FOSSIL INC FOSL
January 11, 2012 - 11:24am EST by
skca74
2012 2013
Price: 79.80 EPS $4.50 $5.57
Shares Out. (in M): 63,800 P/E 17.7x 14.3x
Market Cap (in $M): 5,000 P/FCF 20.0x 15.0x
Net Debt (in $M): 225 EBIT 470 543
TEV ($): 4,750 TEV/EBIT 10.0x 8.7x

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  • Consumer Goods
  • Fashion
  • margin expansion
  • Market Expansion
  • Negative Sentiment

Description

Investment Thesis:  Recent market volatility due to macroeconomic pressures and misunderstanding about Fossil’s near term investments/cost pressures have pushed the stock to bargain valuations.  Fossil is a well-managed retailer with significant and underappreciated growth potential trading at 8.0x 2012 EV/EBITDA and 14.0x 2012 P/E, while generating a 7.0% 2012 FCF yield.  Fossil is worth $120/share, or over 50% upside from today’s price of $78.08 using a blended EBITDA and P/E valuation.  Due to the external issues mentioned above and the company’s cost pressures, which I believe are not fundamental and will be fixed, the multiple has compressed dramatically (recently trading at forward 12x EBITDA and 23x P/E multiples) despite revenue growth in the 20% plus range (which could prove conservative considering the company has posted 30% plus growth over the last 5 quarters) over the next several years and earnings growth in the 25-30% range.   By 2013, the company should earn $7.00 per share and will be generating over $400MM in cash (a 8.6%FCF yield).  This is extremely cheap given the strength of this management team to navigate what I believe to be a multi-year growth story.  Fossil’s growth is multi-fold coming from the expansion of its retail stores in theUS and worldwide, as well as from the emerging watch cycle, which is only in its beginning phases.  The move away from stainless steel and leather watches to various other materials has and will positively impact Fossil's GM as the newer modern materials are often cheaper.  Additionally Fossil's international growth, particularly inAsia (especially as international has higher margins) and its emergence as a worldwide known lifestyle vintage American brand, is also a significant contributor to its growth and margin expansion.

 

Why now?

The market is mispricing Fossil’s stock due to macroeconomic volatility and misunderstanding about near term cost pressures and its inventory. Due to the sovereign debt crisis in Europe and the corresponding austerity measures put into place, along with slowing GDP in the US and the downgrade of US debt, the stock market is extremely nervous and is panic selling high multiple growth stocks in favor of the safety of US Treasuries.  Fossil stock has dropped double digits on little to no company specific or fundamental news, providing the wonderful opportunity to pick up a well-run growth name for cheap.

Despite the weak macroeconomic backdrop, Fossil and its wholesale retailers, continues to see strong double digit sales growth in all channels.  In terms of the cost pressure, Fossil faced unanticipated increases in labor costs in itsChinafactories. It is working on its sourcing to lessen that pressure in the future. Moreover, after recently speaking with the CFO, Mike Kovar, it is clear that Fossil has pricing power and will be able to increase prices to further offset cost pressures without affecting its sales growth (expected by Q4’11 or early 2012).  Additionally, the market is fearful that inventory is up on a year over year basis, but that is a result of Fossil trying to smooth its inventory over the year versus having it back ended loaded where it has a bulk of its sales. This allows its factories to run at full utilization year around. 

 

Recent Events

On January 10, 2012, Fossil agreed to acquire Reno, NVbased Skagen Designs, Ltd. for $225 million in cash plus 150,000 shares.  Fossil also agreed to pay an additional 100,000 shares if sales exceed certain threshold requirements. Skagen is a Danish-inspired manufacturer, marketer and distributor of watches, jewelry, sunglasses and clocks sold in 75 markets.  Skagen’s  is complementary to Fossil’s current portfolio from a design and pricing perspective (prices range from $90-$325 between Fossil and Michael Kors.)   The acquisition should be synergistic as Fossil leverages its distribution footprint and back office capabilities.  Long term there is significant potential for Fossil to take Skagen from a watch/jewelry brand to a lifestyle brand while also expanding its distribution further into Europe andAsia.

Brief Description

Fossil is a global aspirational lifestyle brand that designs, manufactures and distributes consumer fashion accessories globally.  Originally a mono-brand company, Fossil’s now sells an extensive line of watches for men and women as well as accessories, jewelry, handbags, soft leather goods and shoes, under its own brand name as well as under licensed brand names. Due to its broad distribution points, product categories and price range, Fossil caters to a wide spectrum of consumers.  Fossil’s wholesale distribution includes retailers from Neiman Marcus to Wal-Mart. Additionally Fossil sells through specialty as well as its own retail stores. 

