|Shares Out. (in M):||53||P/E||0.0x||0.0x|
|Market Cap (in $M):||5,511||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-162||EBIT||0||0|
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I believe Fossil shares (FOSL - $103.28) represent an attractive risk/reward short-opportunity, with a near-term potential catalyst and a more concrete catalyst in the next 12-18 months that could reset earnings meaningfully lower. Assuming the status quo, I believe FOSL shares are reasonably valued today, however, I believe the next several years will be anything but ordinary business conditions. FOSL is a manufacturer and retailer of watches, jewelry and accessories for both the Fossil brand and a collection of licensed brands globally. The Company’s primary revenue stream comes from wholesale sales (75% of 2013) to a collection of mostly mall-based retailers, as well as a direct business of FOSL stores (543 stores at 12/31/13, including 76 Watch Station International Stores). While jewelry and accessories are also sold by FOSL, 78% of LTM sales are generated from watches. Additionally, 50% of 2013 sales were from licensed brands, and 22.4% of 2013 sales were generated from the Michael Kors (KORS) brand specifically. I believe that while this KORS license agreement has been a significant positive for FOSL over the past several years, it will soon be time for payback with Michael Kors as the royalty agreement gets re-negotiated. Additionally, I believe consumer headwinds, a less favorable watch industry, especially in typical FOSL price points, and the looming threat of the iWatch and other smartwatches make it increasingly difficult for FOSL to grow earnings meaningfully over the next several years. In the case where overall sales remain sluggish and the KORS license resets to more reasonable terms, I believe FOSL is worth ~$72, representing downside of nearly 30%.
As discussed above, FOSL is primarily a seller of FOSL-branded and licensed watch sales worldwide. Most of the watches sold range in price from $85 - $600, and are considered affordable fashion as opposed to the high-end luxury watches manufactured by boutique swiss brands. It is also viewed more favorably than the low-end watches from Timex, etc. In addition to the Fossil and Skagen wholly-owned brands, FOSL has license agreements with Diesel, DKNY, Armani, and Michael Kors in addition to many others and will soon be launching a line of Tory Burch watches in limited quantities. The business operates at roughly a 17% operating margin, with the wholesale business in the mid-20s and the direct to consumer business a lower margin business that tries to feature the brand. Essentially, for licensed brands FOSL is a contract manufacturer. They have design personnel, own their own manufacturing facility overseas, and have been doing all this for some time. That has enabled FOSL to build license relationships over time and they can be very efficient in managing the supply chain and rolling out new products. FOSL competes primarily with Movado and Swatch Group (in addition to other boutique brands), who also manufacture watches for a variety of brands. Generally speaking, FOSL is susceptible to traditional risks of consumer-oriented companies, including weakness in the spending environment, a shift in consumer preferences, and pricing pressure due to increased competition.
Below is some financial information including EPS consensus for 2015 and 2016 and the current capitalization of FOSL. I have included 1H to 2H comparisons because it shows what is required for the Company to hit their earnings estimates.
While there are three parts to the FOSL short thesis, I will address the first two fundamental drivers first. In my opinion, the fundamental case alone makes FOSL at best fairly valued, and any potential weakness beyond what is expected by the market or a potential KORS royalty reset adds significant downside potential for the stock. The key fundamental drivers impacting FOSL are a deteriorating consumer environment, specifically in watches, and the looming threat of more smartwatches hitting the market. If you are only interested in the juicy catalyst, read the Michael Kors renegotiation section below.
Consumer Weakness and Deteriorating Watch Industry
Data from the Federation of the Swiss watch industry also shows a robust market for watches that has cooled more recently. To caution those reading, this data represents units and dollars of swiss watch exports. This is not the exact same market as FOSL, but directionally, it seems like what is happening with swiss watch exports is probably not too far off from what is happening with the watch industry more broadly.
