Fossil Group, Inc. (FOSL) Q4 2017 Earnings Report, Transcript and Summary

Hello, and welcome to the Fourth Quarter 2017 Fossil Group Incorporated Earnings Teleconference. My name is Michele, and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Ms. Allison Malkin. Ma'am, you may begin.

Thank you. Good afternoon, everyone. Thank you for joining us, and welcome to Fossil Group's fourth quarter and full year 2017 earnings conference call. I would like to remind you that the information made available during this conference call contains forward-looking information and actual results could differ materially from those that will be projected during this call. Fossil Group'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 8-K and 10-Q reports filed with the SEC. In addition, the company assumes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise except as required by law. Please note that you can find a reconciliation and other information regarding non-GAAP financial measures discussed on this call in our earnings release filed on Form 8-K and in the Investors section of our website. Please note that you may listen to a live webcast or replay of this call by visiting www.fossilgroup.com, under the Investors section. Now, I would like to turn the call over to the Company's Chairman and CEO, Kosta Kartsotis.

Thanks, Allison. Good afternoon, everyone, we appreciate you joining us today. I will begin with a view prepared remarks before returning the call over to Jeff Boyer, our CFO. Following Jeff's comments, we'll have Greg McKelvey, our Chief Strategy and Digital Officer, join us for the Q&A. As we entered 2017, we embarked on making significant changes in the company to improve our business model by focusing on four key operational objectives; to advance our connected tech agenda, to leverage scale to drive cost out of our supply chain, to become more digitally enabled, and to continue the transformation of our business through New World Fossil. Although it had has been a challenging year, we have accomplished many of the goals we set out for ourselves. Our connected products nearly doubled in size reaching over $300 million in just two years. Our product cost on connected products were down nearly 20% from last year. Operationally, we have reduced our overhead expenses by $95 million versus last year. And on the digital front, we made significant progress on increasing our digital marketing investments and drove strong e-commerce growth. Lastly, we completed our credit facility refinancing to provide an appropriate near-term capital structure for our business. Within a tough environment and while executing a number of strategic initiatives, we are pleased to deliver our fourth quarter operational results with sales and earnings near the top of our expectations for the quarter. These numbers reflect the focus and outstanding education of our team as we transition our business, bringing innovative new products to the market and drive operational efficiencies that can ultimately enhance our profitability. The most important business in our company is our traditional watch business. Although this business remains difficult due to the dramatic growth of wearables in the overall risk market, we are continuing to innovate with differentiated new ideas and materials and watches that we feel will resonate strongly with consumers this year. This business will be enhanced by the growing interest in smartwatches among our core fashion consumer. As we entered this year in smartwatches, we are excited about the potential for our new product launches and their ability to positively impact the business. Given our success in 2017, we remain confident that wearables can be one of the key catalysts that offsets the declines that we've seen in our traditional watch business. In the second half of the year, we introduced a number of new hybrid and displayed smartwatches across 14 brands. Response from our customers continues to be very strong, and we are encouraged by these early results; particularly for some of our key brands including Fossil, Skagen, Kors and Emporio Armani and Diesel. Our connected business nearly doubled last year but we fell short of the aggressive goals that we set for ourselves in this new business, and we learned a lot that will help us in 2018 and beyond. The overall wearables category is very robust in creating a significant opportunity for the company. Industry research shows that it was a $17 billion business overall last year and will grow to $32 billion by 2020. It is clearly a younger customer and largely a female aspirational fashion customer that loves brands and the innovation that we launched last year with slimmer cases, brighter displays and new functionality. And this year's launches will have again, additional features and looks that we think will be very compelling. With the ongoing enhancements of technology, the product and experience will get better and better. Wearables was 20% of our total watch sales for the quarter and even stronger in the United States, and had a positive impact on the sales trend for a number of our key brands and on our overall watch sales. Our total Fossil watch business was up 2% in the fourth quarter, improving from up 1% in the third quarter. The growth in wearables improved the growth rates for Fossil watches by more than 10 percentage points in the quarter. The same is true for Michael Kors watches where the growth of variables positively impacted growth trends by 8 full points for the quarter. Our launches of Emporio Armani smartwatches led the brand to a double-digit growth in the fourth quarter. Another of our focus area has been to leverage our considerable scale in wearables to drive supply chain efficiencies, reduce cost and improve margins. Our strategy this year was to drive significant volume in wearables to raise awareness quickly and get these great products on as many risk as we can while leveraging the volume we have to drive cost efficiencies. Importantly, we have made significant progress on improving our product cost and learned a lot about how to better operate this business. We now feel we have a platform from which to operate in this rapidly growing market. Our significant advantage in fashion traditional watches, combined with our wearable capabilities, put us in a unique position to compete in the evolving risk wear business. As to our digital efforts, in 2017, we put significant resources and efforts into our digital marketing capabilities and into expanding our e-commerce capabilities, both for our own sites and for our wholesale.com partners. We continue to focus on developing and growing our brands digitally across e-commerce platforms, as well as mobile and social media channels. We also increased our overall investment in digital marketing. We've optimized our marketing mix to achieve the most efficient path to purchase and identify the most receptive customers. As a result, over one-third of our Fossil brand business started with the digital interaction via social, search, digital media, e-mail or other digital marketing effort. Our CRM efforts drove an increase in repeat customers while our celebrity campaigns and upper funnel marketing efforts drove healthy new customer acquisition growth. Our celebrity campaign delivered over 2 billion impressions with over 50 million social engagements and our social followings expanded by 20%. These successful programs propelled our celebrity featured styles to achieve top performer status across all watches. This past year, we also took a number of actions to respond to changing consumer needs. We launched buy online pickup and store in the United States, continued our personalization efforts, expanded our online review capabilities and enabled online chat functionality. As a result of these programs, our own e-commerce platforms across the globe continued to drive significant growth, expanding 31% in the quarter with sales growth of 23% in the U.S., 59% in Europe, and 44% in Asia. This past year, we significantly expanded our growth with many per-play online retailers in United States and all over the world. Our business with this critical group of online retailers grew by 77% this year. When combined with our own e-commerce platform, this online channel represented about 17% of total sales in the fourth quarter, up from 9% in last year's fourth quarter; including e-commerce sales from our traditional wholesale partners, this would push our total e-commerce sales even higher. We made excellent progress on our New World Fossil initiative this past