Fossil (NASDAQ:FOSL) reported third-quarter earnings yesterday -- sort of. It seems management felt the need to perform a voluntary audit on its stock-option practices, and therefore will delay its official filing, pending the results of the audit.
However, the preliminary results are more of what investors have come to expect from the watch and accessory company. Net revenues, which increased 16.4% year over year, continue to be robust both by region and segment. A noteworthy positive was the performance of the Fossil watch brand, which had domestic sales decrease by only 3.3%, versus the double-digit declines over the past four quarters.
On the balance sheet, inventory, which grew a heady 21% year over year in the second quarter, only increased 3.4% year over year in the third quarter. In the conference call, Fossil CEO Kosta Kartsotis felt that inventory would be flat by year-end, compared to year-end 2005.
Although the recent positive inventory management is good news, my biggest concern is with operational expenses. Over the past decade, the company has managed to slightly expand its gross margin. This should alleviate concerns about management's long-term ability to manage inventory. However, the company's operating margin, which has been compressing since 1999, is at its lowest level in more than a decade. One would expect increasing revenues to generate economies of scale and operational leverage.
And for those investors focusing on earnings-per-share growth, the operating margin slippage has been masked to some degree by a decreasing tax rate and share buybacks, which help to prop up earnings per share. However, the negative trend in Fossil's share price since its peak in late 2004 might indicate that operational inefficiencies are catching up with the company.
I estimate that management needs to get operating margins to at least 14% to generate economic profits, or at least cover its cost of invested capital. This should be a realistic expectation, since operating margins have been more than 20% on similar gross margins in the past. Consider Claire's Stores (NYSE:CLE), which manages slightly higher gross margins and generates superior operating margins at 17%. Even more impressively, Claire's can maintain those higher gross margins while turning its inventory over five times a year, compared to Fossil's two to 2.5 inventory turns.
If Fossil's management can gain some operational efficiencies, or simply cut costs, the company could prove undervalued. And even at today's price, Fossil's value looks more appealing than competitor Movado Group (NYSE:MOV), which could stand to gain some operational efficiencies of its own.
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Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