I’ve attempted to break out the 0 – 500 Swiss Franc section of the market also because those price points are more representative of FOSL’s market. A few things from the data are clear: 1) FOSL has clearly been a market share gainer over the past several years and 2) the overall watch market does appear to be decelerating which will make continued high single-digit or low-double digit revenue growth for FOSL that much more difficult. This year, FOSL’s key markets have seen unit volumes decline, versus revenue CAGR’s of mid to high single digits since 2010.
It is probably too early to tell if the brand as a whole is suffering, but it does seem clear that growing revenue by building stores while comps go negative is a short-term fix for revenue growth. Retail revenue growth has contributed roughly 30% of the aggregate revenue growth at FOSL since 2011. If the Company continues to build stores as the organic trend weakens, they could be in the difficult position of increasing their fixed cost base as sales begin to decline, setting up future profit shortfalls relative to consensus and outright declines.
To be clear, it isn’t that I believe FOSL is a bad business by any means. I simply believe it has benefited from a large tailwind that seems to be reversing. Given only these fundamental headwinds, it seems the stock is at best fairly priced at 14.2x 2014E earnings. As discussed below, I believe these headwinds could become even more meaningful with the launch of various smartwatches in late 2014 and beyond.
The Smartwatch Threat
Recently, several device manufacturers have released smartwatches in an attempt to capture some of the fast-growing wearables market and get in front of the rumored iWatch launch later this year. Most of the projections of wearable devices are pretty pie in the sky, but here is one just for reference: IDC expects the market to grow to $7.1bn in 2018 from $342mm in 2014 (20x). I have no idea if smartwatches and other wearables will be the next big category in electronics, but at price points expected to range from $200 - $500, it seems any penetration of smartwatches will likely come at the expense of FOSL and other traditional watch manufacturers. While FOSL has a partnership with Google, the competition is likely to be far worse in this space than traditional watches as several manufacturers have already developed and launched products. Manufacturers such as LG, Samsung and Sony are all pushing hard into the space and are increasingly adding features that they believe will generate mass appeal. In addition to GPS, many of the watches are expected to provide some fitness or health monitoring capabilities. I do not expect smartwatches to change the game overnight, but if done correctly, this should be a constant threat on traditional lower-priced watches over time. Technology takes time to get right, but over time there are other examples of large categories of products that have been displaced/replaced with better technology (digital cameras, satellite navigation.) It is difficult to gauge the exact size of the opportunity, though I have seen reports suggesting smartwatches could cannibalize 10-20% of the traditional watch market over time, with much of that cannibalization occurring at the low end of the market. I suspect the real game-changer is likely to come from Apple and the rumored iWatch.
If anybody is going to get the smartwatch right, the safe money is on Apple. Given the company’s cult following and network effect related to other products, there will likely be a decent number of early adopters choosing Apple as their first smartwatch brand. As stupid as this sounds…if the iWatch becomes “cool” there is probably a lot more risk to FOSL and other manufacturers in the near term. While we mostly only hear rumors about potential capabilities, the expectation is that the iWatch will be revealed next week on September 9th along with the iPhone 6. I do not know if the iWatch will cure cancer or allow for time travel, but some of the recent Apple hires that are likely related to the iWatch suggest a product with some interesting capabilities:
Here is a an article about the development generally: http://9to5mac.com/2013/07/18/apple-stacks-iwatch-team-with-sensor-fitness-experts/
Again, this sounds really cool. I don’t know exactly how it will take off, but I think we will learn more in the coming months and my guess is that Apple will do a better job than everything else we’ve seen. Does that mean it will pass the lofty expectations? No. But in order for it to impact FOSL and other manufacturers, it really doesn’t need to. This is the first shorter-term catalyst to the thesis. I think from a trading perspective, the iWatch and continued smartwatch releases make the FOSL bull case more difficult to get comfortable with. Competing against Apple in a newer category is probably only going to be bad for traditional players.