year. This is our ongoing comprehensive program to reinvent our company to drive efficiencies and speed throughout the organization, to streamline the way we work and enhance our margins and ultimately drive significant economics to the bottom line. Our goal continues to be to build a leaner and more nimble operating platform that can support improved profitability in the future, all while better serving our customers and competing in the new retail environment. We set a high target when we launched the program last year to drive $200 million of profit improvements in the near-term, and we're well on our way to delivering that. So far, with our efforts to date, you are seeing many of the benefits of this program in the fourth quarter, and we are ahead of the schedule we set for ourselves. Though many of these efficiencies are reflected in our P&L this year, we expect acceleration of these benefits, particularly in the gross margin area, as we move in to 2018. As to our 2018 outlook, as mentioned, we have made a lot of progress on our key objectives this past year, but we still have a lot of work to do and have a number of challenges ahead. The traditional watch business and our price points is clearly being negatively affected by the significant growth in the overall smartwatch category. There is a difference cadence to the wearables business, it is a significant opportunity but we have to continue to improve on this model. Our hybrid watches are selling very well in our own channel but not as well in the wholesale channel; we have to increase our awareness on this topic. And the disruption in retailers continuing with more sales and customer engagement moving to digital. As we look ahead to 2018 and beyond, there is significant work necessary to successfully transform our business model to meet the evolving challenges in this high margin category, but we are confident we have the strategies and the team to meet those challenges. We have four overarching objectives that drive our strategies and initiatives; to improve our profitability, to innovate our product offerings, to expand our e-commerce and digital marketing, and to transform our business model. First, to talk about profitability. In this upcoming year, we will become a slightly smaller but a more profitable business. Sales will contract in 2018 as we exit unprofitable stores and businesses and product lines. Connected watches are expected to experience strong growth this year, but the absolute dollar decline in traditional watches in our wholesale channel will be greater than that growth. Though overall sales would decrease as a result, our operating income is planned to improve. A portion of our improvement in operating income will come from exiting unprofitable stores and product lines, but most of the improvement in profitability is a result of our New World Fossil initiative which we kicked off in early 2017. Through a combination of category management programs, direct and indirect sourcing efforts and organizational efficiency initiatives, $80 million in benefits were reflected in our operating income last year. We've been extremely pleased with our organization's efforts under this program so far, and New World Fossil benefits are expected to expand to $200 million when completed in 2019. Our second overarching strategy is innovation. Innovation has always been the cornerstone of our business model and 2018 will be no different. Our design capabilities are unique and are focused on new ideas and watches with differentiated looks and unusual materials. We have a number of initiatives launching this year that are quite different that we believe will resonate with our customers. Our consumer research shows that our brands are well known for great design and fashion relevance, and we are continuing to push on this topic. We also continue to maintain our size and scale advantage over our competitors which provides us with the resources and ability to be an industry leader in traditional watches. To fully utilize our scale and size advantage, we continue to pursue a number of additional brands to incorporate them into our portfolio license businesses. Our strength and innovation has expanded into smartwatches and continues in both display and hybrids formats. Late in 2017, we added to heart rate, an enhanced fitness application to our display models. These latest smartwatch models quickly became bestsellers in only two months. We also saw a strong response to our marketing efforts where we emphasized Google Assistant, which is Google's virtual personal assistant that is now integrated into smartphones, home devices and smartwatches. This year, across both owned and licensed brands, we will launch four new formats of display and hybrid smartwatches during 2018. In addition to current product features, our 2018 innovation plan is focused on curating the best fitness assistant experiences that Google's powerful platform allows. Our objectives remains to bring fashion, branding and style to the connected watch business by tailoring the technology that our customers want with each of our brands unique point of view. These great new offerings are expected to continue to support significant growth in our Connected Products category. Our third strategy is to build upon our digital infrastructure improvements and expand our e-commerce programs. Based on a successful social media programs in 2017, we will continue to expand our social media program such as celebrity campaigns to increase our social media platform engagement. We will expand buy online pickup and store capabilities for more of our global markets, enables ship from store capabilities and increase our collaboration with wholesale partners to optimize online performance. We are excited about our e-commerce expansion opportunities, including expanding the number of markets in which we have direct e-commerce. Our final overarching strategy for 2018 will be to continue the transformation work we began in 2017 as part of New World Fossil. As I've mentioned, we have made a lot of progress on the initial transformation of the company which is projected to drive $200 million in gross margin and efficiency benefits through 2019. We will be working this year on the next phase of New World Fossil, which will begin with a deep dive into insight on what the traditional and connected watch businesses will look like over the next five years. The consumer world is changing quickly and we must continue to reinvent the company by increasing speed and simplicity and reducing complexity and cost. This will include further expansion of our digital capabilities for not only digital marketing and e-commerce, but also for consumer insight, analytics and the use of data across many parts of our company. This next phase in New World Fossil is also a multi-year project and could benefit us with a similar profit improvements as the first phase. In closing, our performance this past year is not where we wanted to be, but we are confident that we are making progress on the initiatives that will ultimately deliver strong and sustainable growth for our business. We remain focused on stabilizing and growing our core watch business on bringing more innovation to Connected Products with new features and function, driving efficiency through the company while investing in our e-commerce and digital marketing opportunities. Importantly, in 2018, we are extremely focused on delivering improved profitability. We have planned our top line conservatively to put pressure on the things we have more control over, our gross margin structure and our expenses, that we feel we planned the year prudently, we will operate aggressively in the marketplace, positioning the company for growth. Our recent financing has provided additional operational flexibility in the near-term. However, we are continuing to take steps to further strengthening in our financial position to enable us to execute our strategies well into the future and to position of a business model for continued strong cash flow generation. Our longer term view is that after top line contraction in 2018, our initiatives should begin to stabilize sales levels in 2019 with sales growth returning in 2020 and continuing to grow annually thereafter. And with our New World Fossil transformation initiatives, we are targeting growth and operating income to expand from low single digits this year to a high single digit level by 2020. Our long-term goal is to return to double-digit operating margins. And now, I'd like to turn to call over to Jeff for more comments.

