Fossil Group Inc (FOSL) 2006 Q2 法說會逐字稿

Welcome to the Fossil 2006 second-quarter earnings conference call. At this time all participants are in a listen-only mode. Following today's presentation instructions will be given for the question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Tuesday, August 15, 2006. At this time I would like to turn the presentation over to Allison Malkin of Integrated Corporate Relations.

Good morning. Before we begin you should be aware that during this conference call certain discussions will contain forward-looking information. Actual results could differ materially from those that will be projected during these discussions. Fossil'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 our Form 10-K and 10-Q report filed with the SEC.

In addition, Fossil undertakes no obligation to publicly update or revise any forward-looking statement whether as a result of new information, future events or otherwise. If any non-GAAP financial measure is used on this call a presentation of the most directly comparable GAAP financial measure and a reconciliation of the non-GAAP financial measure to GAAP will be provided as a supplemental financial information to this release under the earnings release section of the Investor Relations heading on our website.

Please note that this call is being webcast live on Fossil's website. It will be available for replay on the website under the Investor Relations heading after the conclusion of this call. And now I'd like to turn the call over to Fossil President and CEO, Kosta Kartsotis.

Good morning and thanks for joining us to discuss our second-quarter fiscal 2006 results. Joining us today is our CFO, Mike Kovar. I'd like to start off this morning by providing an overview of our second-quarter results and then review with you our performance in each of our businesses and initiatives. Mike will then review our financials and update our guidance. At the conclusion of prepared remarks we will open the call for any questions you may have for us this morning.

Our second quarter marked solid progress toward achieving our annual goals and included strong sales growth internationally, encouraging results from the continuing launch of adidas watches, continued momentum in accessories, accelerating trends in our company-owned Fossil retail stores, and a reduction of inventory growth on a comparative basis. Second-quarter net sales increased in excess of 14%, $259 million, with diluted earnings per share of $0.16. This compares to last year's earnings of $0.13 per diluted share.

Some highlights of our second quarter include progress in bringing our inventory levels down. The 21% year-over-year increase in the second quarter was a significant improvement from the 29% year-over-year increase we reported in the first quarter. Our expectations for the remainder of fiscal 2006 are for further reductions with the goal of reporting year-end inventory balances equal to those reported at the end of fiscal 2005.

Two, we improved profitability in our retail segment stemming from a 29% increase in sales, inclusive of a strong 8.3% increase in same-store sales. In comparison to last year's quarter, operating income from our retail stores improved by $1.5 million. We're also excited about the results of our newest accessory stores which I'll touch on later in the call.

Three, we continue to roll out our new adidas watch business with positive results. Year-to-date sales were approximately $11 million. adidas offers us significant global expansion potential and we continue to believe that we will meet our original objectives for this brand in 2006.

And finally, we continue to grow our global watch business, reporting a 10% increase in watch sales even while posting a decline of 6% in global sales of Fossil watches. This demonstrates the strength of our portfolio of watch brands and our ability to drive growth across our expansive global network.

And now I'll share with you our second-quarter performance by business area and update you on our current initiatives. International sales growth in our Fossil watch brands of 4.4% was offset by a 19% sales decline domestically including off-price sales. Fossil brand watch sales were negatively impacted during the quarter by disruption in the marketplace. The good news is that trends in the domestic watch category appear to be improving. Fossil brand sales at retail on a comp basis in department stores declined by only 4% domestically, suggesting that consumers are responding favorably to our current assortment.

We believe the impact of the Federated retail consolidation is behind us and we expect an improved performance from our Fossil domestic watch business in the second half of the year. With retail inventory levels below last year, improving comps and brand building efforts through the catalog, Web and our point-of-sale advertising, we are confident in our ability to get our Fossil watch business back on a positive track.

The weakness of our Fossil watch business in the United States during the quarter was partially offset by sales growth from our licensed watch brands with robust increases from Diesel and Michael Kors. The recent Federated consolidation will likely positively impact our licensed watch sales. In comparison to May Company doors that provided us limited distribution for our license brands, Federated has historically been a solid supporter of our licensed businesses within their retail divisions.

We also experienced a solid performance in our mass-market business during the quarter with sales increasing 24.7%. We are encouraged by these results considering we are up against retailer inventory reductions and the loss of the Wal-Mart direct import program we supported last year. We expect solid growth over the balance of the year for this business and we continue to position ourselves as a key resource to Wal-Mart and others in this channel.

Sales from our luxury watch businesses -- Michele, Burberry and Zodiac -- increased 20% in the domestic market during the quarter. Burberry and Zodiac reported robust double-digit gains during the quarter as we continue to grow our presence for these brands in the luxury department store channel. Michele results were solid and we are continuing to explore opportunities to grow Michele internationally by leveraging our global distribution network.

Turning to our domestic accessories business -- we continue to see solid growth across most brands and categories during the quarter and as a result reported a 19% increase in sales. Both Fossil and Relic handbags, belts and small leather goods as well as the Relic eyewear business contributed to our continued growth in the segment.

As we've mentioned in the past, watch sales account for only a small portion of the department stores' accessory business. Therefore we believe we still have a large segment of the non-watch businesses which we can capture based on the strength of our offerings. We're also increasing our emphasis on building our accessory business in select international markets beginning in the second half of the year.

Internationally we continued to see strong sales growth during the quarter. Both in Europe and internationally total sales increased 19.3%. In Europe sales gains stemmed from our Fossil and licensed brands as well as the contribution from the adidas launch. New retailers were also a significant growth driver with strong performances by our Fossil and Armani brands during the quarter. Other international sales, which includes the Asia-Pac region, Canada, Mexico and our U.S. export business, rose by 20.6%. We experienced solid double-digit growth from our Asia-Pac subsidiaries driven by Diesel, Burberry and Armani watches.

