0.14 – $0.18 compared to forecasts of $981m / $0.75.
  • Soft demand and some production issues were blamed for the shortfall but at the end of the day it is increasingly clear that Fitbit’s products are commoditising fast.
  • GoPro fared little better with Q3 16A revenues / adj-EPS of $241m / LOSS$0.60 some 22% below forecasts of $310m / LOSS$0.37.
  • GoPro also went on to say that Q4 16E would also miss estimates with revenues of $600m – $650, some 8% below what the street was looking for.
  • GoPro blamed production issues around the Hero 5 black for the shortfall but I can’t help wondering how many users bought the perfectly good, and 37% cheaper, YI 4K Action Camera instead.
  • YI (Xiaoyi in China) is also coming out with a drone which will carry its 4K camera like the Karma does and this too, will be a t a substantially lower price.
  • Furthermore, when one looks at Fitbit, sales in Asia were down 45% in Q3 16A primarily as a result of a plethora of cheap and adequate health tracking products from Chinese brands such as Xiaomi.
  • These are the issues that beset both Fitbit and GoPro which could have been avoided if they had begun development of their ecosystems much earlier.
  • Unfortunately, like most companies that experience sudden and rapid growth, they have become reactive rather than proactive which is what has landed them in this pickle.
  • If GoPro and Fitbit users knew that they would have an easy to use, fun and vibrant ecosystem to enhance their health monitoring or home movie experience, they would want to stay rather than experiment with far cheaper Chinese equivalents.
  • Both seem to have cottoned onto this concept now but they have only done so once they got into trouble which is much too late.
  • This means that their ecosystems are neither mature enough nor large enough to provide the kind of stickiness that they so desperately need.
  • The result is that users don’t seem to mind leaving to try something else as they have nothing invested in these companies beyond the hardware.
  • Without that critical stickiness, GoPro and Fitbit have to compete on price which is something they cannot afford to do given their high cost base in developed countries.
  • This is why I fear the end game for both of these companies is acquisition.
  • Their hardware is excellent but users are increasingly not willing to pay a premium for it, meaning that gross margins and revenues are going to come under sustained and intense pressure.
  • Someone with a strong ecosystem such as Apple, Google, Tencent, Alibaba or Baidu could easily pick these companies up and combine their good hardware with their own ecosystems to make them much stickier.
  • However, in the absence of M&A, the outlook is very bleak indeed and their shares are likely to continue to suffer from heavy selling pressure.
  • The question is at what point do the shares sink so low that the acquirers are flushed out?
  • I suspect the answer is lower than where we are today.

Wearables – Deadly drift.

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Still, no one knows why they should buy one. 

  • Apple Watch 2 has failed to revive the flagging smartwatch market in yet another sign that wearables remain a solution looking for a problem.
  • The latest data from IDC shows that the smartwatch market (a subset of wearables) declined by 51.6% YoY in Q3 16 with Apple Watch shipments declining by 71.6% to just 1.1m units.
  • The overall wearables market is growing around 25% but it is the cheap and cheerful pedometers and basic fitness trackers that are making all the running.
  • To make matters worse, these are already commodity products with most priced well below $100 where no one is making a sustainable return.
  • I think that the reason why there is so little differentiation remains that no one has really figured out how to make a wearable product a must have.
  • Even Apple, which has a legendary ability to come up with compelling use cases, has struggled and the main question asked by potential users is: “Why would I buy it?” rather than: “How much is it?”
  • Fitness tracking is already a commodity and one with which many users rapidly tire.
  • Health tracking is also in its infancy as the sensors are still not close to being good enough to provide safe and secure health monitoring although Philips is making every effort to make its devices medical grade.
  • Outside of that, wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • The market will grow this year but at a much slower rate than the triple digit growth it experienced in 2015
  • Furthermore, the value of the market will be very challenged with brutal price erosion potentially driving the value of the market into negative territory.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2017 will be even more difficult for wearables in general as the ravages of commoditisation bite despite some unit growth.
  • Apple is the only company with exposure to this market that has the capability to maintain its pricing and not feel the problems of this market in its income statement.
  • Microsoft, Tencent and Baidu are my top picks but I think that Apple remains a safe place for long term income based investors.