Thanks, Kosta. Before I cover our financial performance for the quarter, I'd like to build on a number of Kosta's comments. Overall, 2017 was a challenging year, more challenging than we originally expected. The midprice fashion watch business and our strongest channel, wholesale, was under significant pressure from the smartwatch segment. We have put a strong foundation in place to start improving our profitability in 2018. We have a sizeable presence in fashion focused variable products, both display and hybrid. We are quickly improving the margin profile of this business. We are aggressively building out our digital capabilities to reach consumers in new ways and sell our product in a growing number of online channels. We recognize that we must make our business model more profitable and we are executing well against our New World Fossil initiative, improving our product economics and reducing expenses. That we're executing on many positive fronts across the enterprise, we are on a segment of retailers going through significant structural change in both, product and channel. However, our long-term goals remain the same, to return to a profitable high-return business. Now turning to our financial results; reported net sales for the fourth quarter decreased to 4% to $921 million, while fourth quarter constant currency net sales decreased 7%. Overall, sales were in line with expectations, driven by modest improvements in our direct channel while our wholesale business continue to contract in the low double-digits. Store closures negatively impacted total direct channel sales by roughly 450 basis points. Excluding store closures, our direct channel posted mid-single digit gains with positive store comps and solid increases in our online business driven by growth in connected sales. Our connected watch business, which represented almost 20% of total watch sales continue to contribute significantly to the overall top line trend and grew over 40% in sales for the fourth quarter compared to last year. For the quarter, we reported a loss of $1.65 per share, including $2.20 per share in tax-related charges, mainly from the impact of the recent changes in tax legislation combined with valuation allowances established on deferred tax assets, and $0.09 resulting from $6 million in New World Fossil restructuring charges. Excluding these items, adjusted EPS was $0.64. Last year, our fourth quarter EPS was $1.3, and included an $0.18 impact from restructuring charges. After, excluding the tax charges and restructuring costs, the fourth quarter EPS decline this year was driven by lower sales and gross margin, mainly due to our connected product mix and higher interest expenses, partially offset by lower operating expenses. Currencies, including both the translation impact on operating earnings and the impact of the foreign currency hedging contracts, favorably affected the EPS comparison in the fourth quarter by $0.09. Our watch business declined 6% in constant currency for the quarter, finishing the back half of the year with an improvement in sales trajectory for the category. Sales in our traditional watch business also challenging performed within our overall expectations. Sell through trends of our traditional watches remained fairly stable in the Americas, though we did experience some declines in trends among certain of our wholesale partners. We continue to grow our connected watch business, delivering $142 million in sales for the quarter, 44% higher when compared to the fourth quarter of last year. We're continuing to see strong sell-through's in key display watches, especially in our own stores where we control the customer experience. While we did not achieve the ambitious wearables plans we initially set for this year, the business is favorably impacting our watch category in a material way, a 7-point improvement in the growth rate this quarter. And we're achieving that 7-point improve largely driven by display watches, we're taken advantage of the awareness of the segments of the wearables category. Hybrids; we're having more modest success will take longer to build considering there is no significant competition at scale in the marketplace right now. Total Fossil brand sales declined 2% in constant dollars compared to last year, finishing the year with consecutive sequential improvements for all four quarters this year. The decline in the Fossil brand was driven by weakness in our leathers and jewelry categories. Fossil brand watch sales increased modestly in the quarter, up 2% in constant dollars with smartwatches, both display and hybrids, positively impacting the category growth rate by 11 points. Display watches continue to represent the largest percentage of wearable sales for the Fossil brand; though we are achieving success in hybrids with Fossil in our direct channel where our marketing efforts, store experience and celebrity influencer campaigns are yielding results. With our Fossil First campaign, with Kristen Bell, the Fossil Q Accomplice hybrid is now one of our top 10 SKUs in our Fossil watch collection. In our retail channel, comp sales for our Fossil and watch station business increased 2%, representing our first positive comps since 2015, despite ongoing retail traffic declines. Our watch performance for these businesses, both online and in-stores, was encouraging with comps of 5%, further demonstrating the impact that wearables is having on the category. E-commerce sales, which are included in comp sales, increased 31% for the quarter. We're also seeing some stabilization in the trajectory for Michael Kors where watch sales declines slowed to 10% for the quarter with smartwatches positively impacting that rate by 8 percentage points. In the Americas, fourth quarter sales decreased 9% on a constant-currency basis to $442 million with declines in all three product categories. Watches declined at a similar rates as the total Americas region has continued softness in traditional watches were partially offset by connected watch sales. With our best sales performance continuing to come from Fossil, which did grow in the region for the quarter, up 4%, driven by connected performance across all channels. Most other brands posted sales declines in the quarter. While both, our wholesale and retail businesses declined in the quarter, our retail business was significantly stronger than wholesale. In Europe, reported sales increased to 1% to $337 million. While on a constant-dollar basis, sales declined 6%. As we said in our August earnings call, Q3 sales benefited from early deliveries to wholesale customers who opted to take shipments earlier than planned, given price adjustments, which we were required to announce to our customers in advance. In turn, Q4 sales were negatively impacted by the sales benefit seen in Q3. Sales declined across all product categories. We continue to see traction in our direct business with positive comps across most categories in particular, strength in watches. Wholesale, which is impacted by the sales shift into Q3 declined. Additionally, we are seeing wholesale customers in certain European countries experienced some deterioration in traditional watch sell-throughs as the European customer accelerates their adoption of online channels. Fossil watch sales in Europe were relatively flat, with growth in connected sales offset by declines in our traditional watch sales. Within our watch portfolio though, Emporio Armani, Armani Exchange and Diesel grew. However, this growth was more than offset by declines in other brands, including Michael Kors and Skagen. Across the Eurozone, sales were down modestly while distributor markets in Eastern Europe and the Middle East declined significantly. In Asia, reported sales declined 1% to $142 million, and on a constant-currency basis, declined 3%. Our Fossil brand was essentially flat in Asia, driven by strength in watches offset by Men's leathers. And Emporio Armani, our second-largest brand in Asia, posted strong growth, driven by both traditional and connected watches; most other brands were down in the quarter. Growth in India and China was offset in decline in nearly all of the countries within the region, with the sharpest decline coming from Japan. In the quarter, gross profit decreased to $448 million and gross margin declined 230 basis points to 48.7%, driven primarily by the impact of Connected Products due to both, the increase in sales mix of Connected Products, which carry lower overall margins, as well as additional product valuation reserves. We increased our connected sales volume by more than 30%, though we are well ahead of the initial cost goals that we are targeting for this year. However, we did not hit the aggressive sales goals that we had set for ourselves this year in this new category. Consequently, we are carrying greater