Mexico, which was added as a subsidiary at the beginning of February, also contributed to the sales increase. Solid growth in our Asian markets during the second quarter was also positively influenced by continued rollout of our shop-in-shops. The shop-in-shop approach increases our point-of-sale presence, and by having our own employees in the retail environment we are able to interact with the consumer and react to their needs with appropriate product offerings. The strategy also allows us to distribute multiple brands in categories within the same environment.

As we previously mentioned, we believe China and India could be large growth opportunities for our business model and we are excited about the prospects that our current brands will have within these markets. We have recently begun distribution in China and expect over time that this region will become a strong growth vehicle for us. Furthermore, we believe adidas, which already enjoys particularly strong brand recognition in China, should assist us in opening doors for other brands.

Turning to our jewelry initiative, we experienced net sales growth of 52% in the category during the quarter. We continue to be pleased by the progress we see in our jewelry business after only five years. Our Fossil jewelry line continues to grow in Germany, its most penetrated market, and we are experiencing solid results in other European markets where we had launched the brand over the last couple of years. In addition, the recent launch of Diesel jewelry added $1.8 million in sales during the quarter. After continued testing and tweaking of the European Fossil jewelry line to fit in the U.S. market we believe we are in a position to launch Fossil jewelry in the United States wholesale market next year.

Turning to retail -- as I mentioned earlier, we experienced solid contributions from our worldwide retail operations during the second quarter. Sales rose 28.8%, comprised of a 26.9% increase in the average number of doors and an 8.3% increase in comp store sales. We've also begun to roll out our new Fossil accessory store concept. A redesign of the store has a modern vintage look and focuses on a more aspirational lifestyle customer. From a merchandising perspective we believe the new concept provides more of a total accessories environment to the customer with less of a focus on watches specifically.

The results of the new stores that have opened are surpassing our original expectations. As we've mentioned before, our retail strategy is to position Fossil stores as the destination within the mall for customers to shop for accessories. We are excited about the opportunity this strategy presents as it relates to our future retail growth.

We ended the quarter with 182 stores, including 110 full price stores, 37 of which are outside the United States, and 72 outlet locations. This compares to 146 stores at the end of the prior year quarter that included 82 full price stores including 25 outside the U.S. and 64 outlet locations. We anticipate that by year end we will have a total of 197 stores including 123 full price stores, 44 of those outside the United States, and 74 outlet stores.

And finally, we continue to move forward with our catalog initiative. We are planning to mail approximately 4 million catalogs this year, the majority of which will be mailed during the holiday season. Our spring and summer editions have been well-received and we feel strongly that this initiative will assist us in improving our Fossil watch business and reinforcing our brand image. We are already seeing positive signs of this in our retail stores and through our website. We believe the catalog is an ideal way to convey our Fossil image and provides the Company with a better ROI than some of the traditional marketing programs we've focused on in the past.

As we look ahead our priorities are focused on improving the trends in our domestic Fossil watch business while continuing to reduce inventory and our expense growth. We believe our ongoing brand building effort for Fossil combined with the continued momentum in accessories and our luxury and licensed watches will allow us to achieve our operational and financial goals for fiscal 2006. And with solid contributions from some of our newer initiatives combined with continuing growth from our jewelry category and our retail stores, we believe that we are positioning the Company for solid earnings growth for years to come. Now I'll turn the call over to Mike to review our financial results.

Thanks, Kosta. First, I'd like to once again summarize the results of our second quarter in comparison to the prior year quarter. Net sales increased 14.6% to $259.2 million compared to $226.2 million. Gross profit grew 8.3% to $127 million or 49% of net sales compared to $117.3 million or 51.8% of net sales. Operating income totaled $16.2 million or 6.2% of net sales compared to $16.3 million or 7.2% of net sales. Net income totaled $11.2 million compared to $9.7 million. And diluted earnings per share totaled $0.16 on 68.3 million weighted average shares outstanding compared to $0.13 on 73.9 million weighted average shares outstanding last year.

Second-quarter sales mix breakdown was as follows -- 20% from domestic wholesale watch sales; 18.4% from domestic wholesale accessory sales; 16.7% from Fossil owned retail store locations; and 44.9% from sales generated in over 90 countries outside of the United States. The 14.6% sales growth for the quarter consisted of the following increases and decreases by category and geographic region. Domestic watch sales decreased approximately 5.8% to $51.8 million compared to $55 million in the prior year.

Other domestic sales, which include our accessory and sunglass businesses, grew 19% to $47.7 million compared to $40.1 million last year. Sales generated from European based wholesale operations increased 18.7% to $77.3 million compared to $65.1 million in the prior year quarter. Other international sales, again which consist of our export sales to distributors and sales from our Canada and Mexico and Asia-Pacific wholesale operations, increased 20.7% to $39 million compared to $32.3 million in the prior year quarter. And as Kosta mentioned, the acquisition of our Mexican distributor earlier in the year assisted with that growth.

Finally, sales from our own retail stores grew 28.8% to $43.4 million compared to $33.7 million in the prior year quarter, again as a result of a 26.9% growth in the average number of doors opened during the second quarter and comparable store sale increases of 8.3%.

Gross profit margin decreased by 280 basis points to 49% in the second quarter compared to 51.8% in the prior year quarter. This decrease is mainly attributable to a higher mix of lower margin off-price sales as we continue to rebalance our various watch brand assortments in an effort to reduce our discontinued product inventory.

To a lesser extent, our gross margin further declined as a result of, one, higher inbound and outbound freight expenses due primarily to increased fuel costs in comparison to the prior year quarter; second, increases in our provision for inventory reserves; and lastly, slightly lower gross profit margins related to our jewelry business as a result of component cost increases. Foreign currency rate and sales mix changes had no significant impact on our second-quarter gross profit margins in comparison to the prior year quarter.