Michael Kors License Renegotiation
As discussed previously, for licensed brands FOSL is essentially a contract manufacturer of watches and other jewelry and accessories. Per the 10-K, FOSL pays royalty rates ranging from 4-20% of defined net sales. While I do not have any special knowledge of a renegotiation with Michael Kors, there are many logical points that make a renegotiation seem very likely. For reference, this renewal is mandatory as the license with KORS expires at the end of 2015.
Because we know that KORS is growing much faster than the rest of the FOSL business and we can see that the FOSL royalty rate is going down, I think it is reasonable to conclude that KORS is likely in the ballpark of 10%, and is certainly below 13% (as you can see the average rate trending below 13%.) Assuming a 10% royalty rate for KORS also seems to make sense relative to the other pieces of the licensed business (they show a relatively constant 15.4%):
This license began 10 years ago, before KORS was as hot of a brand, and I suspect KORS is eagerly anticipating the upcoming negotiation. Given that KORS can clearly see others likely pay a higher rate, and the 10-K ranges go up to a 20% royalty rate, I suspect KORS will ask for a materially higher payment. I estimate that KORS has contributed roughly 62% of FOSL’s overall growth from 2011 to 2013.
Assuming a 10% royalty rate from FOSL, I estimate KORS made just $42mm in EBIT on the same KORS sales. Assuming a 20% royalty rate after 2015, the two companies would be closer to parity, which still strikes me as too generous for FOSL. Contract manufacturers do not typically make more money than the brand.
These do not look all that different to me. I admit, I do not know if they are technically very different or require very different manufacturing processes, but on the surface, Coach and KORS both seems like good enough brands so there shouldn’t be that much of a discrepancy. Maybe even more troubling if you are FOSL is the following disclosure from the KORS 10-K: “Marchon has been our exclusive eyewear licensee since January 2004, and will remain our exclusive licensee through December 31, 2014. Beginning in January 2015, Luxottica Group will become our exclusive licensee and will continue to develop distinctive eyewear inspired by our collections.” This was a 10-year agreement that KORS decided to switch. I admit I do not know the full details behind the switch, but there seems to be some precedent that KORS is willing to change its licensee for its best interest.
Overall, I believe the KORS license renegotiation, which should be set no later than 12/31/15, will be a negative catalyst for the stock, as I believe it will likely be set at materially higher royalty rates. I think it is unlikely the companies end the relationship, but when push comes to shove, I think FOSL relies on KORS far more than KORS relies on FOSL. That should work itself out in the rate that FOSL pays to KORS for the license.
Instead of providing a full set of projections, I think it is more important to understand the key drivers of the business. FOSL is in an increasingly competitive space as evidenced by slowing top-line sales, a need to spend more on SG&A, and the introduction of smartwatches and other wearables. I think it is going to be increasingly difficult for FOSL to grow and meet projections, but even if they do, 14x seems reasonable for what is slowing growth. If any of the fundamental headwinds presented above materialize, I think it is quite possible the FOSL business ex-KORS will turn negative. In that case, KORS becomes a larger driver of the business by 2015, and the potential royalty reset is even more impactful on EPS. If you assume Fossil continues to meet current projections and KORS continues to grow at a faster rate, I believe KORS could be as large as 30% of FOSL’s business by 2015. A royalty rate reset to 20% at the end of 2015 would then yield ~$6.67 in pro forma EPS. Again, this assumes the other pieces of the business are not materially affected by slowing demand trends or smartwatches. I also think there is some chance the rate goes above 20%, as other licensees are currently getting 20% and KORS has been the best performing brand at FOSL. On those numbers, earnings would have barely grown for two years. Should the fundamental case play out and overall sales become more challenging, I believe FOSL earnings could fall below $6 / share in 2015 adjusted for the royalty reset. Below is a pro forma 2015E EPS sensitivity table assuming growth CAGR’s for the Non-KORS business from 2013 – 2015, and different royalty rates on KORS. The analysis assumes underlying margins are stable and KORS continues to grow at 25% and 20% for 2014 and 2015, respectively.
