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Executives

Allison Malkin - Integrated Corporate Relations

Kosta N. Kartsotis - Chief Executive Officer, Director

Michael W. Barnes - President, Chief Operating Officer, Director

Mike Kovar - Chief Financial Officer

Analysts

Neely Tamminga - Piper Jaffray

Brad Stephens - Morgan Keegan

Barbara Wyckoff - Buckingham Research Group

Ronald Bookbinder - Global Hunter

Anna Andreeva - J.P. Morgan

Bill Baldwin - Baldwin Anthony & McIntyre

Fossil, Inc. (FOSL) F2Q08 Earnings Call August 12, 2008 9:00 AM ET

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Fossil 2008 second quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Allison Malkin with ICR. Please go ahead, Madam.

Allison Malkin

Thank you. Good morning. Before we begin, you should be aware that during this conference call, certain discussions will contain forward-looking information. Actual results could differ materially from those that will be projected during these discussions. Fossil's policy on forward-looking statements and additional information concerning a number of factors that could cause actual results to differ materially from such statements is readily available on our Form 10-K and 10-Q reports filed with the SEC. In addition, Fossil undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

If any non-GAAP financial measure is used on this call, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the non-GAAP financial measure to GAAP will be provided as supplemental financial information to this release under the earnings release section of the investor relations heading on Fossil's website.

Please note that this call is being webcast live on Fossil's website. It will be available for replay on the website under the investor relations heading after the conclusion of the call.

And now, I would like to turn the call over to Fossil's CEO, Kosta Kartsotis. Go ahead.

Kosta N. Kartsotis

Thanks, Allison. Good morning, everyone and thanks for joining us. Also here today are Mike Barnes, our President and COO, and our CFO, Mike Kovar. This morning, we will provide you with an overview of our second quarter results, as well as our outlook for the balance of the year. At the conclusion of our prepared remarks, we will open for questions.

We are pleased to report record second quarter results. This performance clearly demonstrates the strength of our business model. Our diversified global distribution of high margin accessories gives us a significant long-term opportunity. The combination of great brands and innovative product development, executed with cost and inventory discipline, puts us in a position to perform reasonably well despite difficult economic conditions in several markets worldwide.

Specific highlights of the quarter included net sales of $353 million, a gross profit margin of 53.9%, and earnings per share of $0.36, reflecting a 71% increase from $0.21 last year.

Our performance was driven by key growth initiatives, including our direct-to-consumer and international businesses. Our direct-to-consumer segment enjoyed a terrific performance, recording sales growth of 25% in the quarter, with total comp store sales rising 4.2% ex currency.

Our global accessory store comps were 2.7%, which included a 5.1% increase in the United States, which is on top of a 5.6% increase in Q2 last year. The momentum we are experiencing in this segment indicates that the innovative styling in our watch and accessory lines is resonating with consumers around the world and that the infrastructure we’ve been building to support this initiative is paying nice derivatives.

We are also seeing that these trends are continuing into the early part of Q3. As a result, we are maintaining our pace to open between 80 to 85 stores this year, with more than half of these outside of the United States.

On the international front, we experienced net sales growth of 9.5% ex currency, fueled by a 21.4% increase in our other international segment. We are making excellent progress in advancing our wholesale business in the Asia-Pacific region and are experiencing solid growth with our distribution partners around the world.

While our European wholesale business reflected a slower growth rate of 2.9%, we are confident that we will see some improvement during the second half of the year.

One factor that will help us internationally is that our accessory business continues to gain momentum outside the United States. The opening of our retail stores overseas is introducing more customers to our leather products and this is giving us additional wholesale opportunities.

For example, we have established a successful men’s leather business in our U.K. department store and they are now testing women’s leather. We are also doing leather test in both Australia and Japan. We also have a solid and growing business in Germany in leather goods.

Another bright spot is the fact that the Fossil brand increased in sales 13% ex currency during the quarter with all categories combined. In addition, our Fossil watch comps within our own retail stores were in the plus 15% range during Q2. These results are very promising as we enter the more seasonal second half of the year with an improved assortment and more focused branding efforts. The brand is continuing to gain momentum worldwide and this is again a significant long-term opportunity.

We also have a number of new initiatives that we believe will further advance our long-term growth opportunities, including we are very excited to announce today that we have signed a licensing agreement with DKNY for jewelry that will launch in Europe in Q3 of this year. As you know, our jewelry business is very strong in Europe and there is an appetite there for branded jewelry. We also have a very successful DKNY watch business in Europe, so we expect the jewelry to be very successful relatively quickly.

Most of this product will go to the same specialty and department stores where we sell DKNY watches and participate in our extensive shop-in-shop programs that we have in Europe.

We also have unveiled our Fossil men’s footwear line at the recent footwear show and got a strong response and will be shipping to a relatively small number of doors in the United States and Germany in the spring of next year. A women’s line is also in the works, with an anticipated launch date of fall 2009.

We have assembled several world-class footwear professionals that have done a great job in delivering an assortment that further promotes the image of the Fossil brand. We believe this is a natural extension to our leather goods categories and will benefit from the strength of the brand in the United States and Germany.

We also recently launched to the trade another new business category, which is Michelle handbags. The line was very well-received, the product is terrific, and we will be shipping also in the first quarter of 2009. The distribution will be in luxury department stores in the United States plus some unique specialty stores across the country. This should be a strong business for us and complements the Michelle watch business, as well as the sunglass line that was launched earlier this year.

From a balance sheet perspective, we ended the quarter with cash balances of $212 million and minimal debt. The inventory growth was slightly higher than sales growth during the quarter but included 61 new retail stores opened over the last year.

