Description

FOSL is an exceptionally misperceived, left-for-dead small cap situation — perhaps the most so we’ve recently encountered. In a tape that is neutral to the consumer, which perhaps we won’t see this Q or next, we think it’s reasonably got 200-300 percent upside. But while we may not see that benign environment for a minute, even in this recent death march some inflections are too good to ignore. FOSL hasn’t had a solidly profitable 4Q for years; if what they report this week shows stability, soon enough folks will realize it’s a harbinger for profitable growth to come. We see a path to ~$3.00 in EPS in 2022 without pressing the model too hard, which even in this ugly tape gets you the first 100 percent of upside or ~25 bucks a share for just about free.

Quick history here. FOSL was a $130 stock that now sits at $12. It’s been left for dead by the sell side and forgotten by the buyside, albeit for good reasons. The CEO had visions of grandeur, extrapolating the Michael Kors 2010-2014 phenomena and building a bloated cost structure in hopes of doubling the revenue base. The management team then attempted to chase a fad with lower margin, higher capex Connected Watches, while forgetting the one reason people still buy watches these days: as fashion jewelry. Connected Watches became 20% of the watch business carrying half the margin structure of the traditional business (30% vs 60%). That mix shift is now reversing. FOSL cannibalized and eroded a good underlying business that was doing 20% EBITDA margins, had low capital intensity, operating in a duopoly business (licensed watches alongside Movado) with high ROIC.

EBITDA Margins troughed at 3.3% in 2019. Management realized their folly and took out $475m of bloated costs out in the last 3 years. We think underlying margins are now at least 1,000bps higher on a revenue base 10% lower than 2019.

Over the last couple of months, top line trends have positively inflected dramatically. A myriad of data sources – website, google trends, and import/export data suggests a dramatic acceleration vs. 2019 AND 2018. We also procured NPD data, which tracks the actual wholesale and AMZN sales of ALL of FOSL’s brands in the US and that corroborates the aforementioned sources. Beyond the here and now, we’ve also worked with FOSL’s former VP of Product, former VP of US Sales, former SVP of European Sales, competitors, and their 2 largest channel partners who not only reaffirm the current explosion in demand, but have also suggest that wholesalers are preparing for record open to buys of this product for 2022.

We think Q4 is the beginning of FOSL 2.0. YTD EBITDA margins have been 7.4% but given a resurgent fashion cycle should make itself clear in Q4 we see a path to revenue approaching 2019 levels and mid-teens Q4 EBITDA margins leading to the full year breaching 10%. If they crush Q4, it would highlight that open-to-buy is exploding everywhere and $2.50-$3.00 in EPS next year only requires +LSD growth with modest margin improvement (will be lapping 1Q21 depressed margins).

By YE 2024 FOSL could be a $50 stock, compounding topline at a MSD rate, getting to 15% EBITDA margins and >$5/share in 2025 earnings.

Detail to follow:

Summary Thesis

·         One of the Most Misperceived Situations We’ve Ever Seen – Mgmt. Initiatives have Structurally Repositioned the Business – We see Path to $3.00 EPS in 2022

·         Fundamentals Inflecting, Corroborated by Months of Primary Research/Channel Checks (incl. Working with Numerous Former FOSL Employees, Company’s 2 Largest Channel Partners & Competitors) & NPD Data

·         Expanded Distribution a Multi-Year Tailwind

·         Further Margin Tailwinds from Channel, Geographic & Product Mix Shifts

·         Current Valuation a Joke – only need +LSD % growth for path to $3.00 EPS to materialize (+152% upside)

Structurally Improved Earnings Power - 2 massive restructurings since 2016 have removed $475m of costs leading to materially higher earnings power as sales recover to Pre-Covid levels.  We believe EBIT margin can approach levels last seen when the stock was $100+/sh

-          FOSL has dramatically transformed its business since 2016 resulting in a structurally more profitable business. As sales continue to recover to pre-COVID levels, we expect to see a continued uplift in profitability and cash flow generation

o    To fully understand/appreciate both the magnitude and necessity of this transformation one needs to have context of FOSL’s past (high-flying FOSL circa 2010-2014) – as the company was experiencing rapid growth (a combination of Michael Kors success and the fashion watch cycle more broadly), FOSL CEO Kosta envisioned doubling the company’s $3.5bn top-line business to >$7bn business on its path to becoming a global powerhouse

