2023-08-10 09:22:49 ET
Summary
- Fossil Group's stock price has dropped by 46% YTD. A 13% sales fall, declining gross margin and operating and net losses in Q2 2023 indicate further price weakness is possible.
- The company's outlook is subdued too. Its restructuring efforts give some hopes of improvement in operating margin over 2024 and 2025, but how it plays out remains to be seen.
- At this time, it's best to steer clear of FOSL.
Since the last time I wrote about the watch manufacturer and retailer Fossil Group ( FOSL ) in November last year, its share price has dropped by 46%. This was expected, considering the company's weak financials and outlook indicated as much, which had prompted me to give it a Sell rating. Its second quarter (Q2 2023) results released yesterday further confirm continued weakness. The stock fell by 4% after the numbers came in.
The results
I believe the only reason it didn't fall more is because the figures were already priced in. No matter how I look at them, there are really no redeeming features in the latest update, in continuation with the trend from Q1 2023 . Here are the key developments:
- Net sales declined by 13% year-on-year (YoY) on both a reported and constant currency basis, on poor performance across all regions.
- The gross margin, while still strong at 48.7%, declined from 51.6% in Q2 2022 due to promotions, an unfavourable exchange rate and currency hedging losses.
- Operating expenses also declined, by 5.1%. But since revenues fell more proportionately, they now are 59.6% of sales compared to 54.5% in the same quarter last year.
- Despite the decline in operating expenses, however, the company continues to clock an operating loss, which increased by over 3x to USD 35.3 million from USD 10.9 million in Q2 2022. The net loss also increased, though by a relatively smaller 39%.
- The numbers weren't any better on an adjusted basis. The company just about cut an adjusted EBITDA loss in Q2 2022, but the figure has now ballooned to USD 15.4 million. The adjusted operating loss increased by 3x, almost the same as the reported figure and the adjusted net loss rose too.
The outlook and restructuring underway
In line with poor performance during the quarter, Fossil has also slashed its outlook for 2023. It now expects sales to drop by 5-10% compared to some hopes of growth earlier. Its previous forecast range pencilled in anything from a growth of 1% to a decline of 5%. It also now expects an adjusted operating loss, with a margin of between -2% and -4%. This is in contrast with a 0-3% margin guidance earlier.
However, there's some case for optimism for the company's operating profits, at least, going forward. At present, it's undertaking a 36 month long restructuring programme called "Transform and Grow" [TAG] (see chart below), which was earlier expected to entail cost savings of USD 100 million by 2024. It has now upgraded the forecast to generate "approximately $300 million of annualized operating income benefits by the end of 2025".
Outlook for 2024
The company has seen a YoY decline in both cost of revenues and operating expenses for the last four quarters already. So far, however, it attributes the fall in operating costs in 2023 to declining sales. Any mention of the impact of TAG is missing so far.
So for the purpose of forecasting for the next two years or until the end of the restructuring period, here I assume that all the cost savings from it come into play in 2024 and 2025. This can have a positive bearing on the operating profit going forward. Here's how.
First, let's consider 2024. Sales are forecast to continue shrinking at the midpoint of the range provided for 2023, which comes to 7.5%. The midpoint of the operating loss margin range of 3% along with the sales forecast, gives both the number for operating loss and costs.
This implies a cost decline of 4.3% in 2023, which is a smaller decline than the 6.8% fall already seen in the first half of the year. If both sales and costs decline at the same rate in 2024 as they do in 2023, and there's and additional cost saving of USD 100 million, in line with earlier expectations, the company sees a USD 6 million operating profit in the next year. This is a definite improvement over the loss expected this year, but the operating margin will still be quite small at 0.4%, if this outlook plays out.
Outlook for 2025
Next, let's look at 2025. Here, I have assumed continued decline in sales and costs at the same rate as expected in 2023 and 2024. Additionally, there's an additional USD 200 million of cost savings expected because of TAG, as per the company's updated estimates. This results in an operating income of USD 160 million and an operating profit margin of 12%.
The company itself targets and adjusted operating income margin of 10% with TAG. So these estimates appear to be essentially in line, and even a bit more optimistic, than the company's own outlook. It sounds a challenging target from where Fossil is at in the present, but its own past performance (see chart below) indicate that it's possible.
The valuations
While my forecasts for it do indicate a potential for improved operating margins by 2025, but that's at the cost of sales growth. In fact, the assumptions include a 21% fall in sales during the years that TAG's underway from 2022. That's hardly the ideal way to bring about an earnings improvement.
For this reason, even though its valuations on their own would indicate a case to consider FOSL, they are a trap. Consider the trailing twelve months [TTM] price-to-sales (P/S) ratio of just 0.08x. This is far lower than the 0.89x ratio for the consumer discretionary sector and also its own past five-year average of 0.24x.
Also, its tangible assets per share from the full year 2022 data, comes to USD 7.2, which is 3x the current share price. These are not attractive, they are a reflection of investors' caution on the stock.
What next?
I'm not holding out much hope for now for the stock for now, however. Even if we overlook the poor latest performance, the fact remains, that the company's own outlook is muted. I'm particularly dismayed by the downgrade in the sales forecast.
There is some hope considering its restructuring efforts, with a possible return to healthy operating margins by 2025. But my estimates suggest that it comes at the cost of a continued sales decline. If there were any reason to believe otherwise, that would make some case for FOSL. But when it has seen falling sales on average over the last 10 years, I'm not optimistic. I am maintaining a Sell on FOSL.
For further details see:
Fossil Group: Stay Away Until Restructuring Impact Shows Up