Welcome to the Q3 2018 Fossil Group Incorporated Earnings Conference Call. My name is Adrienne, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session. Please note this conference is being recorded. I'll now turn the call over to Allison Malkin. Allison Malkin, you may begin.

Thank you. Good afternoon, everyone. Thank you for joining us, and welcome to Fossil Group's third quarter 2018 earnings conference call. I would like to remind you that information made available during this conference call contains forward-looking information and actual results could differ materially from those that will be discussed 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.

Good afternoon, everyone, and thanks for joining our call today. I will begin with a few comments and then turn the call over to Jeff Boyer, our CFO, to cover our Q3 financial performance and the outlook for Q4. Following Jeff's comments we'll have Greg McKelvey, our Chief Strategy and Digital Officer, join us for the Q&A. Note that our sales comments today will be based on constant currency unless otherwise noted. Our approach for 2018 was to plan our top-line prudently, but operate all elements of our business very aggressively with the overall goal of improving our profitability. I'm pleased to state that this approach continues to work well for us. In the third quarter, due to the outstanding efforts of our global teams, we performed better than our expectations on all key dimensions. Sales levels, though down, were near the high-end of our guidance with even stronger performance versus our forecast on gross margin expansion and expense management initiatives. We also continue to make great progress strengthening our balance sheet, as we reduced inventory and improved our overall working capital position versus the year (2:52). In the third quarter, sales declined 11% on a constant currency basis. With our focus on profitability this year, we are exiting marginal businesses, closing underperforming store locations. And as previously announced, we made two (3:10) licensing agreements. These exits and store closures had a significant negative impact in Q3, creating a top line drag of about 6-full percentage points. Other important sales metrics which provide additional insights into our business performance include: our connected product grew nearly 30% in the quarter, primarily due to the successful launch of our Generation 4 product across multiple brands. With this continued growth, smartwatches represented almost 18% of our total watch sales, up from 13% in…

Thanks, Kosta, and good afternoon, everyone. We're pleased with our progress this quarter as we drove double-digit growth in connected watches with favorable customer response for our next-generation smartwatches, we expanded gross margin to 53.6%, reduced expenses by $17 million, and we delivered a much stronger balance sheet. While our business continues to face top-line headwinds, stemming from the declines in the traditional watch category, but especially in the wholesale channel, we remain focused on narrowing the gap with gains in connected and e-commerce sales. And we continue to deliver benefits from our New World Fossil initiatives and from exiting marginal businesses and closing unprofitable stores as we become a smaller but a more profitable company in 2018. We reported net income of $5 million for the third quarter compared to a net loss of $5 million last year. Our reported earnings of $0.10 per diluted share included New World Fossil restructuring charges of $0.09 per diluted share. Last year our third quarter EPS was a loss of $0.11 and included a restructuring charge of $0.08 per diluted share. Excluding these items, our adjusted EPS was $0.19 this year as compared to a $0.03 loss last year. Currencies including both the translation impact on operating earnings and the impact of foreign currency hedging contracts, unfavorably impacted our EPS comparison in the third quarter by $0.01. Sales, which were slightly better than expectations, decreased 12% to $609 million and decreased 11% on a constant currency basis. We launched new connected products during the quarter with additional features and functions including heart rate and GPS that were well received by consumers helping to drive a 29% sales increase in the category. Note that the third quarter connected product sales growth rate also reflects incremental clearance sales of previous generation connected product. While…

Thank you. We'll now begin the question-and-answer session. And our first question comes from Edward Yruma from KeyBanc. Your line is open.

Hi, good evening, guys. Thanks for taking my question. I guess first, there seems to be a pretty strong divergence or has been between the performance you guys are seeing in your DTC channels versus what you are seeing at wholesale. I know that there's a higher SKUed to wearables in DTC, but can you help us think through, should that divergence start to compress? What can you do to help your wholesale partners I guess some more your product? And then as a follow-up you guys did a great job kind of de-levering the balance sheet. I guess, how do we think about threshold by which you could maybe take a more structural reduction to interest expense? Thanks so much.