Investment Highlights

Early Stages of Watch Cycle

Fossil is to watches what Coach was to handbags about 10 years ago. The company realizing a void in fashion and was the first to market innovative, fashion forward styles using new materials, such as acrylics, resin, ceramics and rose gold.  As evidence of the excitement in the watch and accessory categories, one of Fossil’s wholesale customers, Macy’s, has consistently called out the strong performance of those categories in its earnings conference calls since mid-2010.  Moreover, other retailers have indicated the strength of watches including Signet (who called out fashion watches) and Tiffany’s (who said “Watch sales continued to post 30% plus growth in our own stores.”   Additionally, as of June 2011, Swiss watch worldwide exports climbed 45% on a two year basis which indicates the ongoing strength of watches. 

Looking at past cycles, like the Decker’s Ugg boot cycle (which continues after over 8 years) or handbag cycle (which Coach capitalized on for about 10 years), indicates that this watch cycle will likely last at least 5-8 years (we are in year 2).  This provides Fossil with multiple years of double digit growth.  The cycle, because it is about fashion, innovation and newness and not about time keeping, engages the customer who buys multiple watches on a more regular basis, further driving sales.  The handbag cycle is the clearest example as it shows how consumers moved from 1-2 handbags per year to multiple purchases per year. Management has indicated this phenomenon in watches as well.  Fossil, as one of the world’s largest watch manufacturers and distributors, can now drive trend themselves, further benefitting from the increased interest in watches.  The last watch cycle management saw was twelve years ago when there was movement from leather to stainless steel watches. Now the move is even broader – going from stainless steel and leather to new materials such as acrylic and plastic. There is also increased awareness about watches as a fashion accessory and it caters to both men and women – so the potential growth is even greater than the handbag explosion seen a few years ago. 

International Growth Opportunity

Asia Pacific

International expansion, especially into Asia, remains Fossil’s largest growth opportunity. Asiais currently only 12% of total sales with current OPM in the low 30s, but is expected to grow to a third of the business with the long term year or year growth of at least 30%.  Fossil began its international Asian business through distributors, who charged premium prices (sometimes up 25-40% vs. US prices, and who set up the brand to be aspirational.  As Fossil takes over from the distributors, it is able to maintain that premium pricing and thus earn higher margins (80% gross margins). Fossil is capitalizing on its current momentum in Asia by investing in the region – it has recently added significant resources to the area including personnel who used to run Nike Asia and Swatch China. In Korea, Fossil is currently selling the licensed product but has plans to develop the Fossil brand in the region by opening two stores in Seoul.  As the Fossil brand grows, the company plans to develop the same model of concessions within department stores.  In the Korean department stores, there may be 3 to up to 8 cases with sales of over $1500 per sq. ft. with 35-45% pretax margins.  Korean revenue last year was $25M and this year is expected to be $75M, up 200%.  The growth opportunity in Japan is also tremendous as Fossil only has 15 Fossil stores and less than 30 concessions while Coach has over 150 locations inJapan. 

Within the Asian market, Fossil only has between 200-250 concessions (shop n’ shops).  Within a few years, it is expected to grow concessions by another 500 locations and, in the next five or six years, have “thousands” of concessions.    As Fossil increase its DTC business (vs. wholesale business) within the Asia segments, segment operating margins should increase to the low 40s from the current low 30s (GM in the concession business are 80-90%.)  More importantly, consolidated OPM should improve from current high teens range to 23-24%, significant upside.  In terms of concession growth, the biggest growth opportunity within Asia is inChina. Chinais currently only $10M in sales with only 30 concessions.China’s luxury focused market, Fossil sells licensed brands such as Armani and Burberry, where it can leverage its relationships and marketing that the brands themselves have already done.  Additionally due to the growing middle class who seeks aspirational product, Fossil sees a huge opportunity for its namesake brand in addition to its licensed brands such as Adidas and Michael Kors. According to a study completed by Bain & Company in November 2010, watches (in the mid-price range which is Fossil’s sweet spot) and handbags are indicated as the drivers of growth of the domestic luxury market.

Europe

Europe, at 25% of sales, is developing in a similar manner toAsiawith a distributor model that Fossil expects to eventually take over (maybe 5-10 years).  After speaking with the Company, I feel confident about the growth rates as Q3 quarter-to-date is running up 35%.  Europe is just now where theUSwas at the early stages of the watch cycle, so it is expected to see continued increased sales as the new materials and innovative designs are introduced through its wholesale channels despite the broader macro issues.  While it has great distribution and sales inGermanyand theUK, there is enormous growth potential in Scandinavia as well asEastern Europe,RussiaandAfrica.  Furthermore, like inAsia, Fossil plans to grow out its namesake band as well.

