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In Earnings Workout, we scrutinize quality of earnings, the balance sheet, the conference call transcript and federal filings in an effort to assess whether a company may be vulnerable to future disappointment. We believe that Fossil's Q3 results exhibited several red flags.

Fossil (NASDAQ:FOSL) reported 3Q EPS of $1.09, ahead of the $1.04 Street consensus on higher than expected gross margins and better than expected SG&A leverage. Fossil now expects gross margins in 4Q to be slightly lower (versus flat previously) due to a smaller FX benefit. For FQ4, the company expects EPS of $1.75-$1.78, which compares to its prior guidance of $1.78-$1.82. Management attributed the lower guidance to pressure from recent strength in the U.S. dollar. Q4 revenue is expected to be up 20% y/y compared to the consensus +22.0% estimate.

Q3 Revenues increased 22.7% (+18.3% organic growth plus +4.4% FX benefit), with growth of global watch sales, up 24.8%, leather products up 25.3% and jewelry up 12%. North American wholesale business (37% of revenues) increased 15.8%, representing meaningful deceleration from the 48% growth in 2010 and the 35% growth in the first six months of the year. Y/Y gross margin declines have been partially masked by FX benefits from a weaker dollar. In Q3, gross margin decreased 110 basis points to 55.9% in from 57.0% in the Prior Year Quarter, inclusive of a 170 basis point favorable change resulting from a weaker U.S. dollar. Overall operating income was positively impacted by $15.8 m as a result of translating foreign-based sales and expenses into dollars. However, recent dollar strength has diminished this tailwind. On the Q3 CC, management commented, “When we originally gave guidance for Q4 back in August, we were expecting about 80 basis points of currency benefit to gross margins, based upon the then-prevailing FX rates. Given the recent strengthening of the US dollar, we are now expecting a currency benefit to gross margins of approximately 30 basis points. As a result, we see fourth-quarter gross profit margins coming in slightly below last year's Q4 level. We expect Q4 operating expense as a percentage of sales to remain fairly consistent with last year's Q4 level.”

Fossil management believes an increase in the sales mix of higher margin international wholesale sales and direct to consumer sales as well as price increases across a select number of styles will partially offset the impact of the strengthening U.S. dollar. As management explained on the Q3 CC, “The first thing is that we are advancing our store growth in Q4 compared to last year, so you will see direct-to-consumer as a percentage of the mix increase by over 300 basis points from where we were in Q3. And that's a much higher spread in comparison to Q3 to Q4 last year. We're also expecting to see a higher spread in terms of mix benefit toward our international operations, including Asia, where a lot of that growth will come through concessions, where we are operating basically in a retail model as well. So those are the primary factors why we see the ability to bring in a gross margin that's going to be a little more consistent, albeit slightly below last year, than we've seen over the last couple of quarters.”

It should be noted that direct to consumer and e-commerce sales have slowed in recent quarters. In Q2, direct to consumer net sales increased 25.7%, the result of comparable store sales gains of 22.0% and a 2.8% increase in the average number of company-owned stores while the e-commerce businesses increased 20.2% y/y. However, this segment, especially e-commerce, slowed noticeably in the third quarter. In Q3, direct to consumer sales increased 19.7%, primarily the result of comparable store sales gains of 14.1% and a 4.8% increase in the average number of company-owned stores open during the quarter. Net sales from the Company's e-commerce businesses remained relatively unchanged in Q3. Within the 14.1% comp increase, Fossil had a 16.9% increase in North America, Europe was up 5.1% on top of a 10% in the prior-year quarter, and Asia was up 16.8% on top of a 23.9% last year.

In response to a CC question about the company’s outlook, management commented, “We generally don't talk in terms of granularity in terms of the business for the first six weeks of the current quarter, but I would say that our expectations for Europe are similar for Q4 in that we expect to see strong double-digit growth in our wholesale categories within that region. And we are seeing a little bit of a slight dip in retail comps right now, but that's something we're looking at that we think can be assisted with focusing more on some productivity metrics that are out there. Japan is still very challenging from a macro perspective. We do expect to see that business improve as we go into the fourth quarter. And then, as we also mentioned, we've seen somewhat of a slight decline in our wholesale business in Australia. Our retail comps were up strongly in Australia. We're having some challenge with the wholesale business, and it's primarily due to a number of our department store customers becoming a little more promotional with the watch business that we really don't want to participate in.”

FOSL’s margin the past 3 quarters has also been adversely affected by increased sales to third-party distributors and off-price retailers. According to the third quarter 10Q, “Production cost increases accounted for more than 200 basis points of the decline. Additionally, a higher percentage of lower margin sales to third party distributors and off-price retailers negatively impacted gross profit margin in the Third Quarter. Partially offsetting these declines in gross profit margin was an increase in the sales mix of higher margin international wholesale sales in comparison to North American wholesale sales.” We believe that higher sales to third-party and off-price retailers need to be closely watched as sales through this channel are lower margin than corporate average and may be indicative of higher than planned inventory levels.

Inventory increased 31.8%, versus the revenue increase of 23% and the expectation for revenues to increase 20% in 4Q11. On the Q3 CC, management stated, “In terms of Q4 we do expect inventory increases to be in line with sales. As I mentioned in the prepared remarks, there's always a little noise around the end of the year relative to Chinese new year and the expectations of labor challenges once Chinese new year is done, although we believe that, as we look at it today, that inventory should be somewhere in the 20% range in terms of growth. And that, as I said, is consistent with our sales expectations. With selling higher-priced goods, obviously we are carrying higher average unit costs as well within the inventory, so I would say those things kind of line up together. There's really no imbalance between what we're selling and what we carry in inventory. So our AURs would be equally impactful on inventories as well. As we move into 2012 I think we have an opportunity to continue to look at becoming a little more focused on our inventory growth in terms of sales.”

In sum, given the sales slowdown, the FX headwind, the higher inventory, and the increased reliance on sales to third-party distributors and off-price retailers, we believe that there exists the potential for 4Q disappointment.

Source: Earnings Workout of Fossil: 3Q11 Red Flags