Now I would like to turn the call over to Mike Barnes to review our sales highlights in more detail.

Michael W. Barnes

Thanks, Kosta. Good morning, everyone. I will start the review of our domestic business, where we saw sales rise 1.5% for the quarter, with watches up 2.3% and non-watch categories up 0.5%.

Domestic wholesale watch growth was driven by our licensed watches and Michele brands and was partially offset by a modest sales decline in Fossil watches. Mass market watch sales were also down but as we noted last quarter, some shipments moved into Q1 this year versus Q2 last year.

Growth from our licensed watch category was led by a strong Emporio Armani business as well as continued success with the rollout of Michael Kors.

Given the softness in the U.S. economy and the fact that department stores are holding down inventories to increase turns, we are pleased with the results of our domestic watch business. We’ve maintained a leadership position in this category and we are continuing to outperform others in the space. We believe the second half of this year could result in an improved performance as department stores flow inventory for the holiday season, given the health of our stock to sales ratios at the end of this quarter.

As mentioned on previous calls, we are continuing to experience great sponsorship from our department store customers. We believe the newness coming in the second half of the year, combined with improvements in our inventory flow, especially compared to last year, will also help drive our second half performance.

As previously noted, our proprietary luxury watch brand, Michelle, experienced a solid increase in wholesale shipments for the quarter. This sales strength, combined with a lower rate of returns compared to the prior year quarter, helped to deliver a strong net sales performance for the brand and Michelle remains the best-selling watch in the fashion, luxury tier of distribution.

We also launched Michelle sunglasses in late March and we are currently reacting to selling information to improve the overall assortment as we move this business forward. And as Kosta mentioned a moment ago, we plan to introduce Michelle handbags in the spring of 2009, which we expect will further build awareness for this brand. We have previewed the Michelle handbag line with key customers during the market last week and the reception was very positive.

Our domestic accessory business experienced a 0.5% increase in wholesale shipments during the second quarter, driven by growth in Relic handbags, Relic small leather goods, and the continued rollouts of the Fossil accessory jewelry and our Fossil 54 handbag line. These increases offset declines in Relic eyewear, primarily due to a reduction in towers at a key retailer in comparison to the prior year, and Fossil women’s accessories. Relic handbags and small leather goods had a great quarter, with wholesale shipments increasing 15% and retail selling increases even higher.

We’re in a great inventory position and we look for this trend to continue into the second half of the year.

Our Fossil accessories jewelry line is outperforming the broader category and we expect to increase our door penetration from about 500 doors at the end of Q2 to approximately 900 doors for holiday. As to the Fossil 54 handbag line, we ended the quarter with 71 doors and expect this to grow to just over 100 doors by holiday.

We experienced a 3.2% decline in Fossil women’s leather shipments during the quarter but had we not been up significant close-outs from the prior year quarter, would have seen increases of about 2% for the line.

Our stock to sales ratios are healthy and with newness starting to hit the stores, we are expecting a stronger performance during the second half of the year.

As to our international wholesale business segment, we had a solid performance for the quarter, with net sales increased by 20.4%, or 9.5% excluding currency. In Europe, wholesale shipments rose by 16.8% or 2.9% ex currency. Ex currency, we posted high-single-digit increases across our Fossil watch and jewelry lines and our Emporio Armani business. The Diesel watch business also performed very well, with wholesale shipments increasing 11% during the quarter and the expansion of our Michael Kors business added additional growth as well.

These increases were partially offset by declines in our DKNY watch, Emporio Armani jewelry, and our Fossil eyewear business. We have been refreshing the DKNY watch line and we expect this to improve in performance during the back half of the year. We believe the performance in our eyewear business is really reflective of the weakness within this category. Long-term, including the back half of the year, we expect our Europe segment to perform at a much better pace than we experienced during the second quarter. We feel that the 90% growth we saw over the first six months is more indicative to what we should expect in the back half.

We will benefit from an approximately 1300 door launch of DKNY jewelry as Kosta mentioned earlier and continued growth in our core watch and jewelry lines; in addition, future expansion into other categories, such as small leather goods and handbags.

In our other international segment, wholesale shipments rose by 27.1%, or 21.4% ex currency. This strong performance continues to show the benefit of our globally diversified business model. We experienced strong double-digit growth across our Fossil and licensed watch brands with most of our significant operating subsidiaries, providing double-digit sales growth as well.

Our increasing presence of shop-in-shops and concessions in the Asia-Pacific region continued to provide an excellent opportunity for us to build awareness for our brands and gain market share in the department store environment.

Our distribution partners in Asia and South America continued to provide solid growth for our watch businesses and we are looking to further penetrate these markets with our jewelry and accessory offerings. We remain extremely enthusiastic about our long-term opportunities from our newer businesses in China, India, and Korea as well.

Our direct-to-consumer segment had a terrific quarter, with sales rising 24.8%, or 22.5% excluding currency. This was primarily the result of a 27.9% increase from retail store growth and comparable store sales increases of 4.2% ex currency.

Our growth engine in this segment, which is the Fossil accessory store concept, delivered global comp increases of 2.7% in 71 comp stores that were opened during the quarter. If not for a very difficult quarter in our Australian stores, comps would have increased nearly 5% in our global full price accessory stores. Regardless, we experienced solid growth in the U.S. accessory stores with comps rising 5.1% against a prior year comp of 5.6%, and our Europe stores were up 5.4% ex currency. On a positive note, during the third quarter to date, we’ve even seen improving trend in the Australian comp store numbers as well.