Growth in DTC Business

Store Growth Potential – Domestically and Internationally

Fossil is in the nascent stage of its worldwide store growth. With just over 360 total worldwide retail stores, including 95 outlets, Fossil has significant opportunities to increase its customer reach. Fossil’s branded stores allow it to more fully showcase its products, including brand extensions such as clothing and footwear.  This is important in conveying to customers that Fossil is a lifestyle aspirational brand, not just a watch company.  Within theUS, Fossil has less than 200 stores and only 103 full price accessory stores compared to Coach which has over 350 full price accessory stores. The potential for full price in theUSis at least 400 units.  Internationally, Fossil also has a huge runway in which to grow its store base potentially in the thousands according to management. The growth of Fossil’s footprint internationally is imperative to further developing the brand, especially in the Asian markets.  The retail stores have had strong success in the last few years with double digit comparable store sales including a 22.2% comp on top of a 15.5% comp in 2010.  Management expects that strong performance to continue. Overall, Fossil’s stores are extremely productive with sales per square foot rates of $623, $775, and $693 in itsUSaccessory stores, European accessory stores, and Asia Pacific accessory stores, respectively. 

Fossil’s outlet stores are used only to discontinue merchandise.  It does not buy for the outlets or make new assortments for it. The key benefits of having an outlet strategy is that it allows Fossil to liquidate inventory at a better price vs. third party liquidators and it further promotes the brand. Its discounts are about 25-75% off suggested retail price. In Q2, however, Fossil was able to raise AUR to reduce its promotional rate without negatively impacting sales.

Fossil also operates 27 clothing stores in the US. These stores also include some watches and accessories and help to promote Fossil as a lifestyle brand. Additionally they operate stores under the Watch Station name and sell their own brands as well watches by other manufactures.  

Ecommerce Business

The last aspect of the DTC business is Fossil’s ecommerce initiative which is used as both a revenue and marketing tool.  Fossil has five commercial websites at this point in theUS,Germany,UK,SingaporeandAustralia.  It is currently expanding online intoKorea,Italy,Japan,FranceandAustria.  Fossil is repurposing old media spend into controllable items such as its websites and catalogs which will further sales and also allow the company to manage and tell the brand’s story.  From a commercial aspect, Fossil has the necessary technology (IBM web sphere) to do merchandising globally so it doesn’t need significant resources in each country and it can have uniform and tight assortments.

 

Strength of Fossil’s Brand Portfolio

Fossil Brand

Well known domestically, Fossil’s namesake brand will generate about $1.2bn in revenue this year and is viewed as an authority in the watch/accessory community. The Fossil brand includes its namesake brand Fossil, as well as Michele, Relic and Zodiac.  Fossil expects that it can generate 4-5x this revenue as it grows its international business.  In Q2’11 alone, the Fossil brand was 17% of sales and saw growth in, not only watches, but also Fossil branded accessories, which grew 22%.  Because Fossil has the ability to reach consumers at many different price points, it is able to push innovation and trend even further. Fossil has seen great results (even its wholesale retailer Macys mentioned in its Q2  earnings call that watches were very strong), Key growth drivers of the name, in addition to building international brand awareness and retail presence, is to grow its domestic retail presence as well as its extension businesses such as clothing and footwear (which bring in a larger traffic base).  Within accessories, handbags and jewelry continue to outperform.  In handbags, Fossil is using better leather and hardware and has seen AUR increase to $159 to $169 leading it to increase 44% in Q2. It is positioned in the sweet spot just under the price point of Coach’s offerings and also competes very favorably with private label brands.

 

Fossil has stores in inGermany,UK,Italy, HK Australia,Singapore,Taiwanand now expanding intoJapan,Korea, and china.  Consumers are reacting strongly to the offering and the brand is gaining momentum through the new websites, catalogs and recently launched CRM initiative. 