Fitbit Q2 16A – Breathing space

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Fitbit has earned time to develop its ecosystem. 

  • Fitbit reported good Q2 16A results as demand continues to be steady while the company works on its ecosystem.
  • Q2 16A revenues / adj-EPS were $586.5m / $0.12 compared to consensus at $578.2m / $0.11.
  • 7m devices were shipped (up 27% YoY) which was particularly encouraging given Apple’s 50% decline YoY.
  • Although life is much tougher now than it was 12 months ago, Fitbit is still profitable and is generating cash meaning that it will be able to launch new products as well as work on its ecosystem.
  • Although most attention remains on the hardware, it is the development of the ecosystem that will determine whether Fitbit thrives or withers.
  • The vertical that Fitbit has chosen is digital health and wellness which makes sense given that the only success that wearables have really found to date is within this segment.
  • The idea is to get users to upload, share and analyse their data in the cloud such that they become more engaged and use the device more.
  • Wearables suffer greatly from users getting fed up with them and leaving them to gather dust in drawers which is something that Fitbit must address.
  • it has been much better than its competition at keeping users engaged. but still only a small percentage of the 49m devices that Fitbit has shipped to date are still in use.
  • If Fitbit can keep its users engaged and generating data, then it users will choose its devices when they come to upgrade giving it the ability to earn better margins.
  • Furthermore, if it can become a go to place to store health and fitness data, it could expand into other device types along the same sort of lines and users will have a strong incentive to stay.
  • Its chief competitor in this space is Apple with its HealthKit API but given that 87% of the world and more than 50% of USA do not use an iPhone, there is enough space for Fitbit to grow into.
  • Despite the stabilisation at Fitbit, its guidance for the full year continues to look very ambitious.
  • Fitbit earned adj-EPS of $0.22 in H1 2016A, and is guiding for $0.17-$0.19 in Q3 16E and $0.72-$0.84 in Q4 16E.
  • Fitbit is very dependent on the holiday selling season and I think it will have difficulty in meeting the very heavy year end expectations.
  • With the shares on 25x 2016E PER, there is not much room for error and it will be some time before its fledgling health ecosystem gains critical mass.
  • Hence, I would be inclined to wait before looking at this one seriously again.
  • That being said, I would have it in a heartbeat should I be forced to choose between this, GoPro and HTC.

Wearables – Wrong direction

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Precipitous decline underscores the problem. 

  • It looks like demand for smartwatches has precipitously declined in Q2 16A, taking the overall outlook for wearables with it.
  • To me this is just another signal that the market is not ready for wearables mostly because no one has really figured out what to do with them.
  • Data from IDC (see here) is indicating that demand for smartwatches fell by 32% to 3.5m units in Q2 16A mostly driven by a decline in Apple Watch shipments to 1.6m units from 3.6m shipped right after its launch in Q2 15A.
  • Given that smartwatches are around half of the total market for wearable devices it is easy to see how the entire market could easily decline this year.
  • These figures bring into sharp focus the problem with wearables which is that no one really has any idea what to do with them meaning that most users are just not that interested.
  • To make matters worse, I can’t see this problem being fixed anytime soon.
  • The one exception to this is e-health where enabling users to track certain biometric characteristics could have substantial benefits for disease diagnosis and prevention.
  • Unfortunately, none of the devices are able to do this with anything like the kind of accuracy or reliability that would make it safe to rely on the data.
  • I have long thought that inaccurate health data is bad at best and dangerous at worst and so I do not see any real threat to the medical devices industry for now.
  • Currently, wearables are good enough to monitor biometric data for recreational and basic fitness uses but nothing more.
  • This makes a wearable nice to have but it still means there is no burning reason why a user must have one of these devices.
  • This has been echoed in Apple stores, where the Apple Watch tables are the least visited and the most asked question is “why should I buy one?”
  • This is why shipments of Apple Watch have been so far below bullish forecasts and why many users stop using a wearable within three months of purchase.
  • Consequently, I continue to think that wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2016 will be very difficult for wearables in general as the ravages of commoditisation bite against a backdrop of increasingly indifferent users.
  • Apple is the only company in this space that I would consider investing in but its exposure to wearables is tiny relative to its market capitalisation.
  • Hence, wearables is not a theme in which I am looking to have exposure to for the balance of 2016.