The exciting part about our Fossil stores is that we are experiencing strength across most markets and stores continue to further our Fossil brand awareness and our wholesale channels internationally. As Kosta mentioned earlier, we are seeing opportunities to broaden our category presence in many markets as a result of the increased exposure provided by our retail stores.

Globally, we ended the quarter with 263 stores. This includes 129 full priced accessory stores, 66 of which were outside the U.S., and 82 outlet locations, including six outside the U.S. Additionally, 33 apparel stores and 19 multi-brand stores. This compares to 202 stores at the end of the prior year quarter, including 78 full priced accessory stores that had 35 outside the U.S. and 76 outlet stores with four outside the U.S., 33 apparel stores and 15 multi-brand stores.

During the second quarter, we opened 13 new doors, including 11 full priced stores and two outlet stores. For the full year 2008, we still expect to open between 80 and 85 total stores. As previously stated, we will concentrate on the full price accessory concept with slightly more stores begin opened internationally than domestically.

As a final note on stores, you might note that we have purchased the Watch Station name and global web domain and have opened our first multi-brand outlet store in Florida under this brand. We view this as a future growth opportunity as well.

At this time, I will turn the call over to Mike Kovar to discuss our financial results.

Mike Kovar

Thanks, Mike and good morning to everyone. First I’ll summarize our second quarter results from this morning’s press release -- net sales increased 15.2% to $353.2 million compared to $306.5 million last year. Gross profit grew 26.4% to $190.3 million, or 53.9% of net sales, compared to $150.5 million, or 49.1% of net sales.

Operating income increased 51.2% to $35 million, or 9.9% of net sales, compared to $23.1 million or 7.6% of net sales. Reported net income rose 71.3% to $25.1 million compared to net income of $14.7 million last year. The second quarter effective tax rate of 21% was well below last year’s rate. Normalizing this quarter’s effective tax rate to our structural rate would have resulted in net income increasing 37.7% over the prior year.

Diluted weighted average common shares decreased to 69 million shares compared to 69.7 million shares, resulting in reported diluted earnings per share increasing 71.4% to $0.36 per share compared to $0.21 per diluted share last year. Again, normalizing the effective tax rate to our structural rate would have resulted in second quarter diluted EPS growth of about 39.1%.

Our sales mix breakdown for the second quarter in comparison to last year continues to shift toward a higher percentage of internationally based wholesale and direct-to-consumer sales, with an offsetting reduction in our domestic wholesale sales percentages. Specifically, the 2008 second quarter sales mix was as follows: 16.1% from domestic wholesale watch sales; 11.8% from domestic other activities; 19.5% from worldwide direct-to-consumer businesses; 33% from European wholesale sales; and 19.6% from wholesale sales in other international locations.

The 15.2% sales growth for the quarter consisted of the following increases by category and geographic region -- domestic watch sales increased 2.3% to $56.8 million, compared to $55.5 million in the prior year quarter. Other domestic sales, which include our leather, sunglass, and jewelry businesses increased 0.5% to $41.6 million compared to $41.4 million in the prior year quarter.

Sales generated from European based wholesale operations increased 16.8% to $116.4 million, compared to $99.7 million in the prior year quarter.

Other international sales, which consists of export sales from distributors and sales from our Canada, Mexico, and Asia-Pacific wholesale operations, increased 27.1% to $69.4 million compared to $54.6 million in the prior year quarter.

And finally, sales from our worldwide direct-to-consumer businesses grew 24.8% to $69 million compared to $55.3 million in the prior year quarter.

Second quarter gross profit margin increased by 480 basis points to 53.9% compared to 49.1% in the prior year quarter. For the second quarter, our gross profit margin was favorably affected by a weaker U.S. dollar, which contributed approximately 200 basis points to overall margin improvement. Additionally, our ongoing margin improvement initiative and an increase in the sales mix of higher gross margin international and direct-to-consumer sales further drove margin improvement.

To a less extent, gross profit margin was favorably impacted by higher outlet store margins due to a reduction in year-over-year discontinued inventory balances and lower levels of markdowns. An increase in sales mix of our lower gross margin distributor sales partially offset these increases in gross profit margin.

Operating expenses as a percentage of net sales increased 240 basis points in the second quarter to 44% compared to 41.6% in the prior year quarter. Total operating expenses increased by $28 million to $155.4 million in comparison to the prior year quarter and included approximately $7.5 million related to the translation of foreign base expenses as a result of the weaker U.S. dollar. Operating expenses in the prior year quarter included approximately $4.4 million related to expenses associated with our equity grant review.

Excluding expenses related to foreign currency translation, and the prior year equity grant review expenses, the increase in operating expenses was principally driven by increased expenses associated with our retail store growth, increased bad debt reserves due to the deteriorating financial condition of several of our domestic wholesale customers, costs associated with transitioning our Italian subsidiary to our centralized FAC platform in Europe, and increases to support higher levels of sales.

Direct-to-consumer operating expenses as a percentage of direct-to-consumer net sales increased to 59.4% in the second quarter compared to 50.7% in the prior year quarter, resulting in approximately $6 million, or $0.05 per diluted share in additional operating expenses. This growth is principally related to retail store growth and infrastructure additions, including payroll costs related to headcount increases in our sales management and construction departments and expansion of our international retail infrastructure. We believe this trend will continue into the third quarter, to the effect of approximately $0.03 per diluted share, but should normalize during the fourth quarter of this year.