Licensed Brands

Fossil has a strong portfolio of licensed brands, including high end names such as Marc by Marc Jacobs and Armani. These brands have performed above average.  In Q2 alone, Michael Kors brand grew over 90% and contributed over $100m in revenue while focused mostly in the U.S.It is in the early stages in Europe and showing tremendous potential in Asia.  It is expected to earn $300m by year end.  Other key brands (though in earlier stages), such as Marc by Marc Jacobs grew 156% and are should follow the same trajectory as the Michael Kors brand – thus several years of significant growth.  Fossil is also able to leverage the marketing and brand cache of its licensed portfolio to further sales in emerging markets.  Fossil expects that these newer licensed brands will follow in Michael Kors’ growth trajectory.  Fossil is very selective about brands its licenses as it does not want to cannibalize it others brands and only wants names that can be at least $100m in revenue. In October of 2011, Fossil announced a strategic partnership with Karl Lagerfeld, under which Fossil will design, develop and distribute a line of men’s and women’s watches under the Karl Lagerfeld label.  Given the strength of the Karl Lagerfeld brand, it too, expects to follow the growth demonstrated by Michael Kors. Under its licensed brands, Fossils manufactures and distributes watches as well as jewelry with prices points on average of $95. Fossil’s success has led to calls from many people/brands who want to partner with them and, due to its strong performance, it has had no issues with renewals.

 

Valuation

Summary Multiple

(In Thds)       2011 2012 2013
Price $78.08   EBITDA 519,164 595,838 712,117
Shares Out 63,809   EPS $4.32 $5.57 $7.01
Mkt Cap $4,982,207          
     Net Debt ($224,701)          
EV $4,757,506   EV/EBITDA 9.2x 8.0x 6.7x
      P/E 18.1x 14.0x 11.1x
             

To see the true upside potential of Fossil’s growth, you need to look at the valuation post the near term solvable cost pressures/margin issues. By looking at the valuation from a point one year from today, you can account for the increased penetration of the watch cycle as well as increased growth inAsiaand N. America DTC. Additionally, it shows the amount of FCF generated in that time, which can be added back to the valuation. So as of December 2012, using a one year forward multiple of 10x EBITDA (which is less than where FOSL was trading at just six months ago) and adding in the cash generated over the next four quarters gets to a value of $120. 

         
Target Multiple 9.5x 10.0x 10.5x
         
'13 EBITDA   712,117 712,117 712,117
EV   6,765,116 7,121,174 7,477,233
Add Net Cash $224,701 $224,701 $224,701
Add Cash FY2012 $333,745 $333,745 $333,745
Market Cap 7,323,561 7,679,620 8,035,679
  Shares Out 63,809 63809 63809
Price Target $114.77 $120.35 $125.93
  Upside   47% 54% 61%
         
 

 

 

Appendix

 
In Thousands              
FYE 2007A 2008A 2009A 2010A 2011E 2012E 2013E
Revenue $1,432,984 $1,583,242 $1,548,093 $2,030,690 $2,588,717 $3,031,015 $3,563,203
Revenue Growth Rate   10.5% -2.2% 31.2% 27.5% 17.1% 17.6%
Revenue Est - First Call       $1,970,880 $2,577,800 $2,988,000 $3,421,400
Rev Growth Rate - First Call       27.3% 30.8% 15.9% 14.5%
               
GM% 51.8% 53.8% 54.6% 56.9% 56.4% 56.5% 57.0%
OM% 13.0% 13.0% 13.7% 18.5% 18.1% 17.9% 18.4%
NM% 8.6% 8.7% 9.0% 12.6% 10.5% 11.3% 11.9%
               
EPS--Actual/Projected $1.75 $2.02 $2.07 $3.77 $4.50 $5.57 $7.01
EPS Growth Rate   15.3% 2.5% 81.9% 19.4% 29.0% 25.9%
EPS - First Call       $3.65 $4.51 $5.49 $6.50
Fully Diluted Shares 70,333 68,323 67,153 67,687 63,000 61,750 60,500
               
EBITDA $219,281 $243,412 $252,961 $416,974 $519,164 $595,838 $712,117
Capex      (40,246)      (63,934)      (37,687)       (46,538)      (125,000)        (75,000)       (75,000)
Cash Interest            755            569            443          1,026          1,821           2,000          2,000
Cash Taxes       40,219       77,240       62,957       107,787       157,144       185,093       228,287
FCF-E $138,061 $101,669 $151,874 $261,623 $235,200 $333,745 $406,830
FCF Yield 2.77% 2.04% 3.05% 5.25% 4.72% 6.70% 8.17%
               
               
EV/Sales 3.3x 3.0x 3.1x 2.3x 1.8x 1.6x 1.3x
EV/EBITDA 21.7x 19.5x 18.8x 11.4x 9.2x 8.0x 6.7x
EBIT/EV 3.9% 4.3% 4.4% 7.9% 9.9% 11.4% 13.7%
P/E 44.6x 38.6x 37.7x 20.7x 18.1x 14.0x 11.1x

Catalyst

  • Continuation of the watch cycle and continued sales momentum
  • Increased DTC growth in 2012 and beyond
  • International expansion
  • Signs of turn in macroeconomic situation
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