levels of Connected Products that we need to clear and have deferred some receipts into the first quarter of 2018. We've recorded $18 million in valuation charges this quarter, which totaled roughly $40 million for the year to support our efforts to clear this inventory. This negatively impacted our overall gross margins by 190 basis points for the fourth quarter. Excluding the valuation charges, our connected margin would have approached 40% for the fourth quarter and full year. Significant drivers, partially offset the margin compression from connected sales include the benefits from our New World Fossil initiatives which improved margins by 130 basis points. Gross margins were also favorably impacted by currency movements, mainly from a stronger euro and a shift in sales mix towards higher-margin international sales and better margin channels such as e-commerce. Also significant in the quarter were lower markdown rates within our wholesale customers and an improved transfer direct channel margins which declined much less than in prior quarters due to more targeted promotions. Fourth quarter operating expenses were $397 million, 6% or roughly $26 million lower than the fourth quarter of last year. Expenses included $6 million in restructuring charges while 2016 fourth quarter expenses included $13 million in restructuring charges. The lower expenses in the fourth quarter resulted from lower store expenses given the significant number of stores we've closed since last year, as well as corporate overhead reductions and cost reductions in our regional organizations across the globe. Marketing was also lower in the quarter as we reduced fixture spend and invested more in digital campaigns this year, compared to more expensive television advertising executed during the fourth quarter of last year. For the full year, our market investments as a percentage of sales was roughly in line with last year. Though we significantly reduced spend in less productive areas such as fixtures and displays and we deployed our market dollars towards higher return in digital related activities. Our fourth quarter operating income was $51 million compared to $66 million a year ago. Fourth quarter other income of $2 million was lower than last year, mainly due to net foreign-currency contract losses compared to net gains recognized in the fourth quarter of last year. Interest expense increased $3.6 million to $11 million due to higher interest rates. Income tax expenses were $112 million in the quarter, which included a $107 million additional charge due to the tax cuts and jobs act at that was signed into law in December, and a charge related to a valuation allowance on our deferred tax assets. The new tax legislation includes significant changes to various areas of U.S. federal income tax laws, including reducing the tax with U.S. earnings to 21%, and moving from a global taxation regime to a modified territorial one. In terms of the impact, I won't to touch on every element but I will cover them with significant ones. The tax reform charge totaled approximately $63 million, and is comprised of $29 million for the revaluation of our deferred tax assets using a 21% future U.S. tax rate versus the previous U.S. tax rate of 35%. I also included in the charge related to tax reform was a net expense of approximately $34 million for the onetime repatriation tax. Note, that due to foreign tax credit carryforwards and the current year net operating tax loss, the actual cash repatriation tax liability is about half of this amount or about $16 million payable over an 8-year time period. In addition to the tax reform related charges, we recognize a non-cash charge of $44 million to establish a valuation reserve on our deferred tax assets. Given our recent operating losses, we've reserved against all of our deferred tax assets in the U.S. and certain international subsidiaries. As Kosta highlighted, we are pursuing an aggressive series of actions to expand and further accelerate our New World Fossil initiative to significantly transform our business model to address the continued challenges and changes in our markets. As we generated taxable income in the future, these deferred tax assets could be realized overtime. The impact from the tax reform and valuation allowances resulted in combined charges of $107 million or $2.20 per share, and were not contemplated in our guidance for the fourth quarter that we provided back in November. The actual amount of tax reform charges that I just highlighted may differ from our estimates due to, among other things, a change in interpretations of the applicable revisions to the U.S. tax code, changes in assumptions made in developing our estimates, as well as regulatory guidance that may be issued with respect to the new tax laws. Our accounting for the tax effects of the new tax laws will be completed in 2018. Our review of income tax projections for future periods also continuous in light of the changes imposed by the new tax legislation, particularly the guilty provisions that target low tapped foreign intangible earnings. Because of the complexity of these new guilty provisions, we are continuing to evaluate this provision. We are not yet able to reasonably estimate the effect of the guilty provisions and we have not made any adjustments related to potential guilty tax in our financial projections. As a result, we are providing a range of 2018 income tax expense estimates, excluding any impact from guilty. Now turning to our cash flows and balance sheet; our ability to generate cash flow remains strong even in a disruptive environments. During the quarter, we generated operating cash flow of approximately $120 million, invested $8 million in CapEx and reduced borrowings by $41 million. We improved our net debt position by roughly $121 million compared to a year ago. We ended the quarter with $231 million in cash, compared to $297 million last year, and debt of $446 million compared to $636 million a year ago. Inventory levels at year-end increased 6% versus a year ago driven entirely by our connected business. We have significantly reduced our inventories of traditional watches, we are working to clear the previous generation Connected Products over the next few quarters. Accounts receivable decreased like by 2% to roughly $357 million, and the wholesale DSOs increased by 2 days compared to the prior year due to shifts in customer mix and the elimination of an early pay discount from customer programs in selected parts of Europe. Depreciation and amortization expense totaled $19 million for the quarter. In January, we amended and extended our credit agreement with our banks. This amendment extends to facility until December 2020, and provides us with ample liquidity and greater covenant flexibility, especially during our peak working capital periods. We also reduced the bank facility to $750 million from roughly $1 billion, given the significant progress that we've made to reduce our net debt position. Structurally, the amended facility includes a $425 million term loan with scheduled pay downs through maturity, and a $325 million revolver with the borrowing base covered mainly by our accounts receivable inventory balances. The amendment also includes a higher fee structure. We're pleased to have the support of our banking partners as we work through the transformation of our business and navigate a challenging retail environment. Now let's move to our 2018 outlook. Over the next several years, Fossil Group will continue to transform of the company smile to address changes in consumer behaviors and their purchases of traditional watches and connected devices, as well as jewelry and leathers. During the Company's ongoing transformation, we believe certain operating metrics are the most appropriate performance measures. These metrics include sales, gross margin, operating expenses, operating margin, interest expense, adjusted EBITDA and cache taxes. Therefore, we'll focus our guidance discussion on these metrics. As Kosta said earlier, as we look ahead to 2018, we continue to focus on our customers by bringing exciting new product innovations in great store retailing [ph] to the market. We're moving quickly to expand our capabilities in the digital world as we see consumers continue to adapt their shopping patterns and demand more from digital experiences. By focusing on our key strategies of innovating our product offering, expanding e-commerce and digital marketing, and transforming our business model, we are positioned to improve our profitability in 2018 even as we face near-term top line headwinds. Our traditional products including traditional watches, leathers and jewelry, continue to represent a significant market opportunity. Great brands and innovative products continue to command significant market share