12x that figure doesn’t seem unreasonable to me if sales are slowing meaningfully and as I’ve already articulated, I think the current price reflects continued growth and meeting of expectations. Overall, I believe FOSL is a compelling risk/reward short opportunity with several catalysts on the horizon.
|Entry||09/10/2014 05:25 PM|
Do you have any insight into what has driven increased watch-wearing and watch-buying over the past decade? Simply a long-term fashion trend? I wondered if it was driven by adoption by Asian consumers, but the data does not seem driven especially by Asian buyers. The article below suggests it is a long-term fashion trend.
The reason I ask is that I am getting that this trades about 17x 2014 earnings pro forma for Kors re-negotiation. I think you get similar numbers. So a market multiple for a company growing faster than market. So it seems like slower growth (than guidanceand street forecasts) are already priced into stock, no?
I understand there is still the smartwatch catalyst to your thesis (and that may trump everything), but I am trying to figure out how much we are depending on that.
|Subject||FOSL Update: The non-answer answer|
|Entry||11/13/2014 11:01 AM|
A couple updates. First, very briefly, the fundamentals of the Company are fine. Comps continue to be weak, the North American business has been weak, and it is being offset by some strength in Europe and Asia. The Company said that at currency FX rates, there would be a $.30/share hit to EPS in 2015, and they will try to give 2015 guidance early next year either on their Q4 call or on their analyst day. I think a number of fundamental drivers to the downside have yet to hit, as the iWatch hasn’t been released and generally watch market trends haven’t deteriorated significantly. I’d say on the fundamentals the stock is expensive given the looming threats and hot watch market, but not incredibly so. EBIT has barely grown in the first 3 quarters of this year because it is taking incremental spending to achieve lower and lower growth rates. Of course, that didn’t stop ISI from valuing the company at $150 by using 16x a two-year forward EPS number implying 28% EPS growth (13.3% CAGR). I’d like to think that a lot of negative stuff can happen in the next two full years that makes that valuation approach a bit of a stretch. Namely…the KORS license.
The stock rallied in my view because of the extension of the KORS license agreement. What was noticeably absent from the announcement though, were any details on the economics of the relationship. As I wrote in my initial write-up, I believe KORS has far more leverage in this negotiation given they own the brand and have contributed so much to FOSL’s growth over the past several years. The license was supposed to expire at the end of 2015, but it was curiously renewed a full year early. From the conference call, it sounds as though FOSL approached KORS to get this renewal done (again suggesting FOSL wanted it badly). Does anybody actually think that KORS just signed a 10-year deal a year in advance for no incremental economics? What would be their incentive to actually exercise their option early and extract no incremental value? It makes absolutely no sense, and I strongly suspect that FOSL paid some increase in royalty rate to get the KORS deal done again. The bear case wasn’t realistically that they would lose the KORS deal, but that it would be reset to market terms for a brand that was so significant to FOSL and I believe that has now been done…it is just that the market is focused on the renewal instead of the economics of the renewal. Most telling was the conference call. The Company was asked three separate times by analysts, and dodged the question every time. Instead of responding, they talk about growth prospects and really anything other than the economics. Not answering the question is the answer in my view. The main reason not to talk about the economics, or even confirm they are similar, is because they are now worse and perhaps materially worse. Here are the excerpts (the third question in particular is really the most telling and most direct…I bolded for emphasis):
Omar Saad - Evercore ISI Group - Analyst
Wanted to ask my one question on the 10-year license renewal with Michael Kors. Congratulations on that, as well. It's obviously been a great relationship. Can you help us understand maybe some of the underlying dynamics, especially since I think last quarter you had announced a renegotiation, a similar 10-year extension with Armani. That one, I think, had lapsed and was running month to month for a while whereas this one I think was a little more preemptive. Maybe help us understand the backdrop there. Are those situations really different or is it more of the same?