Operating income increased by 51.2% during the second quarter to 9.9% of net sales compared to 7.6% of net sales in the prior year quarter as a result of increased gross profit margin partially offset by decreased operating expense leverage. Operating income was favorably impacted by approximately $9.2 million as a result of a translation of foreign-based sales and expenses into U.S. dollars.

Other income and expense increased unfavorably by $3.2 million, primarily driven by increased foreign currency transaction losses. These losses are a result of four contracts previously entered into at rates below the relative quarter in foreign currency exchange rates.

Our income tax expense for the second quarter was $6.9 million, resulting in an effective income tax rate of 21.4%. The lower effective tax rate for the second quarter was a result of a reduction in reserves for certain income tax liabilities. Barring any additional discrete events, we estimate our effective tax rate for the second half of this year will approximate 37%.

Second quarter net income increased by 71.3% to $25.1 million, or $0.36 per diluted share, compared to $14.7 million or $0.21 per diluted share in the prior year quarter. Second quarter net income was favorably impacted by the lower effective tax rate and also by net pretax foreign currency gains of $6.3 million, which added about $0.06 per diluted share. Prior year second quarter net income included approximately $0.04 a share of stock option review related costs.

Turning to the balance sheet, our cash, cash equivalents, and securities available for sale as of the end of the second quarter totaled $212 million, in comparison to $178 million at the end of the prior year quarter and $268 million at the end of fiscal year 2007. We have repurchased approximately 2.3 million shares of our common stock since the end of the prior year quarter for approximately $78 million. This includes approximately 300,000 shares under the 2 million share buy-back we announced several months ago. We expect to complete this buy-back by early December.

Accounts receivable increased by 16.2% to $175.8 million at the end of the second quarter, compared to $151.3 million at the end of the prior year quarter. DSO in comparison to the same quarter last year remained unchanged at 45 days. DSO over the last several quarters has been increasing on a year-over-year basis as a result of our international wholesale businesses growing faster than our U.S. wholesale businesses. And although this trend continued somewhat during the second quarter, the effect of it increasing our consolidated DSO was offset by an increase in sales mix from our direct-to-consumer segment and increasing bad debt allowances.

Inventory at quarter end was $285.4 million, representing an increase of 20% from the prior year quarter inventory of $237.8 million, and included inventory related to an additional 61 retail stores being opened since the end of the prior year quarter.

Additionally, in-transit inventories from our factories at the end of the second quarter more than doubled in comparison to last year as our inventory flow has improved. And as a result, we should be in a much better position to meet demand than we were this time last year.

Capital additions for the first six months of the year totaled $28 million and we are expecting full year 2008 CapEx of approximately $75 million to $80 million, of which a significant portion of this relates to new retail store openings and costs associated with the implementation of a new SAP point of sale system for the stores.

Depreciation and amortization expense for the first half of 2008 was $17.9 million and we are estimating full-year 2008 depreciation and amortization expense of just over $40 million, with the increase over 2007 levels primarily related to our direct-to-consumer businesses.

As it relates to guidance for the remainder of the year, as we have mentioned before, as we continue to grow our retail store base and web based businesses, sales from our direct-to-consumer segment increased as a percentage of our total sales mix, benefiting our profitability in the fourth quarter generally at the expense of the first and second quarter when due to seasonality, it’s more difficult to leverage expenses against sales.

In addition, our current guidance includes the most recent strengthening of the U.S. dollar and increased slightly ahead of where we were projecting it during our May earnings call. As a result, we are currently estimating second half of fiscal 2008 net sales to increase in the mid-teens range. We expect third quarter diluted earnings per share to approximate $0.53, a 23% increase over the prior year third quarter diluted earnings per share of $0.43 that included about $0.03 of stock option review related expenses.

For the full fiscal year 2008, we currently estimate net diluted earnings per share in the range of $2.27 to $2.30, as compared to $1.75 in diluted EPS for fiscal 2007.

In conclusion, we are pleased to begin the second half of the year in a solid position. Our brands are performing well across the globe, our direct-to-consumer initiative is fueling nice increases, and we have identified several new opportunities to advance our growth. We will continue to plan our expenses and inventory appropriately, given the environment and are confident in our abilities to achieve our annual goals.

With that, I would like to turn the call back over to the Operator to begin the question-and-answer portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Neely Tamminga with Piper Jaffray. Please go ahead.

Neely Tamminga - Piper Jaffray

A couple of questions here for you; first on just inventory, where would you expect inventory growth might tend to be at the end of Q3 and Q3? Could you help us think about that, given the different moving parts going on?

Mike Kovar

Our expectations for Q3 are to be reporting similar to Q2 inventory increases in excess of our sales increases. If you’ll recall last year, we had some inventory flow issues with some production issues we had coming out of our China factories. Taking you back a little bit further, if you’ll recall early last year, we talked about adding a new operating system in our factories and we also consolidated four watch factories down to two watch factories in the first half of last year, which impacted our flow toward the back half of the year. So we were probably entering the back half of last year without the inventory really needed to meet the demand and we think we missed some sales because of it in the second half of the year.

So year over year, we’ll see slightly elevated inventory levels at the end of Q3 but that should come back into balance by the end of the year.

Michael W. Barnes

What we have done is we have kind of spread out some of our production where instead of trying to produce it all in the month of September, we’ve moved some of the key item production up earlier and some of that is in the building already. And we did miss what we think was significant sales, some of it on our key items, which hurt our sales in the third and fourth quarter. So we think we are in a great inventory position. Our inventory at the end of the third quarter should be slightly ahead as well and for the same reason, we missed a lot of sales in the fourth quarter. We shipped late, which caused us to be the combination of missing sales trend in December and shipping late caused our inventories at the end of the year at retail to be higher than we wanted also and it affected our first quarter.