even in the disruptive retail environment. Our teams continue to innovate with exciting new designs, distinctive uses of colors and materials and unique features across our products. This innovation along with the breadth of our great brands remains a significant competitive advantage for Fossil Group. Our success with wearables this past year gives us confidence that wearables will continue to be a growth driver in 2018 and beyond. The wearables markets is an exciting and growing market and we continue to believe our ability to bring great brands, designs and fashion together, with exciting new technology features will drive growth in this category. We have a number of exciting technology innovations in the pipeline and look forward to sharing those with you as we hit closer product launch dates during the year. Given the significant launch activity in 2017, and the current size of our wearables business, growth rates will naturally slow. That said, we do see strong double-digit growth in this category in 2018. While were excited about both our connected in traditional innovations in 2018, the retail sector continues to be challenging as consumer behavior and shopping patterns evolve. We expect this patterns to continue in 2018, particularly in our traditional categories in the wholesale channel with the traditional retail model is under pressure and technology is driving further disruption. We are planning our traditional business prudently and expect 2017 trends to continue in 2018, and this represents of the higher end of our sales guidance. The lower end of our sales guidance contemplates further disruption to traditional watches, primarily in the wholesale channel. That said, we are working aggressively to reverse these trends. Importantly, we are adopting our business model to deliver profitability in this new environment. We continue to take action to adjust the size of our retail store fleet to improve profitability and we expect to further reduce our retail store count in 2018. Retail stores are an important part of our brand experience, but given the changes in consumer shopping behaviors, reducing our store fleet to improve profitability and working capital while focusing our store teams on brand building experiences will be important. In addition to retail store closures, we are also refining our wholesale and concession distribution in certain geographies, which will help our teams focus on the most significant opportunities, while also improving profitability. We also face of further top line headwind in 2018, given the Burberry and Adidas licensed contracts which ended in December. In total, store closures, business exits and the impact of Burberry and Adidas licenses will have an approximate 550 basis points negative impact to our top line growth rate in 2018. Given the phasing impact of these actions, we expect the negative top line headwinds to have a more modest impact in Q1, and then intensify as we move through the year. In addition to these business drivers, currency could continue to impact our business. Over the past few years, fluctuations in foreign exchange rates have had a significant impact on our financial performance. We established the currency rate used on our guidance earlier in January, but the euro and the British pound, two of the currencies most impactful to results, at approximately $1.20 and $1.40, respectively. Based on the foreign exchange rates embedded in our guidance, we expect currency to be a net tailwind to our performance in 2018, driving a modest benefit to sales and operating earnings, partially offset by the negative impact of foreign currency hedge contracts in other income. Of course, the actual impact of currency may differ as exchange rates continue to move throughout the year. Therefore, for the full year we expect sales to range from negative 14% to negative 6%. For the first quarter, we expect sales to range from negative 12% to negative 6%. Note, that these sales estimates are inclusive of the negative impact of store closures, business exit and licensing terminations discussed earlier. While the challenges across the retail sector and within our categories will led to a smaller revenue base in the near-term, we expect our continuing innovation and New World Fossil initiative to deliver more profitability on the smaller sales space. We launched our New World Fossil initiative late in 2016, and are well on our way to deliver our $200 million savings target. Our teams across the globe have done a tremendous job of rallying behind these significant opportunities. Moving into 2018, we are looking to aggressively expand those efforts to further drive efficiencies in our model be more focused on our consumers. While we delivered significant savings in 2017, 2018 will bring even more improvement as we lap investments from the prior year and continue to accelerate these initiatives throughout the coming year, with a particular focus on improving gross margins through product offerings with improved designed value economics, stronger pricing and enhanced product cost reduction programs with our vendors. Given the experience we now have with the connected business and our improved ability to manage these inventory, we do not expect to repeat the connected liquidation reserve recorded in both the third and fourth quarters of 2017, providing additional margin expansion in the coming year. The weaker U.S. dollar provides an additional benefit to gross margin rates. Considering these factors, we expect approximately 200 basis points to 400 basis points of gross margin expansion for the year, with first quarter gross margin expected to be flat to up 200 basis points over Q1 2017. Overall, Q1 will see the most modest benefit with some acceleration in Q2, and further expansion of the back half as our New World Fossil initiatives continue to drive improvements. In 2017, our New World Fossil initiatives also drove meaningful reductions to our operating expense model and we'll annualize those changes moving into 2018. In addition, further store closures and continued New World Fossil savings will benefit the coming year. We'll also see some expense reductions from variable savings on a lower revenue base. Given that we're continuing and accelerating our New World Fossil initiatives, our 2018 expense plans include a similar level of restructuring charges as incurred in 2017. For the full year, we expect restructuring charges to be approximately $50 million and Q1 restructuring charges, to be approximately $20 million. Due to the phasing of our quarterly revenues and expansion of savings initiatives as we move throughout 2018, our operating expense rates will increase in the first quarter, neutralize more in the second and third quarters, and then leverage in the fourth quarter. Therefore, for the full year, we expect operating income margin in the range of flat to 4%. And for the first quarter, we expect operating income margin in the range of negative 11% to negative 6%. As discussed earlier, the credit facility extension does carry a higher fee structure which we expect will drive an overall increase in net interest expense of approximately $10 million compared to 2017. Interest expense is expected to be relatively flat sequentially throughout the year. Other income and expense, which is primarily related to hedged contract gains and losses was a benefit in 2017. Looking forward to 2018, based on the foreign exchange rates used in our planned assumptions, other income would turn to a negative or expand in 2018, though this will vary as exchange rates move. The magnitude of the net other expense is about $10 million annually, and is expected to be roughly consistent across quarters based on the foreign exchange rates used in the model. As I said earlier, based on our current interpretation of tax reform and the profile of our geographical earnings, including a tax loss in our U.S. companies, we expect tax expense to range from $20 million to $30 million for the full year; we expect Q1 tax expense of approximately $3 million. We're planning diluted share count at approximately 49 million shares. In addition to driving increased profitability in 2018, we are also focused on continuing to drive significant working capital improvement and strong positive cash flow. We see significant opportunity to drive additional efficiency and working capital through tighter management of inventory and improved turns. Given the seasonality of our business and need to reduce our level of connected inventory, working capital benefits are expected to accelerate as we move through the year. We expect adjusted EBITDA in the range of $150 million to $200 million. We're planning to invest approximately $25 million in capital expenditures in 2018. Now I would like to open the call up to your questions.