Operating expenses as a percentage of net sales decreased to 42.8% in the second quarter compared to 44.6% in the prior year quarter. As mentioned during our first-quarter call, we experienced a shift in expenses related to the Basel Watch Fair which occurred during the first quarter of this year in comparison to the second quarter of last year. If included in our second quarter this year, operating expenses as a percentage of net sales would have been 44.4% or slightly below the prior year percentage.

Excluding the impact of the Basel Watch Fair expenses, our operating expenses increased by approximately $14 million mainly due to increased payroll, rent and depreciation and amortization expense. Payroll expense increased by $7.5 million as a result of increased headcount and the $1.8 million in additional compensation expense we recorded attributable to FAS 123R. Rent expense increases are primarily due to the increase in the number of company-owned retail locations opened since the end of the prior year quarter.

Depreciation and amortization expense increased primarily due to capital additions made subsequent to the prior year quarter including new administrative offices in the U.S. and the UK, expansion and automation of our central distribution center in Germany and new store openings. Foreign currency rate changes between the second quarter and the prior year quarter had no material impact on operating expenses.

During the second quarter the increase in net sales and leveraging of operating expenses was more than offset by the decline in our gross profit margin and, as a result, operating profit margin decreased to 6.2% of sales compared to 7.2% of net sales in the prior year quarter and, again, without any significant impact to foreign currency rate changes.

Interest expense increased by $930,000 to $951,000 during the second quarter compared to the prior year quarter primarily as a result of higher outstanding borrowings under our revolving lines of credit. The increase in our revolving lines were principally related to funds used for common stock repurchases since the beginning of the fourth quarter last year and capital expenditures made since the end of the prior year quarter.

During the second quarter other income and expense increased favorably by approximately $2.8 million when compared to the prior year quarter. This favorable increase was mainly attributable to a $1.1 million currency gain in the second quarter versus approximately $1.7 million of currency losses in the prior year quarter. These gains and losses are primarily associated with the revaluation of open foreign currency account balances at the end of each quarter. As the U.S. dollar weakened throughout the second quarter this year in comparison to a strengthening dollar during the prior year quarter, we realized currency gains related to revaluing these foreign currency payable and receivable balances that will ultimately be settled in U.S. dollars.

Our effective income tax rate for the second quarter decreased to 28% compared to 30.5% in the prior year quarter. For both the current and prior year quarter our effective tax rate was well below our historical effective rate of approximately 37%. For the second quarter of this year the effective tax rate was favorably impacted as a result of reductions in certain income tax contingency reserves. In the prior year our effective tax rate was impacted favorably by repatriation of foreign earnings at an effective tax rate substantially below the statutory rate at which certain deferred tax liabilities were originally established.

Diluted earnings per share for the second quarter of $0.16 included a $0.01 per diluted share charge for compensation expense related to FAS 123R and a $0.02 benefit from a lower effective tax rate. This compares to last year's earnings of $0.13 per diluted share or $0.12 excluding the tax benefit related to repatriation of foreign earnings.

Now turning our attention to the balance sheet. We ended the quarter with cash and cash holdings and securities available for sale of $78.3 million compared to $132.8 million at the end of the prior year quarter. At quarter end we had approximately $52.1 million in short-term borrowings outstanding compared to $3.7 million at the end of the prior year quarter. As mentioned earlier, common stock repurchases and capital expenditures made over the last year resulted in lower cash levels and increased short-term borrowings.

Working capital at quarter end was $314 million compared to $355 million in the prior year. Accounts receivable at the end of the second quarter increased by 8.9%, well below the 14% sales increase to $128.5 million compared to $117.9 million at the end of the prior year quarter. Days sales outstanding decreased to 45 days for the second quarter compared to 47 days in the prior year period. The reduction in days sales outstanding reflects improved turns on our wholesale receivables as well as the impact of an increase in our company-owned retail store net sales as a percentage of our total sales.

Inventory at quarter end was $264.6 million, an increase of 21.2% compared to the prior year quarter inventory of $218.4 million. On a sequential quarter basis, we continue to make progress reducing our inventories on a period-over-period comparable basis. As Kosta mentioned earlier, our expectations for the remainder of fiscal 2006 are to continue to make progress in this area with a goal of reporting year-end inventory balances near those reported at the end of fiscal 2005.

To date capital expenditures totaled approximately $25 million. We're expecting 2006 capital expenditures for the full year of approximately 45 to $50 million. This includes installation of an SAP merchandising system for our retail organization, further automation of our distribution center in Germany, as well as normal maintenance, capital expenditures and retail store growth.

Amortization and depreciation expense for the first six months of 2006 was approximately $16 million and we are estimating full-year 2006 depreciation and amortization expense slightly over $30 million.

As it relates to 2006 guidance -- we currently estimate third-quarter 2006 diluted earnings per share will approximate $0.30 inclusive of a $0.01 diluted per share charge associated with FAS 123R. This compares to 2005 third-quarter fully diluted earnings per share of $0.28 or $0.30 including tax benefits.

We currently estimate diluted earnings per share for fiscal year 2006 to be $1.11 inclusive of approximately $0.05 per diluted share negative impact from the implementation of FAS 123R as well as $0.06 per share diluted benefit from a lower share count as a result of common stock repurchases completed by us since the beginning of the fourth quarter last year. This compares to our previous guidance of $1.07 per diluted share for the full year in comparison to fiscal 2005 earnings of $0.90 per diluted share or $1.07 per share including tax benefits.