So we think we are in a much better position right now.

Kosta N. Kartsotis

I think that what we’ve really done is it’s putting us where we need to be as opposed to being behind, and one last comment I’ll make on that is we need to be in a strong inventory position going into the first quarter of next year just because of the fact that the Chinese New Year has been moved up substantially from last year. It moves around every year and this year, it’s early in January. And if we don’t have the inventory going into the season, then we won’t have it.

Michael W. Barnes

I’ll add one other thing. If you look at the composition of our inventories at the end of the second quarter compared to last year, we are in a much better position between active styles versus discontinued styles, and that’s been reflected in our outlet margins, which are up more than 400 basis points year over year.

Neely Tamminga - Piper Jaffray

That’s excellent. Thank you, guys, for the color on that. It’s actually a pretty high class problem to have, I guess. So in terms of the outlets though, Mike, you mentioned outlets and I might have missed this earlier -- you guys have a lot of numbers thrown out on these calls but outlet performance relative to full price, have you seen much of a difference on the U.S. side?

Michael W. Barnes

No, we’ve seen kind of mid-single-digit comps there as well. We’re continuing to see average retail prices increase, driving that margin improvement and we just have a better flow of inventory in our outlets so we are not having to focus on markdowns.

Neely Tamminga - Piper Jaffray

Okay, and then just two more follow-up questions, first on Michelle handbags -- obviously it’s thrilling to come off of the success of the watch and the sunglasses but just wondering where the price point at retail might fall in the handbag range.

Kosta N. Kartsotis

Well, the range is actually from $400 to $12,000. We have a few items with diamonds on them, with kind of high image and very small, limited production obviously. But we expect that it’s going to be about $1,000 average retail. We did get a great response we felt from the key partners that carry Michelle watches and that business, as you are well aware of, the handbag business at those price points can be very lucrative and is a very high image, very strongly branded business and we feel like we are in a great position to capitalize on that. So we are actually very excited about that. We’re going to be shipping in the first quarter of next year to stores in the United States.

Neely Tamminga - Piper Jaffray

Do you expect to get the same sort of marketing support like you did with the sunglass launch at Nordstrom? I mean, are you getting a similar level of commitments on the handbag side too?

Kosta N. Kartsotis

Well, we expect too. We just showed it last week and the response was strong so we expect to get a similar kind of buzz and promotional activity out of our key partners there because the Michelle brand, as was mentioned earlier, continues to be very important to these stores and it’s very important that luxury fashion customer and we think it’s going to translate very well into handbags.

Neely Tamminga - Piper Jaffray

Excellent, and just one last question for Mr. Kovar -- so for gross margins in Q3 and Q4, would you expect gross margins to be up in the back half and up in each quarter but maybe more so in Q4 versus Q3 because of the leveragability on the retail side? Is that how we should be thinking about it?

Mike Kovar

Yeah, you’re going in the right direction there. I think the easier way to look at it is on a sequential basis. We ought to see gross margins slightly improve over the Q2 number we posted and then ever more so over that level in Q4 just due to the relative heavier mix of retail sales that come in during the holiday season.

Neely Tamminga - Piper Jaffray

Excellent. Thanks, guys, and good luck.

Operator

Our next question comes from the line of Brad Stephens with Morgan Keegan. Please go ahead.

Brad Stephens - Morgan Keegan

Mike, on the inventory, can you drill down for us a little bit more? I know it’s up 20% but it was down 10% last year. Can you give us an idea on what percent FX added to it in transit, and then maybe your retail inventories per square foot or per store? And then just what the 61 additional stores adds to total inventories.

Mike Kovar

I would say the in-transit inventory represents over $10 million of additional inventory in the pipeline compared to last year. On the retail store side, we added 61 doors and we carry an average inventory of about 70,000, 80,000 a door in those stores, so that’s close to over $0.5 million, or $5 million there.

As you mentioned, we did report inventories being down Q2 last year of 10%, and if you’ll recall, that was on a 17% sales increase. But to our earlier point, we were probably in somewhat of an unhealthy position looking at the opportunities missed in the back half of last year.

Did you have a third question, Brad?

Brad Stephens - Morgan Keegan

I was just wondering what foreign exchange added and then also if you had inventories per square foot at your retail stores.

Mike Kovar

As we’re measuring obviously inventory growth versus sales growth because obviously we’re getting the benefits of foreign currency gains on the sales side, we’re getting about that same level of benefit on the inventory side. So I would say our inventories are probably up 4% to 5% just based upon foreign currency changes year over year.

Brad Stephens - Morgan Keegan

Okay. Thanks for the color there. Could we go back to Europe again and just talk about the timing issue and the ordering process there? And then just anymore color on what you are seeing -- I think there’s been some slowing in the jewelry channels in Europe.

Michael W. Barnes

We have seen -- the growth has moderated in Europe somewhat. We don’t feel that is has moderated down to the levels that we saw in Q2. I think that what we saw was a little bit of a slow reaction in Europe as the growth started to moderate, and so it was kind of a catch-up for the retailers in the second quarter.

If you look at the full first six months, the growth in Europe was about 9% and we think that’s a lot closer to what we should expect to see going forward than what we saw. We still have some very strong businesses over there. Our jewelry business actually continues to be very good in Europe right now and many of the licensed brands as well as the Fossil watch brand are doing well.

