Our current investment thesis is:
- Fossil has little brand value remaining, reflected in its abnormally large S&A expense, which makes the business essentially unable to generate an operating profit.
- Revenue has declined in 7 of the last 8 years as the business rationalizes operations globally. We see no ability to stem the bleeding.
- Fossil is trading at a deep discount to its equity value, yet we see no way this can be realized to create value. The company will continue to burn cash and eliminate equity.
Fossil Group, Inc. (NASDAQ:FOSL) is a company that designs and distributes consumer fashion accessories globally. The company offers traditional and smartwatches, jewelry, handbags, small leather goods, belts, and sunglasses, and also manufactures and distributes private label brands.
Fossil’s share price has declined rapidly in the last decade, declining 97% since 2013. The business has struggled heavily to maintain sales during what has been a period of evolution for retail.
Presented above is Fossil’s financial performance for the last 4 years.
Revenue has declined at a 9% rate, meaning the company has experienced a decline in 7 of the last 8 years. Revenue is now 52% of the level it was at in 2016. The business has been completely destroyed by a change in industry dynamics, unable to pivot into a sustainable model.
The rise of e-commerce has significantly impacted the retail industry, leading to the growth of online marketplaces. These businesses were able to rapidly gain market share through aggressive pricing, lacking the fixed overheads that many of the current incumbents have. The majority of Fossil’s revenue continues to be through non-digital channels. The competition is especially hot in the affordable segment, as cheap Asian producers pump the market with goods. This is not to say brick-and-mortar is dead, but our view is that the value proposition has changed. Consumers go to locations when they value the experience. This is why luxury is booming regardless of the online presence. Few people would buy a Patek Philippe online. The problem for Fossil is that it is in the affordable segment, where many consumers are price-conscious and looking for the best deal. They use locations for another reason, to try before they buy (Once they find the cheapest option online).
Fossil has acknowledged this, looking to rationalize its locations and focused more aggressively on its e-commerce segments.
The problem with e-commerce, however, is that competition is fierce and margins are tight. Fossil is at a disadvantage as it still needs to operate in physical locations, resulting in greater overheads relative to its peers.
The growing emphasis on health and wellness is leading to a demand for fitness and activity trackers, with technological development allowing for these to be produced mass-market. Smartwatches are an area of focus for Fossil, with the products now encompassing 11% of revenue. Fossil has launched these across many of its businesses, utilizing the brand value alongside production efficiencies to exploit growth. The issue with this segment is that once again, Fossil’s market positioning is acting against it. You can currently get affordable Smartwatches on Amazon, with similar reviews and specifications to Fossil’s, at lower prices. This restricts Fossil’s ability to improve returns as it must remain price competitive.
Further, as Fossil continues to rationalize locations, its growth potential declines. The argument is correct that loss-making stores should be closed to protect profitability but the underlying problem is not being solved here. The best outcome would be to revitalize the brands so that sales return to all of these locations (Not to say that this is remotely easy but is the preferred outcome). Too quickly, struggling businesses are proud to advertise that they are closing underperforming locations as a means of improving performance, but this should be the last option. Now, Fossil has less growth potential and fewer losses, essentially conducting a gradual wind-up while stating they are transforming the business.
Things are not completely dire. The company has strategically focused on improving sales in India and China. China has struggled with Covid-19, only escaping regular lockdowns in recent months as it lifted its zero-covid policy at the backend of last year. This should provide a bump to sales as consumer footfall improves both domestically and internationally from Chinese residents.
We are currently experiencing heightened inflation globally, which is showing itself to be stubborn. This has caused a decline in consumers’ discretionary income, as a greater proportion of income is committed to living costs. For this reason, we have seen a decline in discretionary spending across many industries, especially by those consumers outside of the high-earning bracket. This will compound Fossil’s misfortunes as affordable fashion is usually impacted negatively, given how discretionary the industry is.
Looking ahead, we expect things to continue in a similar vein to the last few months, as inflation continues its slow decline. This will likely cause continued issues for Fossil and losses again in FY23.
If you think Fossil’s revenue trajectory is bad, its margins are worse. The company currently has an EBITDA-M of 2%, despite a GPM of 49%. The GPM is actually very competitive and reflects its low production costs as a scale producer. The issue is that the business is having to spend a substantial amount of money to attract sales. To say this another way, the company is spending $0.47 to acquire $1 of revenue while it costs $0.49 to “create” that revenue.
Management does believe there are $250m+ of cost savings to be achieved, which would result in an EBITDA-M of 17%. We question the achievability of this given it represents 31% of S&A expenses. Further, with revenue so strongly tied to S&A, this would kill revenue.
Worldwide sales were down 17% in Q4, reflecting what has been a compounding year of declining economic health (Source: Q4 Earnings release). This being said, other retailers we have looked at were not impacted to such a degree, reflecting the poor quality of Fossil’s brands relative to its peers. Based on this, we could see a disastrous FY23 if things continue as they are.
Surprisingly to many, I am sure, Fossil’s balance sheet is not terrible. The company’s ND/EBITDA ratio is 1.6x, which is a healthy level. The company could not raise affordable debt if it tried, but it is positive to see that the company is not in a debt spiral.
Inventory turnover is poor, having declined across periods. This likely reflects a slowdown in demand beyond Management’s expectations. Our view is that 4x is a competitive level in retail, leaving the business far below.
Management is currently forecasting a net sales movement of (5)%-1% in FY23, as well as negative operating profit (Adj. OP of 0-3%) (Source: Q4 Earnings release).
Our view is that the coming year will come in below this, basing our expectations on the fact Q4 was so poor. From our research, most retailers have guided a weaker Q1-23 than Q4, expecting a flat year. Management seems optimistic if they believe revenue decline will be restricted to (5)% on the downside.
Fossil is currently trading at 5.7x LTM EV/EBITDA and 0.4x Revenue. This is a reflection of markets pricing in continued loss-making, essentially attributing less than a $1 of value to a $1 of revenue.
Interestingly, Fossil has a book value of $403m and a market cap of $174m. This suggests it could be liquidated for more than the company’s trading value. Further, this implies zero brand value, which is not necessarily the case. This represents an interesting opportunity for a speculator.
Our view would be that markets are pricing the business below liquidation for a reason. Management will not, or cannot, wind up the business. Instead, we believe Fossil will continue to burn cash in the near term, bringing equity value closer to market value.
Scope for upside
Although this paper is bearish, it’s worth highlighting where future value can be found. The key to a turnaround in circumstances such as this is not growth but returning to a sustainable profitability profile. Markets are currently pricing in a low chance of long-term profitability and so to bring improving sentiment, this comes first. Management’s $250m in savings would take the business into profitability (all else being equal) and so the achievability of this should be monitored.
Fossil is a disappointing business. Despite having some quality brands, the business has fallen completely out of favor. The business is essentially paying consumers to buy its products, and this is expected to continue. The company has been damaged by the rise of e-commerce and does not have the brand value it once did.
We never like to be overly negative with a sell rating, but we see genuinely no return to long-term value. Instead, upside will come through a liquidation of brands and a wind-up, which will not happen.