This guidance is based upon the current spot rate of the U.S. dollar compared to other foreign currencies, primarily the euro and the pound, as well as a normalized 37% tax rate. We are estimating sales growth in the low double-digit range for the second half of fiscal 2006.

Now I would like to turn the call over to the operator to begin the question-and-answer portion of the call.

(OPERATOR INSTRUCTIONS). Elizabeth Montgomery, Cowen and Company.

Good job on the quarter. I guess I had one question -- I guess for Mike. Did I hear you correctly that you said that Fossil domestic watches in the department stores were only down 4% but the sell-in was down 19%?

I think what Kosta said is retail sales in the department stores were down about 4% for the quarter; our wholesale shipments were down 19%.

So is that the department stores continuing to destock inventory that they currently own?

It's actually a situation where the inventories were turning faster. This has been an ongoing situation for about three quarters. The stores made a determination -- rightfully so, that they wanted to turn faster and as a practical matter it worked out better because we're flowing newness to them more frequently. It also puts us in a position where as the trends change as we start to show positive trends we can flow inventory in there at a pretty rapid rate because they're not overburdened with inventory. It's actually a very good situation.

So when do you think that we'll begin to see the good situation reflect itself more in terms of the Fossil domestic watch business?

A couple things on the Fossil domestic shipping -- part of it was the disruption; there are some specialty store changes going on; and there's still somewhat of this headwind. But on an ongoing basis if our comp sales are below negative single digit and our shipments are -19, obviously in the long-term situation that will correct itself. So that's why we're -- as we said on the prepared remarks, we're positive about the trend and we think it's going to correct.

Okay. And then in terms of the Q3 guidance, is there any type of a shift going on in terms of new product introductions or advertising spend that would be causing Q3 to be a little bit lower than we thought? Because it sounds like most of the expenses related to the catalogs might fall into Q4?

There are some shifts going on. In addition to that there's the impact of anniversarying certain costs throughout the third quarter itself. Additionally, if you look at the increase in the overall percentage of the business related to our retail stores, that's putting some pressure on our operating margins in the third quarter. We generally don't make money through our retail stores in Q3. Obviously we flow a lot of sales through and really leverage our operating expenses. In addition, we will have continued ongoing launch costs associated with adidas as well as the Marc by Marc line we'll be rolling out in the back half of the year as well.

Okay. Can you remind me what you're anniversarying in Q3 -- what incremental costs you're referring to?

What I'm specifically talking about there, if you remember last year, Beth, we talked about really slowing the growth of our operating expenses in the second half of 2005 as we went on this cost reduction initiative. And really a lot of those efforts didn't take place until the end of the third quarter as it related to headcount increases, etc. We should see a shift of operating leverage in a positive manner by the fourth quarter but we're still not seeing any benefits in Q3.

Okay. And then one final question -- maybe Kosta. How large is the jewelry business right now? Can you just quantify that in any way?

Mike, how did we describe the size of that?

Of the what, I'm sorry?

The jewelry business -- you're talking about annually, right?

Yes.

We'll do close to $80 million with all brands under the jewelry category this year. Fossil still being the obvious lion's share of that.

Okay, thanks a lot.

John Rouleau, Wachovia Securities.

First of all, I guess I'm wondering if you can kind of give us some idea of what assumptions you've made for Fossil watches embedded in your guidance for third and fourth quarter. I know you expected it to improve, but is this primarily in the fourth quarter and are we talking maybe down low single digits or what -- can you help us out with that at all?

We're looking basically at the balance of the year being flat to last year with Q3 being slightly down –- I'm talking low double-digits down -- and the Q4 period being slight increases, again, low double-digits. And again, we're coming off of successive years in which Q3 and Q4 were down significant double-digits.

Right. So you've got easier comparisons plus you've got this whole retail versus wholesale thing working itself out?

Correct.

Okay. And then, second of all, I'm wondering if you can help us out on the off-price side -- it sounds like from an inventory basis you were successful at getting that down. You sold quite a bit to the off-price channel. Any way you can quantify that for us or help us understand what sort of an impact it had on margins so that we can factor that in going forward?

The off-price was just over $8 million for the quarter with slightly negative margins.

So when you look at your gross margins down about 280 basis points, is it fair to say that the sales to the off-price channel had the biggest impact out of everything that you listed?

Yes, I think if you just took the impact of the off-price sales out of that 49%, it's over a 100 basis point differential.

Okay, okay. The comps in the retail stores, very good in the second quarter. Can you help us understand, was that again driven primarily by handbags and accessories or maybe you can help us understand what drove that and maybe what the watch comps were in the stores?

Well, we're seeing, as we said before, a similar situation in our stores that we're seeing in the general retail population -- in other words, slightly down in watches and having increases in all the accessory categories and that continues to be the case. We have seen in our stores a continuing improvement as well and a good response to new products and some of the other things that are going on have contributed to the positive comps.

Okay. And then, Kosta, could you just remind us again -- I think you're scheduled to roll out jewelry into your own stores in the third quarter, is that correct, or what's the timing of that?

That's right. We're going to a large number of our stores, both in the United States and outside, in the third quarter. And then we'll be launching to department stores sometime next year.

Okay, great. Thanks, guys.

David Turner, BB&T.

Good morning. Just following up on John's question about the disparity between the wholesale -- domestic wholesale channel and the retail. Is there significant difference in what is in the company-owned stores versus the wholesale channel from a product standpoint? Or is there any way to look at the retail stores as a leading indicator? I know you've been trying to push the envelope with new products there. Is that having an impact or I guess just trying to get my hands around the disparity between the different selling patterns?