On the first question we have as you know made a huge amount of progress on our digital capabilities, social media, e-commerce et cetera, and that's mostly been around our own brands. So we've – as you know the Fossil brand has been pretty strong over the last couple of years. We are still seeing huge growth in e-commerce and we are working now with our e-commerce partners both pure play and partners to use some of the same messaging and methodology to get that same kind of growth there and this is globally. Part of the issue with it is that we have to be the best in the world with digital capability and we have to be able to do it globally and it's local to (37:54) a large degree so it's very complex. We have been over the last couple of years putting resources in place globally to be able to do that and we're still midway on that journey and we have a lot more work to do to bring everyone else along.

Ed, on the structural changes to the balance sheet, particularly our debt levels on it. We have a term loan that starts to amortize next year with a full payment in December of 2020. As you can appreciate, one of our goals is always to refinance our balance sheet, our debt way in advance of that becoming current. So probably sometime next year, you'll look at us doing some level of refinancing, hopefully, by the mid part of the year which given our ability to generate cash through both operating performance as well as the balance sheet initiative we had we should be in a good position to structurally reduce our debt level. And also given the performance we've had, we expect that our interest rate that we'd have on that lower level of debt will also be much more favorable than we did this the last time. So I think midpoint of next year you should see some refinancing that should reduce our debt level and also reduce our interest rate overall.

Thanks so much and best of luck for holiday.

Thanks, Ed.

And our next question comes from Simon Siegel from Nomura. Please go ahead. Your line is open.

Hi. This is Julie Kim on for Simeon. Thank you for taking our questions. Could you provide color on the traffic metrics between full price and outlet stores as well as the online channel? And as a follow-up could you give color on units versus pricing within both traditional and connected watches?

We don't release traffic information by channel on that. So I'm going to pass on that question. And we also don't go into that much detail in terms of units and ASP. I will tell you that with the amount of liquidation we have done this past quarter, past couple of quarters there's been a little bit of pressure on ASP overall as we liquidated particularly connected products. That should return to normal as we get through this year into next year. So only thing that's really driving that a little bit is, our liquidation of some connected product. In terms of units, the units have been solid, they've still been down overall, but we have some pressure on both the units side as well as on the pricing side.

And then just regarding the full price and outlet stores versus the online channel, could you give any color on I guess just general performance between full price and outlet? And then within online, if you've seen any specific promotional pressure?

We've actually – as we mentioned in the comments, we've had less promotional activity in the last quarter than we've had in the past, especially in our outlet stores. If you look at our comps, our regular priced stores actually did pretty well. When you look at our regular priced e-commerce plus stores, we actually have a positive comp in the Fossil brand. In the outlets where we chose not to be as promotional, we actually – our comps were negative but our gross margin dollars were very solidly plus comps. So we're looking over the next several quarters to really understand what the correct cadence would be? How do we optimize both our margins and our sales in this channel? The other thing I would say is that, just in an ongoing basis with all our digital activities, we're seeing increasing traffic on our own e-commerce sites and our partners globally. And we are doing everything we can to facilitate that growth to be ongoing because that's becoming a larger part of the business. Also driving traffic to our stores as well. So the entire omnichannel thing is kicking in I think to a certain degree.

I would just add on that to build on Ed's comment. We are seeing better performance on our direct channel, full price outlet as well as e-com overall and across the regions on our core, taking out the Burberry, adidas store closures, actually positive in each region on that particular direct measure. Our challenge is in wholesale. It's the wholesale channel that's the most challenged for us. So we do have work to do on that. But from a direct standpoint, we've had mid-single digit growth in that direct channel.

Great. Thank you for the color.

Thanks, Julie.

And our next question comes from Ike Boruchow from Wells Fargo. Your line is open.

