Fossil's Guidance Faux Pas Opens the Door for a Modest Return

| About: Fossil, Inc. (FOSL)
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Strolling along Fifth Avenue after a meeting in Midtown Manhattan, I was enjoying the soft summer breeze when a new handbag display in the window of a Fossil (NASDAQ:FOSL) store caught my attention. I noted the clean, graceful lines and rich colors, deciding that the sometimes quirky sports watch and accessory designer merited a new look. Imagine my surprise when I found that the stock price of Fossil, Inc. had recently taken a trimming.

It seems Fossil management committed an egregious financial faux pas -- downsizing its outlook on coming quarters just three months after raising guidance. Only skirt hemlines are allowed to go up and down that fast without getting panned.

During the second-quarter earnings conference call held earlier this month, Fossil CEO Kosta Kartsotis cited higher production costs and weaker than expected demand as explanations for the company’s newly muted view on the second half of 2011. Relying on overseas factories, Fossil is particularly sensitive to China labor costs, which have risen over 30% in the last year. Also on the rise are costs of silver and leather materials used to make those eye-catching handbags in the Fossil store window.

Fossil shares dropped by 13% on the first day of trading following the new guidance announcement, giving up most of what had been impressive gains since the beginning of the year. Seeing this, I surmised the company must be losing market share to competitors or some other dire and indefensible threat was at the door.

I could only scratch my head when the earnings press release and conference call revealed the new guidance is for a 22% to 24% year-over-year INCREASE in sales in the second half of 2011 -- a rate of expansion well above any economic forecast in any part of the world. The problem is apparently not lack of growth, but the embarrassed disappointment of an enthusiastic “analyst” fan base. Revised company guidance for the second half of 2011 brings guided earnings for the year to $4.44 to $4.50, a whopping $0.19 below the prevailing consensus estimate for the year.

Alright, perhaps the stock was overbought. At its 52-week high set in mid-July 2011, Fossil shares were trading at a price-earnings multiple of 32.7 times trailing earnings. This is lofty for a stock in the apparel industry.

Just a month later, the humbled designer’s stock is fetching only 19.0 times trailing earnings and a meager 14.0 times the revised consensus estimate. Yes, analysts were prompt in shaving $0.13 off the consensus estimate, according to Thomson Reuters, bringing the collective view to $4.48 in earnings per share for the year 2011.

With the appearance of overreaction, is FOSL a buy? The answer would be yes if it can be found that Fossil’s sustainable earnings and cash generation support an intrinsic price higher than the current stock price. I dusted off some old finance concepts and put sustainable growth and capital assets pricing models to work.

First, just how sustainable is the Fossil enterprise? The five years ending 2010 begins in a normal economic period, passes through a major recession and demonstrates performance in a slow economic recovery scenario. The period tested and proved the mettle of Fossil management and its brand. Cash flows from operations over the last six years suggest Fossil is capable of converting an average 10% of sales into cash, a respectable achievement in the sometimes uneven fashion industry. For a business that has scaled the $2.0 billion mark in total sales, it appears the company can generate a solid $200 million in cash -- a level more than adequate to return cash to investors after reinvestment requirements.

Confident in a base business level, I next attempted a valuation of the company based on sustainable growth. (I share the math below.) Return on equity over the past five years has averaged 18.1% - another enviable record. Sustainable growth then is near that mark, since the company does not pay a dividend. Using the sustainable growth rate as a proxy for an earnings multiple, you get an intrinsic value of $72.75 per share based on the consensus estimate for the year 2011. That is well below the current price even after several rounds of concerted selling.

The 2012 consensus estimate provides insight into future return potential. After more number crunching using that proxy earnings multiple (which I also share below), I found a target price of $81.00 per share a year from now. From the current price level that suggests a potential return of about 5%. However, if the broader market is returning about 5.5% to 6.0% per year on average, there is little to justify the added risk in FOSL. The stock’s beta is a modest 1.50, but there is just not enough headroom in FOSL prospects.

This window shopper is remaining on the sidelines in FOSL until shares drop below $74.00. Otherwise the investor would be paying for something more than the base, sustainable business -- a growth promise in which even management appears to have lost confidence.

The Math:

Five year average Return on Equity (ROE) - 18.1%

Sustainable Growth Rate = ROE 18.1% x (1.0 – 0.0 Dividend Payout Rate) or 18.1%

Earnings Multiple Proxy - 18.1 less estimate risk of 10% for 2011 and 20% for 2012

2011 Consensus Earnings Estimate of $4.48 x [18.1 x (1-.10)] = $72.979 enterprise value; less $0.23 per share debt, yields in intrinsic value of $72.75

2012 Consensus Earnings Estimate of $5.12 x [18.1 x (1-.20)] = $81.232 enterprise value; less $0.23 per share debt, yields a target price of $81.00 next year.

Required Return on FOSL

= Risk Free Rate + FOSL Beta x (Market Return – Risk Free Rate) or 8.75%

Expected Return on FOSL = 5.19%

Expected Return on FOSL of 5.19% < Required Return on FOSL of 8.75%

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.