I think there's a lot of moving parts right now due to the disruption in the marketplace with all the shifts in Federated, etc., and just the continuing somewhat of a headwind in watches, although we do see that relaxing somewhat. But our stores are in the midst of this sort of slightly rebranding effort where the products and the way they're presented are more aspirational, they're looking more contemporary. It's kind of this modern vintage look. And the brand has clearly got a lot of strength in it because we're gaining a lot of market share in categories that are better, which is the leather goods in some categories.

The brand continues to be strong. We think we're in a process where through our activities with the Web and the catalog and the stores and the way they look, we think we're growing brand awareness and it's becoming very positive. So we're very pleased with that and we think long-term that plays out pretty well for us. So we're pretty excited on that regard.

Okay. And I don't know that you want to share these numbers, but maybe qualitatively can you talk about how the same-store sales broke down versus was it an AUR increase or was it number of transactions -- or I guess again, just trying to vet the retail business?

We're seeing growth across all channels. And just generally speaking, part of what's happening with Fossil, specifically in watches, is that what we're trying to do and what we've been somewhat [discussing] is putting more expensive products in the marketplace that are slightly more luxury derivative, higher average unit retail and they have a lot more details in them and treatments and more functions, etc. and that seems to be working.

So our average in retail and watches is going up, which is what we expected. So we're targeting this slightly older customer, 20-35, and we're pretty sure that the younger customer is going to come along because they want to go after aspirational brands as well. So we think we're benefiting from some of that in our own stores because we are able to do it more effectively.

Okay, thank you.

Barbara Wyckoff, Buckingham Research.

Good morning. A couple of questions. I guess adidas -- where was it distributed exactly outside of Europe in second quarter? Was it in Asia, Mexico, South America? Can you talk about the expansion, 3Q and 4Q, when and where? And then I want to talk a little bit about the launch and scope of distribution for Marc by Marc Jacobs?

adidas was pretty much distributed everywhere in the world with focus on Europe. There were several distribution points in Asia and very small amounts in the United States -- mostly in the U.S. it was to the adidas stores here. So we're in the process of rolling out to department stores and other channels in the United States from the end of the third quarter, early fourth quarter so you will see more distribution here.

In terms of Marc by Marc, it has actually shipped recently to Nordstrom. That will be somewhat of a flagship account for that and we're getting good response already, so we're pretty pleased with that. But it is also going to a number of other doors in the United States and some others outside of the United States, but the flagship account will be Nordstrom.

Okay. And then the Marc Jacobs stores of course, too, will have it, right?

Absolutely.

Okay. And then on the inventory -- total levels went down nicely. How much aged merchandise do you still have as a percent to your total inventory and what's the game plan for cleaning and clearing it out?

Our plan is, as it relates to most of our fashion product, to continue to utilize our outlet channel to reduce our exposure there and we feel like that along with potentially some opportunities to sell larger quantities in other off-price channels will assist us to clear our inventory down to a more normalized level by the end of the year. We also have a little pressure from some of our luxury brands in some of the discontinued products that don't push as nicely through our outlet stores obviously because of the pricing and we'll have to find alternative channels to reduce those.

But I don't have a percentage on me of total discontinued to total inventory. But I would say by the end of the year our discontinued channels -- or discontinued product styles across the board will be at more normal levels that will be consistent with our plans for receipts in our outlets going forward.

So it's possible that some of the licensed lines would be sold off to a third party, is that what I'm hearing?

We always look for the opportunity if we can, Barbara, to get rid of huge chunks of inventory without severely impacting our margins which basically means if we can sell it at cost or slightly below we'll take advantage of that. So it will be more opportunistic as far as some of those activities occurring in the back half of the year.

Okay. And then I guess lastly, a question about the accessory expansion internationally. Can you talk about what you're having to add to the infrastructure to support this expansion? In the past you always talked about not wanting to take accessories international because it would have to add a whole layer of sales and new accounts, etc. So how are you moving through these issues?

Well, we've been doing some testing as we've told you through this year on accessories and we're getting pretty good response, so we're really looking to make a more concerted effort which would include putting sales reps in some countries, etc. So we're looking at it and we think it's going to be something that the growth will outpace the infrastructure growth. So we're pretty interested in that, especially based on the response we're getting.

And we also -- we've opened and have in the past opened a number of stores outside the United States and we're seeing our leather goods sell pretty well in that environment and increasingly so. So we're expecting that we're going to have a situation where the stores will be our leading-edge to present leather goods and it will give us the benefit of being able to sell to other stores in the marketplace, similar to what we've done in watches. So we're very interested and we think it's a good long-term thing for the Company.

Okay. And then just lastly one more question. Your current thinking on the Fossil brand stores versus multi-brand model that you've been testing -- these Modern Watch stores. You have a couple in Europe that are multi-brand. Where are you on that? Are you just concentrating on Fossil now or what?

We're pretty much concentrating on Fossil, that's where most of the growth has been. And as you know, we've opened a number of stores outside the United States. We opened another store in London in Oxford Street that's doing very, very well. We opened a store in Berlin and Hamburg that are doing very well. We opened three stores in Asia so far this year -- two in Hong Kong, one in Taiwan. We're opening in Vienna later this quarter and also in Manchester and we're getting a great response to some of the new products and the new looks in those stores and we're very excited about it.

We also just recently opened a store in Disneyland in L.A. that jumped out of the box very strongly, it could be equal to or better than our biggest volume stores which are both in Orlando at Universal Studios there and also in Fifth Avenue in New York. So the store jumped out really, really strong. So we're seeing a good positive response to our accessory stores and it's a great vehicle for us to communicate the products we make and this branding effort and to continue to position Fossil globally long-term as a big brand. We think it's a great opportunity for us and it's also a growth and profit driver for us.

