Investors betting on a turnaround for shares of Fossil Group Inc (NASDAQ:FOSL) have been unlucky so far. Since peaking in late 2013 near $130 per share, FOSL stock has lost more than 80% of its value and now trades around $21.
The tide, however, might finally be turning.
In 2017, Fossil will continue making its critical pivot into the wearables category. Early data points suggest this pivot is already resulting in watch sales stabilization. As this pivot scales, Fossil’s operational results should normalize, and so should FOSL stock.
The most recent leg-down in Fossil stock is a result of ugly Q4 results. Sales fell 3% year-over-year and earnings compressed from $1.46 per share in 2015 to $1.03 in 2016. Despite FOSL’s negative reaction, the quarter shouldn’t have been all that surprising to the market. A series of department stores had already reported that watches under-performed in the critical holiday period, while Michael Kors Holdings Ltd (NYSE:KORS) and Fitbit Inc (NYSE:FIT) announced sub-par holiday results.
The writing was mostly on the wall for Fossil to report a poor Q4. Consequently, FOSL stock had already declined some 13% in 2017 prior to the earnings announcement.
In other words, the bad quarterly report felt baked into shares well ahead of time. That makes this most recent selloff look like an opportunity.
Why I Like FOSL Stock Here
Broadly, the bull thesis for Fossil is fairly straightforward.
The traditional watch and jewelry market is being disrupted by wearables. This has been killing operating results at FOSL, the leading player in the traditional watch market in the U.S. Fossil, though, is adapting to the change by doubling down on wearables. The company is attempting to leverage its size to not only steal back market share, but also grow reach by tapping into the wearables space.
Mr. Market seems to be pricing shares for lackluster results in a shrinking traditional watch market. That gives FOSL stock a low-risk profile. If operating results normalize through success in wearables, however, earnings could have enormous upside. Earnings were $1.63 per share in 2016. Just two years ago, the company earned $7.10 per share.
Early data points suggest Fossil will be able to normalize its operating results through expanding into wearables. In Q4, watch sales were flat in constant currency. That compares to a 2% decline in Q3 and a 9% decline in Q2. There is a clear trend of watch sales stabilizing.
The biggest catalyst there is the introduction of smartwatches to the product portfolio. In 2016, Fossil sold 1.5 million smartwatches, most of which came in the fourth quarter. Moreover, the 1.5 million devices Fossil sold in 2016 pales in comparison to the 6.5 million devices Fitbit sold in last quarter alone
As the wearables product portfolio grows to include connected jewelry, a similar sales stabilization trend should play out with jewelry sales.
Fossil: Digging Into the Numbers
Overall, Fossil’s long-term revenues should stabilize in a base case and grow slightly in a bull case. FOSL also is getting leaner with its New World Fossil initiative (a multiyear profit improvement plan that includes shuttering stores and narrowing the product portfolio), so costs are coming out of the system. A reasonable base-case assumption, then, is for Fossil’s revenues to stabilize long-term at a higher margin.
Operating margins were 4.2% in 2016 versus 9.0% in 2015. With costs coming out of the system, it seems equally reasonable to assume that operating margins move up to around 7% in five years.
Stable revenues around $3.04 billion on 7% operating margins implies operating income of over $210 million. At a 25% effective tax rate and on roughly 48 million shares, that is a five-year EPS target of $3.33, or roughly 15% annualized growth from 2016. The stock is only trading at 12.4 times trailing earnings.
From this standpoint, the numbers make sense here for investors to take a bet on Fossil’s rebound through a successful 2017 wearables expansion.
Fossil also has strong free cash flows (just under $3 per share in 2016, giving the stock a near 15% free cash flow yield) and the balance sheet continues to improve (cash is up $8 million year-over-year, while debt is down $172 million).
Bottom Line
Overall, Fossil is a financially strong company that has been hammered by Mr. Market. However, investors seem to be missing the possibility that earnings could soar, though, and 2017 could be the beginning of that.
It feels like an opportune time to buy FOSL stock before its wearables business takes off.
As of this writing, Luke Lango was long FOSL.
