Fossil : Q2 2023 Earnings Call Transcript

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EDITED TRANSCRIPT

Q2 2023 Fossil Group Inc Earnings Call

EVENT DATE/TIME: AUGUST 09, 2023 / 9:00PM GMT

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AUGUST 09, 2023 / 9:00PM GMT, Q2 2023 Fossil Group Inc Earnings Call

CORPORATE PARTICIPANTS

Jeffrey N. Boyer Fossil Group, Inc. - Executive VP & COO

Kosta N. Kartsotis Fossil Group, Inc. - Chairman & CEO

Sunil M. Doshi Fossil Group, Inc. - Executive VP, CFO & Treasurer

CONFERENCE CALL PARTICIPANTS

Christine Greany The Blueshirt Group, LLC - MD

PRESENTATION

Operator

Good afternoon, ladies and gentlemen, and welcome to the Fossil Group Second Quarter 2023 Earnings Call. (Operator Instructions) 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 Greany of the Blueshirt Group to begin.

Christine Greany The Blueshirt Group, LLC - MD

Hello, everyone, and thank you for joining us. With us today on the call are Kosta Kartsotis, Chairman and CEO; Jeff 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. 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 readily available in the company's Form 8-K,10-Q and 10-K reports filed with the SEC. In addition, Fossil 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 results to constant currency results and other information regarding non-GAAP financial measures discussed on this call in Fossil's earnings release which was filed on Form 8-K and is available in the Investors section of fossilgroup.com.

Now I'll turn the call over to Kosta to begin.

Kosta N. Kartsotis Fossil Group, Inc. - Chairman & CEO

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 channels in the Americas and Europe and 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'll be activating several of these for 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 has 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 toward elevated and sustained profitability.

We are announcing new initiatives under our previously announced Transform and Grow plan and undertaking a comprehensive 3-year transformation program. We will do this work in partnership with Alvarez & Marsal which has an exceptional track record of leading in retail and consumer business transformations.

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AUGUST 09, 2023 / 9:00PM GMT, Q2 2023 Fossil Group Inc Earnings Call

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 is being further enhanced by the expertise of a 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 the recent quarters.

In the past few years, we have seen many headwinds with softness in the traditional watch market and ongoing unplanned 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 year's 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 TAG, 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 & Marsal to assist us with developing a more comprehensive transformation plan that expands beyond tech. 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 in 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 3 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 in the low to mid-50s range and is critical to helping us achieve our longer-term goal of approximately 10% operating margins.

As we begin this important work, we decided to establish a transformation office comprised of key members of our organization and the A&M team. Establishing this office leverages our joint capabilities to drive meaningful change in progress.

Five 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 is operating with a digital-first mindset. Next, we are acting with speed and precision, and it is gratifying to see our teams embrace the opportunity in front of us. And third, we are prioritizing shareholder value creation. We recognize the transformation we're undertaking will take time, but we are committed to getting it right to create value for all stakeholders. Moving to number four, the strategies under our transformation are grounded in preserving our meaningful brand ethos and heritage 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 3 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 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 3 focus areas.

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

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AUGUST 09, 2023 / 9:00PM GMT, Q2 2023 Fossil Group Inc Earnings Call

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 through redesigning our supply chain and sourcing practices. Also included is the 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-50s 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've 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 that transformations 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 Sunil to take us through the financials.

Sunil M. Doshi Fossil Group, Inc. - Executive VP, CFO & Treasurer

Thanks, Kosta, and good afternoon, everyone.

Our second quarter results came in below our expectations as we continue to see challenges in our Americas and Europe wholesale channels, a slower recovery in Greater China and increased promotional mix which pressured our gross margins.

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

Starting with sales. Global sales in constant currency were down 13%. About 5 points of the decline can be traced to 2 factors: a decrease in our smartwatch category as we've reduced emphasis on the category and also store rationalization initiatives.

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 to 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 sell-out 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 edits and promotions, and we believe this will create more open-to-buy opportunities heading into Q4 peak selling.

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AUGUST 09, 2023 / 9:00PM GMT, Q2 2023 Fossil Group Inc Earnings Call

Our direct-to-consumer channel remained healthy in the region 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 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 than planned. Within the wholesale channel, our underlying sellout decreased approximately 14% in traditional watches. Although inventory levels in the trade have moderated versus the first quarter, we expect Q3 wholesale sales to be similar to Q2 as key accounts continue to work down their inventory levels.

In our direct-to-consumer channels, comparable retail sales grew double digits with positive comps in both stores and owned e-commerce. We 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 2 primary focus areas in the region: reigniting 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 in Fossil brand is 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 categories where comparable retail sales performance has been positive, a good indicator that we are on the right path with our initiative 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 steadier performance across the region.

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 for 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 rates, gross margin was 50.7%, 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 in conjunction with our Transform and Grow program. Excluding restructuring costs and impairments, SG&A was down 6% versus last year. This reflects reductions in fixed costs, partially offset by variable cost increases associated with revenue growth in 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 was $28 million and adjusted operating margin was minus 8.6% 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 was 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. Ending 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

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