§  To achieve this, Kosta put in place an SG&A structure capable of supporting it. The subsequent decline of the business left behind a severely bloated and unnecessary cost structure

§  As a result, Kosta focused on rightsizing the cost structure to align with reality and reposition the business

o    This led to the company launching its 1^st restructuring initiative, New World Fossil 1.0 (NWF 1.0) in 2016

§  FOSL successfully completed NWF 1.0 in 2019, achieving $200mm of run-rate cost savings (store footprint & SKU rationalization, headcount reduction and renegotiated supply contracts)

§  While this was a success, fundamentals remained challenged, so FOSL launched NWF 2.0 in 2019, targeting $250mm of incremental cost savings (zero-based budgeting, tech-driven efficiencies), which were later increased to $275mm due to COVID

o    Despite FOSL successfully achieving $475mm of cost savings since 2016, the full benefit has yet to be observed in FOSL’s P&L given the continued pressure on the company’s topline

o    To put into context the magnitude of the structural changes that have taken place, we estimate that if sales simply return to 2019 levels, EBIT margin would be +1,000bps higher than 2019 (+750bps above 2018 even with sales 13% lower). If we assume FOSL can grow sales beyond 2019 levels, we see further upside to profitability

Inflecting Fundamentals – Quantitative and Qualitative Evidence

-          Our work indicates FOSL sales are recovering faster than the market appreciates

o    Data - NPD watch data (tracks actual wholesale sales in the US) indicates dramatic acceleration from 3Q to 4Q, with sales surpassing 2019 levels (+10.5% vs. 2019)

§  Acceleration driven by broad-based strength across FOSL’s portfolio of brands with Michael Kors (+18% vs. 2019) & Fossil (+39% vs. 2019) leading the way

§  NPD data indicates FOSL taking share within the category, gaining +100bps market share vs. 2019

o    Store level - Dozens of channel checks across multiple geographies at the store level suggest accelerating sales from 3Q to 4Q, with volumes continuing their recovery towards pre-COVID levels

§  (1Q22 volumes trending similar to 4Q)

§  “[we] are seeing a lot more business, a big improvement. We’re getting back to 2019 levels” – store check

§  “[we’ve] been doing better than expected, business has consistently improved each month” – store check

o    Independent channel checks/primary research (including numerous former FOSL employees in addition to wholesale partners) – additional primary research corroborates the feedback received at the store level, implying a meaningful inflection in FOSL’s business

§  Former VP of Product – “have heard accounts were scrambling for inventory” (in reference to wholesale channel)

§  Former SVP – “Americas is rocking it” (in reference to conversations with suppliers)

·         “Macy’s business in December was so good they almost cleaned out all their inventory” (in reference to channel checks)

·         “sense is momentum builds in 2022” (in reference to outlook)

§  Separately, our conversations with wholesale partners indicate open-to-buys are expected to increase across the board in 2022

·         Wholesale checks from department stores

·         “Business in 4Q was explosive and the strength has continued into 2022… planning 2022 +DD % Y/Y”

·         “These brands haven’t slowed down, even after stimulus checks ended”

·         “Michael Kors & Fossil brands are the leaders in the category”

o    Note: this is corroborated by NPD data

§  Anecdotally, we have heard sentiment is positive within the company owing to employees receiving a max bonus (a level which was never reached from 2012-2020)

-          The company itself has expressed a similar message to the market in recent quarters regarding the outlook for growth

o    3Q21 earnings

§  “As we look at the next year, we expect to achieve strong topline growth as our categories have only partially rebounded from the pandemic”

§  “We've been transforming the business model for a number of years overall. With that we're really looking to return to growth for the next several years.”

o    2Q21 earnings

§  “We believe we're at the beginning stages of a consumer trend in traditional watches that will carry us into the back half of the year and beyond”

-          FOSL’s repositioning was showing early signs of success prior to the onset of COVID

§  Source: 8-K filed 6/3/2020

Expanded Distribution a Multi-Year Tailwind

-          Our independent channel checks/primary research indicates FOSL is likely to gain incremental distribution over the coming year which we expect to provide additional uplift to FOSL’s sales trajectory

o    Although the exact timing is uncertain, our understanding is FOSL has reached agreements to expand distribution across the Signet banners (Zales & Kay) and will re-enter distribution with both Macy’s & Dillard’s

o    Given the scale of these wholesale partners, we see this as an additional growth opportunity (and a positive indicator for further distribution gains)

