- Fossil reported Q1 earnings impacted by worldwide store closures amid the COVID-19 pandemic.
- The company has responded to poor demand for its traditional watches in recent years by focusing on connected wearables as a growth opportunity.
- Despite the ongoing challenges, we think the company can get through this difficult environment with a relatively stable liquidity position.
- The stock is speculative but has upside as the outlook improves with its stores reopening, supported by its diverse brand portfolio and ongoing restructuring initiatives.
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Fossil Group Inc. (NASDAQ:FOSL) has been challenged over the past decade, given the emergence of smartwatches at the expense of its core traditional watch market leadership position. The company responded by shifting its focus on designing "connected wearables" for its portfolio of brands which have seen some more favorable momentum in recent periods. The company just reported its latest quarterly result, which was significantly impacted by the COVID-19 pandemic with retailers shut down worldwide. Despite continued weakness expected in the coming quarter, we highlight some positives, including a relatively stable balance sheet position with limited debt and progress in its internal restructuring program known as "New World Fossil 2.0". We think the company can get past the current challenges, and the stock has value at the current level.
FOSL Q1 Earnings Recap
Fossil reported its Q1 earnings on June 3rd with a non-GAAP EPS loss -$1.54, which missed estimates by $0.03. Revenue in the quarter at $390.7 million declined by 16% year over year but was favorable $9.4 million ahead of expectations. The weakness here was expected, given the impact of the COVID-19 pandemic with effects being seen in the Asian market since early February.
(Source: Company IR)
Temporary worldwide store closures at company-owned locations along with wholesale retail channels resulted in a sales decline in all regions, including a 20% drop in the Americas market. There was weakness across all product segments, including a 14% year-over-year decline in watches and a 24% drop in jewelry sales on a constant currency basis. The gross margin in the quarter at 35.9% was down from 53.3% in Q1 2019 in part pressured from the liquidation of the older generation connected wearables inventory.
The only silver lining here is that management noted that, before the store closing, sales were trending positive up 1% on a comparable basis. The company's direct to consumer e-commerce "fossil.com" saw a 150% year-over-year sales increase in April, and growth approached 200% in May, partially offsetting the brick and mortar challenges. Approximately 50% of all sales are going through some type of online retail channel.
Fossil took various steps to mitigate the financial consequences. The company reduced payroll by furloughing employees along with cuts to SG&A, while eliminating the majority of planned capital expenditures for the rest of the year. Inventory levels rose, considering lower volumes, but management intends to limit purchases from suppliers. This should support in liquidity in the near term with reduced cash expenses.
With an update on operations, Fossil and wholesale channels are now in the process of reopening stores in phases across all regions. Management notes that early indications suggest traffic is down from last year, but conversions are higher. Presumably, loyal customers are coming in with the intent of purchasing. From the conference call:
In recent weeks, the reopening of wholesale doors and Fossil retail stores have started to phase in across all geographies and channels. In the Americas, we recently opened our eight Texas stores as well as 26 outlets and plan to gradually reopen an additional 150 locations over the next several months primarily dictated by local and state regulations.
In Europe, we have opened 49 of our 155 locations beginning with Austria, Germany, Netherlands and Belgium, and we'll have another 46 open in the next two weeks primarily in France and Italy. In the Asia Pacific region where we currently have 90 stores, approximately half have reopened thus far.
FOSL Management Outlook
Looking ahead, management is not offering any financial guidance but expects Q2 to be a continuation of the weak trends. Considering that retail stores were effectively closed worldwide for April and much of May, the company is anticipating a 60% to 70% decline in sales with impacts lasting through the end of the year. From the conference call:
With the majority of our global business effectively closed during April and May, we currently anticipate that second-quarter net sales will decrease by approximately 60% to 70%, reflecting declines in retail and wholesale, partially offset by ongoing strength in both owned and third-party e-commerce.
As economies begin to reopen, we believe challenges for retail will exist for the foreseeable future and anticipate the operating environment will be highly promotional. We are aggressively managing our cost base and have expanded our New World Fossil initiatives to deliver increased savings under our 2.0 program.
The strategy here is to focus on managing costs and improving efficiencies through a restructuring program known as "New World Fossil 2.0". Announced in 2019, the circumstances around the pandemic is moving forward initiatives targeting $200 in operating expense savings between 2019 and 2021. As a result of the COVID-19 circumstances, the management is targeting an additional savings of $50 million this year.