 

Fitbit Q1 16A – Forced hand.

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Fitbit is being forced to spend to stay ahead.

  • Fitbit reported good Q1 16A results but cut guidance in order to ramp up spending placing unrealistic expectations of profitability in H2 2016.
  • This is particularly worrying as there are clear signs that commoditisation is forcing the company to increase spending, hitting profits.
  • Q1 16A revenues / adj-EPS were $505m / $0.10 nicely ahead of consensus at $443m / $0.03 but EPS for the quarter ahead is going to be weak.
  • Q2 16E revenues are expected to be $565m-$585m ($575m midpoint) ahead of consensus at $533m but expectations of adj-EPS at $0.08-$0.11 are way below consensus of $0.26.
  • Gross margins are slipping as commoditisation creeps in but the real problem is OPEX.
  • Fitbit is right in that it needs to spend on R&D and sales and marketing to stay ahead of its rivals, but general and admin expenses (G&A) are a real worry.
  • In Q1 15A G&A expenses were $13.0m or 3.9% of sales but in Q1 16A they jumped to $35.7m or 7.1% of sales.
  • My threshold for G&A is 5% and this sudden elevation has all the hallmarks of indisciplined expansion.
  • This in turn makes me worry about the quality of the investments that the company is making in both R&D and sales and marketing.
  • If these investments do not produce results, then commoditisation will accelerate and gross margin will continue to decline hitting the already fragile profitability.
  • The good news is that Fitbit knows exactly what it has to do which is to increase the stickiness of its users through the refinement of its embryonic ecosystem.
  • This alone puts Fitbit miles ahead of GoPro when it comes to dealing with aggressive competition and slowing and saturated end markets.
  • When it comes to an ecosystem the key is the number of users and the degree to which they are engaged with one’s services.
  • Fitbit posted some encouraging figures at its 2015 year end results in January with 16.9m active users making up 59% of the registered user base.
  • These users were also more engaged with an average of 7.5 connections to other users compared to 4.9 at the end of 2014.
  • Unfortunately, Fitbit declined to update these figures leading me to believe that there was nothing particularly good to report.
  • This is concerning because if the investments that it is making in R&D and sales and marketing pay off, it is in user numbers and engagement that the results will be first seen.
  • Gross margin stabilisation and profits will then follow but it is in the ecosystem where the loyalty and preference will be generated that will give Fitbit pricing power.
  • Somewhat inexplicably, Fitbit also raised its adj-EPS guidance for the full year to $1.12 – $1.24 from $1.08-$1.20 meaning that to meet guidance Fitbit needs to generate 83% of its net profit in the last 6 months of the year.
  • Given the environment, this looks to be a very tall order and I suspect that there is a heavy cut to full year EPS guidance coming either in June or October.
  • My concerns around both the market for its products and its fiscal discipline lead me to believe that Fitbit could realistically generate adjusted EPS of $0.80 for the full year.
  • This leaves the company with a 2016E PER of 18.5x which is quite punchy for a company showing little profit growth and at high risk of commoditisation.
  • I would be more comfortable between $10-12 a share rather than the $14.90 that it is currently at but if forced to choose I would have this over GoPro.

Wearables – All pain, little gain.

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Wearables are already a commodity despite unit growth.

