Is There Still Time to Buy Fossil?

By Demitri Kalogeropoulos - August 9, 2012 | Tickers: COH, FOSL, TIF | 0 Comments

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It isn’t often that a large, widely followed company sees a 30% jump in market cap over the course of one trading day. But when a pop like that happens, as it did with timepiece retailer Fossil (NASDAQ: FOSL) on Tuesday, it’s clear that something was seriously out-of-whack in Wall Street’s value estimates. Mispricings of this magnitude just aren’t supposed to happen.

While the professional analysts get busy tinkering with their valuation models and revising stock price targets, investors are left wondering how those estimates could have been so wrong in the first place. And a timelier question also comes up in the wake of this stock’s jump: Is it too late to buy Fossil?

More on that in a second. But first let’s dig in to the earnings beat (pdf) that added over $1.5 billion to Fossil’s market cap and sent other luxury retailers like Tiffany (NYSE: TIF) and Coach (NYSE: COH) up for the day.

Solid earnings

The company reported record sales of $636 million, a boost of 14% from the year ago quarter, matching analysts’ expectations. Profitability ticked up, too, on the back of strong watch sales that helped deliver an EPS beat of $0.14 over the $0.78 that analysts were forecasting. Fossil also updated its earnings guidance for the year, actually lowering the target – slightly – to $5.25 per share.

So the company reports a healthy increase in sales, solid profitability, and lowered guidance, and for this it is rewarded with…1/3^rd greater market cap. Only on Wall Street could that make sense.

But we don’t have to look far to find the source of this insane volatility. Fossil’s big bounce this week comes on the heels of the 50% plunge that the company suffered after reporting its first quarter earnings (pdf) back in May. Those earnings were also a record for Fossil but came with a disappointing outlook. Still, it was nothing that would justify a selloff like that.

What really sent investors running was a warning from the company on the “softening” environment in Europe. That, combined with Fossil’s exposed position as a luxury retailer seemed enough to convince investors to avoid the stock at all costs. After the company allayed those concerns this week investors jumped back in to the stock head first. Coach and Tiffany, also Euro-sensitive luxury retailers, joined the rally.

The bigger picture here, though, is that Fossil has been growing at such a clip that the company’s growth is particularly hard to predict. From 2010 into 2011, Fossil logged seven straight quarters of growth at over 20%. And, assuming the company meets its own sales estimates for the second half of this year, it will have doubled total revenue in just three years. The problem is that as those growth figures get harder to beat every quarter, the stock's volatility has spiked. Investors can't tell if the company is slowing down to a new normal or just going through some growing pains.

Source: SEC filings and Yahoo! Finance.

The graph above shows Fossil's quarterly sales growth along with the stock's price on the day those earnings were reported. The stock's roller coaster ride kicks in to gear in the third and fourth quarters of last year as the company hit the year-mark on its 30%+ quarters from 2010. Fossil's PE ratio has swung from 16 to 28 over this short time frame and now sits at 18, which is just a bit richer than Coach's (16) and Tiffany's (17).

So Wall Street is playing a quarterly guessing game around whether Fossil is a super growth stock or just a growth stock. Meanwhile investors who don't measure their holding periods by the second are being offered a solid business at alternatively good -- and great -- prices. My take is that Fossil's business is about much more than the quarterly growth rate that Mr. Market seems to be bidding for.

Licensed to profit

Take the company's unique business position, for example. Most luxury retailers, including Ralph Lauren and Coach, don’t own their factories but instead contract manufacturing out to independent suppliers. Fossil bucks that trend by controlling its own factories as part of a vertical integration that also extends into distribution and marketing. They even have an in-house art department that handles the company’s advertising. Talk about micromanaging.

Not only does this tight integration give Fossil control over key aspects of product quality and branding, but it also attracts licensing revenue from premier brands like Adidas, Armani, and Burberry, who all want to take advantage of Fossil’s global design, production, distribution, and marketing networks. Licensing revenue, which has surged to over 70% of sales, is driven by multi-year exclusive contracts and has expanded from watches to include handbags, jewelry, shoes, belts, and leather goods. To me, that looks like both a sustainable competitive advantage and a compelling source for further growth.

Bottom line

So what might a retailer with this kind of growth be worth? A simple PEG analysis that assumes an 18% growth in annual earnings and pays a slight premium for growth -- targeting a ratio of 1.10 -- gives us a stock price of just over $100 a share, or 19 times 2012 earnings. That’s smack in between the $130 Fossil was selling for 3 months ago and the $90 it hit recently, implying overreactions in both cases.

But if you’re not a fan of paying up for potential growth, you could always bide your time and bank on another market freak-out to offer a more attractive entry point. I wouldn’t delay too long. Wall Street will eventually get it right. Even a broken clock can manage that, on occasion.

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