Description

Fossil Group (FOSL - $6.40) - Short

Summary

I believe Fossil Group (FOSL or the “Company”) is a compelling short opportunity with a near-term catalyst that could drive 40-50% declines and with the prospect of a 100% return over multiple years.  FOSL is predominantly a global manufacturer of mid-priced luxury watches sold under the Fossil Brand, as well as under key licensed brands including Michael Kors and Armani. Sales are largely made through its wholesale business, though the Company has its own stores and e-commerce site as well.  Fossil has been struggling for years from a combination of a weak brand, a weak category, and a weak distribution channel. Given the continued pressure from connectable devices, a struggling watch business at Michael Kors, and the bulk of sales being from department stores, it is hard to see how any of the pressures over the last three years will improve.  Because the Company operates with high gross margins and low operating margins, a continuation of current trends for even twelve months is likely to cause losses and eventually, significant cash burn. Finally, given recent developments with the Coronavirus in China, there is the increased likelihood of a significant disappointment in 2020 earnings guidance and cash flow.  Asia is the one region where Fossil has been growing, and despite that growth the consolidated Company continues to experience meaningful declines. Though I do not believe Fossil will survive long-term in any event, pressures in its Asian business could exacerbate the Company’s demise. With even 10-15% cumulative declines in revenue going forward (expected to decline 12% in 2019 alone), I believe Fossil will be burning cash and show de minimis EBITDA.  Long-term, assuming trends continue, I believe the Company’s equity will be worthless.

Why Does This Opportunity Exist?

• Stock currently screens cheaply on trailing and even current year numbers.  However, this is a very operationally leveraged business and EBITDA can erode rapidly.

• Smaller capitalization company, so it is likely off the radar for larger funds and investors

• The stock has already come down significantly over the past several years so some investors may believe the short has run its course.  Of course, there could be 100% downside.

• Relatively clean balance sheet.  Although this is true today, if sales decline, this Company will quickly begin burning meaningful amounts of cash, and leverage could increase rapidly.

Current Capitalization

Shares: 50.5

Market Cap: $323mm

Net Debt: $117mm

TEV: $440mm

Business Description

Fossil Group is a designer and manufacturer of medium-priced fashion watches, small leather goods and other accessories, with the bulk of sales (~80%) being traditional watches and smartwatches.  The Company sells its own brands including Fossil, in addition to licensed brands including Michael Kors (~23% of 2018 net sales), Armani (~15% of 2018 net sales) and others. Sales are global, with the bulk continuing to be the wholesale channel, as well as an e-commerce site and 454 Company-owned stores globally.  A snapshot of key financial information is below:

What should immediately jump out are the large negative numbers for constant currency growth that have persisted for years.  Additionally, the Company’s operating profit margin continues to decline as sales decline, though not as bad as it could have been given large restructuring savings.  The most profitable segment for the Company is Asia and it has been the lone bright spot on the top-line and the most profitable segment on a margin basis. In addition to large restructuring programs to recalibrate the cost structure of the Company by pruning unprofitable products and stores, the Company has had no choice but to try to reinvent itself for the wearables and connected device revolution. In my view, this pivot in strategy, while likely necessary, will lead to continued disappointment as the Company is simply not set up to compete with technology giants and does not have a strong enough brand to woo consumers to its technology.  I think any time a Company’s stated strategy involves “transforming its business model” there is a significant amount of risk, and what might have been assets previously may not transfer as well to the new approach.

Company Pressures

The short thesis for Fossil is based largely on the five points below:

Struggling watch category with a difficult transition to technology ahead – Read any filing or transcript from FOSL or Movado over the past two years and you will hear the same thing – “this is a challenging time for the watch industry.”  In my opinion the traditional mid-tier watch companies such as Fossil are not likely to see great times again going forward. There is a fundamental change occurring in the watch industry today and Fossil’s shift to try to sell technology watches is evidence of that trend.  Unfortunately for FOSL, I don’t think they will have much success doing it and the evidence is already in the numbers. For the past two quarters, connected device sales have fallen, though they blame liquidations of older watches as the culprit. Big picture, I believe the transition to becoming a more technology-focused company will have many problems:

• For FOSL, the competitive set goes from smaller, niche fashion brands that have similar amounts of capital and talent-bases and where FOSL may have had a brand recognition advantage to Apple and Google (with its recent Fitbit acquisition especially), who have far more resources, better technology, a network effect with other devices and services they own and brands that are synonymous with technology.  It is hard to see what Fossil’s competitive advantage in connected devices will be when they rely on other vendors for the operating system and when they do not have any other connected devices, which is a key reason consumers purchase wearable devices in the first place. It is a stretch to believe the Fossil brand will hold its own against things like the Apple Watch or even watches from Garmin. Of note, FOSL is already discounting its Gen 5 Smart Watch by 25% and retail ASPs are not materially different from Apple watches to begin with.  https://www.fossil.com/us/en/wearable-technology/smartwatches/smartwatches.html

• Per the Company’s 10-K, as of now, technology products for FOSL have lower gross margins.  Even if the Company is successful in the transition, it seems as though they are mixing into an area with lower margins and their current margin structure does not allow room for error (or lower gross margins…).