In addition to that, when you factor in the fact that we are going to launch DKNY jewelry and that’s going to be about a 1300 door launch of a new business in Europe, that’s going to be a big positive impact in the back half of the year. As we’ve stated many times, the branded jewelry business is much stronger in Europe than it is in the United States, so we expect for that to be very successful. The DKNY watch line is actually much larger in Europe than it is in the U.S. as well, so I think that’s going to be great.

The last thing I would factor in there is we are starting to see a lot more interest in our other categories, especially in our leather category. As Kosta mentioned in his prepared remarks, basically we have a very strong men’s leather group department store in the U.K. right now and they are testing ladies, which is a much bigger business overall than men’s as a category. And we are seeing it in other places too. We even have some distribution partners -- we had one partner in the Middle East do a very nice seven-door test in both handbags and small leather goods, and they were really excited about the results that they saw.

So we are starting to see a lot of traction pick up in these other categories and we think that’s going to help us a little bit in the back half as well.

Kosta N. Kartsotis

We also have a very strong retail opportunity in Europe. We opened last year more stores in Europe than we did in the United States and again the same thing this year. In this year, close to 90 stores I think in Europe and they actually are very, very strong, doing very well. They are actually more productive per square foot, the margins are higher, and obviously the profitability is higher over there. And the brand growth that is coming out of that is very strong.

Europe is we think a huge long-term opportunity for us. It’s actually less competitive and more profitable. We have an early mover advantage in Europe. We actually do more in Fossil per capita in Germany and other places in Europe than we do in the United States, so we feel like we are in a very strong position to capitalize on this even further.

Brad Stephens - Morgan Keegan

Thanks for the color. Last question then -- on the gross margins, very impressive performance and I know you broke out what currency was in the release. Could you give us an idea of what the other portions of the improvement were between mix and the margin mania and any other color?

Mike Kovar

We believe we are still seeing in the neighborhood of 50 to 75 basis points from the margin mania initiative. We should see that continue year over year into the third quarter, and then as we you know, Brad, we’ll start to anniversary that in the fourth quarter.

That probably could have been higher, if not for some slightly escalating production costs out of China. But again, we feel very comfortable with the progress we’ve made on the improvement from that initiative.

Additionally, we are still seeing better consolidated margins because the mix of sales goes toward our much higher margin businesses on the wholesale side internationally and then obviously our direct-to-consumer businesses. I would say that would represent the balance of that improvement.

Brad Stephens - Morgan Keegan

Do you have a number on how much the mix was?

Mike Kovar

It was over 100 basis points.

Brad Stephens - Morgan Keegan

All right, guys, good luck.

Operator

Our next question comes from the line of Barbara Wyckoff with Buckingham Research. Please go ahead.

Barbara Wyckoff - Buckingham Research Group

Can you share some metrics on the new stores, update us on that, accessories -- your accessory store versus certain core watch stores? Can you update us on Adidas? And then, can you talk a little bit about the price points on the Donna Karan DK jewelry, 1300 doors, I mean, how should we be modeling this? And then last, could you talk a little bit about the timing and the scope of the Watch Station [rollout]? Thank you.

Kosta N. Kartsotis

We’ll start with the last question first. The Watch Station, as we mentioned earlier, we actually bought that name and brand for Luxottica. As you know, they had started a chain of watch stores some years ago and they had been getting out of it slowly and they converted some of their Watch Station stores to [inaudible] and combination Watch Stations. And what they have done is basically sold us the trademark for a relatively small amount of money. It’s registered globally. We’re in the process of taking our 19 multi-brand locations around the world, and some of those had been acquired through us buying distributors, et cetera, such as in Switzerland. We also had opened some stores in the United States to test the concept under the Modern Watch Company name. We have some stores in Asia as well.

What we are going to do actually is take all those 19 locations and re-brand them under the Watch Station brand. We actually have a new store prototype that we just opened in Orlando in the last couple of months or so that is actually in an outlet center but it’s the outlet store -- it’s a premium outlet mall in Orlando. The store is doing very, very well so we feel like the Watch Station brand long-term is a big opportunity for us. So we are in the process of aggregating all these locations. As you know, we also have several multi-brand concessions around the world too, such as 45 locations in the House of Fraser stores in the U.K. and in Asia. So long-term, we feel like there’s a multi-brand distribution play for us under the Watch Station brand. It could also be a web play around the world as well.

The brand is somewhat well-known in some parts of the world because Luxottica had opened some stores around the world in Europe and in Australia and Asia, et cetera, so we feel like we can play off of that. So it’s kind of an incubator business. We think that long-term, a multi-brand Watch Station store for us to put all our brands, plus some of our competitors in there could be a great opportunity for us.

Having said that, we are focused on the current accessory store rollout over the next several years.

Mike Kovar

I can give you a little color on Adidas and the full price store metrics. Our Adidas business was flat quarter over quarter, still up about 4% over last year. Mike, do you want to maybe add a little more color on that?

Michael W. Barnes

Well, we are starting to see a little bit better improvement in the Adidas business, you know, year-to-date. We’ve gotten through all of the transition issues pretty much. We’ve also gotten through some of the quality issues that quite frankly we had last year and we think we are pretty well-positioned right now. In fact, we are working on a couple of different promotions with retailers both domestically and internationally that we think is going to help the back half of the year for Adidas quite a bit.

