Earnings Transcript for FOSL - Q2 Fiscal Year 2023

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: 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 Kartsotis: 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. 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 three years. As you'll hear today, we are on a definitive path to right size 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 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 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. 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 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 right size 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 Doshi: 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 two factors

A - Christine Greany: Terrific. Thank you, Sunil. Kosta, 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?

Kosta Kartsotis: Well, this is a robust transformation plan that touches multiple dimensions of the business. And we've developed a detailed multiyear project designed to retool the company for efficiency and growth. With A&M's team working closely with ours over an extended period of time, we'll 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 is 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.

Christine Greany: Thank you. Moving over to Jeff. Could you take us through the key elements of your end-to-end optimization program? Where do you see the greatest opportunity there?

Jeff Boyer: Sure, Christine. There are there key focus areas under this pillar of our expanded TAG program. The first area is inventory management, the second is sourcing and the third is our supply chain. I'll start with inventory management. Historically, we have often had conflicting sales and demand plans, have taken a 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're working on enhancing our merchandise spending capabilities, including improvements to the company's assortment planning and life cycle management processes, which will enable better focus and depth on critical SKUs and improve overall SKU productivity. Also, we're taking actions to improve alignment and effectiveness of our various planning functions. And where beneficial, we'll use technology and analytics to improve the demand-sensing capabilities, increase the new product introduction 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 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 costing 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 our traditional watch business and in other categories. And finally, we'll 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

Christine Greany: Thank you, Jeff. Sunil, how quickly do you start to expect capturing the operating income benefits here?

Sunil Doshi: Yes. Thanks, Christine. And to a degree, 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 help reducing operating expenses, offset underlying inflation, as I mentioned, and also enables 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 offset underlying inflation and revenue declines associated with streamlining product categories and distribution. We are ramping up our team for this expanded effort and we'll have more specifics to share in the upcoming quarterly calls.

Christine Greany: Got it. 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 over the past several quarters?

Jeff Boyer: A fair question, Christine. Very recently, we've made a decision to significantly reduce our overhead investment in smartwatch development and support. As we pull back on future development, we will be working with select partners to determine potential options for our display and hybrid product, and we are evaluating alternatives to carry forward the development work we currently have underway. We expect to continue to sell and distribute Gen 6 and Hybrid HR products over the coming quarters and plan to support both our display and hybrid products for the next several years during their warranty period.

Christine Greany: Helpful. Moving back to Sunil. What does the shape of the working capital look like over the next several quarters? And what's the cash flow outlook?

Sunil Doshi: Yes. Thanks, Christine. Our working capital levels started 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 in the wholesale have been challenging, we have been keeping a more conservative flow of inventory into our warehouses. 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, 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 flows. CapEx plans are generally limited to maintenance-type activities. And more broadly, our Transform and Grow plan contemplates initiatives that will structurally improve our working capital efficiency into the future.

Christine Greany: Great. 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?

Kosta Kartsotis: 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. We have a major product and marketing launch in the Fossil brand coming in September that has a totally new look and it's tuned to the additional cohorts that we have not catered to in the past. This came from research we did last year that identified new potential customer segments for the brand. Into next year and longer term, we'll be focused on driving awareness and brand heat with engaging marketing and communications, leveraging our digital capabilities. In our core licensed brands 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 are also seeing better performance in Asia, which can serve as an offset to balance the near-term headwinds in Americas and Europe. In 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 tailwinds into the future.

Christine Greany: Great. Thanks, Kosta. Well, that concludes our Q&A session for today. I'll let you, Kosta, wrap up the call with any closing remarks.

Kosta Kartsotis: Well, thanks for joining us today. We greatly appreciate the interest, and we look forward to speaking with you on our third quarter call in November. Have a good day.

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