After three quarters of accelerating growth on both the top and bottom lines and expectations ramping for continued growth over the next 3-4 years, we feel that watch, handbag, and leather goods accessory maker, Fossil (FOSL) could be poised for an explosive move higher late this year and early next.
Although the stock is extended and at all-time highs, our research indicates that the earnings expectations for the company have been deliberately low-balled by management. If we are right and earnings come in much better than expected in the second half of this year, current prices may yet prove to be a good entry point compared with where they may trade in the first half of next year.
The hallmark of most big winning growth stocks in the stock market has always been accelerating growth. Based on research done by Bill O’Neill & Co., the majority of growth stocks showed 3-4 quarters of accelerating year-over-year growth right before their stocks staged the most significant portion of their advances. Perhaps one of the most recent examples of this trend was Crocs (CROX) back in 2007. After reporting growth of 147% in its earnings for 2007, the company’s rate of earnings growth accelerated the next two quarters in early 2008 to just over 200% on a year-over-year basis. These numbers ultimately served as fuel for a major move in the stock.
While it is true that CROX’s growth was much stronger than FOSL’s has been and will be going forward, we are seeing a material acceleration in Fossil’s business of late. In a certain sense, we are wondering whether FOSL could become a “mini-me CROX”? Consider the following facts:
- Fossil has now seen 3 quarters of accelerating year-over-year sales growth of +13.7%, +21.7%, & + 30.6%.
- Year-over-year earnings growth has begun to accelerate noticeably: Q4 2009 was up 51.2%, Q1 2010 was up 107%, & Q2 2010 earnings were up 136%.
- Margins were at record seasonal highs for the first half of this year. There is still ample room for operating margin growth in the second half of this year, a catalyst that could lead to big earnings beats the next two quarters.
- According to company management, the watch category is in the early innings of a multi-year trend. As investors gain wind of this fact (like we recently have), additional money flows should move into the stock.
After some in-depth research on FOSL’s historical quarterly trends, it seems as though estimates for the second half of this year have been set too low. Management seems to have taken a page from Apple’s (AAPL) hand-book by deliberately low-balling guidance for Q3 and Q4. This seems to be becoming a trend for FOSL’s management team. Our job is to understand the game they are playing and capitalize on it.
Let’s begin with stating that the company recently bested estimates for the two most recently reported quarters by roughly 60% and 90% respectively. Now, looking ahead to the second half of this year, FOSL’s management has guided for earnings growth of only 40% in Q3 and 7% for Q4. You have to love these guys - their business is accelerating and here they are low-balling numbers for Q3 and, in particular, for Q4.
Why are Q4 estimates way too low? Well, in our view, it is simple. A historical analysis of the company’s past five years of Q2 to Q3 to Q4 earnings shows that the company has averaged a sequential increase in its earnings of 100% between Q2 and Q3 and 50% quarter-over-quarter from Q3 to Q4. Management goes out of its way to emphasize the inherent seasonality to both the company’s sales and “back-ended” profitability to investors in its S.E.C. filings. Here is an excerpt from the last year’s annual report:
Our business is seasonal by nature. A significant portion of our net sales and operating income are generated during the third and fourth quarters of our fiscal year, which includes the "back to school" and Christmas seasons. The amount of net sales and operating income generated during the fourth quarter depends upon the anticipated level of retail sales during the Christmas season, as well as, general economic conditions and other factors beyond our control. In addition, the amount of net sales and operating income generated during the first quarter depends in part upon the actual level of retail sales during the Christmas season. The seasonality of our business may adversely affect our net sales and operating income during the first and fourth quarter of our fiscal year.
As we continue to grow our retail store base and e-commerce businesses, sales from our direct to consumer segment increase as a percentage of the total sales mix, benefiting the Company's profitability in the fourth quarter, generally at the expense of the first and second quarters when, due to seasonality, it is more difficult to leverage direct to consumer expenses against direct to consumer sales.
In previous annual reports, the company has explicitly stated that 70% of their operating income is garnered during the second half of each year. If we were to apply these percentages to the numbers FOSL has put up so far this year, then we are looking at $3.90 a share in earnings for 2010. That's an almost 20% beat for the next two quarters.
Assuming we are right, this would most likely mean that 2011 numbers would get quickly raised by the Street to somewhere along the lines of $5.50 a share. With the stock currently at $51-$52 and the company poised to possibly grow their earnings almost 100% this year and maybe 50% next year, we feel that FOSL could have a move into the mid-to-high $60s, or even higher, by the early part of next year.
As such, we remain buyers on pullbacks ahead of FOSL's early November earnings report.
Disclosure: Long FOSL stock and calls