My Investment Thesis On Fossil Group Inc (FOSL) by Jay Siva, Latticeworks
Fossil Group Inc. (FOSL) is a vertically integrated (from design, all the way to point-of-sale) global consumer fashion accessories company that offers men’s and women’s fashion watches, jewelry, handbags, leather goods, belts, and sunglasses. The current valuation fails to account for the new opportunity that lies ahead of FOSL. Insiders and management own significant stakes, ensuring incentives are aligned. Camera shy CEO, Kosta N. Kartsotis, owns 13% of outstanding common stocks, and he earns no salary. The current share price offers investors the opportunity to buy a good business at a double-digit normalized free cash flow yield.
Fossil Group Inc (FOSL)
A new trend that arises from smart watches, strong currency headwind, increased marketing and advertisement related expenses (54% increase in last 5 years), and increased growth investments, led to margin compression, but the market fails to recognize the new expansion into the growth markets like China and new product development, Smart watches. Based on my sleuthing, newly introduced 2nd generation smart watches (Q Wander & Q Marshal) are sold out in multiple locations. 1st generation watches are no longer available in Fossil stores or online via Fossil’s website. I have received good reviews from sales people. They either have the 2nd generation watch or are planning to buy one in the near future. I believe that FOSL placed itself in a unique situation to capture the new trend: wearable devices that fit technology, fashion, and fitness altogether.
Although the current market price assumes that the revenue will continue to decline, I believe this is not the case for FOSL. Currently, the company trades for 7X 2015’s FCF. New long-term growth-related investments and liquidation of excess inventory compressed the margin and true cash flow potential. As these costs go away, margin will expand and so will the FCF. Historically, EBITDA margins float around ~20%. If the EBITDA margin goes to 18% FOSL will generate $7.28/Share, implying a 23% FCF yield.
The sleuth analyst:
Fossil Group is one of the highest shorted stocks, measured by short interest of float(36.37%). I have been visiting multiple Fossil store over the past two weeks. I believe wall street is wrong.
FOSL is selling lots of smart watches. I have talked to more than 15 sales associates at different locations. They all said the same story, good very positive story. Some stores even ran out of stocks. I have talked to customers those who wear them right now; they are happy with the generation-2 watches, especially about the battery life.
I also visited the same location multiple times in the past two weeks to talk to different sales people at the same location, and I didn’t find any inconsistencies among them.
Rose gold is the most popular among them; some locations didn’t even have any stock.
Competitive Advantage/Industry Highlight:
- Barriers to entry seem to be low in plain sight, but it is hard to break into the industry and run a profitable business operation. It is very difficult to grow one brand globally since it is required to have critical mass to have a successful operation.
- A higher start-up cost with higher uncertainty doesn’t justify the huge initial investment. It is necessary to spend a huge amount of money on advertising to communicate the brand value. FOSL spends close to $250 million on advertisement every year. It is also necessary to create a brand image, even before you start selling through department stores or other channels. When the brand goes through distributors, the brand will not be able to communicate the image unless it has already been established. FOLS has enough brand names in its portfolio to expand its operation globally. FOSL’s licensing business is seven times larger than the closest competitor (MOV). It makes FOSL a natural partner for other brands. Guess even tried to join FOSL, but Callanen International (Guess watch maker) sued FOSL, claiming it violated the antitrust and unfair competition law. I don’t anticipate any risk that comes from one brand will leave from FOSL to another manufacturer.
- The vertically integrated nature of Fossil’s business helps it to understand the new market trend and adapt itself quickly to new fashions/trends. It has seven weeks lead time while its closest competitor, Movado, has six months lead time. Fossil can even run some experimental products, which it normally does, before producing on a larger scale.
- Unlike many of Fossil’s competitors, FOSL sells fashion watches along with luxury watches. Fashion watches tend to have shorter shelf/store time, indicated by the inventory days. Fashion watches are less sensitive to the economy as compared to luxury watches.
