Description

We believe FOSL represents an attractive, contrarian long given pessimistic market expectations combined with a possible change in business trajectory following the recent launch of new fashion smartwatches. Although risks are high and we have limited visibility into the level of traction these new products are getting at this early stage of launch, we believe the current set up offers asymmetric risk/reward.

Company Description

FOSL is a global designer and distributor of watches and other fashion accessories under owned (primarily Fossil) and licensed brands. Owned brands consistent of around 50% of revenues. Licensed brands involve Diesel, DKNY, Emporio Armani, Kate Spade, Marc by Marc Jacobs, Tory Burch, and Karl Lagerfeld, with Michael Kors being the most significant, representing about half of licensed sales and 25% of total revenue.

Sentiment in the stock is quite low, with a series of earnings disappointments and negative revisions bringing the stock down 75% over the past two years. Negative sentiment is further exacerbated by secular concerns surrounding new competition from consumer electronics companies with their smartwatch offerings.

While we acknowledge the headwinds posed by new competitors, notably the Apple Watch, we believe concerns are somewhat overstated. We believe FOSL has faced a perfect storm of headwinds over the past two years, which we summarize below:

• Negative currency impact from a strong USD with a cumulative -$2.20 gross EPS impact over the past two years.
• Maturation and slowdown of the Michael Kors brand.
• Competition from Apple Watch and others.
• Macro related consumer headwinds including department store related weakness to which FOSL is over-indexed.

We think the market may be overly pessimistic about the company’s long term prospects given secular risks to traditional watch demand from new smartwatch competitors.

• We think the primarily value proposition for both smartwatches and traditional watches is that of a fashion accessory. Therefore, the market will remain fragmented as consumer fashion preferences are highly varied. Smartwatch products like the Apple Watch will individually only satisfy a small segment of consumer tastes. Consumers will continue to pick out different watch styles to satisfy their own fashion preferences and stylistic decisions
• The market is naturally skeptical a traditional watch company’s ability to compete with much larger consumer electronics companies. Naturally the smartwatch products that FOSL puts out will be inferior from a technological standpoint to the Apple Watch. However, our read is that from a hardware standpoint, these new FOSL smartwatches are good enough. From a functional standpoint, we believe consumers use smartwatches primarily for activity tracking, cell phone notifications, and telling time. We believe the new FOSL products accomplish these tasks sufficiently.

FOSL’s Smartwatchs as a Potential Driver

FOSL has recently launched over 100 smartwatch SKUs across multiple brands, with the most significant being Michael Kors and Fossil branded smartwatches. While early, with Michael Kors Smartwatches just launched in September (and we believe not reaching many stores until October), we believe these watches are off to a strong start. Management recently confirmed on their earnings call that Michael Kors smartwatches exceeded their expectations with demand exceeding supply “by a long shot.” Our checks also confirm strong sales for Kors and decent sales for Fossil smartwatches, although it is difficult to extrapolate this data before we get data from the key holiday selling period. Notably, new Michael Kors smartwatches have consistently ranked among the top selling watches on Macys.com, only to be exceeded by the Fitbit Charge 2 and the Apple Watch (which is to be expected, and encouragingly, certain colors of the Kors smartwatch rank higher than certain colors of the Apple watch).

We think these new lines of fashion smartwatches serve an interesting and underserved niche in the marketplace, one that offers smartwatch functionality from a fashion first perspective and leverages strong fashion brands. We think the initial strength of the Michael Kors smartwatches demonstrates the potential of a fashion smartwatch that leverages a well-established fashion brand combined with good marketing support and prominent distribution.

Somewhat ironically given the market’s focus of smartwatches as a threat, we note that fashion smartwatches could serve as a multi-year driver of product newness for FOSL. For products that sell well, we would expect an expanded offering of styles and silhouettes compared to the relatively few options being offered today. Notably as the technology matures, we would expect to see smaller, more feminine smartwatch products from FOSL (the current smartwatch is quite bulky, given constrains imposed by the hardware).  

It is important to highlight that we are still very early in the launch process, and it is difficult to gauge the sales level of the combined FOSL smartwatch portfolio, although I believe early signs are encouraging and market expectations are low.

Risks

• While there are signs of stabilization in the business, the core watch business at FOSL has yet to stabilize and could decline further. The company has utilized higher promotions at outlets and special channels to drive sales this year given weak demand. Furthermore, Michael Kors traditional watches continues to drive most of the declines in the licensed watch category.
• While initial sales of recently launched smartwatches appear strong, our visibility is low and it is unclear whether this strength will continue into the key holiday period.
• FOSL’s earnings are very vulnerable to strength in the USD.
• FOSL’s watch brands are exposed declining mall traffic, and are particularly indexed to weak US department store trends. Macy’s, a large customer, has also announced a large number of store closures.
• Certain licensed brands (Adidas and Burberry) will not renew when their contracts expire, presenting a revenue headwind.
• We don’t focus much on the leathers and jewelry business given watches represent 75% of revenues, but the company recently noted some product issues in leathers, which could represent another headwind.

Valuation

FOSL currently trades at 12x CY P/E and 0.6x CY revenues. We exclude acquired intangible amortization, restructuring charges, and currency hedging gains for our earnings calculation. While 12x earnings is not an inherently attractive multiple for a business facing numerous pressures, we note that these earnings are off of depressed operating margins of 6%, versus historical margins of between 10 and 18%.

The company recently announced aggressive restructuring activities which would generate over 200mm of annualized savings (compared with 2016E operating income of 160mm). Of course if the business fails to stabilize, much of these savings may not flow to the bottom line. We believe that if not for the numerous headwinds facing the company, FOSL would actually be a decent business: one of the largest global watch companies with dominant market share in the $150 to $350 watch category, in an industry with high barriers to entry. As a result, we believe that if the core business manages to stabilize, FOSL has several levers to re-gain some of their historical margins. 

Catalyst

Catalysts

• New products continues to track well.
• Stabilization in the core business and new product launches changes the financial trajectory of the company.