[Operator Instructions] And the first question comes from Ed Yruma from KeyBanc Capital Markets.

I know there are lots of puts and takes around the release of wearables last year, there were the liquidation. How should we think about the shipments for wearables this year and your ability to kind of have a longer product life cycle that maybe you have last year, given some of the early schedules?

One thing I would say is, we -- through last year, through last couple of years, we learned obviously a lot about the cadence in delivery and launching on these wearables. We also learned, for example, that a huge part of that sales are in December so it's quite a different profile in terms of timing. So through last year, as you know, we were moving as aggressively as we possibly could, we wanted to get critical mass quickly so we can get awareness out there and also get our costing down, we did that; we didn't have our timing right on the styles and the way we launched in the cadence was not correct. So having gone through all that, we've taken a reserve on the inventory. We're now in possession, we are -- made a huge amount of progress on variables, we've learned a lot and we're in a position now to be more opportunistic and more balanced about how we approach it. We do not expect to have inventory issues again this year. The one thing I would add is just -- we were surprised quite a lot, and I would say, the number one thing we're surprised about is the size of the wearables market. The watch business is about $65 billion globally, our part of it that we participate is about half of that, Swiss is about half; so say, $32 billion addressable market. Last year, in wearables, it was $17 billion market and it's expected to go to $32 billion in 2020. So we are surprised that it's that large and the reason is, it's largely female; we see that in our own business, or in both Fossil and in Kors. Our analytics show clearly, largely, female aspirational customer fashion and anecdotally what we see in the rest of the wearables market is, it is also largely female and fashion and aspirational. We also see this in our sales numbers in traditional watches, the brands that we are getting hurt the worst in declines is really our fashion brands and most of them in United States. So the fact that this is largely female puts us in a unique position. I think ongoing to capture a larger share of the market that wearables market, has -- we put more and more products, put ourselves in a position to capture a bigger share of that with our brands and lifestyle and with our interesting materials. The only thing I would add is that interestingly enough, it's health and wellness is driving a lot of that, a lot of our launches this year will be based on that. And the other thing I think that will accelerate all this, obviously, the technology is going to get better and better, this year's products are much improved. But incoming, I think what we mentioned on the notes was that the use of voice; so Google's Digital Assistant, we think is going to add a lot of emphasis to this, not just this year but ongoing. So we think overall, we're in a good position to continue to grow in this market.