- FOSL generates revenue through wholesale (~75%) and retail operations (~25%). The wholesale business comprises a large portion of EBIT. Having multi-brand watches at various price levels has a significant advantage when it comes to wholesale business. Since department stores are more concerned about how much money they could make per square foot when selling watches, they tend to carry all the watches at various price ranges to attract more customers of all levels.
- FOSL is heavily shorted stock for a variety of reasons: I don’t believe that short sellers will continue to be right.
- The threat from the smart watches: I think FOSL is well prepared to face the new trend. Their new wearable watches are a very hot product in the market. They are close enough to iWatch in terms of functionality, even though IOS has blocked certain features. Based on the communication that I had with sales associates, it will be rectified through 3rd party apps in the near future.
- Margin compression: The market fails to recognize the growth investments, an increase in advertising and marketing expenses, and currency headwinds. I believe the margin will recover as the new investment starts to work out. FOSL is spending a huge amount of money on expanding its international business, as they tend to be high margin businesses rather than the businesses it has in the USA. Opening new stores tends to cost EBIT margin in the short run as indicated by the below graphs. I believe sell side analysts are more focused with margin than the possibility that comes in the near future. Most of the new stores in Asia are concession, and they don’t have fixed rent payments, but rather a % of revenue. I don’t believe this will have a negative effect, even if the market crashes.
“Our international margins are higher than our U.S. margins on the wholesale side, primarily due to the fact that we are afforded the luxury of selling at higher prices. We don’t have the same competitive landscape in the watch business in most of the markets internationally as we find here in the U.S., and therefore, the — we can price much more sharply. Our gross margin sort of generally anywhere from probably 5 to 10% higher in the international wholesale segment than they are in the U.S. segment on a like-per-like product perspective.” – Mike Kovar – Fossil, Inc. – CFO, 2008-Q2, CCT
- Fossil Group’s new acquisition, Misfit, and the new licensing agreement with Kate Spade will open up new channels to market its products, wearable technology, through consumer electronic stores (CE). Misfit and Kate Spade already have self-spaces in multiple CEs, even though both of them don’t have good enough products to compete with Fitbit. Management is positive that it will change soon.
- FOSL only generates 17% of its total sales from Asia; management believes that its recent investment will increase the sales volume in Asia where Swatch is a market leader.
- FOSL has experienced management, and it has experience dealing with negative watch demand. In fact, the company still runs by one of the founders.
“ For fiscal 2014, Mr. Kartsotis, our CEO, continued to refuse all forms of compensation, expressing his belief that, given his level of stock ownership, his primary compensation is met by continuing to drive stock price growth, thereby aligning his interests with stockholders’ interests. As a result, the following references to Named Executive Officers in this Compensation Discussion and Analysis do not include Mr. Kartsotis. – Definitive Proxy, 2015”
- Capitalization and Multiples: with very conservative assumption.
- PUBLIC COMP
Trades at the lower end of the peer group. Fossil Group generates 25% of its revenue through Michael Kors brands and 75% comes from other brands. As such, I believe FOSL should trade above Michael Kors, or at the very least, it should trade on par with Michael Kors. If it does, FOSL would be worth $60 on a normalized earning basis. If it trades at the median, FOSL will be at $65.
- EQUITY FAIR VALUE UNDER SELECTED VALUATION SCENARIOS
- Assume the wholesale revenue drops by 20% (conservative &Base) 10% drop for aggressive case, for the sake of conservative valuation. Wholesale is the higher margin business. Retail sales Flat. It is reasonable to assume Wholesale EBIT margin is 24%; Retail margin is 13% based on historical data; EV/EBIT:8x based on peer valuation; EV/EBIT:10x based on historical trend (aggressive case).
Implied Share price sensitivity Table:
Implied upside from $30.35 sensitivity Table:
Behind all the pessimism that arose from the margin compression and the new smart watch introduction from other companies, Fossil Group is trading at a very good valuation. Analysts are more obsessed with the margin compression and fail to look the possibilities that lie ahead in the future. I believe patient investors will eventually reap the benefits.