Results of Operations

 

The following table sets forth, for the periods indicated, (i) the percentages of our net sales represented by certain line items from our consolidated statements of income and (ii) the percentage changes in these line items between the years indicated.

 

						Percentage								Percentage
						change from								change from
Fiscal Year		2006				2005				2005				2004				2004
Net sales			100.0	%			16.4	%			100.0	%			9.0	%			100.0	%
Cost of sales			49.8				19.1				48.7				11.7				47.5
Gross profit			50.2				13.8				51.3				6.5				52.5
Operating expenses			40.0				13.9				40.9				14.7				38.8
Operating income			10.2				13.2				10.4				(16.9	)			13.7
Interest expense			0.3				*				-				-				-
Other (expense) income - net			(0.1	)			*				(0.5	)			(212.0	)			0.5
Income before income taxes			9.8				15.4				9.9				(24.4	)			14.2
Income taxes			3.4				51.1				2.6				(41.5	)			4.8
Net income			6.4	%			2.5	%			7.3	%			(15.5	)%			9.4	%

 

* not meaningful

 

The following table sets forth our consolidated net sales by segment, and components of certain segments, and the percentage of net sales related to each respective segment, and components of certain segments, for the fiscal year indicated:

 

		Amounts in millions												Percentage of total
Fiscal Year		2006				2005				2004				2006				2005				2004
International wholesale:
Europe		$	378.7			$	316.3			$	304.3				31.2	%			30.3	%			31.8	%
Other			171.8				142.1				127.2				14.1	%			13.6	%			13.3	%
Total international wholesale			550.5				458.4				431.5				45.3	%			43.9	%			45.1	%
Domestic wholesale:
Watch products			239.0				232.5				230.5				19.7	%			22.3	%			24.1	%
Other products			203.7				179.2				151.1				16.8	%			17.2	%			15.8	%
Total domestic wholesale			442.7				411.7				381.6				36.5	%			39.5	%			39.9	%
Direct to consumer			220.8				173.0				144.2				18.2	%			16.6	%			15.0	%
Total net sales		$	1,214.0			$	1,043.1			$	957.3				100.0	%			100.0	%			100.0	%

 

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Fiscal 2006 Compared to Fiscal 2005

 

Net Sales.   The following table is intended to illustrate by factor the total year-over-year percentage change in sales by segment and on a consolidated basis:

 

Analysis of Percentage Change in Sales Versus Prior Year

Attributable to Changes in the Following Factors

 

		Exchange Rates				Acquisitions				Organic Growth				Total Change
Europe wholesale			2	%			—	%			18	%			20	%
Other international wholesale			—				9				12				21
Domestic wholesale			—				—				9				9
Direct to consumer			1				—				24				25
Total			1	%			1	%			14	%			16	%

 

Fiscal 2006 is a 53-week year as compared to a 52-week year for fiscal 2005.  This extra week was included in the first quarter of fiscal year 2006.  We estimate this extra week increased net sales and operating expenses by approximately $16 million and $5 million, respectively, as compared to fiscal year 2005.  This discussion should be read in conjunction with the Consolidated Financial Statements and the related Notes attached hereto.

 

European Wholesale Net Sales.   The following discussion excludes the impact on sales growth attributable to foreign currency rate changes and acquisitions as noted in the above table. European wholesale sales growth was primarily due to sales volume increases in FOSSIL jewelry and FOSSIL and licensed brand watches, as well as the contribution from our new ADIDAS watch licensed business that was launched in early 2006.  FOSSIL jewelry sales grew by 25.3% as a result of continued market share growth in Germany and from expansion into other parts of Europe.  Net sales increases in our FOSSIL watch brand of 3.6% are the result of renewed innovation and design in our product offerings.  Licensed watch brand net sales increases of 21.3% are related to market share growth in certain European markets and new styles introduced across many of our licensed brands.  We also believe our watch businesses in Europe benefited from overall improved economic conditions during 2006 in comparison to 2005.  Net sales from the ADIDAS watch brand, a newly-licensed watch business we launched during the first quarter of fiscal year 2006, contributed approximately $14.7 million to European net sales.

 

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Other International Wholesale Net Sales.  The following discussion excludes the impact on sales growth attributable to foreign currency rate changes and acquisitions as noted in the above table. Other international wholesale sales include sales from our Asia Pacific and Canada subsidiaries, export sales from the United States and sales from our Mexico business that was acquired in early 2006.  Net sales increases from this segment of our businesses were principally related to sales volume growth in our licensed brand watches.  Licensed watches increased by 24.6%, principally related to renewed innovation and design in new styles introduced into this segment of our business during 2006 and further penetration of certain licensed brands into many of our Asian Pacific markets. 