Hi, thanks for taking the question. I guess, Jeff could you maybe talk about the watch business in a little bit more detail? The growth rate of total watches was running I think down mid-single digits in the first half and now down low-double digits. And so I'm just trying to understand the wearables are clearly getting to a size where they can't double every quarter. I think we get that. But what's the right growth rate for the wearables from here? And then again within the traditional watches, it looks like they decelerated from low-double-digit to looks more like down 16%, 17%. Just how should we think about that? I mean you guys have talked about a more profitable, but a smaller business. I mean how much smaller did the traditional watch category need to shrink to? And then again just trying to think about how – what the growth rate of wearables looks like as we move into 2019?

Yeah, I'd tell you that we haven't given specific guidance on 2019 at this point. But probably the way to think about it is there's still great growth in the connected products and we have a lot of great product coming out. You heard Kosta mentioned in his comments about the fact that we're unveiling some fitness-oriented product tomorrow that we think will help our particular business really well on the connected space. So there's still a lot of growth there. Will it grow at doubling? No. Will it grow at a 10%, 20% level? Yes, we can get. That's a good growth rate that's out there. On the traditional side, you've asked kind of two questions in there as how to think about the traditional growth that we've had. We did have a bit of a slowdown in the third quarter and there is two pieces to that. One piece of it was being less promotional in our retail and outlet stores that did cause a drag, a point or two drag overall in the watch business, as we weren't nearly as promotional both from a retail and outlets standpoint. The other thing that we witnessed more than we had thought and caused a little bit drag results to Europe. The Europe wholesale business is going through a channel shift as well. The projections we have, show that that business will stabilize out in the future, can't say exactly when. The biggest issue still remains this channel shift that we mentioned that the consumer is shopping more online and the wholesale channel, in traditional watches, the one that is down the most. From a traditional watch standpoint, our latest estimate in the first half in the U.S. I believe was it was down mid-single between 5% and 10% was what the traditional watches down in our category. So the issue we've had is more of a channel issue than necessarily the traditional watch side of it. And it will stabilize at some point but we are continuing to manage it prudently and be aggressive about margin and cost until we get to that point.

And one thing we have been doing as we mentioned before is that there is a significant amount of innovation and new product ideas in traditional watches that we are shipping right now. We're seeing some earlier results to that across all our brands. But we are focused on new differentiated innovation across the spectrum trying to do everything we can to jolt that business and we'll see how it plays out over the next couple of months.

Got it. Thanks, guys.

Thanks, Ike.

And our next question comes from Laurent Vasilescu from Macquarie. Your line is open.

Thank you for taking my question. This is Wilson Huang (46:01) on behalf of Laurent. I want to ask on your gross margins which are up 720 bps. Can you walk us through the puts and takes in more detail? You had valuation charge and 100 bps in FX for the remaining 300 bps or so. How much was New World Fossil? How much was mix? And was there any impact from ASU 2014-09 which I believe had 150 bps benefit in the second quarter?

On the decomposition of it overall you're right about the absence of an inventory valuation reserves this quarter versus last quarter. That was roughly about 350 basis points. Because connected is growing faster there is a bit of a drag on that of about 80 basis points of connected mix. But in terms of the rest of the mix equation from a product to regional standpoint, we are selling some higher-margin products in some regions that actually have higher margins. So think about 100 basis points favorability in that piece of it. Our retail margins overall were up roughly 100 basis points as well and that's further conversations we had on the promotional activity that we've had. Currency is about 100 basis points and roughly the optimization is about 100 basis points. The lower markdowns are just about 50 basis points. So you can see we have really a broad range of benefits. Accounting changes did not impact our markdowns or anything to material effect in the third quarter.

Okay, great. Thank you.

Okay, sure.

And we have no further questions. I'll turn the call back over for final remarks.

Adrienne, I appreciate you helping us on this call. I want to thank everybody for joining us on the call today and look forward to updating them in February when we do our fourth quarter call and fiscal 2019 guidance. Thanks much.

Thank you, ladies and gentlemen. This concludes today's conference call. Thank you for your participation, and you may now disconnect.