Q2 2023 Fossil Group Inc Earnings Call

August 9, 2023

Good afternoon, ladies and gentlemen, and welcome to the fossil group's second quarter 2023 earnings call. At this time all part parties are in a listen only mode. This conference call is being recorded and may not be reproduced in whole or in part without written permission from the company.

Now I'll turn the call over to Christine Greening of the Blue shirt group to begin.

Okay.

Hello, everyone and thank you for joining us with US today on the call are Kosta cards Saturday Chairman and CEO .

Boyer Chief operating officer, and Sunil Doshi, Chief Financial Officer, I would like to remind you that information made available. During this conference call contains forward looking information and actual results.

Could differ materially from those that will be discussed during this call.

Awesome for policy on forward looking statements and additional information.

Concerning a number of factors that could cause actual results to differ materially from such statements is rapidly available in the company's form 8-K, 10-Q, and 10-K reports filed with the SEC.

In addition, thoughtful assumes no obligation to publicly update or revise any forward looking statements, whether as a result of new information future events or otherwise except as required by law.

During today's call we will refer to constant currency results. Please note that you can find a reconciliation of actual defaults to constant currency results and other information regarding non-GAAP financial measures discussed on this call in fossil earnings release, which was filed today on form 8-K.

Available in the investors section of fossil group Dotcom now I'll turn the call over to Kosta to begin.

Thanks Christine.

The first half of 2023 has proved challenging affected by macro challenges and choppy demand trends, resulting in softer than expected Q2 performance.

Q2, net sales declined 13% as we saw continued headwinds in our wholesale channel in the Americas and Europe .

A slower recovery in greater China.

Comp retail sales remained healthy with 3% growth primarily from our own dot com sites, where much of the benefits from our digital transformation are bearing fruit.

We continue to make progress on our growth initiatives and we will be activating several of these four Q4 selling that will expand into next year.

Many of the macro challenges we saw in 2022 have continued into this year, most notably a cautionary tone among our wholesale partners, especially in the Americas and Europe .

In addition, our smartwatch business have continued to underperform.

Despite these challenges we need to improve our financial performance and we are taking decisive action to do this and put the company on a path towards elevated and sustained profitability.

We are announcing new initiatives under our previously announced transform and grow plan and undertaking a comprehensive three year transformation program.

We will do this work in partnership with Alvarez, and Marsal, which has an exceptional track record of leading retail and consumer business transformation.

Together, we will leverage the company's critical assets as we work to reignite growth on the top and bottom line.

We have deep roots in the watch industry, a legacy brand with tremendous equity and a committed team that has been further enhanced by the expertise of our best in class external resource.

Before taking you through our detailed plans, let's take a few minutes to talk about where we've been in recent quarters and.

In the past few years, we have seen many headwinds with softness in the traditional watch market and ongoing and planned declines in our smartwatch business.

So far in 2023, the wholesale channel in the Americas, and Europe has been difficult as stores have underinvested in the watch business.

While we expect this channel to level out over time, the near term impact has pressured our operating results.

And lastly, China's reopening has been slower than anticipated through the years first half.

In March of this year, we introduced our transform and grow plan designed to reduce operating expenses improve operating margins and advance the company's commitment to profitable growth.

We have been making steady progress with CAG, but we recognize the need to do more and acted with a sense of urgency taking steps to drive accelerated change.

Specifically during the second quarter, we engaged Alvarez <unk> marsal to assist us with developing a more comprehensive transformation plan that expands beyond Tac.

This new plan greatly expands the scope of work and goes beyond operating expense reductions to include aspects of the business that we had previously not included.

This expanded project will better tackle gross margin and increase our scope and operating expenses ultimately driving operating income benefits for our business.

Indeed, we now expect to capture $300 million of annualized operating income benefits over the next three years.

As you'll hear today, we are on a definitive path to rightsize, our operating model in tandem with reigniting top line growth.

We believe this new plan positions us to return to gross margins as low to mid <unk> range and is critical to helping us achieve our longer term goal of approximately 10% operating margins.