I'd just add one other key message, which is we spent at the last two years -- often the acquisition of misfit, building out the wearables business model. We're not launching products, we've installed the business model; that business model is in place, proven and is scaling and driving meaningful growth in the business. So we are -- we now have the flywheel going and we're going to prudently plan the business but we expect this to be a long-term growth driver and just really, we're congratulating the teams across the world that have made that happen.

The next question in the queue comes from Omar Saad from Evercore ISR.

I wanted to just ask a couple more questions on the wearables front. Could you guys talk a little bit, just a little bit more detail on the inventory reserves and where you are with that or why you're comfortable that you're done with that process? Also maybe a little bit more learning's in the categories, '17, 2017 versus '16, especially with the inventory reserve situation? And then I thought it was interesting that you mentioned the wholesale versus retail, if you're seeing a pretty different dynamic or maybe you can expand upon that and maybe what the read-through is for the strategy going forward?

This is Jeff. Omar, I'll answer the inventory reserve question and we kick it over to Greg and some of the learning's. From inventory reserve question, we did get an excess inventory position, but we have been very conservative and looking at our sell-through estimate going into FY '18. We've got good experience in the fourth quarter in moving through some products. We've got a pretty could handle at what price we did sell product through. The quantities we own, obviously, we know the generation we got a sell through. So we got a pretty solid plan to sell-through the product. I would tell you at the appropriate profitability, we could really liquidate quickly, but that's not the best way to do it so we're going to liquidate the products through the next 3 quarters. Be essentially out of it by the time we get into the fourth quarter as new products hit, but we feel very good taste on a history of what we sold at price points in the fourth quarter this year.

I just add, as you mentioned, the business models in place and that I mean, it's large, we scaled across 14 brands, we're delivering consistently on time, high-quality product with dramatically lower costs and sustainable margins are now getting nearer and the teams are over delivering. But as we look to next year, what's happening is that the product and consumer trends are now becoming very clear. We launched the Fossil this products that has fitness and health at the very end of the year. Last year, those immediately became bestsellers. We also saw tremendous response from customers on our marketing that the future Google Assistant. So the product turns of health, fitness and wellness and then voice search and voice integration experiences in to these products, are what's going to drive these categories over the next several years. So our teams tend to position ourselves in our new product innovations to deliver this across a variety of brands and product formats. And then the second is dimension. That female fashion customer, we are seeing the adoption that we need to know that this is -- that we are not only well positioned in the category, but with our core customer, and that's critical because that's where our design and branding and our distribution sets us apart.

And then the wholesale versus retail dynamic? Would you mind just addressing that, I thought that was interesting.

Yes. What we found and we mentioned this before which is as you'd expect, these product are new and there is some training that goes with it. So they're actually selling better on our own environment. So on our own website and in our own stores, they're setting better. Especially you can expect better than our typical wholesale. The other thing I would add though is that we have seen increasing knowledge and awareness and adoption on this [indiscernible]; so there's less and less training at the point of sale now. In fact, we're seeing something like 50% of the sales on wearables globally was done on e-commerce, both our e-commerce sites as well as our partners. So it's clearly becoming more understood. One other thing I would mention on the hybrid issue is we -- hybrids are actually doing very well in increasing in our stories. And when we communicate it well, it's doing very well. I think the immediate adoption of this place smartwatches, I think, is really taken some of the options out of the hybrid market, but is doing very well, it's got a lot of fans, we're going to expand it. We think long term, that's a very significant business and it will have a large impact on the overall watch business so we're continuing to do that. And as more and more awareness gets out about these products both at wholesale and at retail, we think the wearables are going to grow.

The next question comes from Simeon Siegel from Nomura.

Can you talk about what categories and I guess, the amount of storage you are planning to exit maybe what are their sales loss and expense savings you'd expect from that? And then sorry if I missed it, but just to elaborate on the product reserves, just to be clarified, sorry, are you taking reserves on product you're expecting to clear later on or is this product at that you've already cleared through this quarter?