•  Because technology items are typically purchased in the holiday season, the business is likely to become more seasonal.  This could put additional strain on the company’s working capital/balance sheet as they must support the fixed cost burden the whole year and hope for holiday season sales.

Primary distribution channel remains challenged – Although FOSL doesn’t disclose sales by channel (not surprisingly, this was discontinued in 2014 when things started to look bad), triangulating information over a number of years leads me to believe that the wholesale channel continues to represent between 40% - 50% of total sales today, down from 75% of the business approximately six years ago.  The Company’s core wholesale customers are as follows: Amazon, Best Buy, Dillard’s, JCPenney, Kohl’s, Macy’s, Neiman Marcus, Nordstrom, Saks Fifth Avenue, Target and Wal-Mart. With the exception of a few of these customers, these companies are all likely to experience substantial sales declines in the next several years and many have already begun closing stores.  The current developed market business is declining “high double digits” in the wholesale channel. Using rough numbers, this decline alone will probably create declines of 7-8% on the consolidated top-line for the foreseeable future, needing to be offset by Asia growth, e-commerce, and company-owned stores.  As traffic to department stores declines, Fossil also loses the free brand presence/marketing within those stores and the ancillary benefits of traffic to Fossil retail locations, which are near many of these department store locations.  Unfortunately for FOSL, this doesn’t seem to be only about the channel. The company’s owned retail locations are also comping negatively, suggesting underlying issues with the brand and product assortment (i.e., this isn’t a tech company…), in addition to channel weakness.  Sales have declined at an 8.6% CAGR since the end of 2014.

Michael Kors sales are expected to be weak – One of Fossil’s largest license partners is Michael Kors.  Fossil sells Kors-branded watches and the Kors brand made up approximately 23% of FOSL sales as of the FY 2018.  Recent commentary from Capri Holdings (owner of Kors) suggests a dim outlook for Kors watches and is also telling regarding Kors’ ability to sell connected devices:

“Retail revenue was below our expectations with comparable store sales declining in the low single digits. Our third quarter comparable store sales reflect low single-digit growth in Asia, flat results in Europe, and a low single-digit decline in the Americas where stores were impacted by lower-than-anticipated traffic during the month of December.  Additionally, we saw a greater-than-expected decline in watches, which negatively impacted total comparable store sales by approximately 200 basis points. Excluding the impact of watch declines, comparable store sales would have been flat.” – 2/5/20

“In our watch category, trends further decelerated in the third quarter. Despite continued innovation, the decline was greater than anticipated. This reflects continued decreases in fashion watches and the greater impact of competition from tech-driven companies in the smartwatch market. This category will likely remain challenged and have a continued impact on North American retail comparable store sales as well as future licensing income.” – 2/5/20

“So -- and I would tell you, I think it was -- you saw it in our prepared remarks, but we have an even greater decline in our tech watches than we have anticipated. And clearly, the customer voted for those companies that are more in the tech wearable business than we necessarily are. And it's very difficult for us to compete against them, in particular, where they have an ecosystem that's linked to many other products with the consumer. So we're trying, we're trying hard, but it's definitely an uphill battle. So I think that the watch declines will continue to impact North American comps all the way through next year. It's less of a percentage of the Europe business, and it's a -- not de minimis, but it's a very, very small percentage of the business in Asia in watches compared to what North America and, to a lesser degree, Europe are.” – 2/5/20

Note that this impact on Kors is partially an overlap with the wholesale channel described above.  With that said, it is a meaningful portion of the business, it makes any recovery in wholesale seem even tougher and this commentary is pretty harsh as it relates to Fossil’s new technology strategy.

Incremental restructuring savings will be difficult – Because I believe the topline will continue to decline for the foreseeable future, Fossil is going to require significant cost cuts to prevent cash burn.  In Q4 2016, the Company announced a restructuring plan to “reinvent themselves” which was expected to yield $200mm in total savings through the end of 2019.  Though it is difficult to know exactly how much they saved, there is no doubt the Company has done a good job controlling costs as they’ve experienced continued revenue declines.  With that said, after spending four years and $50mm in restructuring costs, it seems as though the low-hanging fruit is largely captured. Going forward, savings will be increasingly difficult, though I’m sure they will try.  Further, if the Company continues to be on the defensive and cannot reinvest in its business or technology transformation, how can it possibly ever reverse the top line?

