Fossil (NASDAQ:FOSL) has been in decline since about the 3rd quarter of 2013 and continues to weaken. Causes of this decline have been plentiful and strong, including: the secular decline of traditional watches, the downfall of the prominent Michael Kors (NYSE:KORS) watch brand, the regulation on gifting of Chinese officials and even the strengthening of the US Dollar. The fact remains that the business has faltered. While sales have only deteriorated from $3.2 billion in FY13 to $3 billion in FY16, operating margins have absolutely cratered, going from 17.2% in FY13 to ~4.8% during this latest fiscal year (an over 12% drop!). The stock price reflects this drastic downward spiral in business, falling from $127 a share in October of 2013 to the current price around $19.50.
And I still think there is more pain to come. Upon sifting through the evasive "real" guidance, you can see that sales and margins are STILL in decline (and shares are still trading at a premium valuation for a business that is still broken and in decline). There is a margin recovery story out there, but it relies on continued heavy SG&A cost cuts offsetting gross margin declines. Management points to minimal growth to achieve outsized margin recovery, but a clear path has yet to be laid out. The translucent guidance set in the last release gives a GAAP and an "adjusted" scenario, with what I'll call the "real" guidance in between the two.
Applying an appropriate multiple reflective of the state of the business to the "real" guidance this year shows meaningful downside to the current valuation. Assuming what is in my opinion a generous 14x-16x multiple on the mid-point of the appropriate guidance equates to a $12-$13.76 share price, or a 20%-38% decline from the current level of $19.50. I'll explain later why the mid-point of the guidance is probably fairly close to accurate, as well as why I consider 14x-16x fairly generous.
Understanding the Guidance
The first issue when determining a "fair value" for FOSL shares is trying to peg an actual earnings estimate for FY17 and FY18. Even after weeding through to the "real" guidance, you're left with an abnormally wide range of $0.51-$1.21. Below is the company-provided breakdown of the FY17 guidance.
(Source: Company Press Release)
The chart clearly lays out what is incorporated in both the GAAP and adjusted EPS guidance. In my opinion, it isn't right to exclude the currency impact or incremental interest expense from the EPS estimate. Neither of these items are necessarily one time in nature. It is fair to add back the restructuring charge to determine an EPS estimate, however, as this charge should be a one-time occurrence. When you only adjust for the restructuring charge, the "real" guidance range then becomes $0.51-$1.21.
Assuming $0.80-$0.90 for analytical purposes makes sense for a number of reasons.
From a modeling perspective, it makes sense rationally. To get there it assumes:
- Low-single digit decline in constant currency sales less a 200bp detriment from currency (management provided the currency outlook. when looking at the currency changes, I feel the detriment could be greater than that, but for argument sake, 200bps works).
- Gross margin deterioration of ~200bps. Inventories are in better position than they were last year, but wearables mix (plus a 10 pt reinvestment into wearables) trends point to GM's drifting down into the high 40s level.
- SG&A dollars decreasing 4%-4.5% or $40m-$60m. This makes sense due to further store closures, and continuation of the New World Fossil initiative, partially offset by wearables reinvestments. This analysis probably assumes more SG&A savings realized than what will ultimately occur, but is a cautious step when looking at the stock on the short side.
- ~$17.5m incremental interest expense as per guidance.
- No further share repurchases. When looking at it from the short side, it's not too draconian from a sales perspective, and gives management credit in their ability to monetize cost savings.
- It's the mid-point of guidance and it brackets consensus.
First quarter guidance making the similar adjustments equates to sales down (13%)-(9.5%) and EPS of ($0.30)-($0.15). I do think that this guidance will probably be easy to beat, given the low sales trajectory they are baking in. The low sales level makes sense from a store closure standpoint, but seems to be a low bar. That being the case for the first quarter, I don't think the implied guidance for the remainder of the year is a walk in the park. The sales detriment will have to get better sequentially throughout the year. Given the GM deterioration (management noted specific weakness in 3Q), SG&A dollar savings need to decline at a rate to offset the gross margin deterioration.
Simply put, the guidance when including the currency detriment implies a further deterioration to operating margins (implies 2.6%-4% vs. 4.9% in FY16). There is no real reason to believe that currency will reverse itself and benefit 2018 or beyond, nor a clear bridge to margin recovery. New World Fossil initiatives (supposedly ~$200m per annum, of which 40% have already supposedly been achieved) may have to be reinvested or reallocated and not necessarily flow immediately to the bottom line. These low margins shouldn't be looked at as artificially low, or one time in nature.