As we began this important work we decided to establish a transformation office comprised of key members of our organization and the <unk>.

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Stablish in this office Leverages, our joint capabilities to drive meaningful change in progress.

Key principles are guiding the transformation.

First we are leading with a digital first approach after several years of investment we have built a robust digital infrastructure and our team has operated with a digital first mindset.

Next we are acting with speed and precision and it is gratifying to see our team has embraced the opportunity in front of us.

And third we are prioritizing shareholder value creation, we recognize the transformation. We are undertaking will take time, but we're committed to getting that right to create value for all stakeholders.

Moving to number four the strategies under our transformation are grounded in preserving our meaningful brand ethos inherited in the watch industry.

And lastly, as we evolve our operating model, ensuring we embed agility into everything we do is critical.

With that backdrop, let's discuss the dimensions of our expanded transform and grow plan, which comprises of three major focus areas.

These include driving sales productivity.

Reengineering end to end operations to drive gross margin expansion and generating overhead cost reduction and capital efficiency.

The first two areas are new and in directly results from the rigorous and comprehensive review we undertook this past quarter.

Importantly, we have identified and begun work on tactical initiatives within all three focus areas.

We have identified meaningful opportunities to improve our existing sales productivity well.

We will be driving value through pricing and adjusting many of the historical pricing practices that remained in place for many years.

We will also optimize our product assortment and mix, enabling us to invest behind fewer and higher impact story.

And lastly, we will implement initiatives to improve our store productivity, particularly in our outlets.

On the second focus area, we will reengineer end to end operations to drive gross margin expansion.

With a greater focus on fewer products done well, we will undertake a more meaningful change to our end to end business operations.

This starts with an integrated approach to business planning and naturally extends to redesign our supply chain and sourcing practices.

Also included is a continuation of our store rationalization program.

Our third focus area is generating overhead cost and capital efficiency.

In large part we began this work earlier this year as part of our initial $100 million program, which remains on track.

Our work has uncovered incremental savings opportunities as we rightsize, our overall expense structure to reflect a smaller and more nimble company.

Our extensive work in recent months to identify these opportunities gives us confidence that we have ample runway to achieve our goals.

The actions I. Just described are expected to result in a gross margin profile in the low to mid <unk> range and to help us achieve our long term goal of 10% operating margins.

At the same time, our teams are focusing on our most compelling growth opportunities designed to recapture growth and drive the top line.

All of which are underpinned by the extensive digital marketing and tech capabilities, we built in recent years.

As a reminder, our key growth pillars include revitalizing the fossil brand maximizing our core licensed brand portfolio in watches and jewelry and growing our premium watch offerings.

We're continuing to progress against these opportunities and as the tag plan takes shape you can expect us to reinvest in these areas.

We recognize a transformation like this take tremendous discipline and focus.

We are committed to providing updates on our transformation and growth plan in the upcoming quarters.

And finally I want to thank all of our fossil teams worldwide for their significant efforts to improve our business overall and now I'll turn the call over to <unk>, who will take us through the financials.

Thanks, Kosta and good afternoon, everyone. Our second quarter results came in below our expectations as we continued to see challenges in our Americas and Europe wholesale channels.

Lower recovery in greater China, and increased promotional mix, which pressured our gross margins.

The Q2 impact of foreign currency on our P&L was in line with our expectations and included a 60 basis point headwind to our reported sales of 110 basis point headwind to gross margin at a 140 basis point headwind to operating margin.

Starting with sales global sales in constant currency were down 13%.

About five points of the decline can be traced to two factors.

A decrease in our smartwatch category as we've reduced emphasis on the category and also store rationalization initiative.

Sales into the wholesale channel represented our biggest headwind and were down 19%.

In contrast, comparable retail sales grew 3%, primarily reflecting a double digit increase in our own e-commerce sites.

I'll walk through sales results in each region in more detail the highlight key drivers of performance.

First in the Americas net sales were down 13% in constant currency.

Sales into the wholesale channel were down 23%, which was in line with our expectations for the quarter and sequentially better than Q1.

