Most Wall Street analysts will focus their research with the time horizon of less than one year. With 17 analysts covering Fossil (FOSL), It is very difficult to have materially different points of view. However, if we do our research with the time horizon between three and five years, the difference in time horizon will help us to gain a competitive edge against the Wall Street analysts.
Fossil is a global brand focusing on design, development, marketing and distribution of consumer fashion accessories. It operates in four segments: North America Wholesale, Europe Wholesale, Asia Pacific Wholesale and Direct to Consumer. Fossil offers its products under its proprietary brands, including FOSSIL, MICHELE, RELIC, SKAGEN and ZODIAC, as well as under the licensed brands consisting of ADIDAS, ARMANI EXCHANGE, BURBERRY, DIESEL, DKNY, EMPORIO ARMANI, KARL LAGERFELD, MARC BY MARC JACOBS and MICHAEL KORS, along with the much-anticipated Tory Burch line launching in the fall of 2014. As of Dec. 28, 2013, it owned and operated 123 retail stores and 119 outlet stores located in the U.S., as well as 214 retail stores and 87 outlet stores internationally. Fossil was founded in 1984 with headquarter in Richardson, Texas.
Fossil has tripled its under $1 billion sales in fiscal 2004 to today's over $3 billion business. In fact, the global watch industry growth has been strong with above 5% CAGR since 2008 (as shown in the graph below), and Fossil Group has even produced 15.7% CAGR consolidated sales growth from 2008 to 2013.
Source: Fossil Presentation
The Management Team of Fossil
Kosta Kartsotis, the CEO and chairman of Fossil Group, has successfully tripled Fossil sales in less than a decade. He joined Fossil in 1988 and has served as CEO since 2000. According to Bloomberg Rankings' list, Kartsotis is one of the lowest paid CEOs whose companies have the best-performing stocks. In fact, he does not take an annual salary or stock compensation, but is the biggest individual owner of Fossil Group shares. As a shareholder of Fossil, I cannot imagine a better person to run Fossil other than Kosta Kartsotis.
Why Did Fossil Drop After 1Q 2014 Earning Release?
Although Fossil maintained its annual guidance for 2014, it lowered its guidance for second-quarter 2014 without providing sufficiently answers about the Michael Kors renegotiation and concrete timeline for the launch of smart watches. In addition, operating margin was down 40 bps to 13.5% with the SG&A rate increased 190 bps to 43.6%, and total inventory rose 15.7% year over year to $601.9 million. All the concerns drove Fossil down to around $100 per share today. However, I believe that all negative factors have already been reflected in today's depressed price. If we look out more than a year, we should see the potential catalysts, combined with strong licensing brands (Michael Kors and Tory Burch) and well-established distribution channels.
Unleash the Smartwatch Potential
According to Smartwatch Group, the global smartwatch industry increased 10 times to $700 million market in 2013 and will be expected to grow further to $2.5 billion market in 2014. No wonder that Fossil formed a partnership with Google in pursuing opportunities in wearable technology. Samsung has taken 34% of the smartwatch market, together with several different players each claiming less than 10% of market share, the fragmented smartwatch market should enable Fossil to grab at least 10% market share. In fact, Fossil has great competitive edge in the watch market based on its manufacturing and sourcing capacities, design and creativity, and well-established wholesales relationship with department stores, specialty chains, independent retailers and licensed boutiques around the world.
My assumption is that Fossil will be able to generate $300 million sales from smartwatches in three years. In addition to the 12% net profit margin of Fossil Group, smartwatches can produce $36 million net profit. If I apply a 16x PE multiple for the smartwatch division, it will be worth about $10 per share. Indeed, the smartwatch growth rate should be much higher than the traditional watches as illustrated by the fact that the smartwatch sales have increased by tenfold from 2012 to 2013. Once Fossil makes inroads into the smartwatch industry, I believe that the market will consider Fossil being one of the technologically innovative companies and value Fossil with a PE multiple higher than 16x.
Much-Anticipated Tory Burch Line
Fossil remains on track to launch Tory Burch in the fall of 2014 with a unique assortment of Swiss-made watches. To estimate the potential sales impact from Tory Burch, it is logical to relate Tory Burch to Michael Kors license sales. Although it is difficult to verify the exact amount generated from the Michael Kors license sales, I assume that the Michael Kors sales might be close to $600 million. As we all know, both Tory Burch and Michael Kors are the highly demanded brands in the fashion world. It is likely that Tory Burch can produce about $300 million to $500 million sales for Fossil since Fossil has already had the experience of handling and building the Michael Kors fashion accessories business. Again, by applying a 16x PE multiple, Tory Burch business can contribute another $10 per share value to Fossil shareholders.
Shareholder-Friendly Stock Buyback History
No only did the management team of Fossil make acquisitions, such as Skagen, when it deems strategically importance, but also act responsibly in returning money back to shareholders. Fossil has repurchased 17% of its outstanding shares over the last three years. I expect that Fossil will continue utilizing its free cash flow to repurchase shares in the future.
According to GuruFocus, Fossil has financial strength of 8 and profitability and growth of 9. The DCF valuation is $186.75, providing a 46% margin of safety. As a 10% top line grower, Fossil should trade higher than the forward 12.5x PE multiple. Since Fossil historically trades at 16x PE multiple, the current valuation significantly undervalues Fossil's future earning potential.
|In Millions of USD (except for per share items)||2016||2015||2014|
|Cost of Revenue, Total||1,844.20||1,676.55||1,524.14|
|Selling/General/Admin. Expenses, Total||1,744.94||1,586.31||1,442.10|
|Total Operating Expense||3,589.14||3,262.86||2,966.23|
|Income After Tax||483.09||439.18||399.25|
As discussed above, both Tory Burch and the smartwatch will help sales growth from and beyond 2015; together with the positive momentum from the international sales and additional store openings, Fossil can reasonably be modelled for 10% sales growth. In addition, I assume that Fossil will be capable of maintaining the operating margin of 16.5% and reducing its share outstanding by 5% per year. By applying Fossil's historical average 16x PE multiple and $9.71 EPS in 2016, Fossil should be worth $155 per share, producing more than 18% annual return for its shareholders.
If the U.S. economy recovers, the American wholesales business will be able to grow more than my model's expectation. Furthermore, if the Tory Burch and smartwatch division can perform better than expected due to great consumers demand for fashion and high-tech wearable accessories, Fossil might have a chance to double. Although it is not prudent to model such optimistic assumptions, fashion and technology can sometimes give investors a pleasant surprise and reward them with great returns. I will treat the 100% return as a bonus while I can comfortably forecast 18% annual return.
First, good portions of Fossil sales come from Europe. If Europe's macro environment deteriorates, Fossil will be adversely affected. Second, Fossil will make investment in Asian infrastructure to help drive the double-digit growth in Asia. If the investment fails to deliver the expected return, the 10% sales growth will need to be revised downward. Third, retail business can be volatile due to fashion and technology changes. Nevertheless, Fossil's strong brand royalty, manufacuturing and sourcing capacities, financial strength and well-established distribution channel can help to alleviate some adverse impact.
The Bottom Line
Fossil is a rare find in today's market since it is currently trading at 12.5x PE mulitple of 2015 earnings with great top-line growth and foreseeable catalysts from both Tory Burch and the smartwatch. In combination with a shareholder-friendly share-buyback history and an unbelievable CEO and chairman, I am happy to have the privilege to invest along with Kosta Kartsotis.