Risk to a short position
There is one major primary long-term risk to the short position, and that is what I like to call "the Dream." There is an optimistic dream about what Fossil could eventually look like if the wearables market grows as it has projected. FOSL would meaningfully partake in the market and margins (thus cost savings) are also realized as management has theorized. If all three of these events happen in concert, you have a scenario where FOSL is realizing $5.00+ in earnings power (and even an extremely optimistic dream of $10). I will first discuss this dream, and then explain why I am hesitant to believe it.
On the 4Q16 conference call, management outlined the expected wearables addressable market of $26b by 2020, consisting of $15b in the connected watch category, $7b in the hybrid watches and $4b in connected jewelry. Management also claimed that they can get to a low-teen operating margin. Assuming the non-wearable categories decline by ~5% from today through 2020 and making some basic assumptions on the % of the addressable market share FOSL captures, and the margin they earn, one can see some pretty high earnings power estimates. I'm using the 2020 market sizes as a proxy, and not actually assuming that these earnings estimates are achieved by 2020, only a picture as to what the dream economics would eventually look like. The table below summarizes these outcomes, given various assumptions:
(Source: Jared Orr and company provided financials)
Why I'm skeptical
Objectively, I'm skeptical on the sheer SG&A cost saving amount that is necessary to achieve that low-teens operating margin. You can make assumptions to determine the magnitude of cost savings necessary to achieve this kind of profitability. To hit just the middle of this chart (12% op margins at a 1.5% market share capture) would require $258m of additional expenses taken out of the structure, without any reinvested. I assume ~5% reinvested coming out of the GROSS margin line. This assumption comes from management commentary on the last call. Connected wearables have a mid-40s% margin currently, and in 2017 "reinvesting" 10% of that. I make an assumption that 5% of that comes back before this "dream" scenario. Any revision downward to that assumption would mean MORE SG&A would need to be saved in order to hit the desired operating margin targets. A table bridging the moving pieces under the 1.5% market share and 12% op margin scenario can be seen below:
(Source: Jared Orr and company provided financials)
Under management's New World Fossil initiative, management has $200m of cost savings identified, of which 40% has been achieved, leaving $80 of identifiable costs yet to be taken out. To achieve the desired goal, another $178m of savings need to be taken out, without any reinvested.
Let's look at this the other way. I assume the market share is and traditional sales assumptions are accurate, and my GM mix analysis is also accurate (that is to say that the 49-50% GMs are now the new norm), and SG&A remain flat in dollar terms. This puts the earnings around $1.60, which seems like a more likely scenario in my opinion.
14x-16x this year's $0.80-$0.90 is a fair target price for a FOSL short. There is a "dream" scenario out there, but the time horizon is undefined, and the place in the market is yet to be determined. Without that "dream," the model is broken and a lower ~12x multiple would be more appropriate. A more premium multiple (like the ~23x it currently trades) is inappropriate because these levels of earnings are not one time in nature, and we do not yet have a clear path to massive earnings acceleration. Assuming 14x-16x multiple on $0.80-$0.90 equates to a $12.60-$14.40 share price. This is the range that I'm looking at for a current fair value and is ~5.4-5.6x FY17 EBITDA.
Currency and incremental interest expense shouldn't be seen as one-time items ($0.80-$0.90 is a fair estimate for this year). Considering that you could drive a truck through THIS year's guidance range, FY18 just seems too uncertain to venture any sort of intelligent guess as to what EPS will look like.
While there is a "dream" scenario, it seems pretty unlikely at this point and remains a "show me" story. I don't think it's necessarily IMPOSSIBLE given recent actions of store closures etc., but I believe it highly improbable given new industry dynamics and likely lower margin profile. For now, FOSL shouldn't be valued as a cutting edge tech company with a large pathway to outsized growth, but a company that continues to witness lower sales with bleeding margins. As such, in my opinion, this warrants a lower multiple off of this new lower earnings base, which would equate to ~$13-$14. Therefore, I would be shorting Fossil at current levels, as I for one am definitely not a believer in "the Dream."