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Fossil Inc. (FOSL) reported second-quarter 2011 adjusted earnings of 73 cents per share, beating the year-ago adjusted earnings of 58 cents per share by 25.9%. However, it lagged the Zacks Consensus Estimate by 2 cents.

Adjusted earnings in the reported quarter exclude a gain related to foreign currency of 7 cents per share, while the prior-year figure excludes a benefit of 22 cents related to a reduction in certain income tax liabilities. On a reported basis, earnings were flat at 80 cents per share in both the reported and the prior-year quarter.

Fossil’s profits were driven by double-digit growth in watches and leather goods and a comparable store sales increase of 22% globally. Furthermore, continuous innovation in the assortments, implementation of growth strategies and efficient utilization of the global distribution infrastructure led to solid performance in the quarter.

Revenue Details

Worldwide net sales of Fossil during the quarter grew 34.9% to $556.7 million, exceeding the Zacks Consensus Revenue Estimate of $534.0 million, reflecting sales growth in the company's watch and leather product categories.

All major watch brands reported strong double-digit sales growth leading to a hike of 32.1% in watch sales globally, whereas the leathers business sales volume climbed 30.4% in the second quarter 2011.

Net sales of FOSSIL branded products also expanded by 17.2%. Moreover, a weaker U.S. dollar also contributed $26.9 million to sales.

Segment Sales

Net sales from the North America wholesale segment increased 36.0% to $213.1 million, primarily driven by increase in the leathers business. Further, a rise in watch sales and sales to foreign distributors, located in Latin America and Caribbean, also contributed to the sales growth in the quarter.

European wholesale net sales grew 31.7% year over year to $141.8 million, as all the major watch brands experienced sales volume gains. Additionally, sales increased on the back of increase in wholesale shipments, sales to third party distributors, and increase in leather sales volume.

Net sales in the Asia-Pacific Wholesale segment increased 46.3% to $67.9 million driven by increases in the company’s watch sales. Company-owned retail concessions also boosted the region’s increased mix of sales.

Direct-to-Consumer segment net sales grew 30.5% year over year to $24.8 million, primarily due to gains of 22.0% in the constant dollar comparable store sales and a 3.0% increase in the average number of company-owned stores open in the quarter. The company’s e-commerce Business segment revenues also grew 20.2% year over year.

Margins

Fossil’s gross margin in the quarter contracted 140 basis points (bps) to 56.0% versus 57.4% in the prior-year quarter. The downswing in gross profit margin was due to increased production costs.

Additionally, lower-margined U.S. wholesale sales, sales to third party distributors and off-price retailers increased as a percentage of the sales mix, thus negatively impacting the gross profit margin.

Operating margin remained relatively unchanged from 15.5% in the second quarter 2011 compared with 15.6% in the prior-year quarter. Increased net sales and lower operating expenses as a percentage of net sales were offset by a lower gross profit margin in the quarter.

On the positive, operating income in the quarter was favorably impacted by approximately $10.8 million because of translation of foreign-based sales and expenses into U.S. dollars.

For fiscal 2011, Fossil expects production cost increases, principally consisting of labor and material costs, to continue to impact gross profit margin. However, a potentially weaker U.S. dollar and an expected increase in the sales mix of higher margined international wholesale sales and direct to consumer sales during the fourth quarter of fiscal year 2011 is expected to partially offset the impact of production cost increases.

Other Financial Update

The company had cash, cash equivalents and securities of $332.2 million at the end of second quarter 2011 compared with $443.0 million at the end of the prior year. Fossil also had $13.7 million of debt at the end of the reported quarter.

Inventory was $450.7 million in the quarter, up 51.5% from $297.5 million at the end of the prior second quarter. Higher inventory levels resulted from accelerating inventory purchases to compensate for the watch sales trends globally. Fossil expects inventory increases to slow down over the balance of the year with projected fiscal year-end inventory increases in line with expected sales increases.

Accounts receivable increased by 38.8% to $226.1 million at the end of the reported quarter compared with $162.9 million at the end of the prior-year quarter, primarily due to an increase in wholesale sales. Days sales outstanding for the wholesale segment was 47 days in comparison to 46 days in the prior-year quarter.

Since the end of the second quarter 2010, Fossil had invested approximately $343.4 million to repurchase approximately 5.2 million shares of its common stock.

Guidance

Concurrent with the earnings release, the company provided its outlook for third quarter and fourth quarter 2011. For the third and fourth quarters of 2011, Fossil expects its net sales to increase in a range of 22% to 24% with constant dollar net sales increasing in a range of 18% to 20 %.

Further, for the third quarter of 2011, earnings are expected to be in the range of $1.00 to $1.03 per share, while it is expected to be in the range of $1.78 to $1.82 for the fourth quarter 2011. This guidance results in estimated fiscal year 2011 earnings per share in a range of $4.44 to $4.50.

Recommendation

We are encouraged by Fossil’s in-house team of dedicated designers and product specialists who help steer the company ahead by following emerging lifestyle and fashion trends to bring innovative and unique products to its customers. However, stiff competition from Guess? Inc. (GES) and difficult macroeconomic conditions are matters of concern.

The company currently retains a Zacks #2 Rank on Fossil shares, which translates into a short-term Buy rating. On a long-term basis, we provide a Neutral recommendation on the stock.

Source: Fossil Misses on EPS but Has Designs for Growth