Having said that we still think the multi-brand idea, the Modern Watch Co. long-term globally is a huge opportunity for the Company as well because most of the products in those stores are stuff we make ourselves and the gross profit is very high. We have five of those stores open now and, as you know, we have a number of concessions around the world in Asia and also in the UK where we actually own multi-brand concessions inside department stores that are very successful as well.

So we're operating a pretty good number of these kinds of situations and we think long-term to expand that is a huge opportunity for the Company and a very profitable one. So we're kind of still in the incubator stage of Modern Watch in the United States. We'd like to do some testing outside, but that's probably on the second priority to us right now.

Okay, great. Thanks. Good luck.

Brad Stephens, Morgan Keegan.

Good morning, guys. On the liquidation sales, you said it was $8 million for the second quarter. Were there any liquidation sales in the first quarter?

Yes, about half the amount of what we put on the second quarter.

Okay. And do you have any assumptions for that for the balance of the year -- in your current guidance?

No, consistent with what we've done in the past, Brad, with guidance, we have not included that discontinued activity simply because it is somewhat unpredictable. So any additional discontinued activity throughout the balance of the year should add to the sales expectations but obviously bring the overall gross margins down.

Okay, great. When you talk about the Fossil business for the balance of the year in the guidance you gave earlier, is all that booked at this point or is a good portion of that still at once orders, pending sales performance, etc.?

It's a combination. We do have sales plans out there from all our customers and we generally know what our shipment is going to look like as long as the trends stay where they are. If sales trends increase then the shipments increase and vice versa is true. So based on everything happening as we planned then it will flow like that. But you know, we do have a number of things in the marketplace that we've shown customers already, they're very excited about them and we do think there are prospects for growth, especially when you consider the inventory levels at retail are low. So we're pretty optimistic about the future.

Okay. On gross margins going forward here. When I look at the fourth quarter, just roughly running through this, it looks like your guidance implies you're going to get back almost everything you gave up last year in gross margins. Can you give us just some color given rising transportation, higher gold and silver raw material prices and the increased penetration of accessories -- how we think about gross margins over the long haul?

I think over the long haul we'll -- right now we're in a situation where our domestic watch business, which produces margins that are historically in excess of our domestic accessories business, is becoming less and less a part of the overall pie, which is putting a little bit of pressure obviously on our margins. Some of that is being made up in an increase in the sales mix of our retail stores and also our international business.

So we believe that as we look into 2007 and beyond that we'll get back to reporting more normalized margins -- one, just because we think we'll be in a better position to not have to continue to affect significant amounts of discontinued product sales. But at the same time we still see more of an opportunity for growth at much higher rates in our retail stores and for our international businesses that historically have had some of the higher level margins from the Company.

That's all said with the disclaimer that we don't know what currency rates are going to do well into the future, but obviously as the U.S. dollar weakens against major foreign currencies around the world that's also a huge benefit to our margins as well.

All right. And then the last question for Kosta. Kind of a long-term vision question -- where do you see the penetration of retail at looking out three to five years from now? Accessories, the same question? And then part of your longer-term plan I know is to acquire other licenses, etc. Where are you at on that front and would you look more at accessories, non-watch type acquisition going forward?

Obviously we've been doing this for some time in terms of the store sales growth and it's becoming a bigger percentage of the Company. We think that's going to continue, especially now that we are on a pretty good track internationally where we can open a large number of stores outside the United States. And as we said before, the exciting thing to us is that those stores outside the United States not only communicate our brand image and kind of seed the market for the Fossil brand, but they also are very profitable. In fact, the stores outside the United States are more profitable than the ones inside because generally prices are higher outside the United States, so that's a good thing for us.

So we think that the stores -- percentage of the total Company will grow probably for the next whatever number of years. Accessories is also on a very fast track and it's got a big opportunity. We have a situation where we've been growing a lot in handbags and we're a pretty big player in there, but the handbag business is many times the size of the watch business in the United States and around the world. So it gives us an opportunity as we continue to grow market share, we think we can get even much larger in those categories. So that's going to be an ongoing situation probably as well where -- especially under the Fossil brand that the accessories becomes a bigger percentage of the Company.

As far as licenses goes, we're always in discussions with other companies and looking at strategies, etc., and where companies are going. And our basic template is we're looking for big international global brands that can fit into our model that we can grow around the world and become part of our portfolio. And we are right now undertaking a couple of launches of adidas. It's a big global rollout for us and it's going to be a very large business long-term so we're very excited about that.

And of course Armani we think has got the opportunity to double or even more from where it is. It's a big long-term growth track, especially if you consider the emerging market -- Eastern Europe, India, China, Russia, etc. -- we think this business is just going to get larger and larger and larger. The same thing is true for Burberry, and Fossil has got a huge long-term opportunity. So we're kind of focused on making sure we optimize the ones we have while we're adding some new ones and then there will be additional licenses in the future as well. So we're kind of blocking and tackling on the ones we have and looking for the future as well.

And your other question is, yes, I think it is possible that we could license or acquire a leather goods brand that would enable us to grow our accessories business either on the licensed side or the acquisition side so we're looking at both of those opportunities. Because we are kind of in leather goods right now; we have a situation where we have very competitive advantages, very strong design, sourcing, distribution and we have a lot of wherewithal to execute it profitably. So we're very interested in the long-term future and growth of that as well.

Last question -- sorry, and I'll get back into the queue then. How long does it take you once you sign a license to be up and running?

Generally I'd say it takes a year or slightly more than that once we sign to get going.

All right, great. Thanks, guys.

That's generally what I think we've done in the past.

Thanks.

(OPERATOR INSTRUCTIONS). Steven Martin, Slater Capital.

Kosta, as your average selling prices go up, since a lot of your overhead, handling costs, etc., are a function of units and not necessarily dollars, should you be able to manage down some of those expenses?

