Fossil: The Missing Quadrant (Updated)

Source: Fossil.com

We’ve heard this story before — Apple introduces the iPod and dominates the MP3 Player market, Apple launches the iPhone and soon Blackberry and Nokia are toast, Apple announces the iPad and now tablets have become synonymous with “iPad”. That leaves us with Apple Watch, released two years ago. Will history repeat itself? Will the Apple Watch leave its competitors in the dust, fighting over shrinking market share? The market certainly seems to think so. It has been said that history rhymes but does not repeat, and while Apple Watch is likely to be a success, some hidden value has emerged with other watchmakers in the market.

Fossil Group (FOSL) is a fashion design and watch manufacturing company based in Richardson, Texas. Founded 33 years ago, it manufactures watches under its own brand, as well as other fashion accessories such as jewelry, handbags, and small leather goods. Watches make up approximately two thirds of its sales.

Fossil Group Key Statistics*:

Fossil Group Key Trends*:

* figures are approximations taken at the time of this writing

Revenues and profits have faced substantial headwinds with the introduction of the Apple Watch, and its stock price has unambiguously reflected this. Currently at $10.84, its 52-week high is $36.87, and three years ago it was trading at $106. With that being said, it remains a going concern, with a highly liquid balance sheet. High profile retail names such as Macy’s and JCPenny have been struggling as of late. Because of this, FOSL has been unreasonably lumped in with these dying giants via Retail ETF’s. There is an opportunity to profit from this mispricing.

Given its deep value status, the market has essentially decided that Fossil is on its last legs, and will suffer the same fate as Blackberry, Nokia, and the dozens of MP3 players prior to the iPod. While this is certainly a possibility, it hinges on the assumption that the watch market operates identically to music players, smartphones, and tablets. However, take away this crucial belief, and you have a stock that is deeply undervalued. Let’s see what Jony Ive, Apple Chief Design Officer, says about the Apple Watch:

“Regardless of whether we declare an interest in fashion or not, we are making products that are more and more personal… products that you wear and you wear every day. We’ve not done that before and we’ve got a lot to learn.”

It seems as though the chief designer at Apple himself is saying the Watch is a unique item, and not analogous to previous products. What makes the Watch different is that it is primarily a fashion accessory, something that is visible to others when worn. The iPod and iPhone spend most of their time in your pocket, and the iPad on your coffee table. Apple, with their brilliant-as-usual foresight, recognizes that this market is different from others it has previously competed in. There are currently dozens of Watch bands for sale on Apple’s website, which underscores this point. Recall that there were only third party iPhone cases available for many years after the iPhone debut in 2007. Wall Street, on the other hand, views the Watch as merely an extension of the iPhone that sits on your wrist. Going back to our critical assumption, the Watch is not like other products, and therefore we cannot immediately conclude that Fossil will suffer the same fate as previous Apple rivals.

Where does that leave us? Well, let’s reexamine what exactly watches are, and where they will evolve from here. Watches are of course used to keep time. In addition, they are fashion items. If timekeeping was the only traditional function of a watch, Timex and Casio would dominate the watch market. The hundreds of models, and well as luxury brands confirm that this and will continue to be a fashion item. Additionally, they have taken on many other, “smart” functions. These newer functions include heart rate monitoring and mobile notifications, although new features will undoubtedly be added in the future.

This isn’t intended to be a debate on the merits of the Apple Watch, I am sure it will continue to be a success. However, does everyone find the watch to be desirable or fashionable? In my opinion, the answer is a clear “no”. Being a fashion product, styles and trends tend come and go in cycles. As soon as something becomes too popular, it ceases being popular. Fashion-oriented consumers tend to be fickle, and this puts a natural ceiling on a contemporary item like the Apple Watch. With that being said, we still have a missing quadrant in the chart above. Apple (and to a lesser degree, Fitbit) have expanded the market for wearable technology. This aligns nicely with the structural trend of consumers being more health conscious and wanting data for their activity levels. My central thesis is that Apple Watch has expanded this market, and it will remain unfulfilled with the Watch alone.

This holiday season, Fossil is launching over 300 connected watches across 14 brands. These so-called hybrid watches are fashionable, come in many varieties, and will integrate with your smartphone. Some look futuristic, with AMOLED screens similar to an Apple Watch. In addition, others have the appearance of a traditional analog watch, with the smart features hidden within the device. You will soon have access to the mobile notifications and fitness tracking available on a smartwatch, while still having the option of wearing what looks like a traditional mechanical timepiece. This makes Fossil Hybrid Smartwatches are the fourth quadrant in the chart above. Designed to fit your individual taste, these watches will have the Fossil brand as well as 14 others, including DKNY, Marc Jacobs, Armani Exchange, Michael Kors, Kate Spade and others. The launch will include 300 styles with “fashion-first tech accessories”. Building on top of Android Wear 2.0, these watches will be compatible with both iPhone and Android. What makes this a particularly appealing move is the scale Fossil will achieve with multiple branding. It is well positioned to be the dominant supplier within this category of the overall watch market. Fossil will not have the same limitations as a single fashion item like Apple Watch. While I maintain that Apple Watch will continue to be a success, there is room for more than one firm in this new market. Fossil is well positioned to fill that remaining demand.

Looking at the chart from the beginning of 2015, FOSL has a poor performer as of late. However, with holiday season around the corner, catalysts will be emerging. The stock has seemed to settle on a floor at approximately $10.70 (Orange Line). While this floor has occasionally been tested, sharp reversions with high volume above the floor suggests that it has staying power. In addition, the MACD has had a bullish crossover late last month (Green Line) which corresponded with a spike in Volume Moving Average (Blue Circle). What I recommend is initiating a position here, with the understanding that it could dip lower before the catalyst this Christmas becomes fully recognized by the market.

While Fossil Group has continued to struggle over the last couple years with the introduction of the Apple Watch, I maintain that the watch market is different for Apple, and primarily falls under the fashion, not technology, category. FOSL has unjustifiably received a cheap valuation from the market, which gives long investors an opportunity to profit. Apple Watch ultimately expands the market for smartwatches and connected devices, and Fossil’s approach to multichannel distribution will give it economies of scale within this segment. While some investors remain skeptical, at this point, the bar is set so low that even a modest jump in income will likely trigger a short squeeze and send the stock soaring. Wall Street fundamentally does not understand technology, and Fossil presents a solid case to profit from this inherent weakness.

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