§  Signet – FOSL distribution to expand to include traditional watches (currently only Fossil-branded smartwatches) and Michael Kors & Kate Spade licensed brands

·         Signet has 2,486 stores in North America, of which approx. 37% & 20% are Kay & Zales stores

§  Macy’s & Dillard’s – FOSL will once again (previously had distribution years ago) distribute Michael Kors jewelry through both Macy’s & Dillard’s (MK represented 17% of FOSL revenue in 2020)

Further Margin Tailwinds from Channel, Geographic and Product Mix Shifts

-          Accretive Digital Mix Shift

o    Digital mix shift remains underappreciated – channel accretive to profitability (based on our conversations with various formers, we estimate FOSL’s e-comm channel profitability approx. +300bps higher than brick & mortar)

o    Similar to other retailers, COVID has meaningfully accelerated FOSL’s e-comm business (FOSL owned e-comm penetration approx. mid- to high-teens % vs. 2% in 2017) while NWF 1.0 & 2.0 cost savings have enabled FOSL to invest more heavily in their e-comm stack while broadening out their geographic presence.

o    FOSL has discussed this opportunity frequently over the past year and our work suggests it continues to gain traction

§  “We have plans to aggressively expand our offering of traditional watches, smartwatches, leather, and jewelry offerings on these platforms that we're already on, and at the same time, expand the number of marketplaces and wholesale.com sites in each of our three regions, Americas, EMEA, and APAC” – 1Q21 earnings call

-          Accretive European and Asian Geographic Mix Shift + Long Term China & India Tailwinds

o    Approx. 60% of FOSL’s business comes from Europe & Asia – both regions have been slower to recover from Covid than the US (owing to more stringent COVID restrictions)

o    Europe and Asia carry materially higher gross margins than North America (in excess of +1,000bps higher than Americas) resulting in a margin tailwind as those regions cyclically recover

o    FOSL has an established and growing presence in China & India, with both markets becoming large enough to move the needle today and will become a larger underlying driver of total multi-year growth for FOSL

§  To date, the recovery in Asia has largely been driven by strength in China & India

·         Notably, FOSL’s presence in both regions has historically been small, however, the shift to digital/e-comm has resulted in Asia consistently posting +HSD % growth (incl. pre-COVID)

-          Accretive Product Mix Shift Back to Traditional Watches

o    Product mix shift away from Connected/Smartwatch to drive margin uplift

§  In response to the launch of the Apple Watch, FOSL expanded into the Connected/Smartwatch category in 2016

·         As connected product penetration (% of FOSL watch sales) increased (peaked in 2018 at 20%, $395mm sales), FOSL experienced significant gross margin pressure (approx. 30-35% gross margin vs. 55-60% for traditional watches)

§  Our work suggests the rebound we are seeing in FOSL watches is fueled primarily by traditional watches – as traditional watches continue to outpace, FOSL will see a nice uplift  

Current Valuation is a Joke

-          We see a reasonable path to FOSL generating >$3/share of EPS in 2022 (currently trading

-          2021

o    The company provided FY21 revenue guide of $1,880-$1,920 (+17 to +19% Y/Y, -14.9% to -13.4% Y/2Y) & EBITDA $160-$182mm (8.5-9.5% margin)

§  3Q revenue came in -8.8% Y/2Y with $62.5mm of EBITDA (12.7% margin)

o    4Q21 revenue was guided (provided) -12.4 to -7.2% Y/2Y, with EBITDA (implied) $67-$89mm (10.7-13.4% margin)

o    Our work suggests sales and profitability have meaningfully exceeded the company’s (seemingly conservative) guidance, with 4Q revenue approaching 2019 levels (despite ending with 19% fewer stores)

§  Taking into account the aforementioned mix shifts, this equates to >$100mm of EBITDA and >$1.00 EPS in 4Q (highest since 2016)

-          2022

o    Given the continued momentum into 2022 YTD and with additional growth levers (continued recovery of international markets), we expect 2022 sales to increase +LSD % Y/Y

o    Assuming only a modest improvement in gross margin Y/Y (arguable conservative – easy 1Q22 compare) equates to approx. $3.00 EPS

-          Assuming 10x P/E multiple equates to $30/sh (+152% upside) & layering on $4/sh YE22 net cash gets you to $34/sh (+186%)

Risks

-          COVID

-          Global Macro

Catalyst

4Q Earnings Release.