Pick that Fossil (FOSL US), an interesting value stock

The story: Fossil watches came under the radar more than a year ago, after reading about them on a post at Value and Opportunity, one of the blogs that I admire. Since then, the stock is down more than 60% as Fossil is in the middle of two transitions:
a) tries to accelerate the shift from mechanical watches to smartwatches (acquired the Misfit activity trackers/smartwatches and cross-fertilised their technology developing an interesting wristwatch collection)
b) tries to increase online sales while closing shops in department stores
Though Fossil doesn’t have enough time left, as debt could become an issue if the turnaround doesn’t bear fruit in the next two years.
I think today the stock offers an attractive risk-reward balance. If the transformation programme works out, then the stock could become a double or triple bagger. Of course, there is the downside that competition accelerates eating out their small market share. In that case, Fossil could become the next Motorola or Nokia. I want to believe the founder, Mr Kartsotis (owns around 15%) wouldn’t let his poster child go bankrupt.

Business: Fossil manufactures and retails watches and some jewellery/accessories for both owned brands and licensed brands, sells primarily in the US and Europe (mainly Germany). The Company’s primary revenue stream comes from proprietary brand sales (48% of revenue) distributed via Fossil stores (304 stores) and mall-based retailers. Owned brands include Michele, Misfit, Relic, Skagen, Zodiac. Licensed brands contribute 47% of revenue and 23% of 2016 sales were generated from the licensing agreement with Michael Kors (KORS), this agreement expires in 2024. Other licensed brands include Armani, Diesel, DNKY, Kate Spade, Marc Jacobs, Tory Burch. A few years ago most of the revenue was generated from licensing agreements, these declined and now contribute less than half of total revenue. Revenue from licensing agreements shrunk because brands like Burberry decided to discontinue watches and focus on their core products.In some other cases like Adidas, licensors decided that watches is a strategic priority for them and they took development in-house. I think less reliance on licensing agreements could be an opportunity to Fossil as it has more control of its own destiny.

Fossil stock price chart: Down 75% since Oct’15, when licensing agreements started to expire

The niche: In the competitive smartwatch market, Fossil tries to carve out a niche
targeting fashion-aware female wrists that own android smartphones. They try to make appealing hybrid-watches that look normal and less geeky, like the one on the left (ASP $155), while combining all the functions of a FitBit activity tracker. I like them because they don’t need charging every night, their replaceable battery lasts for months.
Addressing a wider market, Fossil watches are iOS compatible and of course, they make male designs too. Most of the watches are sold at prices between US$75-500 and are considered affordable fashion, comparing to the high-end luxury watches sold by boutique Swiss brands.

Valuation: Fossil trades on undemanding multiples, less than x0.5 EV/Sales and x6.5 EV/EBITDA. The consensus isn’t optimistic, forecasting a small decline in revenue and shrinking margins (in line with company’s guidance..).
Even at this state, Fossil is forecasted to generated USD100m of free cashflow (post capex). Well bellow what it used to generate in the past but still punches well above its “valuation” weight, generate a 8% free cashflow yield on EV (i.e. Mkt cap + Net Debt).

Management: CEO Kostas Kartsotis (64), owns 13% of the company, has taken no salary since 2008. Is one of the cases that everyone would be better off if he paid himself a few millions every year leaving the market to decide on the valuation of the stock, without having to borrow US$0.5bn to do buybacks. A man of pride isn’t selling shares to live on. However, a few months ago he pledged half of his holding as a guarantee to borrow from the bank (naturally, the bank would short the stock as a hedge).
Capital allocation: M&A: a) Acquired Misfit in Dec.’15 for USD236m  b) Skagen in Oct.’12 for US$244m. Skagen in ’11 generated US$120m revenue with a 17% EBIT margin. Misfit tech team is still with Fossil.
Share buybacks: spent US$1bn in ’14, US$1bn in ’12, US$0.75bn in ’10.
Their M&A strategy I think makes sense but their share buyback policy was a Disaster.
At least they recognise it was a mistake.

Bull case:
Wearables strategy shows positive signs, in Q4 wearables accounted for 11% of revenue
In FY16 Fossil generated USD170m from smartwatches, on 100 SKUs. Fossil will continue rolling out new smartwatches launching 300 more SKUs towards H2 in FY17, as per 14/2/17 results call.
– Cost-cutting plan in traditional watches, reducing SKUs and retail footprint, driving more sales online
– If we assume Fossil’s ASP in smartwatches stabilises at around US$200m, they would need to sell nearly 6.5m units pa to replenish half of the revenue from mechanical watches. Achieving this within the next three years would require gaining a market share of about 3.5%, as the smartwatch market currently is estimated at 105m units and grows at 20% pa (source: IDC).

– Margin pressure from wearables could soften, as category gains scale

Bear case:
– low barriers to entry: One of the most popular brands, Daniel Wellington, was created with minimal initial investment, relying on social media promotion
– Increasing competition from Apple, Samsung, Fitbit, Movado, Swatch, Citizen
– the watch industry is declining: Federation of the Swiss watch industry shows exports continue to decline, at high single digits into ‘17  

Balance sheet:
Inventory risk: Inventory value US$542m
Debt: still US$300m headroom on current x3.25 Net Debt/EBITDA covenant

Left chart: store count shows closures only started in 2016.
Right chart: same-store sales yoy continue to decline over the last three-quarters

 

 

 

 

 

 
Google trends: Fossil (blue) vs Smartwatch (red): Highly seasonal market, with most of the volumes concentrated around Christmas. It seems like in a few years, time mechanical wristwatches will become a niche.

Relative value: Fossil and Fitbit the cheapest on EV/Sales, with the only difference being that Fitbit, as it burns cash like there is no tomorrow. Fossil trades at a discount to both Swatch and Citizen although they face similar problems in repositioning their business to address the transition to smartwatches

Fossil Q app popularity on Android store (source: similarweb.com)

Although Fossil smartwatches and hybrid watches were launched just 6 months ago, their app downloads seem to be stable and started gathering pace around April.

Next catalyst: 1Q FY17 results, 9 May 2017

 

8 comments

  • Great post, thank you. Interesting turn around story indeed.
    Are they making smartwatches for Michael Kors as well?
    Or, their licensing agreement is limited mechanical watches only?

    • Thank you for the interesting question, yes they still do watches for Michael Kors, they do smartwatches / hybrid watches for them too. Michael Kors places these watches in prominent locations and the early signs on volumes are positive.

  • I like the idea! Thanks for sharing.
    As you are interested in US names, have you looked at Hewlett Packard Enterprise (HPE)? It´s a “hold your nose” name like Sports Direct that makes it interesting. They already done 2 spin-offs and one is still ahead. The FCF yield on the remaining business is quite high. There are some (older) VIC write-ups…

  • Thanks for your comment dude,
    I ll definitely take a look on HPE – though I think the stock had a decent run and someone wonders how much upside would be left? Well, on P/E x10, probably there is something left.. Kodak could be interesting too
    I was thinking to dive into Coty (M&A deleveraging story) and the Western Union, both of them could offer growth at a reasonable price I think.

  • Autsch!

    • Well it’s a risky turnaround.. low visibility and their smartwatch strategy requires a leap of faith .. two positive takeaways from q1: deleveraging is working and restocking continues..

  • Okay, I need to admit, the story is not working, insiders started to sell
    I started SHORTING!
    I think the turnaround is not going to work anytime soon and Fossil started becoming an abandon ship situation.

  • What went wrong: I believed the turnaround could work and missed the fact that management has always been over-optimistic in their guidance. It’s very difficult to achieve a double turn around: create new innovative product while re-defining distribution channels.

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