Coronavirus may pressure near-term sales – Reports from various companies so far have shown significant impacts from the spread of Coronavirus in China.  On its recent conference call, Kors said the following regarding its Chinese business:

“We can only hope for a speedy and positive resolution to this crisis.  Given the extraordinary and appropriate efforts taken to contain the virus, our trading results in Greater China and certain other parts of the Asia region have been materially impacted. Currently, approximately 150 of our 225 stores in Mainland China are closed. Additionally, for those stores remaining open, both traffic and sales have been severely reduced.”

In terms of risks for Fossil, the Company has its manufacturing facility in Shenzen, China.  The 10-K also specifically states that the Company is vulnerable to changes in economic and social conditions in China and disruption in international travel and shipping.  This is all more relevant because Asia was the lone bright spot in Fossil’s business. It is growing nicely, though it is still too small to offset the effects of the 50% of the business shrinking every year.  Additionally, the Asia business is higher profit margin so any slowdown there could be worse for quickly shrinking profits. Without significant growth in Asia, the consolidated numbers could get ugly very quickly.

Obviously, I do not think the Coronavirus is going to end China.  Eventually things will settle down and business will be back to normal.  However, this probably will create a situation where guidance is below expectations and it could cause cash burn in 2020, further eroding the Company’s balance sheet and limiting options.

Financial impact and the future

It is very difficult to imagine a scenario where these long-term trends reverse in a sustainable way.  The Company has been declining in the high single digits for several years and trends seem to be getting worse despite efforts to pivot the business.  There does not seem to be any significant traction in connected devices, Kors continues to struggle in the watch category, and most of the wholesale customers continue to shrink.  Could there be some glimmer of hope for a quarter or two? Sure. Do I think that is going to be sustainable? No…and that’s why I think this is a good short. I do think it is likely the Company gives poor guidance for 2020, but this thesis is more than betting on a quarter.  They could just as easily pull a rabbit out of the hat, announce more restructuring, and the market could get excited. I would probably just use that as an opportunity to short more. Instead of trying to precisely predict the next few years of annual performance, below is a matrix of what EBITDA looks like under various scenarios for cumulative revenue declines and cost cuts, using 2019 guidance as a starting point.  I have assumed that revenue comes out with stable gross margins, but as things weaken it will probably be worse than this and technology growing is worse for margin. Additionally, the Company actually built inventory in Q4 in anticipation of Chinese New Year, so any slowdown could lead to incremental discounting and weak margins.

To these figures, deduct about $30mm in run-rate interest expense and $20mm in capex (they significantly underspend D&A).  They also have a weird tax situation given all the subsidiaries and were genuinely hurt by tax reform, so they pay taxes even when they have negative pre-tax income.  Let’s assume $0 for tax to make this easy and because it doesn’t change the answer. At a 10% total revenue decline from these levels and giving them credit for $50mm in cost savings, they would barely generate cash.  As I think I already showed, 10% declines are easy to believe on an ANNUAL basis and they are expecting negative 12% in 2019. This is happening in generally good times for the consumer. The $50mm in cost cuts would represent 2.2% of revenue and almost 5% of SG&A and this would be after a three-year plan that was focused on cutting costs.  In other words, these assumptions are generous and it already looks bad. For those curious, if you plug -20% in for sales and have $25mm in cost cuts, the Company would burn about $130mm in cash a year, and it would be dead for the most part. Even with EBITDA of $64mm, what multiple do you pay for a Company shrinking, with dying brands, with a dying distribution channel, with no capital to compete against Apple in an industry where they really have no experience…I doubt more than 5x.

Valuation/Conclusion

I believe FOSL is a good long-term short, with a likely return of 100% over a few years.  In the near term, it is easy to see declines of 40-50%, especially with weak guidance likely.  5x $64mm of EBITDA would yield a price of $3.80. Or, if you look at this on a free cash flow basis and assign a 15% leveraged yield, the value would be below $2.  Assuming more of the same, this certainly appears to be headed lower. As a sanity check, I always think big picture…if FOSL disappears, does it really have that much of an impact on the world?  That’s usually a bad sign for a brand/company. It doesn’t make this a certainty of course, but the world is probably all set on mid-priced fashion watch brands.

Risks

• A material change in the 3-4 year trends described above

•  Cost cutting that temporarily keeps the business afloat or leads to a manufactured “beat”

• Some kind of silver lining quarter where trends or second derivates look less bad.  I think all the long-term trends look like they are going the other way

Catalyst

• Poor guidance when they report Q4 2019 results

• Continued EBITDA declines over time, and ultimately cash burning which increases the likelihood of financial distress

• A recession that makes watch trends even worse