The underlying sellout as reported by our major wholesale accounts was down approximately 7% versus last year in traditional watches consistent with the first quarter.

And we exited the second quarter with retailer inventory down over 20% versus last year.

Looking at the second half our expectations for Q3 remained conservative and we expect sales into the channel to continue to lag underlying sellout rates.

We are working closely with our wholesale partners to drive better sell through with assortment and promotion and we believe this will create more open to buy opportunities heading into Q4 peak selling.

Our direct to consumer channel remained healthy in the ratio, but slowed sequentially from the first quarter.

Comparable retail sales were positive driven by double digit gains in e-commerce, while store comps were down low single digits.

We ended the quarter with 146 stores this year down.

Down 7% versus last year.

In Europe total sales declined 19% versus last year.

Sales into our wholesale channel were down more significantly and came in below our expectations with heavier destocking them planned.

Within the wholesale channel, our underlying sellout decreased approximately 14% and traditional watches.

Although inventory levels in the trade have moderated versus the first quarter.

We expect Q3 wholesale sales to be similar to Q2 at key accounts continue to work down their inventory levels.

In our direct to consumer channels comparable retail sales grew double digits, but positive comps in both stores and e-commerce.

Ended the quarter with 92 stores down 19% versus last year.

Sales in Asia were down 5% in constant currency versus the prior year quarter.

As we have previously communicated we have two primary focus areas in the region.

Igniting sales in China.

And continuing to drive sales growth in India.

During Q2 sales in India increased slightly by 1% and were in line with our expectations.

Sales in mainland, China, However declined 7% on a year over year basis.

While the trend was sequentially better than Q1, our current trend in China has pushed our overall growth expectations out to Q4.

We have made adjustments in our go forward inventory mix and marketing tactics heading into Q4, which we expect to help us to drive growth in that market.

From a brand lens the fossil brand is performing better than the balance of our portfolio.

The most consistent performing category and fossil brand as traditional watches which increased 1% in Q2 and has grown 2% year to date.

We are also encouraged by progress in the brand's leathers and jewelry category, where comparable retail sales performance has been positive.

A good indicator that we're on the right path with our initiatives to drive consistent growth in our largest brand.

Looking at our largest licensed brands Kors Armani and diesel we were down versus last year, driven by the outsized sales declines in our wholesale channel in the Americas and Europe regions.

In Asia, we have had steady performance across the regions.

Moving down the P&L.

Second quarter gross margin was 48, 7% down 290 basis points versus last year.

Gross margins included a restructuring charge of approximately $3 million or approximately 90 basis points of impact or certain costs attributable to our transform and grow program and approximately 110 basis points of headwind from FX rates as I mentioned earlier.

Excluding these costs and the impact of FX rate gross margin was 57% down about 90 basis points versus last year.

The decline in gross margin generally reflects a higher promotional mix in our sales, partially offset by lower freight costs.

Total operating expenses were down 5% versus last year restructuring.

Expenses were approximately $5 million, primarily related to severance costs through conjunction with our transform and grow program.

Excluding restructuring costs and impairment SG&A was down 6% versus last year.

This reflects reduction in fixed costs, partially offset by variable cost increases associated with revenue growth at our direct channels.

And higher marketing spend related to growth initiatives in our tag program.

Taken together Q1 operating loss came in at $35 million compared to an operating loss of $11 million in the year ago period.

Adjusted operating loss of $28 million and adjusted operating margin was minus eight 6%, which includes the FX driven headwinds of 140 basis points that I previously mentioned.

Turning to the balance sheet, we made good progress managing our inventory and working capital.

Q2 inventory ended at $324 million down 26% from last year's levels, while overall working capital is down approximately 12% versus the prior year quarter.

The improvement in working capital enabled us to significantly reduce operating cash use in the first half of the year versus the prior year.

And net cash was $132 million and we had $73 million of availability under our revolving credit facility.

Turning now to our outlook.

As we look to the balance of the year. There are two overarching updates that we would like to share first I'll walk through our updated outlook for the year and second I would like to share additional color on the expanded transforming growth plan.