Kosta Kartsotis - Fossil Group, Inc. - Chairman of the Board and CEO
Well, we were very pleased to sign the 10-year agreement. As you know, Michael Kors has been a fantastic opportunity for us. Our two companies work very closely together. We've got very strong business in the US. It's growing very rapidly in Europe. Asia's a huge potential. There's a follow-on jewelry opportunity that's very significant. Men's is going to grow and will become very important, especially as we get larger in Asia. We're building shop-in-shops all over the world; could be a significant number of them. There's a long-term opportunity in travel retail, and wearable technology will follow on in there also. We have very close relationship, it's very significant business for us and them, and we felt it was prudent for us to go ahead and get a contract signed, put it in there for 10 years. There's a significant amount of work and investment made by both parties for this. We felt it was better to get a deal signed early and go unencumbered after opportunity and get back to business. That's why we did it.
Rick Patel - Stephens Inc. - Analyst
Good afternoon everyone. I will add my congratulations as well. Can you talk about the margin profile of your license multi-brand portfolio? You renewed Armani earlier in the year, now you've locked in Kors. As we think about the margins of this portfolio over the next three to five years, is it going to look similar as the last five years? Just curious what's going to change if anything. Thank you.
Dennis Secor - Fossil Group, Inc. - CFO
If you look at the margin profile over the next several years, there's a lot of factors that you need to consider and opportunities and some headwinds. You see that there's opportunities for us as we reduce cycle times, international growth becomes a big opportunity for us, channel mix becomes a lot. So there's a lot of opportunities in an overall portfolio of initiatives that we can use to drive margin, and the profile of the portfolio is one of those. Each contract has different dynamics, and so you can see some mix changes among the brands. But overall we think that there's opportunities longer term for us to drive margin expansion, and like I say, the components of the individual contracts and brands are one element of that.
John Kernan - Cowen and Company - Analyst
Just to circle back to Michael Kors, can you update us on, one, how the brand is performing in Europe, both from a watch and jewelry perspective, how big you think that business can be relative to what it already is here in the US. And then can you just confirm that the economics behind the Kors licensing agreement haven't materially changed? Thank you.
Kosta Kartsotis - Fossil Group, Inc. - Chairman of the Board and CEO
In terms of Europe, the business is growing very quickly in Europe, both watches and jewelry, and it looks like it's going to be a very significant business. And I would say the same thing about Asia, even though it's a relatively small business now. And in terms of the economics of the deal, it fits very well into our business model and where we focused on focusing on the business and growing it and putting major distribution around the world and monetizing the opportunity that's in front of us.
This is in stark contrast to previous statements they have made. In a conference call on June 11, 2014, they had no problem saying that things are typically renewed at similar terms, in a direct response to a question about KORS. Why not now?
Dennis Secor - Fossil, Inc. - CFO and Treasurer – 06/11/14
There is -- the process generally is -- most of the agreements are five-year agreements and we try to structure them at all times so that they are win-win relationships for both parties. We view these as important partnerships and relationships, and we want those to continue. I think historically, generally they have renewed at similar terms.
I believe the writing is now on the wall. I expect a material decline in the earnings trajectory beginning in 2016, if not before due to the KORS royalty reset. The rise in the stock on extending the deal is an opportunity to add to the short at better prices, in my opinion.
|Entry||11/21/2014 03:52 PM|
Any read-through from the MOV preannounce last week?
I'm a bit surprised that FOSL was down barely more than 1% when a comp cites slower growth in the "overall watch category" and trades down 30%...
|Entry||11/13/2015 02:43 PM|
$8 EPS estimate for 2015 when you wrote this up and less than $5 today. Nice work, hope you stayed in longer than your exit recommendation
|Subject||what's the bear thesis at $29?|
|Entry||10/26/2016 04:23 PM|
from my cursory glance, I'm a bit surprised to see almost 40% of the float still short after a 70% drop (from wolverine's excellent call at $103). can anyone tell me why ~7X 2015 FCF is too much to pay?