Summary
- Fossil continues to lose market share in the growing smartwatches market.
- Decreasing economies of scale and rising inflation have a negative impact on profitability.
- The company's shares are still trading above fair levels based on fundamental analysis.
Introduction
Shares of Fossil Group (FOSL) have risen 27% YTD. At the moment, I still do not see a serious reason for optimism. First, revenue in one of the key business segments (smartwatches) continues to decline, while the smartwatches market as a whole continues to grow at a faster pace. Secondly, in the watch market, familiar to itself, in the smartwatches segment, the company competes with technology giants that have a number of competitive advantages both in technology and in the field of watch and phone integration. In addition, the decrease in economies of scale negatively affects the level of operating profitability.
Analysis of current trends
Throughout 2022, the company's revenue continues to be under pressure, which causes investors' concerns. At the end of Q3 2022 , revenue continued to decline by 11.3% YoY. I decided to understand the current trends and make assumptions about the future results of the company.
The company's revenue consists of the following segments: traditional watches, smartwatches, leathers, jewelry and other. The largest share of the company's revenue comes from the watches (traditional watches and smartwatches) segment. At the end of the 3rd quarter of 2022, revenue from the watches segment accounted for 78.7% of the company's total revenue. You can see an overview of the product mix for Q3 2022 in the chart below.
Further, if we look at the dynamics of the company's revenue by segment, we can see that the watches segment, which is the main segment of the business, continues to show a decline in revenue over the past 3 quarters. In the watches segment, smartwatches stand out, where revenue continues to fall at a record pace. You can see the details in the charts below.
If we look at the change in the company's product mix over time, we can see that the share of revenue coming from watches continues to decline throughout 2021 and 2022. The smartwatches segment stands out in particular, whose share of the company's total revenue decreased from 14.6% in Q1 2021 to 7.6% in Q3 2022. You can see the details in the charts below.
Thus, the main contribution to the stagnation of revenue is due to the watches segment, which accounts for the majority of the company's revenue. In the watches segment, the biggest decline is in the smartwatches segment, which continues to stagnate for several quarters.
Particularly interesting is the fact that the company continues to show a decline in revenue in the growing smartwatches market. The smartwatch market is estimated to grow from $18.62 billion in 2020 to $58.21 billion in 2028 with an average CAGR of 14.9%.
Consumers prefer smartwatches from other companies, and as a result, Fossil continues to lose market share to other companies.
Competition
In my personal opinion, the key risk for the company is competition, as the business has to compete with companies such as: Apple (AAPL), Google (GOOG) (GOOGL), Samsung (SSNLF). In my personal opinion, Fossil's competitors have more serious expertise in the field of smart devices.
Some of the models and their main advantages:
Apple Watch: cheaper and Great for iPhone Owners
Samsung Galaxy Watch 5: the watch is cheaper and great for Android owners
Pixel Watch: a watch from Google that's great for Android owners.
In addition, I decided to study sites with user recommendations on which smartwatch to buy. Unfortunately, in most of the selections, the authors recommend watches from Apple, Google and Samsung, and watches from Fossil are not recommended to buy because of their high cost and insufficient technical characteristics. I understand that the opinion of the authors of the recommendation is completely subjective, but a huge number of people, before making a purchase decision, study sites with recommendations and make a purchase decision based on them.
You can see an example of one of these recommendations in the chart below.
Projections & valuation
Based on my own assumptions, I decided to build a DCF model in order to determine the fair price of the business. At the moment, we cannot focus on multiples, as the net profit of the business is in the negative zone. Below you can see my income statement predictions and details of DCF model calculation.
The main assumptions of my model are:
Revenue growth: based on my own analysis, I believe that the company will not be able to demonstrate revenue growth in the following periods. Currently, the company continues to lose market share in the smartwatches market, so I predict revenue decline at -10% in 2023, as well as a 5% decline in 2024 and 2025. Even this is a positive scenario for the company, in my view.
Gross margin: I assume that the company will maintain the current level of gross margin in 2023, which is low relative to previous periods. I think slower business growth will lead to less economies of scale, and rising inflation will lead to higher costs. Thus, I conservatively assume a low gross margin of around 50% in 2023 and a decline to 49% by 2026.
SGA: I'm modeling SGA spending (% of revenue) at a steady 48.5% through 2026.
To calculate a fair price, I use the following parameters:
WACC: 7.3%
Terminal growth rate: 3%
Thus, based on my own forecasts and calculations, I believe that the fair price of the share is $4.7 with a downside potential of 17%.
Risks
Competition: at the moment, I believe that the main risk for the company is competition, as a result of which the company continues to lose its own share in the smartwatches market. I believe that smartwatches are one of the key categories that could be a growth point for business, however, now users continue to prefer models from other brands.
Margin: decreased scale of business activity and continued rise in inflation could result in increased operating costs due to reduced economies of scale and the need to increase spending on salaries, materials, and rent.
Macro: a decrease in real disposable income and a decrease in consumer confidence may have a negative impact on consumer spending in the discretionary segment, which may have a negative impact on the company's revenue dynamics in the following periods.
Drivers
New products launch: the release of new models, especially in the smartwatches segment, which would be more in demand among potential smartwatches buyers, could have a serious impact on both the company's revenue and the attitude of the investment community towards the future business prospects, which could positively affect the price shares.
Marketing campaigns: running a successful and effective marketing campaign could improve brand positioning and boost sales.
Macro: a recovery in consumer real disposable income could have a positive impact on spending in the discretionary segment, which is positive for the company.
Conclusion
At the moment, this is not the best time to buy shares of the company. Despite the fact that Fossil operates in an interesting and growing market, the company continues to show a decline in revenue. In the smartwatches sector, the company has several strong competitors that have more expertise in making technology devices, with the result that Fossil continues to lose market share. In addition, a decrease in the scale of the business leads to a decrease in economies of scale, as a result, efficiency decreases. Now it's a "Sell" recommendation. I will closely monitor the company's reporting and announcements of new models, as well as users' opinions about the company's watches on the Internet.
For further details see:
Fossil Group: Declining Market Share And Pressure On Margins