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On a Previous post I had mentioned about the Sumzero challenge where the contestants are supposed to submit an Investment idea that they feel would be Buffett's next investment choice. After going through a list of around 50 shortlisted stocks I finally came to the conclusion of recommending Fossil. So Why would Buffett consider purchasing Fossil? (i) The business has huge moat. And its products would be in demand for decades to come. (ii) The business belongs to Jewelry industry that Buffett understands really well. This can be said by looking at Berkshire Hathaway Inc’s portfolio of Jewelry businesses.(iii)Balance sheet is strong. Business also generates healthy free cash and does not need any major incremental Working capital. Current RETURN ON EQUITY = 38%. (iv) Company has a Strong management in place. (v) The business is selling for a discount. As of April-4-2015 the stock was trading at $83.75. The fair value is between $132 and $102 per share. Let us look at each of the above point closely.
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FACTORS THAT ENHANCE THE MOAT OF THE BUSINESS BRAND STRENGTH: i) The FOSSIL brand has developed from its origin as a watch brand to encompass other accessory categories, including handbags, belts, small leather goods, jewelry, soft accessories, sunglasses and clothing. ii) Since its inception in 1984, they have continued to develop, acquire or license other nationally or internationally recognized brand names, such as ADIDAS®, ARMANI EXCHANGE®, BURBERRY®, DIESEL®, DKNY®, EMPORIO ARMANI®, KARL LAGERFELD®, MARC BY MARC JACOBS™, MICHAEL KORS®, MICHELE®, RELIC®, SKAGEN®, TORY BURCH® and ZODIAC®, in order to appeal to a wide range of consumers. iii) Their industry is highly competitive and subject to changing preferences in style, taste and price points. By owning the vast majority of their global distribution, they are also able to create and execute consistent pricing strategies and brand image presentations that protect and enhance their proprietary brands and those of its licensors. LICENSING STRENGTH: i) Since 1997, they have attracted highly recognized and respected brand names to license within their watch and jewelry portfolios. They attract such quality brands due to their ability to provide them with access to their global design, production, distribution and marketing infrastructure. ii) As a result of their vertical integration, they, unlike many of their competitors, can offer an integrated solution to launch or increase an accessory category presence on a worldwide basis in a consistent, timely and focused manner. iii) All of its major licensing relationships are exclusive to them and the licensors, which substantially minimizes risks to the licensor associated with dealing with multiple licensees in different geographic regions. iv) Additionally, in order to develop a broader relationship and maintain brand consistency across the accessory categories, they have broadened their infrastructure, allowing them to expand their licensing activities to products beyond the watch category, including their DIESEL, DKNY, EMPORIO ARMANI and MICHAEL KORS jewelry product lines. BREADTH OF BRANDS AND RETAIL PRICE POINTS: i) Through the multiple brands they distribute, they have developed a broad spectrum of retail price points. Within their watch collections, core retail price points vary from approximately $7 in the mass market channel up to retail price points of $4,990 in the luxury distribution channel, although the majority of their collections focus on price points ranging from $85 to $600. ii) The breadth of their brands allows them to anchor a brand to a given price point range and distribution channel, thereby maintaining a consistent brand image while focusing on the quality/value relationship important to the customer and not diluting the brand through overlapping distribution channels. The breadth of price points allows them to cater to various age and income groups while continuing to participate in sales consistently, regardless of a shift in income or the price/value preferences of its customers. OPERATIONAL CONTROL: i) The three entities that assemble the majority of their Asia watch production volume are majority owned by them. In addition, although they do not have long-term contracts with their unrelated accessory manufacturers, they maintain long-term relationships with several manufacturers. These relationships developed due to the significant length of time they have conducted business with the same manufacturers. This helps them to exert significant operational control with regard to their principal watch assemblers. In addition the relative size of their business with non-owned watch manufacturers gives them priority within their production schedules. Furthermore, the manufacturers understand their quality standards, which allow them to produce quality products and reduce the delivery time to market, improving overall operating margins. ii) They distribute substantially all of their products sold in North America from their warehouse and distribution centers located in Texas. In Europe, they distribute their products primarily through their warehouse and distribution center located in Germany. Their centralized distribution capabilities in the U.S. and Europe enable them to reduce inventory risk, increase flexibility in achieving delivery requirements of their customers and maintain cost advantages as compared to their competitors. iii) HOW THE TEXAS WAREHOUSE IS USEFUL? Their warehouse and distribution facilities in Texas operate in a special purpose sub-zone established by the U.S. Department of Commerce Foreign Trade Zone Board. This sub-zone provides the following economic and operational advantages to them: (a) They do not have to pay duty on imported merchandise until it leaves the sub-zone and enters the U.S. market, (b) They do not have to pay any U.S. duty on merchandise if the imported merchandise is subsequently shipped to locations outside the U.S. and (c) They do not have to pay local property tax on inventory located within the sub-zone. BERKSHIRE’S JEWELRY PORTFOLIO AND HOW FOSSIL WILL FIT IN? Berkshire’s Jewelry portfolio consists of: (i) Ben Bridge Jeweler (ii) Borsheims Fine Jewelry (iii) Helzberg Diamonds. Each of these businesses offers broad range of jewelry including fine watches. FOSSIL’s moat will complement the strengths of these businesses and in turn increase the value of Berkshire’s Jewelry portfolio. FINANCIAL STATEMENT ANALYSIS 1. GROWTH IN BOOK VALUE / SHARE: It’s the prime measure Buffett uses to measure Berkshire Hathaway inc’s progress. Thus we need to look at Fossil’s 10 year change in Book value per share. Book value per share grew from $7.27/share in 2005 to $18.53 in 2014 at a Compounded annual growth rate of 9.81% per year for last 10 years. 2. CHANGES IN WORKING CAPITAL AS COMPARED TO GROWTH IN SALES: As Buffett has mentioned in his letters before that his definition of an ideal company is something like See’s Candies that has steadily increased its Free cash flow with very minimal increase in working capital. Below table gives the formula for measuring changes in Working capital with respect to Sales.
A : Current Assets For the years 2005 thru 2014 the value of 'F' has maintained a tight range between 3.89 and 5.10 last 10 years. This shows that the business does not need much increase in working capital. 3. FREE CASH FLOW FOR LAST 10 YEARS : The company's Free cash flow increased from $88 millions in the year 2006 to $288 millions in the year 2014. The agregate Free cash flow during this period is $1,615 million. The Free cash flow has increased with a CAGR of 13.86% 4. RETURN ON EQUITY: Buffett has often stressed on a healthy Return on Equity as one of his yardstick in measuring a performance of a business. Fossil’s current ROE is 38%. In 2005 it was 14.31% and has constantly been increasing every year since then. This indicates a very positive sign that the business needs very limited capital to grow. A LOOK AT THE COMPANY’S MANAGEMENT: Fossil Group was founded in 1984 by Tom Kartsotis . His brother Kosta Kartsotis is the CEO and Chairman of the board. He owns 12% of the company and is said to be one of the lowest paid CEOs of any large organization. This shows his conservative style of managing capital. It very well matches Buffett’s style of functioning. VALUATION OF FOSSIL: Following are the assumptions for valuation of Fossil
i) Base Free cash flow: $300 million. Applying the Discounted Cash flow valuation technique, we get the following ranges
HIGHER RANGE:
LOWER RANGE: |