First we are revising our full year outlook for sales and adjusted operating margin.

Our full year sales outlook is estimated to be in the range of down five to down 10% and adjusted operating margin in the range of minus two to minus 4%.

Let me outline some specific assumptions that are embedded in our outlook.

We anticipate that net sales declines in Q3 will be similar to our year to date trend.

This includes expectations for wholesale declines in the Americas and Europe similar.

Similar impacts from our store closures and reduced emphasis on smart watches partially offset by growth in global comparable retail sales.

Our guidance reflects a sequential improvement from Q3 to Q4 and includes approximately 350 basis points favorable impact from prevailing FX rates.

Notwithstanding the FX impact the estimated sequential improvement in trend from Q3 to Q4 is expected to be driven by three primary factors.

In Q4, we are lapping prior year constant currency sales decline of 12%.

In contrast in Q3 of this year, we are lapping the prior year constant currency sales decline of 6%.

Second we expect to return to positive sales growth in China in Q4.

And third we have significant product and marketing initiatives contemplated in our broader thoughtful brand growth strategy.

And we are delivering newness in our premium watch offerings for Q4 supported by increased marketing.

From an adjusted operating income margin perspective, our outlook reflects a negative adjusted operating margin in Q3 with a low single digit positive adjusted operating margin in Q4.

Please note that Q3 gross margin will include approximately 180 basis point headwind related to a change in accounting related to the timing of certain product royalty expenses.

Offsetting benefits from this change with realized in Q1 of this year.

Now turning to some additional commentary on our transforming growth plan.

Building on coastal comment we made meaningful progress in our transformative growth plan.

We continue to execute on the plans that we outlined in our last call.

We are on track to achieve our $100 million in annualized operating income benefit by fiscal year 2024, and currently estimate that approximately 50% of the annualized operating income benefit will be captured in the current year.

As a reminder, the benefits realized in fiscal year 'twenty three are enabling us to reduce operating expenses.

Offset underlying inflation in our expense base and reinvest into our growth pillars.

We have deferred the timing of some store closures from 23 to 2024 due to generally favorable terms realized on short term lease renewals.

And the revenue margin and expense from these stores are included in our updated guidance.

Second as Kosta noted we have completed a comprehensive review of our business model, which highlighted that we have an opportunity to drive more significant operating income benefit through our transformation program.

With this wider scope, we have increased our program size to $300 million, which includes the original $100 million and expected benefits we outlined in March.

From a P&L perspective, our efforts are expected to not only reduce our operating expenses, but also drive significant improvement in our gross margins.

Although we are in the early days with this expanded effort. Our objective is to capture the entire $300 million in annualized operating income benefits by the fourth quarter of 2025.

The total benefits of the program will help improve gross margin reduced operating expenses and enable reinvestment into our growth pillars, as well as offset underlying inflation and revenue declines from business exits.

Ultimately we view this expanded program as a key enabler for us to achieve our longer term financial goal of 10% adjusted operating margin.

We look forward to updating you with more details of the program in future earnings calls.

With that I'd like to turn the call back over to Christine to take us through some questions and answers.

Terrific. Thank you Neil.

Could you tell us how you're thinking about the probability of success here. What gives you confidence that the organization can execute against this transformation and achieve all of the goals that you laid out for us today.

Well this is a robust transformation plan that touches multiple dimensions of the business.

And we have developed a detailed multi year project designed to retool the company for efficiency and growth.

Within the <unk> team working closely with ours over an extended period of time we.

We will be able to tackle opportunities in the company that can unlock significant improvements in profitability that will enable us to focus more on investing in growth.

We will always be mindful that the key to our future as innovation and branding and this project will enable us to invest more significantly in driving brand awareness and product excitement.

And more importantly, our teams are aligned with our objectives focused on delivering superior execution and energized by the opportunity to win as we work collectively to transform and grow the business.

Thank you.

Moving over to Jeff could you take us through the key elements of year end to end optimization program, where do you see the greatest opportunity.

