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Executive Summary

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%.

Business Description

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.

Historical Info

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

• Consumer Weakness - I don’t think I need to get into a lot of detail on the first point, but generally speaking, it seems the consumer spending environment has not been great.  Many retailers have missed and mall-based department stores in particular continue to report a highly promotional environment.  All else equal, a tougher retail environment makes it tougher to sell $300-$500 watches, especially when watches don’t really go bad and are just a fashion accessory.
• Watch Industry is Cooling - Over the past five years, FOSL and other manufacturers have benefited from a robust environment for watches.  Below are the results (roughly calendar year) for the three largest public manufacturers of watches.  Needless to say, an 18% revenue CAGR since 2009 strikes me as above average growth.

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.

• Michael Kors brand is slowing - While admittedly slowing off an incredible pace, I estimate Michael Kors licensed sales have contributed nearly 63% of FOSL’s revenue growth since 2011.  As KORS revenue growth slows to even low-double digits from the historical rate of nearly 40-50%, the headwinds for FOSL to continue growing revenue increase.
• The direct to consumer business has hit a wall – FOSL’s direct to consumer business represented roughly 25% of 2013 revenue and 12% of pre-corporate EBIT.  However, this business has started to show the first cracks as comparable store sales have slowed meaningfully.  While the Company continues to build stores and revenue overall is rising, I do not think it is sustainable to continue to grow the store base as comps go negative.

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.

• Margins have weakened – Despite continued expected revenue growth for the year, FOSL margins are expected to deteriorate to ~16.6% EBIT from 18.4% three years ago.  In particular, the Company has cited that while demand used to be more “pull” in that customers sought out their products, they are spending more money on SG&A for “demand creation” expense.  In my view, spending more money marketing to drive the top line is a sign of a more challenging environment going forward.
• Current year numbers and projections look increasingly difficult – The combination of the factors above make hitting current year numbers and future projections difficult from a fundamental perspective.  As noted above, based on first half results, the Company has a lot of work to do to achieve its full year revenue and EBIT growth figures.  While they recently revised guidance upwards suggesting some confidence in the figures, the 2015 and 2016 numbers look more challenging.  While there is nothing obviously wrong with the business overall, different pieces are being impacted in smaller ways leading to a headwind for the aggregate business.  2015 and 2016 revenue estimates are for growth of 8.3% and 9.3%, respectively.  Any material miss is likely to hurt the stock and this is before the threats discussed below, including a material royalty reset.

 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.

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 9^th 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:

• Two former Nike FuelBand employees – They are listed as sensing systems engineer and mechanical design engineer at Apple
• Two employees from Sano Intelligence and Vital Connect – Notable people from the medical sensor world
• Paul Deneve, ex CEO of Yves Saint Laurent – Working on “special projects”
• Patrick Pruniaux, sales director at TAG Heuer
• Marcelo Lamego, CTO of Cercacor – Experience in patient monitoring and noninvasive monitoring tools

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.

• While I do not know for sure what the royalty rate for KORS is, many reports suggest that FOSL pays KORS a rate of roughly 10% of revenue.  For starters, I will assume the research community and other articles I have seen have done something to get this 10% figure.  The other way of triangulating this is to check the royalty rate that FOSL currently pays:

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.

• Adding to the likelihood that KORS tries hard to renegotiate for better terms is the fact that as a contract manufacturer, FOSL makes more profit dollars than KORS does on KORS branded sales.  Does that make sense to anybody?  Assuming the traditional 25% wholesale margin, FOSL made approximately $183mm of EBIT from KORS sales in 2013.  By contrast, KORS licensing business runs at approximately a 58% margin due to advertising and other costs:

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.

• I believe KORS also has a strong incentive and an alternate provider should they choose to switch manufacturers.  First, as discussed previously, KORS sales trends do appear to be slowing down.  Any incremental profit, especially when it is so easy to obtain, will likely be pursued.  Secondly, it is worth noting that Movado makes watches for Coach and other luxury brands.  Below are links to Coach and Michael KORS watches:

http://www.coach.com/online/handbags/Product-legacy_sport_rose_gold_crystal_bracelet_watch-10551-10051-W1211-en?cs=rgd&catId=5000000000000287302&navCatId=7100000000000000639

http://www.michaelkors.com/p/Michael-Kors-Michael-Kors-Mid-Size-Rose-Golden-Stainless-Steel-Blair-Chronograph-Glitz-Watch-ROSE-GOLDEN/prod25960005_cat35801_cat35701_/?index=11&cmCat=cat000000cat145cat35701cat35801&isEditorial=false

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.

Valuation/Estimates/Conclusion

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.

Risks

• This business generates cash and generally isn’t terrible
• Change in consumer preferences towards FOSL brands
• Acceleration of growth or comp store sales at FOSL stores
• KORS decides to pay the same rate

• iWatch launch
• Recession which hurts consumer spending
• Change in consumer preferences
• Michael KORS royalty rate reset or switch to another vendor
• Earnings misses