Mike Kovar

On the new store metrics, those obviously continue to improve with our comp performance for the quarter and we feel that year over year, we’ll be delivering the type of margin operating income results there that we talked about during our analyst call, something in the 20%-plus four wall contribution. We’re obviously continuing to add some pretty sizeable infrastructure to the business because not only are we rolling it out in the U.S. but doing the same in Europe and the Asia-Pac region, so we are adding management teams at higher levels, sales teams, planning teams, et cetera. So we are still absorbing some of those costs but feel like as we get into the fourth quarter and then on into the full year 2009, we’ll start to see some nice leverage against that four-wall contribution.

Kosta N. Kartsotis

And then as to your question about DKNY jewelry, the average retail is $42. As you know, our business in Europe is much different than the United States. It’s actually sold mostly through jewelry stores, so it’s a higher average retail. You might even consider in the United States it would be called Bridge, but as you know in Fossil, it went from zero to $100 million relatively quickly. There’s a big interest in branded jewelry over there. We think DKNY fits in there very nicely in our current distribution. At a $42 average retail, we think we are in a pretty strong position for that.

Michael W. Barnes

I think the other thing the DKNY jewelry will offer us is some of the things we’ve seen with Fossil and with our Armani to take a larger presence in a store with a concession that would have a multiple category offering within the stores; in this case, it’s DKNY watches and jewelry.

Kosta N. Kartsotis

That $42 average is wholesale. It’s $85 average retail, I’m sorry.

Barbara Wyckoff - Buckingham Research Group

Okay. Thank you.

Operator

Our next question comes from the line of Ronald Bookbinder with Global Hunter. Please go ahead.

Ronald Bookbinder - Global Hunter

It sounds like things are going really well on the gross margin with the fresh inventories and on the top line. What are you looking for in Europe? You said that you are looking for 9% growth in the back half of the year. What sort of currency impact are you looking for in that calculation?

Mike Kovar

We basically are looking at currency for the remainder of Q3 somewhere in the neighborhood of what the dollar is currently trading at, so we’ll see a slight benefit from currency year over year as the Euro continues to depreciate from last year. But as Mike mentioned, the 9% is the ex-currency expectation.

As we get into the fourth quarter, at the current spot rate it’s going to be a little bit of some wind in our faces as the average Euro rate last year for Q4 was just over 1.51., so we are expect to see some of the currency benefit turn around on us as we get to the fourth quarter of the year and that’s been included in obviously the guidance we gave this morning.

Ronald Bookbinder - Global Hunter

And the bad debt expense reserve, what sort of exposure to you have to Boskov’s, Mervyn’s, Goody’s, and was that looking forward or looking backwards that you took the reserve?

Mike Kovar

At this point, we think our bad debt allowances that we put up in Q2 are adequate to meet our exposure for all of our customers out there that may be having financial difficulties.

Ronald Bookbinder - Global Hunter

Did you have any exposure to Boskov’s, Mervyn’s, or Goody’s?

Mike Kovar

We’re not going to comment on any one customer.

Ronald Bookbinder - Global Hunter

Okay. And in Europe and Asia, just once again, what sort of growth are you seeing with accessories versus watches?

Michael W. Barnes

Well, in both Europe and Asia, especially Asia to a larger extent, our business has been primarily watches and a little bit less jewelry. Europe now has a very large jewelry business and they are really starting to roll out some of the other categories. We are seeing leather goods in Germany, in the U.K. We’re seeing tests in other markets as well, including some of our distribution markets, such as the Middle East, that I mentioned earlier. So they are starting to grow and that’s pretty much an open field for us in the other categories of accessories out there besides watches and jewelry, to a lesser extent.

In Asia, it has been primarily watches but we are seeing tests there too. Leather goods in Japan and Australia with some of our large customers in those regions and we are starting to see opportunities to continue to roll that out.

I think that the store presence that we have all over Europe and all over Asia because we’re not -- you know, our stores are not located primarily in one small region. If you look at Asia, for example, we have stores ranging from Australia, Singapore, Malaysia, Taiwan, Hong Kong, Macau. We’ve opened new stores this year in Japan, our first store and also in Beijing, so we are seeing a lot of excitement in the whole category of accessories for the Fossil brand because of these stores and we are seeing the opportunities start to open up. And as we anecdotally noted over the past five, six years, every market that we’ve opened Fossil stores, we’ve seen the up-tick in our wholesale business so I expect to see that to continue.

You know, the great thing when you look at Europe and you look at Asia is it really shows the diversification of our business model. You know, we talked about the fact that growth was moderated to some degree in Europe, especially in the second quarter, and we expect to see that tick up to more of a first half average of around that 9% we talked about.

But you look at Asia and you see a 21%-plus increase ex currency and it just shows you the great diversity of the business model. You know, our business in Asia continues to be very strong right now and we expect to see our business continue to grow at a nice pace in that region.

So we’re going to continue to look at all of these opportunities and as Kosta mentioned, we think Europe is still a huge opportunity for us and Asia certainly is, so we think we have a lot of growth in our future, including the back half of the year.

Ronald Bookbinder - Global Hunter

Okay, great and congratulations once again in a tough environment.

Operator

(Operator Instructions) Our next question comes from the line of Anna Andreeva with J.P. Morgan. Please go ahead.

Anna Andreeva - J.P. Morgan

My question is on retail, if you could maybe talk about what are the operating margins in retail today and what do you think is the potential there as you continue to expand the accessory concept?

Also, what is the delta in your operating margins in the U.S. versus internationally? And also finally, any initial views on the square footage growth for ’09?

