Watch Out for This Company

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sometimes companies have problems just sticking to what they know. It seems that this is the case with Fossil (NASDAQ: FOSL), and their different divisions that are not necessarily contributing to the company's image or profits. The truth of the matter is, Fossil is a great watch manufacturer, this division is growing faster than the rest, and the company needs to make the smart decision and reward their shareholders with better results.

Diversified Sometimes Is Diworsified

As Peter Lynch used to say, sometimes a company’s diversification became diworsification, because they would buy or get into a business they did not know enough about, and their results would suffer. When it comes to Fossil’s competition, they each offer a lineup of high-quality items, but Fossil needs to just stick to watches.

Fossil has to deal with competition from much larger companies like PVH (NYSE: PVH), which owns brands like Tommy Hilfiger and Calvin Klein. The company also faces such heavyweights like Ralph Lauren (NYSE: RL), and though they manufacture Michael Kors (NYSE: KORS) watches, this company also competes in other segments as well.

If you want proof that these brands all are premium brands, you only need to look at their gross margins. Fossil’s gross margin is the second lowest of the bunch, but still stands at 55.59%. Only PVH carries a lower margin at 53.82%. Ralph Lauren and Michael Kors both command gross margins of better than 59%. When you can get margins of 50% plus in any business, you know you have pricing power.

The problem is, while each of these other companies is diversified into clothing, accessories, shoes, and other goods, Fossil essentially operates three divisions. Fossil’s fastest growing and largest division is their watches unit, which makes up more than 75% of total revenues. Their other two units are leathers and jewelry. The bad news for investors is, their leathers and jewelry business are dragging down the star of the show, which is Fossil watches.

Good Results Made Better

It’s not that Fossil’s results are terrible. In fact, the company’s current quarter was not bad at all. The company’s overall sales increased 15%, and adjusted Earnings Per Share (EPS) increased 23.66%. When you compare these results to the expectation of just 5.7% revenue growth from PVH, or the 6.6% expected revenue growth at Ralph Lauren, Fossil looks very good. However, if you compare Fossil to Michael Kors, the numbers start to work against the company.

While it’s true that Michael Kors sells more than just watches, this is the key product that Fossil licenses from the company. With Kors’ overall sales jumping by 57%, you can imagine the popularity of the brand is helping drive Fossil’s sales as well. In fact, Fossil not only saw growth in North America and Asia, but the company’s wholesale revenue increased 14% in Europe as well. Given the well-known economic issues in the region, these results are very good.

That being said, the breakdown of where the company’s growth came from is telling. Fossil’s fastest revenue growth came from watches, with a 22.61% increase. By comparison, jewelry didn’t do badly, with a 7.91% increase in sales, but leathers reported a 1.15% decline. Given that Fossil is expected to grow earnings by 15% over the next few years, imagine how analysts’ expectations would change, if the company rid itself of these slower growing divisions.

What Would Be The Result?

Fossil currently sells for a forward Price/Earnings (P/E) ratio of 16.74, which is a premium to its expected growth rate of 15% of about 112%. Their two larger competitors, Ralph Lauren and PVH, also sell for a premium to their growth rates. However, Ralph Lauren sells for about 180% of its expected growth, and PVH sells for 131% of its growth rate. By contrast, Michael Kors actually carries a forward P/E that is just 84% of its expected growth rate.

While I could easily make the argument that investors consider buying Kors’ stock instead of Fossil, it’s not that simple. Fossil is less of a pure play on luxury items, and some investors aren’t comfortable relying on high-end goods to drive sales. In addition, Fossil retired over 4% of their outstanding shares in the last year. Fossil also carries about $90 million in net cash and investments.

While Fossil’s balance sheet looks stronger than PVH, with a debt-to-equity ratio of 0.68, it doesn’t rate as highly as Ralph Lauren or Kors. Kors has over $400 million in net cash and investments, and Ralph Lauren carries well over $1 billion. Since Fossil’s management has shown a willingness to reward shareholders, it’s possible that the proceeds from a sale of the leathers and jewelry business could be used for further share repurchases. In addition, the company’s growth rate would certainly increase, as this quarter alone, their revenue would have move up from 15% growth to 22% growth.

Fossil is a great company hiding inside of a good one. If the company took the bold step to spin off or sell their leathers and jewelry business, this stock would be a bargain. Until that time, Michael Kors has better margins, more cash, and a much higher growth rate. The opportunity is available, and if Fossil eliminated its slower growing divisions, investors could watch as the stock takes off.

Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Fossil. The Motley Fool owns shares of Fossil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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