Sure Christine.

Three key focus areas under this pillar of our expanded check program. The first areas of inventory management.

Second is sourcing and the third is our supply chain I'll start with inventory management.

Historically, we have often heard conflicting sales and demand plans have taken us spread the risk approach when it comes to planning and allocating inventory. The result is often too many skus spread too thin to appropriately support growth opportunities.

Going forward, we are working on enhancing our merchandise planning capabilities.

<unk> improvements that accompanies the summer planning and lifecycle management processes, which will enable better focus and depth on critical skus and improve overall SKU productivity.

We've taken actions to improve alignment and effectiveness of our various planning functions.

And were beneficial we'll use technology and analytics to improve the demand sensing capabilities increased new product introductions success rate and develop stronger planning integration.

Next on sourcing.

We have a solid portfolio of vendors and suppliers located primarily in Asia.

For many years, we've worked mostly on a relationship basis, given the maturity level of our manufacturing base.

As we look ahead, we'll be evolving our approach to partner with them on a more analytical and data focused cost can program.

Given underlying material costs and productivity trends, we see opportunity to improve profitability for both our suppliers and for fossil group.

We also believe we have a number of opportunities to improve our procurement process to ensure we're obtaining the lowest cost and various components within a traditional watch business and in other categories.

Finally, we will be expanding our sourcing options to look at other areas of the globe for lower cost products and assembly support.

Lastly, in our supply chain function, we see a number of opportunities to optimize operations and logistics and within our Dcs.

There are three major dimensions.

Optimizing our shipping lines between air and Ocean channels during.

During COVID-19, we defaulted to air shipments to ensure content delivery given ocean and port issues.

As volatility in the shipping channel has abated, we can shift a portion of shipments back to ocean freight for material savings, which is incremental to the current favorable rate trends, we're seeing in both channels.

Second our internal Dcs operate with solid productivity, but.

But we believe there is opportunity to capture another five to 10 points of productivity improvement through further consolidation of providers and internal productivity programs.

Third we provided a significant level of value added services for our wholesalers and third party E com customers as well as the end consumer will.

We will be increasing fees to cover the higher cost of these value added services, such as drop ship and engraving.

In terms of savings opportunities Kristine sourcing has the most significant opportunity given the underlying dynamics I mentioned earlier.

We expect to see 5% to 10% savings on our product spend levels as we execute our planned initiatives.

Better inventory management is expected to deliver the next level of savings starting in 2024.

There are sizable savings forecast for this program and are estimated at approximately 50% of the sourcing opportunity.

Overall this portion of the transform <unk> grow program optimizing our <unk> operation is expected to deliver nearly one third of our total program benefits.

Thank you Jeff.

Tsuneo, how quickly do you start to expect capturing operating income benefit here.

Thanks Kristina.

The degree of building on Jeff's comments, when we started our transformation work earlier this year, we outlined $100 million in annualized operating income benefits to be realized by the end of 2024 and that was primarily focused on operating expense reductions we are making steady progress on this front benefits will primarily.

Reducing operating expenses offset underlying inflation as I mentioned and also enable reinvestment into our growth initiatives.

With the expanded program our goal is to capture the entire $300 million of annualized.

Operating income benefits by the end of 2025 from a P&L perspective. This means capturing benefits from 2023 through 2026, while it's early we expect to see significant benefits in 2024, which will help to reduce expenses begin to generate some gross margin benefit by the back half of the year and to offer.

That underlying inflation and revenue declines associated with streamlining product categories and distribution. We are ramping up our teams for this expanded effort and we will have more specifics to share and the upcoming quarterly calls.

Got it thank you.

So Jeff what is the game plan just switching gears here, what's the game plan for the Smartwatch business have you considered exiting this business altogether, given the ongoing weakness that you've seen there.

Several quarters.

Fair question Christine very good.

<unk> made the decision to significantly reduce our overhead investment in smart smartwatch development and support.

As we pulled back on future development, we will be working with select partners to determine potential options for our display and hybrid products and we are evaluating alternatives to carryforward. The development work. We currently have underway.