Michael W. Barnes

As far as the operating margins, as we mentioned earlier on the call, our four-wall contribution pretax has historically run about 25% on our full priced accessory stores, which is obviously our growth vehicle. And as I also mentioned, we are not seeing that full benefit due to the fact that we are increasing our infrastructure around the world and adding a lot of corporate overhead to the model to be able to support the type of growth we are planning for over the next five years. However, we do expect that as we continue to increase comps, that that performance will get better and we’ll eventually open enough stores to start offsetting the infrastructure additions.

As it relates to international versus domestic, our international margins are higher than our U.S. margins on the wholesale side, primarily due to the fact that we are afforded the luxury of selling at higher prices. We don’t have the same competitive landscape in the watch business in most of the markets internationally as we find here in the U.S. and therefore we can price much more sharply. Our growth margins are generally anywhere from probably 5% to 10% higher in the international wholesale segment than they are in the U.S. segment on a like-for-like product perspective.

Our store growth plans as we mentioned for next year, we laid this out in our five-year strategy that we delivered to Wall Street back in our September analyst conference last year, we are expecting the same type of growth in store base, 80 to 85 stores. Obviously that will be a slightly lower level of square footage increase. It will be starting from a much higher base this year than we were at with the same type of growth in a number of doors this year.

Anna Andreeva - J.P. Morgan

Okay. Thanks so much. Good luck, guys.

Operator

Our next question comes from the line of Bill Baldwin with Baldwin Anthony Securities. Please go ahead.

Bill Baldwin - Baldwin Anthony & McIntyre

Mike, I just had to step away for a minute so this might have been asked, but have you offered any color on what the profitability is of the retail business right now while you are going through this heavy expansion? You know, the impact that’s having on the operating profitability of that business versus a year ago?

Mike Kovar

We talked about the four-wall comps being 20% to 25%. I would say that as we look at this year, that the pretax contribution from our direct-to-consumer segment will be slightly less than it was last year on an operating margin basis simply because we are adding a lot of infrastructure this year. And even though we are growing the four wall profits, we are growing our infrastructure a little bit faster than that. We do expect that as we get into 2009 and start adding the same number of doors we talked about this year and not have to add the same level of expenses to manage these stores, then we’ll start to see that operating margin contribution be accretive to the consolidated margin and probably in excess of what we would be reporting as in our consolidated margins for 2009.

Kosta N. Kartsotis

One other thing I would add is that if you look at our store comps year-to-date globally and you consider the fact that we’re at regular price where all the competitors, everyone else in the mall is on sale, those comps are actually very good and I think it’s a tribute to the execution of our retail team, the repositioning of the brand, the strength of the brand, the catalogs that go out and the website that communicates the brand image, so I think we’re in a very strong position.

One thing I might add is that you can see online our most recent catalog on our website. You can see what the repositioning looks like and what the stores look like and it’s all there and consistent with the website as well.

Michael W. Barnes

Bill, I would also add part of the direct-to-consumer segment is our web-based businesses. As we discussed last year, we opened up our first non-U.S. website in Germany toward the end of the third quarter and had great success with it in the fourth quarter, so a lot of the investments that we are making in the direct-to-consumer channel also include websites in the U.K., Australia, and Singapore that we are planning to have open for holiday this year. So some of those investments are being made in advance of the expected sales contribution but as we continue to grow, we’ll see leverage from that part of the direct-to-consumer segment as well.

Bill Baldwin - Baldwin Anthony & McIntyre

Will you begin to see some sales off of these new websites in the U.K., Australia, and Singapore during the holiday season of this year or will that be in 2009?

Michael W. Barnes

Once they go live, they will be set for commercial activity. So as soon as we take them live, and I believe the U.K. website is going live within the next week or two at the most, but Australia and Singapore will also be up for holiday, so yes, we will expect to see some level of sales contribution.

Bill Baldwin - Baldwin Anthony & McIntyre

One additional question, Mike, and if you’ve given this number, I apologize but regarding the infrastructure spending that you are doing on your direct-to-consumer area this year, can you put roughly some dollars around that so we can get some idea of the impact that’s having on the pretax profitability of that business?

Mike Kovar

Sure. We did disclose, Bill, in the first and second quarter that if you just look at it from the perspective of a leverage comparable, SG&A expense in the direct-to-consumer segment versus SG&A direct-to-consumer sales, in the first quarter we added about $8 million worth of additional expenses in deleveraging the SG&A component. In the second quarter we added about $6 million and we are expecting to add between $3 million and $4 million in Q3. We do expect in Q4, as we obviously get the benefit from the seasonality of our sales in that segment, we are not expecting that the SG&A as a percentage of direct-to-consumer sales will be out of line with what they were last year.

Bill Baldwin - Baldwin Anthony & McIntyre

Thank you very much.

Operator

Thank you, sir. And ladies and gentlemen, that does conclude the question-and-answer session. I would now like to turn it back to management for any closing remarks.

Mike Kovar

Thanks. Should you want to replay this conference call, it has been recorded and will be available from 10:00 a.m. Central Time today until 12:00 midnight Central Time tomorrow by calling 303-590-3000 and entering reservation number 11114464. Again, that’s 303-590-3000; reservation number 11114464, followed by the pound sign. The conference has also been recorded by Street Events and may be access through Street Events’ website at www.streetevents.com, or directly through our website at fossil.com by clicking on investor relations on our homepage and then on webcasts.

Finally, should you have any questions that did not get addressed today, please give Mike Barnes or myself a call. Thanks again for joining us today. Our next scheduled conference call will be in November for the release of our 2008 third quarter operating results.

Operator

Thank you, sir. Ladies and gentlemen, this concludes the Fossil 2008 second quarter earnings conference call. You may now disconnect. Thank you for using ACT conferencing. Have a pleasant day.

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