 

Generally, our international unit wholesale sales prices for watch styles, comparable to those styles in the United States, have historically been higher than our United States unit wholesale sales prices.  We believe this is a result of a less competitive market for global fashion and designer brand watches in comparison to those sold in the United States.  As a result, in the international market we believe our brands compete with more local and regional brands that do not possess the brand awareness or marketing strength in comparison to the brands included in our portfolio of watches. Furthermore, we believe the global recognition of our branded portfolio of watches positions us as a significant resource to retailers throughout the international marketplace.  Our strategy is not to force any one brand into a specific market, but rather allow the market to dictate which brands are important based upon consumer preference.   We believe our global distribution network and our design and marketing capabilities will allow us to acquire or license additional brands that will position us for further penetration internationally as we continue to take shelf space from lesser known local and regional brands.  As an example, we believe the launch of the newly-acquired ADIDAS licensed watch business in 2006 will further advance our product offerings in certain international markets and allow for long-term leverage of our existing distribution infrastructure outside the United States while strengthening our competitive advantage.  We believe ADIDAS compliments our existing portfolio of watches by providing us with a strong performance/sports brand. We also believe our jewelry businesses, including FOSSIL, EMPORIO ARMANI and DIESEL, allow us to leverage our customer base and infrastructure within the international markets as these brands are sold to many of the same customers that purchase our watch products.  For fiscal year 2007, assuming foreign currency rates remain near their existing levels relative to the U.S. dollar, our management believes the international wholesale segment will continue to grow at rate slightly higher than our estimated consolidated net sales.  We expect growth in the Asia Pacific markets to be more pronounced due to the lower level of penetration we currently have in this region, the impact of opening our mainland China office in the fourth quarter of 2006 and our plans to expand our distribution into India.

 

Domestic Wholesale Net Sales.   Domestic watch sales increased 2.8% principally due to sales volume growth in mass market, licensed and RELIC brand watches.  Our mass market watch business increased by $7.5 million, or 35.9%, and is primarily attributable to our successful partnership with Wal-Mart that resulted in being recognized as Wal-Mart’s Vendor of the Year for 2006 in the jewelry, watch and accessory division.  We anticipate continued growth based on the success of our offerings and the significant opportunity that exists to expand both the number of doors and the level of penetration within the mass market channel.  Licensed brand watch sales increased by 24.8% principally resulting from market share gains from our BURBERRY licensed brand and sales resulting from the launch of MARC BY MARC JACOBS and ADIDAS.   Net sales from our FOSSIL watch brand declined by approximately 8.1% during 2006.  Excluding the effect of discontinued product sales from both 2006 and 2005, the decline was approximately 10.1%.  Although the FOSSIL brand net sales declined on a comparative full year basis, the brand’s performance strengthened consistently on a sequential quarter basis throughout 2006 and posted a 4.5% increase during the more seasonal fourth quarter of 2006.  We believe this improved performance is related to renewed innovation and design in new styles introduced to the market during the year.  Consumers seem to be responding to the newness and differentiation in our watch styles and have gravitated towards our higher price point styles resulting in average unit retail price increases of approximately 10% during the year. We also believe the introduction of our FOSSIL brand catalog in late 2005 and increased circulation in 2006, combined with continued investment in our web-based marketing programs were instrumental in the overall improvement of the FOSSIL watch business during 2006.

 

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Net sales from other domestic products, that primarily includes our leather and sunglass businesses rose 13.7% during the year as a result of sales volume growth in FOSSIL women’s handbags and small leather goods, RELIC belts and gift categories and RELIC sunglasses.  Although we have experienced strong double-digit net sales gains in our women’s leather goods categories over the last two years  and are operating in fewer doors given the consolidation of Federated/May, our women’s leather business continues to be very healthy on a comparable door basis.  Net sales from our women’s handbag and small leather goods categories increased by 10.1% and 14.3%, respectively.  We are continuing to drive higher average unit retails in our handbag business by introducing new fabrics and leather as well as unique treatments to our product assortment.  Also fueling the increase in our FOSSIL leather goods category has been the successful introduction of our men’s bag business to the line this year.  Net sales from RELIC belts and gift categories increased by 38.5% primarily due to the strength of our offerings in JC Penney and Kohl’s.  Relic eyewear net sales increased by 67.9% during the year resulting from an expansion into new doors and additional displays.