On the reserve, that's product that we will be clearing through, it's effectively lower cost for market reserve that we paid. So we can identify what we're going to sell this product through to our wholesalers, to our retail channel and recognize what that loss is so it's future looking reserve for the economics that we're going to lose on it let's say, requirements you have from an accounting standpoint, so that's going into the future. In terms of the sales loss from store closures, we have about 60 stores or so that we're going to close this year, and it's about $1 million -- it's about $60 million of sales loss from that. When combined with the licensing terminations that we have as well as some smaller businesses that we are exiting that weren't profitable, we it's about 550 basis points of sales hit that we have headwinds that they have entered. From a profitability on the store side, these stores aren't profitable, it's about $10 million of net profitability were underwater on those stores. So we're going to be more profitable by about $10 million for those closed doors.

The next question in the queue comes from Dana Telsey from Telsey Advisory Group.

On the product you're taking reserves for, how are you get rid of that product? Any way different than you've than in the past, what are you seeing there? And then also if you think of a smaller yet more profitable company, what do you think of as a baseline revenue, base line margins for this business?

On the wearables product that we're liquidating, we have quite a lot of demand, both in our own outlets stores, which are the number of watch stations towards around the world, in addition to that other third-party liquidation companies so there's a significant demand out there that we've planned this out of the next several months, and we don't see it being a problem.

On the second question, Dana, regarding the size of the business and the margin structure. I mean, really, FY '18 is probably the major step down we had an overall sales. We've moved from a couple of years ago being north of $3 billion, you can see that range is about $2.5 billion, this is the range for next year sales. My comments are a little bit of stabilization in '19, so there could still be a bit of a drag in '19, it could be a little bit smarter, but we really think and we're hitting a little bit of inflection points as connected business starts to grow, as the traditional business starts to stabilize, somewhat. On the margin side of it, we do think from New World Fossil initiatives, we have a lot of tailwinds in that initiative in order to going back into that again into a second phase. We think there's a couple of years' worth of a couple of hundred basis points. So if you look where we're at right now, at roughly at the range we gave you at 200 basis points of operating income, hit another couple of hundred points the next few years, you can easily get to about a 600 basis points, 6% operating margin as a company. And at some point in time, those restructuring charge will start to mitigate as well. So you can get to high single digit margin structure at rough numbers of $2.4 billion to $2.6 billion in sales, small profitable and kind of grow from there. So there's a good potential here for penetration and driving the business pretty well.

The next question in the queue comes from Anna Andreeva from Oppenheimer.

Two quick questions from us. Question on the wearables. I guess, can you elaborate what drove the 4Q '17 sales mix versus what you guys laid out in November? And then secondly, on gross margins, how much of the 400 basis points of expansion is the New World Fossil? And did you say how much benefit we should expect from that in '19?

On the sales, we didn't miss sales in Q4. So I'm a little confused about that question. I think we actually came in about what we thought equity came it is a bit better. Where we missed sales was earlier in the year forecasting, way back in Q1, coming out of '17 -- no, '16, goodness, '17, with expectations that in general, be much bigger business. So that's probably where that reference is coming from. And so it was a call we had to make over a year ago on the size of the business, [indiscernible] leaves early and late in 2016 and it had some high sales expectations that proved to be a little bit too ambitious. In terms of the margin performance, 400 basis points of margin performance improvement, and you were referencing, which line item on the P&L again, Anna, on that?

On the gross margin line, the 400 basis points of improvement for the year?

Yes. probably, I think we said 200 to 400, that's about 300, overall. And it's really a combination of a number of drivers on that. The absence of those inventory reserves gets you about 150 basis points on it. Our New World Fossil initiative gets you about 150 basis points as well. So you're about that 300 basis points right there between the 200 and 400; could be some currency favorability that helps as well, if we get some continued facility [ph], be offset a little bit with the typical mix pressure we get because connected to the larger -- I'm sorry, as a lower margin business than the traditional business. So it's those -- the biggest drivers are the absence of the inventory reserve and the New World Fossil initiative to drive about 300 basis points. Then some offices for between mix and connected and currency.

The last question in the queue comes from Ike from Wells Fargo.

It's Tom for Ike, actually. I just wanted to have a clarification about the operating expense guidance. For the year, I think you said about $50 million of restructuring cost, and if you strip that out, I mean, I'm getting SG&A dollars down, let's call it down 10%, plus or minus a couple of percentage points. I mean, I just want to make sure I'm thinking about that correctly. And that seems like a pretty aggressive cost cut. And I know you mentioned wire store closures in the year before, I guess, just how do we think about what costs you're taking out of the business and how that could potentially impact your ability to sort of reinvigorate the top line?

No. A lot of the cost reduction, expense reductions, are in fact, we called them structural around things that we're doing. Store closures is almost [ph] plus $40 million, $50 million of OpEx coming up from store closures. Our New World Fossil initiative is close to $60 million of savings on it. We do get some variable benefit from the sales decline. Our marketing expense closed down because we are not paying royalties and have marketing expenses on that, and that's usually another $20 million. So your math is right but a lot of it is initiatives we have in place for the New World Fossil, store closures and just the variable sales declines that we have. Operator, we're going to be taking some additional calls after this conference call so we'd like to close the call after this point in time and thank everybody very much for joining us. We look forward to speaking with everybody when we report the Q1 results later on this year. So, operator, please close the call.

Thank you, sir. We will now end the conference. Thank you for participating, and you may now disconnect.