  • Pebble is the latest wearables company to show signs of stress as it has decided to lay off 25% of its work force.
  • This comes hot on the heels of Apple cutting $50 (14%) off the entry price of the Apple Watch, a poor reception for Fitbit’s latest product and a slew of M&A and restructurings at the end of last year.
  • The problem is not market growth, but the fact that Apple Watch has taken the premium segment has left the majority of the rest of the market priced well below $100.
  • Top of this list is Xiaomi which prices its Mi Band Pulse at just $13 meaning that anyone who wishes to price their product at a premium has to offer a lot more than just fitness tracking.
  • This is where I think Pebble (and others) have been caught in the middle and why it has become much harder to make any real money despite the market growing nicely.
  • In 2015 the wearables market grew 171% to 78.1m units (IDC) driven mostly by Apple and Xiaomi at the two opposite ends of the market.
  • I think that the reason why there is so little differentiation remains that no one has really figured out how to make a wearable product a must have.
  • Even Apple, which has a legendary ability to come up with compelling use cases, has struggled and the main question asked by potential users is: “Why would I buy it?” rather than: “How much is it?”
  • Fitness tracking is already a commodity and one with which many users rapidly tire.
  • Health tracking is also in its infancy as the sensors are still not close to being good enough to provide safe and secure health monitoring (see here).
  • Outside of that, wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • I suspect that this year will see growth in unit volumes but the value of the market will be much more challenged with brutal price erosion.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2016 will be very difficult for wearables in general as the ravages of commoditisation bite despite unit growth.
  • Apple is the only company with exposure to this market that looks even remotely safe.

Wearables – Not first class

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Medical device makers have more time to save themselves

  • Amid a rather muted first day at CES came the news that another class action lawsuit has been filed against FitBit alleging that its heart rate monitors are dangerously inaccurate.
  • While I think that this lawsuit is somewhat capricious, it highlights accuracy as one of the most important issues that limits the appeal of wearable devices for health and sports monitoring.
  • FitBit even admits this in its response to the lawsuit highlighting that its devices are not “intended to be medical or scientific devices.”
  • Consequently, the medical device industry that sells products for many thousands of dollars can breathe a collective sigh of relief for now.
  • While this lawsuit is unlikely to go anywhere, it creates bad PR which combined with a lukewarm reception for its new sports watch, Blaze, sets FitBit up for a difficult 2016.
  • My position continues to be that inaccurate health data is bad at best and dangerous at worst.
  • It also highlights that single pieces of biometric data are of little value in isolation and that a combination of measures are likely to be required to get any data that is of any real value.
  • This is why Apple’s HealthKit API is so important.
  • HealthKit will allow Apple to put together data from a range of wearable devices and sensors while the device makers themselves will only have the data from their individual devices.
  • This is another case of the whole being much greater than the sum of the parts and I think that HealthKit is intended to be a major long term differentiator for Apple.
  • However this requires for all of these devices to become much more accurate and reliable.
  • Currently, wearables are good enough to monitor biometric data for recreational and basic fitness uses but nothing more.
  • This makes a wearable nice to have but it still means that there is no burning reason why a user must have one of these devices.
  • This has been echoed in Apple stores, where the Apple Watch tables are the least visited and the most asked question is “why should I buy one?”
  • In the long term, wearables are likely to be an important part of the ecosystem once everyone has figured out a use case that makes them a must have.
  • Until then they are a solution looking for a problem and likely to remain in the realm of early adopters, techies and the Apple fan base.
  • Hence, I don’t see wearables having a meaningful financial impact on any of the ecosystem players in 2016, although it is clear that all players are preparing for a time when they will.

Android Wear – Wearing thin Pt III

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Smartwatches and wearables remain in Limbo.