(Source: Company IR)
Longer term, the hope is to stabilize sales and improve profitability. The company sees opportunities in different regions by expanding product categories in new markets. A greater focus on digital and online direct to consumer opportunities, while moving away from dependency from the traditional wholesale distribution, is expected to support margins. Fossil continues to bet on China which they believe remains a growth opportunity. In 2019, the market presented double-digit revenue growth, and they see those trends returning once conditions normalize.
Fossil ended the quarter with $245 million in cash and equivalents, which included $100 million drawn down from its credit facility. While the net debt of $75 million is modest, the company lost about $45 million in cash during Q1, which is expected to continue into Q2 before moderating by year-end as stores reopen. With Q1 data, a reported negative adjusted EBTIDA of -$75.6 million dragged the total over the trailing twelve months to a positive $67.4 million from a positive $168 million at the end of 2019. The current position implies a relatively low net debt to adjusted EBITDA ratio of approximately 1.1x.
(Source: Company IR)
The problem here is that, once the company gets through Q2 with another large loss, the financial position and leverage ratio will deteriorate. Management explains that they are in the process of working with lenders for flexibility related to the financial covenants, considering what continues to be a challenging environment.
Our take here is that Fossil should be able to get through Q2 and Q3 in its current position with an expectation that operations begin to normalize. Efforts to conserve cash through inventory management and broader cost savings, along with the potential for new financing, should support a relatively stable liquidity position for the immediate term.
Analysis and Forward-Looking Commentary
Recognizing the still-weak outlook, the key number that stands out is the company's market cap under $250 million. This is in the context of a company that just did $391 million in sales this past quarter. Even with an expected 50%-60% drop in sales for Q2, Fossil is still on track to do $1.4 billion in sales this year, according to the consensus estimate. Yes, the company is losing money and has struggled with growth in recent years, but we think the underlying business, including the brand portfolio, has a value at the current level. FOSL is trading at a forward price to sales multiple of about 0.18x highlighting what continues to be a deeply discounted valuation and overall market pessimism.
The opportunity for the company is to capture a share of the global smartwatch market which (before the COVID-19 pandemic) was growing at an annual rate of about 20% per year. While Apple Inc. (AAPL) pioneered the segment with the launch of the "iWatch" in 2015, we believe there is room for alternatives and a separate smartwatch fashion-oriented market, in which Fossil has already taken a leadership role.
(Source: Company IR)
The company is already a leading marketer of smartwatches utilizing the Wear OS operating system by Google from Alphabet Inc. (GOOG)(GOOGL), designing models for several proprietaries and licensed brands. The connected technologies, which are outsourced, have advanced significantly in recent years to make the category into a mass-market product going beyond the early novelty aspect. Features like fitness tracking, NFC payments, and smartphone integration are on parity with competitors.
(Source: Company IR)
It's not expected that the connected watches overtake the traditional watches as a product category for Fossil by next year. The company is aware of the market demand dynamics and is shifting the strategy accordingly. The real weakness for Fossil comes down to its brand momentum in categories like leather accessories and jewelry, although they currently represent less than 20% of sales. We believe the way forward will be to optimize its brick and mortar retail presence focusing only on the strengths in the business.
The stock remains highly speculative, but we believe the company can survive, and the outlook will improve once the retail operations come back online. We rate shares of FOSL as a buy with a price target of $6.00 per share. Even with the recent rally in shares off the lows, FOSL is still down by over 40% in 2020, and we believe expectations have been sufficiently reset to a more compelling valuation. Our price target implies a market cap of around $300 million and 0.21x 2020 estimated sales.
While there remains a significant uncertainty to the revenue and earnings trends beyond this year, we think the market sentiment towards the stock can improve if the management initiatives are successful in stabilizing sales. The monitoring points here will be trends in the connected watches business as the growth driver. It will also be important for management to show an improvement in the gross margins while limiting operating expenses. To the downside, the main risks are of a further deteriorating in the balance sheet position beyond expectation. The stock could again see renewed pressure if there are any signs of liquidity concerns.
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This article was written by
Dan Victor, CFA is a market professional with more than 15 years of investment management experience across major financial institutions in research, strategy, and trading roles.
Dan leads the investing group Conviction Dossier, where his focus is on helping investors stay ahead of market trends and inflection points. Dan’s investing vehicles of choice are growth stocks, tactical exchange-traded funds, and option spreads. He shares model portfolios and research to help investors make better decisions, via his Investing Group’s active chat room.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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