Business context and reporting period
Fossil, Inc. designs, markets and distributes fashion accessories, including watches, leather goods and jewelry, through wholesale and direct-to-consumer channels. The filing covers the 13 weeks and 26 weeks ended July 2, 2011, compared with periods ended July 3, 2010. The request metadata says “2010 Q2,” but the filing itself is for 2011 Q2.
Financial performance
Amounts below are in millions of dollars except per-share data.
| Metric | 13 weeks ended July 2, 2011 | Year-over-year change | 26 weeks ended July 2, 2011 | Year-over-year change |
|---|---|---|---|---|
| Net sales | $556.7 | +34.9% | $1,093.6 | +35.7% |
| Gross profit / margin | $312.0 / 56.0% | +31.7%; margin down 140 bps | $613.8 / 56.1% | +34.5%; margin down 50 bps |
| Operating income / margin | $86.3 / 15.5% | +34.1% | $178.8 / 16.4% | +54.7% |
| Net income attributable to Fossil | $51.4 | -5.7% | $107.2 | +18.6% |
| Diluted EPS | $0.80 | Unchanged | $1.66 | Up from $1.33 |
| Operating cash flow | Not provided for quarter alone | $83.2 | Up from $70.6 |
Second-quarter revenue growth was broad-based: North America wholesale +36.0%, Europe wholesale +16.8%, Asia Pacific wholesale +35.3%, and direct-to-consumer +25.7% on an organic basis. Watches were the largest product category, with second-quarter sales of $399.6 million versus $287.8 million a year earlier.
Liquidity, debt and cash flow
At July 2, 2011, cash and cash equivalents were $323.5 million; current assets were $1,150.8 million and current liabilities $345.4 million. Working capital was $805.4 million. Total short- and long-term debt was approximately $13.7 million, with no borrowings under the $300 million revolving credit facility; $1.4 million of letters of credit reduced availability. The company reported compliance with debt covenants.
Year-to-date operating cash flow of $83.2 million was more than offset by investing cash outflow of $15.8 million and financing cash outflow of $138.7 million, resulting in a $69.3 million decrease in cash. Financing outflow principally reflected $155.4 million of share repurchases. Investing included $30.4 million of capital expenditures and $21.3 million proceeds from the sale of three office buildings.
Inventory was $450.7 million, up 51.5% from the prior-year quarter, reflecting production timing ahead of seasonally stronger second-half sales. Management expected inventory growth to moderate and full-year growth to track sales growth.
Material changes and management commentary
- Gross margin pressure reflected higher watch-component and factory-labor costs, as well as a greater sales mix of lower-margin wholesale, distributor and off-price business. China watch-factory labor rates had increased 32% during the fiscal year.
- Operating expenses rose in dollars but declined as a share of sales: 40.5% versus 41.8% in Q2 and 39.8% versus 42.3% year to date. Growth included store expansion, marketing, payroll, strategic Asia-Pacific spending and headquarters-related costs.
- Q2 attributable earnings fell despite higher sales and operating income, principally amid a higher tax rate and unfavorable foreign-currency-related other expense. The effective tax rate was 33.9% versus 12.3% a year earlier; the prior-year quarter benefited from recognition of tax benefits following audit settlements.
- Direct-to-consumer comparable-store sales increased 22.0% in Q2 and 21.7% year to date. The company ended Q2 with 367 stores and expected to open approximately 58–62 stores and close 20 during fiscal 2011.
- The company repurchased 1.9 million shares for $155.4 million year to date under its $750 million authorization. Cash declined from $392.8 million at fiscal year-end.
Guidance, risks and unusual items
Management projected reported sales growth of 22%–24% and constant-currency growth of 18%–20% for each of Q3 and Q4 2011. Diluted EPS guidance was $1.00–$1.03 for Q3 and $1.78–$1.82 for Q4, implying fiscal 2011 EPS of $4.44–$4.50 versus $3.77 in fiscal 2010. Management expected Q3 gross margin just above 55%; Q4 margin was expected to be in line with the prior year but below earlier expectations. It estimated effective tax rates near 35% for Q3 and Q4, excluding discrete events.
Currency hedges were a significant exposure: management estimated outstanding contracts would produce losses of approximately $5.1 million in Q3 and $6.3 million in Q4 at prevailing rates. The estimated net loss expected to be reclassified into earnings within 12 months was $13.0 million. A hypothetical 10% strengthening of the U.S. dollar was estimated to reduce pretax income by $10.8 million and stockholders’ equity by $29.6 million.
Key risks cited include weaker consumer spending, changing fashion preferences, competition, foreign-exchange movements, rising materials and labor costs, supply disruption from sole or limited sources, and customer or license-related risks. The filing also notes a new Richardson headquarters lease with $57.1 million of future minimum commitments. On August 5, 2011, after quarter-end, the company settled shareholder derivative lawsuits: insurers were to pay the company approximately $8.7 million, while the company agreed to issue approximately $7.8 million in shares and grant an option for up to 32,000 shares to plaintiffs’ counsel; the company said the settlement did not materially affect the financial statements.
Important facts for investors to verify
- Confirm the period: the filing is for Q2 2011, notwithstanding the request metadata’s 2010 label.
- Assess whether margin guidance adequately reflects ongoing labor, component-cost and product-mix pressures.
- Track inventory growth, seasonal sell-through and the conversion of earnings into operating cash flow.
- Review the assumptions behind full-year sales and EPS guidance, especially currency rates and the expected hedge losses.
- Monitor the scale and pace of share repurchases relative to cash generation, planned capital spending and liquidity.
- Verify the subsequent lawsuit settlement’s share issuance, option terms and final cash proceeds.