What Has Been Fueling Fossil's Rally?

This review of Fossil's (Nasdaq: FOSL) earning quality is the third of four commentaries that looks at specialty retailers listed in the S&P 400 index, and specifically retailers that have cash management issues. Previously I looked at Ascena Retail Group (Nasdaq: ASNA) and Chico's FAS (NYSE: CHS); Fossil and Saks (NYSE: SKS) will round out this series.

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money has been lost.

The EQ Score database assigns an index rank to the company from 1 (lowest quality) to 5 (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

EQ trends for specialty retailers with cash management issues

Source: Fool EQ Score (week ending March 9, 2012).

Ascena's EQ score has trended up, Chico's down, and Fossil and Saks have shown no trend. All exhibit cash management issues. Regarding Ascena, I recently commented that its income statement and balance sheet metrics were very positive, and its cash management and cash flow, while showing signs of improvement, have been the factor holding this stock back until recently. Chico's inventory levels have outpaced revenue growth, which has put the company's gross margin on a downward trend.  Moreover, Chico's yearlong spending spree has artificially boosted EPS through common shares repurchases, while net income increased only $29 million for the year. Saks is one of many retailers affected by seasonality.  The company's revenue grew slightly year over year (7%), but inventory levels increased 8%. Saks' DSI metric is unacceptably high at 114 days, and its cash conversion cycle is 126 days.

Unearthing Fossil's future -- gigantic, or Titanic?
Fossil designs, develops, markets, and distributes consumer fashion accessories worldwide under its proprietary brands, such as Fossil, Michele, Relic, and Zodiac; and under licensed brand names including Adidas, Armani Exchange, Burberry, Diesel, DKNY, Emporio Armani, Marc by Marc Jacobs, and Michael Kors. The company sells its products through its own retail stores (U.S.: 197 stores, international: 201 stores) and through distributors and department stores, among other channels.

Fossil Revenues Chart by YCharts

Fossil Cash Operations Chart by YCharts

Fossil Shares Outstanding Chart by YCharts

By now, if you have read the previous two commentaries on this retailer group, you should see familiar patterns in financial metrics that affect earnings quality reflected in the charts above: Retailer increases store count to grow revenue and/or uses aggressive revenue recognition tactics; retailer mismanages inventories, cash, and/or receivables; retailer buys back shares to decrease float, which artificially boosts earnings per share; retailer reports higher revenue and EPS that boosts the stock price and possibly benefits management's compensation.

Is there anything wrong with this picture? Yes, because unless you look behind the numbers, you may make investment decisions that will ultimately be incorrect, or untimely.

Some of Fossil's metrics entice the casual stock picker. Revenue, operating income, net income, and EPS are all rising year over year with the usual seasonal swings, which is good news.  However, the rate of positive change in these metrics has been slowing, which is bad news.

Sources: TMF EQ Scan and S&P Capital IQ.

Inventory levels, days in inventory, accounts receivable, and Fossil's cash conversion cycle have been increasing.  Additionally, free cash flow is down 48% from last year, and has been negative four out of the last eight quarters.

Sources: TMF EQ Scan and S&P Capital IQ.

Put in perspective, revenue increased 57% from fiscal year 2009 to fiscal year 2011, whereas inventories increased 99%, and DSI is increasing.  Unlike some of the retailers previously discussed, Fossil sells to store chains in addition to its own stores, so it must manage A/R.  The increased level of A/R as a percentage of revenue suggests that either these customers are taking longer to pay or Fossil is extending favorable payment terms in exchange for purchasing more inventory. Curiously, the company increased its reserve for doubtful accounts from $16 million in fiscal year 2009  to a whopping $18.2 million in fiscal year 2011. 

Another disturbing metric is that operating cash flow minus net income has been negative five out of the last eight quarters, as shown in the second chart above. This is a signal that revenue recognition has been premature.  Also disturbing: Full-time employee counts have skyrocketed from 7,900 in fiscal year 2009 to 13,100 in fiscal year 2011. True to form, Fossil repurchased $199.2 million in stock in 2010, and another $270.9 million last year, thereby boosting EPS. Since Aug. 18, 2011, the stock has soared from $74 to its current level of $132, near its all-time high of $134.  For those of you thinking of climbing aboard this ride: Make sure the name of the ship is neither Titanic nor Hindenburg.