value and opportunity

This is a follow-up to my first post on Fossil. The short summary:

Fossil has a good but not great business with some issues, among others the potential success of smart watches. The reason to dig deeper was the unusual combination of CEO/owner with zero salary and capital allocation with a focus on share buy backs.

Share buy backs

There is a great collection of articles on Teledyne and Henry Singleton “available at CS Investing. One absolute gem inside is a classification of stock buy backs in order of usefulness to shareholders from Hedge Fund Honcho Leon Cooperman:

Cooperman focused on Singleton’s astute use of capital with regard to share repurchases and tied that into the second part of his presentation which focused on the value of share buybacks:
 Cooperman classifies share buybacks into four categories:
o Type I: Combats the impact of option dilution
o Type II: Assists executives that are exercising options
o Type III: Company has no opinion on value but the buyback is done to return capital to
shareholders
o Type IV: Company believes the stock is undervalued and repurchases share

So let’s have a look at how Fossil repurchases shares:

		Shares	USD	Avg Price
Q2	2015	1,3	102,0	78,5
Q1	2015	1,3	114,5	88,1
	2014	4,1	435,0	106,1
	2013	5,3	574,9	108,5
	2012	3	261,0	87,0
	2011	3,1	270,0	87,1
	2010	3,6	199,0	55,3
	2009	0	0,0	0,0
	2008	3,6	105,0	29,2
	2007	0,4	15,9	39,8
Total		25,7	2077,3	80,8

Just compare this to the chart:

What we can see is that Fossil clearly is not a “Type IV” capital allocator. They started repurchasing shares in 2007 but skipped in 2009 when the stock was really cheap. Then, with share prices above 100 USD they kind of got into a buy back frenzy.

Even if they are a “Type III” share repurchaser, in our case this was very inefficient. Buying back shares means distributing cash to those who sell the shares on the account of those who hold. If you repurchase at a too high price as Fossil clearly did, you re-distribute between holders to sellers which is bad for holders.

A quick look at Net debt per share development shows that Fossil at first used existing cash to repurchase shares but then especially in 2013 and 2014 leveraged up to purchase the shares:

	Net Debt/share
31.12.2008	-2,5329
31.12.2009	-6,054
31.12.2010	-6,0584
30.12.2011	-4,2357
31.12.2012	-1,6674
31.12.2013	3,4305
31.12.2014	6,9734

7 EUR net debt per share is not that much, however another negative point in my opinion is that they use loans with covenants and not bonds. I don’t know why, but if you have the choice you should always issue bonds without covenants. Loan covenants have the nasty habit to turn against you in the moment where you are in trouble anyway.

So yes, Fossil looks like one of the famous “cannibal companies”, bu so far only the ones who sold at 100 USD really gained from it.

Management & CEO

Unfortunately, I cannot post a picture of the CEO because for some strange reasons he does not want to be photographed so no one knows how he looks like. As mentioned, he doesn’t take at salary which is unusual.

However He did sell and still sells shares of the company. Back in 2003 or so he owned 10,3 mn shares. now he has filed to own 6,1 mn. In 2009 alon, he sold 3 mn shares at very low prices. His brother Tom, with whom he founded the company sold out in 2010 and left the company.

In an interesting turn of events, the Brother Tom Kartsiotis founded a new company called “Shinola” shortly therafter in 2011. If you look at Shinola’s website, the products look almost exactly like Fossil’s with two differences: The are more expensive and they are “Made in America” compared with Fossil’s “Designed in America”. Business especially for the watches seems to be thriving, another proof that the barriers to entry in the watch markets are very low and that you can create “mid level” brands quickly out of nothing.

So what to do now ?

Let’s just list all the Pro’s and Con’s for or against an investment in Fossil so far:

Pro
+ CEO owns 13% of company
+ doesn’t pay himself a salary
+ “capital light” business model especially the licensing part
+ significant share buy backs, relatively good capital discipline
+ technically cheap
+ transition from growth to value stock
+ Vulcan value, a very good value fund owns 17%, other good investors on board
+ potential activism / take over candidate
+ analyst sentiment is pretty bad although consensus price estimate is still at ~67 USD/share

Cons
– overall market for “trendy watches” seems to be shrinking (mobile phones, fitness trackers etc.)
– buy backs started at 100 USD+
– increased debt to repurchase stock (loans with covenants)
– falling knife stock chart
– change of reporting segments in 2015, less easy to track progress
– best selling licensed brand (Michael Kors) seems to be out of fashion, original Fossil brand is not a “strong” brand
– missed wearable trend, current line-up does not look promising
– no moat, new trendy watch brands can be created and distributed easily by anyone
– general problems for “mall based” or “department store” retailers
– risk of “familiarity bias”

Summary:

Looking at those points, I am not convinced that Fossil is a good investment based on a 3-5 year period. Yes, there is clearly a potential for a short-term rebound but in general I don’t think that it will be easy for Fossil to even maintain current sales and profits. It is just too easy to introduce and distribute new watch brands in the price category where Fossil is strongest. I think this is the bigger direct threat to Fossil,bigger than Smart Watches and fitness trackers although those devices will cannibalize the wallets of consumers who would otherwise buy a third or fourth Fossil or Armani watch.

To sum it all up: I don’t feel that I have any kind of “edge” or specific perspective on the stock. Overall, my current expectation is that real luxury watches might suffer less and might be the better “bet” for the future as those brands have more “Moat” than a Chinese produced fashion watch. So maybe it makes sense to look at Swatch, Richemont and maybe Movado at some point in the future.