 

The significant presence of the FOSSIL brand within the moderately priced department store channel and the RELIC brand in JC Penney and Kohl’s continues to position our company as a leading supplier of watches and accessories in the United States.  We believe, over the long term, opportunities exist for our domestic wholesale watch and accessories businesses to continue to improve and our expectations for net sales growth in the domestic wholesale segment of our business for fiscal year 2007 is in the mid single-digit range.

 

Direct to Consumer Net Sales.   Net sales from our retail stores worldwide increased 27.6% during the year as a result of a 19.8% increase in the average number of stores opened during the year and comparable store sales increases of 7.4%.  Net sales from our e-commerce business increased 18.7% as a result of sales volume growth in FOSSIL leather goods and from the launch of newly developed non-FOSSIL branded websites and FOSSIL catalog.  We operated 198 stores at the end of the year consisting of 120 full-price stores, including 41 located outside the United States, and 78 outlet locations, including 4 stores outside the United States.  This compares to 170 stores at the end of the prior year including 98 full-price stores, 30 of which are located outside the United States and 72 outlet locations, including one store outside the United States.  We opened 36 new stores and closed 8 stores during the year. New accessory stores opened during 2006 reflect a redesign of our historical presentation to a more contemporary vintage image that focuses on a more aspirational lifestyle customer.  The results of the new stores that have opened are meeting and in some cases surpassing our original expectations.  Our retail strategy is to position our FOSSIL stores as the destination within the mall for customers to shop for accessories.  We are currently targeting 50 to 60 new store openings in 2007, assuming the locations and economics meet our initial criteria.  Our focus will be on our full-price accessory concept in the United States and Europe, and to a lesser extent the Asia Pacific region.

 

A store is included in comparable store sales in the thirteenth month of operation. Stores that experience a gross square footage increase of 10% or more due to an expansion and/or relocation are removed from the comparable store sales base, but are included in total sales. These stores are returned to the comparable store sales base in the thirteenth month following the expansion and/or relocation.

 

Gross Profit.   Gross profit margin decreased 110 basis points in 2006 to 50.2% compared to 51.3% in 2005. This margin decline can be attributed primarily to a sales mix shift toward lower margin product sales in our international segment and the impact of increased discontinued product sales, through both non-traditional channels and our outlet stores at lower than historical gross profit margins.  To a lesser extent, gross profit margin further declined as a result of an increased sales mix in our domestic segment of lower margin mass market watches and higher markdown levels, primarily in the domestic accessories business, due to the transition of May Company stores to Federated.  Additionally, gross profit margins were negatively impacted as a result of certain new styles added to our global watch assortment which generated lower gross profit margins than historical averages.  However, we currently have an initiative in place that we believe will result in improved gross product margins across our various product lines beginning in the second half of fiscal year 2007.   Partially offsetting these gross profit margin decreases were increased sales, as a percentage of total sales, from our higher margin producing full-price company-owned retail stores.

 

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Our consolidated gross product margin is impacted by our diversified business model that includes but is not limited to: (i) a significant number of product categories we distribute, (ii) the multiple brands we offer within many of these categories, (iii) the geographical presence of our businesses, and (iv) the different distribution channels we sell to or through.  The components of this diversified business model produce varying ranges of gross profit margin.  Generally, on a historical basis, our fashion branded watch, jewelry and sunglass offerings produce higher gross profit margins than our leather goods categories.  In addition, in most product categories that we offer, brands with higher retail price points generally produce higher gross profit margins compared to those of lower retail priced brands.  From a segment standpoint, our direct to consumer business generally produces the highest gross profit margin to the Company as a result of these sales being direct to the ultimate consumer.  Gross profit margins related to sales in our international wholesale segment are historically lower than our retail segment, but historically higher than our domestic wholesale segment primarily due to the following factors; (i) overall retail prices for comparable product sold in the United States are generally higher in our international businesses as a result of less competitive fashion and designer brands being offered in these markets, (ii) the product sales mix in our international wholesale segment, in comparison to our domestic wholesale segment, is comprised more predominantly of watches, and (iii) the watch sales mix in our international wholesale segment, in comparison to our domestic wholesale segment, is comprised more predominantly of higher priced licensed brands.  As we move forward into 2007, we believe we have an opportunity to improve gross margins because we expect net sales growth to be more pronounced in our international wholesale and direct to consumer segments than our domestic wholesale segment.  We also believe that our efforts to reduce our global inventory levels during 2006, which included significant levels of discontinued product sales at or slightly above cost,  will allow us to improve our consolidated gross profit margin in 2007 as we expect reduced levels of discontinued product sales in 2007 in comparison to 2006.

