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Friday, January 8, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Clocking Growth at Fossil

When thinking of fossils, most people conjure images of dinosaurs and other relics from the past. Using the Foolish 8 screening technique, however, I've found a Fossil (Nasdaq: FOSL) that is alive and emerging as very successful fashion accessory brand. If you aren't familiar with the Foolish 8 screen, it identifies small-cap companies that share eight characteristics often exhibited by successful stocks.

The screen is fairly stringent, seeking companies growing sales and earnings at greater than 25%, maintaining a 7% or higher net margin, having positive cash flow from operations, and carrying a relative strength of greater than 90. In addition, insider holdings have to be at least 10% of the company's outstanding stock. For the lowdown on the Foolish 8 spreadsheet, check out this link.

For those of you not hip enough to peruse the watch section of your favorite department or specialty store, Fossil has become one of the hotter brands over the past few years. Expanding off its success in watches, the company has also launched a line of small leather goods, belts, handbags and sunglasses. While these other items are doing well, watches still accounted for 72% of the company's 1997 sales. You can tic into their background and product offerings via their home page.

Investing in fashion brands involves more risk than many other businesses, as trends (and earnings and cash flow) ebb and flow before you know what happens. Those of us attending high school in the 1980s can remember Izod shirts and LA Gear sneakers, two fashion brands that were hot before heading off into bankruptcy. On the other hand, other brands such as Swatch and Polo have adapted and maintained their leadership for quite a long time. (Let's all hope that Martha Stewart doesn't end up in this category.) Adapting products and marketing to meet changing consumer preferences will be required for long-term success.

As indicated by the company's passing the Foolish 8 screening process, Fossil's recent track record is strong. In addition, the company is expected to post long-term earnings growth of 20% per year, yet trades at a below-market price/earnings (P/E) ratio of 21 based on 1998 earnings estimates. Looking into this year, the company is trading at a tad over 17x First Call consensus estimates. Quite attractive, assuming the company meets expectations.

On the subject of meeting expectations, it is worth noting that the company has beaten analyst expectations for the past nine quarters. This quarter is unlikely to be any different. On December 29, Dow Jones Newswires carried a story from company CFO Randy Kercho stating that "there is an opportunity to beat [First Call's $0.46 consensus estimate]." Assuming that the number will meet that number rather than exceed it (as is likely), this year's earnings per share will have grown 48% on top of last year's record results.

Fueling the growth has been continued acceptance of the company's core watch brand, along with increasing sales for its accessory line. The company has expanded into making private label watches for retail chains such as Emporio Armani and Eddie Bauer, which is also boosting sales and profits. Although all of its product lines are offered domestically, the 30% of sales from international markets are currently derived almost exclusively from watches. As the brand strengthens, other products are expected to be introduced into those regions.

Looking at the income statement for the first nine months of 1998, sales were up 23% as earnings increased 60%. This dramatic jump in earnings was primarily caused by improving gross margins and only modest increases in selling, general and administrative (SG&A) expenses. Gross margins increased 1.3 percentage points to 49.2% thanks to a better product mix and lower costs from the stronger dollar. The relatively small increase in SG&A expenses indicates that the existing company infrastructure was sufficient to meet demands caused by increasing sales.

One comment in the company's 10-K that surprised me is that advertising expenses between 1995 and 1997 was essentially flat in the $14-$15 million range. Given Fossil's desire to increase brand recognition and introduce new products, I would have intuitively expected the number to increase. The recent sales success demonstrates that increased advertising has not been needed. Over time, however, this line item will likely be forced higher to maintain the brand's positioning. An increase in advertising costs would dampen future SG&A leverage.

The balance sheet looks healthy, with no long-term debt and $28 million in cash ($1.33 per share). Inventories don't look out of hand, with 82 days sales on hand (based on Q3 sales) compared with 86 days last year. Another positive indication is that accounts receivable outstanding has decreased from 55 days last year to 49 days this year. Cash flow from operations in the first nine months was a positive $11 million as the company very effectively managed its working capital.

Fossil holds many of the characteristics embodied by successful growth companies. If you can tolerate the risks inherent in the fashion industry, this stock could be worth watching.

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