Good question, Steve. I think if you look at one -- one of the things that's putting a little bit of pressure on our distribution cost is the fact that we are mixing more heavier in the U.S. toward our accessories business, which doesn't flow through the automated facility as quickly and as efficiently as watches. A lot of those orders are actually done cross dock and take a little more manual labor handling. So we are experiencing some levels of slightly increased unit costs on the distribution side from an overweighted mix of accessories.

That's predominantly the handbags like a couple of years ago?

Handbags, belts, anything that obviously is a little bit larger in a package going out to the customer.

So to the extent you're getting some leverage because of watch prices you're offsetting that against the accessories?

Correct.

Okay. Kosta, you made a comment about the adidas brand and you were more optimistic about exceeding your targets. I think your original guidance to us was $30 million for this year and given what you've achieved and what you know about sell-in can you update us on that target?

We're still focused on that $30 million number. This is actually our largest launch of a brand ever, from 0 to 30 the first year. And there's a lot of -- as you can imagine, a lot of issues with that getting it executed, getting the distribution, getting it out there and there's obviously going to be some stuff that doesn't work. So it's a big program for us.

What I was talking about really on adidas as a long-term business, we think it's going to be very substantial in size and we're off to a great start, we're focused on that original $30 million plan this year and then growing it from there.

All right. And your inventory at your own retail stores, how does that look on a year-over-year basis?

Very healthy.

Up, down, sideways?

Slightly up but less than the sales increases -- much less than the sales increases.

Okay. And one last one -- housekeeping, Mike. Shares outstanding actual counts at the quarter end versus quarter end last year?

Actual count?

Yes.

Actual count of around 67 million I believe versus around 72 million and I'm estimating that without numbers in front of me.

All right, thanks very much.

John Rouleau.

So I just want to be clear, Mike, in terms of the off-price. It sounds like there's no expectations built into your sales for off-price. However, on the inventory side with your projection of being relatively flattish or close to that in the fourth quarter, does that factor in any additional off-price sales in the second half or are you truly just going to be opportunistic with that?

Well, we're looking to be opportunistic with that. We do anticipate that during the back half of the year the amount of discontinued product that we could flow through our outlet stores will grow obviously with the seasonality of those stores -- be able to take a lot more of that product through our own channel and lessen the need to go outside of our own outlet channel just to get rid of discontinued inventory.

Okay. So really don't assume much in our margin. Because I know for sales we're pretty clear but on the margin side obviously it has an impact. So it sounds like don't assume a comparable or a margin impact in the back half of the year unless you tell us otherwise here.

Yes, and again, I would say we're going to be very opportunistic on that front. If we can get rid of a couple hundred thousand pieces of a brand and not have to carry that inventory for excess number of months until we flow it through our outlet stores, then that's something we'll look at.

Okay. Kosta, with the new store prototypes seemingly performing so well here, just wondering -- I'm assuming most of the stores going forward will be the new Fossil stores, will be the new prototype and maybe any sort of remodeling program that you might anticipate rolling out next year given the better performance of those stores?

Yes, we actually have a program in for remodeling. We're doing a couple of stores actually in the next couple weeks. One is our Galleria store here in Dallas and another one in the Galleria in Houston which have been stores we've had for eight years or so that have always performed very well, very profitable. So we're in the process of doing that. We had remodeled a number of our other stores as well. So we're going to put that in for next year.

And we're also going to be looking at potentially an accelerated growth track for those stores. One thing I should mention is we recently hired a President of Retail to help us take and expand our global retail footprint that has a lot of experience, she'll be starting in the next couple of weeks or so. So we're very excited about the future of our retail business.

So the accelerated roll-out or square footage, would that be coming from both an increase in the domestic and the international side or would that be international primarily fueling that?

It will be both and we're going to be looking at it over the next several months. Obviously we've got a big time crunch the next four to five months. But we'll be looking at the performance of those and just analyzing our plans for next year. But potentially it could be an accelerated number of stores for next year.

Okay, good. And then quickly -- you touched on it but didn't really go into much detail. The Wal-Mart direct import business, it sounds like that's gone away or maybe it's decreased. What happened there? And then obviously you're still putting up some good numbers in mass market, so it sounds like the growth is coming from another area?

Wal-Mart basically decided to take that direct import program on themselves.

And had that been the initial -- when you took on this group was that the initial program that you took on and then it obviously ballooned in to target some other areas. Is that a fair analysis of what happened?

No, I think when we originally started the business with Wal-Mart we had both their direct import program and their normal replenishment business. Now we're down to the replenishment business with obviously some opportunity to support them on any type of promotional product they're running through their stores.

And are you doing the direct import business for some of the other mass merchants? Is that fair to say?

Not at this time.

Okay. And then I guess, Kosta, the very last question here is you mentioned that the U.S. watch industry is getting a little bit better here on the margin. You've also talked in the past about a lot of new competition and a lot of quote-unquote brands that maybe shouldn't be or haven't historically been in the watch business kind of getting into the watch business. Is that starting to lessen a little bit? Is that part of what's happening with the industry getting a little bit better or are people maybe just returning to watches a little bit more than what we've seen? Give us a flavor of what's going on in the U.S. market.

I think there's always been a lot of new brands entering the market, especially in the last five to six years or so. And some of those have not lasted very long as you can tell. There's been a number of them that came in for a short while and then left pretty quickly and I think that process still continues. Everybody that's in any kind of merchandising business wants to be in the watch business and they're always pursuing it and they sometimes put it in there and it's in there a short amount of time, they don't get much space and they leave.