  • Tag Heuer, Intel and Google have launched the Tag Heuer Connected smartwatch at an event in New York on November 10th.
  • The device will be available as a limited edition of 50,000 pieces and will retail at $1,500.
  • The device is powered by Intel, which I suspect has fronted most of the hardware costs, and runs Android Wear meaning that Google probably did most of the software.
  • Consequently, Tag Heuer will have set the specification and design but very little else.
  • The launch of this device followed a management change at Tag Heuer and a new strategy to target the affordable luxury segment.
  • When it comes to Swiss watches, affordable luxury has some cross over with the kind of price points that one is seeing for the Apple Watch and it was this thinking that drove the launch of this product.
  • The aim of this device is to create a connected watch that has character which is something that many Android wear devices sorely lack.
  • Consequently, it is the same size as a mechanical watch with the case and strap being made from the same materials as the original.
  • It also has a very low power mode that uses ambient light to reflect off an always on monochrome representation of a watch face making the smartwatch function much more like a regular watch.
  • I have been previously concerned that this move could damage the Tag Heuer brand but this is now less of an issue given its recent move to shift its brand towards more affordable luxury and younger consumers (see here).
  • However, the biggest problem in my opinion remains obsolescence.
  • Even for the most fashion conscious glitterati $1,500 is a lot of money to spend on a device that is very likely to be obsolescent within a year.
  • This is a major reason why I suspect that the very high end Apple Watches have sold in tiny volumes.
  • At 50,000 units, the Tag Heuer Connected is really an experiment in order to give the company an idea about how it should protect the segment of its portfolio that overlaps with smartwatches from other companies.
  • I continue to really struggle with the case for smartwatches as they are little more than a remote control for a smartphone and remain a solution looking for a problem.
  • Even Apple has failed to come up with a compelling reason to buy an Apple Watch and until it does I think this whole segment will remain in Limbo.
  • It is at this point that they will make a valuable contribution to the ecosystem but until then, the digital consumer ecosystem will continue to be defined by the smartphone and the tablet and very little else.

Fitbit Q2 15A – Peak performance

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Fitbit showing every sign of doing a GoPro.

  • Fitbit reported blowout Q2 15A results but the shares fell 16% as gross margins saw some pressure from product mix.
  • Q2 15A revenues / EPS were $400m / $0.21 compared to estimates at $319m / $0.08.
  • Q3 15E revenues / EPS are forecast to be $335m-$365m / $0.07-$0.10 compared to consensus at $263m / $0.06.
  • Given that this is the first time that Fitbit has reported to the market, it is of little surprise that estimates were handsomely beaten.
  • However, what caught the market out was declining gross margins which were 47.2% in Q2 15A compared to 51.5% in Q2 14A.
  • Fitbit attributed this to a substantial mix shift towards newer products where Fitbit has had less time to drive down the component costs compared to older products.
  • This is counterintuitive in the world of consumer technology as typically the prices of devices fall faster than the components that are used to make them.
  • This means that gross margins are at their highest at launch and then decline over the life cycle of the product.
  • I suspect that Fitbit is currently able to hold its pricing flat over the life cycle of a product while still being able to optimise the cost of the components.
  • This would explain this unusual state of affairs and its very high gross margins but it also strongly implies that Fitbit is currently operating without any real competition.
  • This is unlikely to last and I suspect that as the market becomes more completive, Fitbit will have to begin cutting prices over the life cycle of its products.
  • This brings us neatly to the ecosystem issue.
  • By creating an ecosystem around its devices that users love and upload their data to, Fitbit should be able to isolate itself somewhat from the ravages of competition when it finally emerges.
  • It is making the right moves in this direction, but in the grand scheme of things, its user count is tiny at just 9.5m at the end of 2014A.
  • Fitbit has shipped 25m devices cumulatively and consequently, I think that the active user count of its ecosystem is probably somewhere around 13-14m users currently.
  • Fitbit has decided to only update this figure on an annual basis but I think that this will be the most important metric going forward in terms of understanding Fitbit’s long term profitability.
  • This is because if users love the ecosystem, then they will be predisposed to buy a Fitbit next time which will allow Fitbit to keep pricing and margins in the face of increasing competition.
  • However, in the short term, I think that Fitbit is at risk of following exactly the same pattern as GoPro.
  • GoPro rallied enormously on a wave of hype and optimism after its IPO that bore no resemblance to reality only to crash when the market figured out that its short term assumptions were too high.
  • Following the correction, GoPro has traded much more in line with its fundamental performance and I think that Fitbit could easily follow the same pattern.
  • Consequently, I see no reason to get involved with this stock at all until the froth has been wiped from the price of the shares.
  • GoPro is much less frothy, is half the valuation and has a better grip on the importance of the ecosystem.
  • It is GoPro that I would go to if I was forced to choose between the two.