We expect to continue to sell and distribute gen six and hybrid HR product over the coming quarters and plan to support both our display and hybrid products for the next several years during their warranty periods.

Helpful. Thank you.

Moving back to see Neil what does the shape of working capital look like over the next several quarters and whats the cash flow outlook.

Yes, Thanks, Christine our working capital levels start to come down in the first quarter and came down even more in Q2, primarily as we manage our inventory levels down from last year.

As our sales into wholesale have been challenging we have been keeping a more conservative flow of inventory into our warehouses. These.

These actions have reduced our use of cash through the first half of the year compared to last year and in the second quarter, specifically a cash from operations was slightly positive.

Capex remains relatively small as well.

Looking at the balance of the year as we manage our inventory levels down we expect to see a continued decrease in our working capital versus the prior year.

Which will be a benefit to our overall cash flow Capex plans are generally limited maintenance type activity and more broadly our transform and grow plan contemplates initiatives that will structurally improve our working capital efficiency into the future.

Great. Thank you I just have one final question for Kosta.

Can you provide us with a progress report on the growth pillars, what should we be looking out for in the second half of this year.

Well, it's important we move forward on our growth agenda. The fossil brand was relatively strong again this quarter, especially in watches and we expect that trend to continue.

A major product and marketing launch in the fossil brand coming in September that has a totally new look and has tuned two additional cohorts that we have not cater to in the past this.

This came from research we did last year, then identified new potential customer segments for the brand.

Into next year and longer term, we will be focused on driving awareness and brand heat with engaging marketing and communications leveraging our digital capabilities.

And our core licensed brand portfolio, we recognize the current headwinds that exist in wholesale.

That said, we're also set up for ongoing growth in our jewelry businesses and plan to emphasize men's watches within these brands as we are seeing stronger consumer response in men's versus women's of late.

We're also seeing better performance in Asia, which can serve as an offset to balance the near term headwinds in Americas and Europe .

And our premium watch business, we have significant runway ahead over the years to come through product marketing and additional distribution to capture revenue and margin growth.

The premium segment has outperformed the broader category and we believe it has <unk> into the future.

Great. Thanks Kosta.

That concludes our Q&A session for today I'll, let you close to wrap up the call with any closing remarks.

Well, thanks for joining us today, we greatly appreciate your interest and we look forward to speaking with you on our third quarter call in November have a good day.

Thank you. This concludes today's conference call. Thank you for participating you may now disconnect.

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Good afternoon, ladies and gentlemen, and welcome to the fossil group's second quarter 2023 earnings call. At this time all parties are in a listen only mode. This conference call is being recorded and may not be reproduced in whole.

Or in part without written permission from the company now ill turn the call over to Christine <unk> of the Blue shirt group to begin.

Hello, everyone and thank you for joining us with US today on the call are kosta carts.

Salmon and CEO , Jeff Boyer, Chief operating officer, and Neil Doshi, Chief Financial Officer.

I would like to remind you that information made available. During this conference call contains forward looking information and actual results.

Could differ materially from those that will be discussed during this call.

Fossil group's policy on forward looking statements and additional information.

Concerning a number of factors that could cause actual results to differ materially from such statements is radically available in the company's form 8-K, 10-Q, and 10-K reports filed with the SEC.

In addition, thoughtful assumes no obligation to publicly update or revise any forward looking statements, whether as a result of new information future events or otherwise except as required by law.

During today's call we will refer to constant currency results. Please note that you can find.

Reconciliation of actual results to constant currency results and other information regarding non-GAAP financial measures discussed on this call in fossils earnings release, which was filed today on form 8-K and is available in the investors section of fossil group Dot Com now I will turn the call over to cause that to begin.

Thanks, Christine the first half of 2023 has proved challenging effected by macro challenges and choppy demand trends, resulting in softer than expected Q2 performance.

Q2, net sales declined 13% as we saw continued headwinds in our wholesale channels in the Americas, and Europe , and a slower recovery in greater China.