But I think that probably has not abated, there's probably still a lot of people trying to do that. But generally in the United States the watch business is healthier. The stores in '05 had seen across the board decreases in sales which had never happened before and that is actually less of an issue this year and I think everybody is pretty positive that they can start growing again. We've seen pretty good response to our offerings at market last week and the sell-throughs are good, the inventory turns are good and that's always a good sign and it leads you to think that that headwind may be abating to some extent.

So I think we're in somewhat of a healthier situation. And I think we're in a position with our infrastructure, design, resource capability and our power in the market -- I think we're in a good position to have growth and that's really what we're focused on, especially when you look at our own stores and their performance and what's happening there and our ability to reposition the brand slightly more aspirational, make it hotter through the catalog and our website which we're continuing to get huge traffic -- our website is.

I think we're in a very good position for growth in the United States for Fossil in watches and of course it's going to happen in accessories. So we think we're in a pretty good position. And then we're looking to expand that outside the United States. We do think that our experience that we're getting with the Web, not only on a sales traffic issue, but just in marketing and communication, there's a lot of research that shows that there's a huge amount of consumers that are shopping online before they go in a store.

And we're very interested in expanding our website around the world which we're going to be doing in the next couple of years to really help communicate and making our marketing spend more efficient and continue to build the Fossil brand globally which someday is going to be very large and it's going to contribute quite a bit to the Company.

Okay, great. Good luck.

Barbara Wyckoff.

Two questions following up. Can you update us where you are in the SAP implementation worldwide? I know you talked about the retail platform, but what about rollout by country, where are you in that process. And then secondly, how much of the inventory is supporting new initiatives such as the adidas, Marc Jacobs, etc., and how much is aged and distressed merchandise at this point?

On your first question, Barbara -- let me take your second question first. On the age of the inventory I would say there's no significant pressure from inventory related to new product launches. Obviously with adidas it's causing somewhat of an increase in our overall inventory but not distorted based upon the sales we're seeing for that brand. On the discontinued side, as I mentioned earlier, we are a little heavier on certain brands than what we'd obviously like to be at this point, but don't have a percentage of the total inventory that those represent.

I would say on Fossil, which has historically been from a unit perspective, our most significant pressure point from flowing that product out we're probably at around 200,000 to 300,000 units that, again, if the opportunity exist we would choose to exercise selling them outside of our own retail channels. And the first question -- I'm sorry, go back to that.

Just where you are in the SAP implementation by country and then (multiple speakers)?

We are currently looking at continuing the rollout of SAP, primarily in Europe as it relates to our Italian and UK operations, those are the next two largest subsidiaries that we have outside the United States. We expect that one of those two will be coming on board by the end of next year and the other will be starting soon after that. As it relates to the merchandising system for our retail stores, we expect that to be completed by sometime around the end of the first quarter, early second quarter next year.

Okay. So the merchandising system was put ahead of the rollout or no?

I'm sorry?

It seems like the Italy/UK is taking a little longer than we had expected. Was the merchandising sort of fast-tracked ahead of that?

I wouldn't say one's competing with the other for resources. But we're just looking at obviously where it makes most sense for us to leverage the opportunity of putting someone on SAP. We've got a lot going on right now in our UK. We talked about our initiative with gaining some concessions there with the House of Fraser and we want to make sure that when we do decide what subsidiary to implement SAP through next that we have the right resources in place to make that happen.

And then just one additional comment on your inventory question. As we talked about earlier -- I think John asked a question -- reaching year-end flat inventories in comparison to last year is not contingent upon us selling inventory through third parties -- discontinued inventory.

Okay, great. Thanks for the clarification.

Brad Stephens.

A follow-up on John Rouleau's question. In the mass market you referenced when you started this up that you had some startup expenses. Were those one-time in nature or will there be support for that infrastructure ongoing given the pullback at Wal-Mart?

We have a minimal infrastructure to support Wal-Mart and the little bit of business we're doing with others in that channel. So it's basically 12 or 13 people that support that business with some resources in Hong Kong for purposes of procurement and design, but there's no significant infrastructure there. As we said earlier, even at the reduced level of sales compared to what our original projections are, or were, we're still delivering operating margins from that segment consistent with the overall operating margin for the Company. So it's not a drag on our operating margins at this time even at a reduced level.

Okay. And Swatch had made the comment that they're seeing a lot of low-cost Chinese imports flood the market in Europe. Can you address that? Is that in fact an issue or do you expect it to be an issue going forward?

I'm not sure exactly what that refers to, but there has been in the last several years, you can tell by our growth in Europe. We've put a lot of product in the market and our watches are made in China using typically Japanese or other movements. That may be what they're referring to as the marketplace has changed whereas instead of consumers buying maybe Swiss made watches or Swiss -- Swatch watches, they've been buying watches from our Company. As you can see, our growth has been pretty significant over there. That may be what they're referring to.

All right, great, thanks.

Thank you, Sir. Management, at this time I'd like to turn the presentation back to you for any closing remarks. Please go ahead.

Thank you. Should you want to replay this conference call it has been recorded and will be available from 10 AM Central Time today until 5 PM Central Time tomorrow by calling 303-590-3000 and entering reservation number 110066213; again that number is 303-590-3000, reservation number 110066213. The conference call has also been recorded by StreetEvents and may be accessed through StreetEvents' website at www.StreetEvents.com or directly through our website at Fossil.com by clicking on Investor Relations on our homepage and then on webcast.

Finally, should you have any questions that did not get answered today, please give Kosta or myself a call. Thanks again for joining us today. Our next scheduled conference call will be in November for the release of our third-quarter operating results.

Thank you, management. And ladies and gentlemen, just a correction. If you would like to listen to the replay the access number is 11066213. Once again that's 11066213. Thank you. At this time we will conclude. You may now disconnect and please have a pleasant day.