 

Operating Expenses.   Operating expenses increased approximately $59 million during 2006 and, as a percentage of net sales, decreased to 40.0% of net sales compared to 40.9% for the prior year.  2006 operating expenses increased approximately $3.4 million as a result of businesses acquired in 2006 and approximately $2.9 million due to foreign currency exchange rates.  Excluding the operating expenses of acquired businesses and the impact of foreign currencies, operating expense increases during 2006 primarily reflect increases in payroll related costs, rent and depreciation and amortization expense.  Increased payroll costs were mainly related to additional headcount to support new initiatives, including the ADIDAS watch and new DIESEL and MICHELE jewelry businesses launched in 2006, non-cash compensation expense due to the implementation of FAS 123R and increased payroll expense in connection with our retail store growth.  Payroll expense increases also included an approximate $3.5 million associated with the additional week in the first quarter.  Rent expense increased 21.0% primarily due to the expansion of our retail stores. Depreciation and amortization expense increases are primarily related to leasehold improvements and in-store fixturing associated with new retail store openings during 2005 and 2006, additional hardware and software additions and depreciation related to the SAP implementation in France finalized in May 2005. Our management anticipates 2007 operating expenses (excluding expenses recorded in connection with the Special Committee’s review of our equity granting practices), as a percentage of net sales, to decrease slightly in comparison to 2006 levels, assuming foreign currency rates remain near their existing levels relative to the U.S. dollar. We expect this decrease to be more pronounced in the second half of the year, primarily due to the seasonality of our net sales.

 

      The following table sets forth consolidated operating expenses by segment and the percentage of net sales related to each respective segment for the periods indicated.

 

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		Amounts in millions
		2006								2005
		Operating				% of Net				Operating				% of Net
Fiscal Year		Expense				Sales				Expense				Sales
Europe wholesale			141.8				37	%			116.5				37	%
Other international wholesale			52.8				31	%			43.3				30	%
Domestic wholesale (1)			196.9				44	%			188.4				46	%
Direct to consumer			94.1				43	%			78.0				45	%
Total			485.6				40	%			426.2				41	%

 

(1) Certain corporate costs not allocated to individual operating segments for management reporting purposes and intercompany eliminations for specific income statement items are reflected in the domestic wholesale segment.

 

Operating Income.   The decline in our gross profit margin was partially offset by the leverage in our operating expenses resulting in our operating profit margin decreasing to 10.2% in 2006 compared to 10.4% in the prior year. Excluding expenses recorded in connection with the Special Committee’s review of our equity granting practices and additional cost related to the restatement of our historical financial statements, management believes operating margin for 2007 could increase by 100 to 200 basis points compared to 2006 based upon the estimated improved gross profit margin and leveraging of operating expenses. However, as we continue to grow in the watch, jewelry and retail store segments, we believe we may continue to experience a greater percentage of our operating income in the back half of the year.

Interest Expense. Interest expense increased by approximately $3.2 million to $3.6 million compared to $321,000 in 2005.  This increase is related to the impact of higher outstanding borrowings under our revolving lines of credit that were principally used to fund approximately $85 million of common stock repurchases occurring during the fourth quarter of fiscal year 2005 and the first quarter of fiscal year 2006 and capital expenditures of $50.8 million during 2006.

 

Other Expense (Income) - Net.  Other expense (income) - net primarily reflects interest income from cash investments, foreign currency transaction gains or losses, minority interest expense of our majority-owned consolidated subsidiaries and equity in the earnings of our non-consolidated joint venture in Spain. During 2006, other expense (income) - net decreased favorably by approximately $4.7 million principally due to $2 million of currency gains recorded in 2006 compared to $3.8 million of currency losses in 2005.  This favorable increase was partially offset by a $1.2 million reduction in equity in the earnings of our joint venture in Spain.

 

Income Taxes.   Our effective income tax rate increased to 34.7% during 2006 compared to 26.5% in the prior year. The lower effective tax rate in 2005 was the result of our ability, pursuant to the American Jobs Creation Act of 2004, to reduce previously recorded deferred tax liabilities by repatriating foreign earnings at an effective tax rate substantially below the statutory rate at which these deferred tax liabilities were established.  The Company expects its effective tax rate to be in a range of 37% to 39% in 2007.

 

Fiscal 2005 Compared to Fiscal 2004

 

Net sales.   The following table is intended to illustrate by factor the total year-over-year percentage change in sales by segment and on a consolidated basis:

 

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Analysis of Percentage Change in Sales Versus Prior Year

Attributable to Changes in the Following Factors

 

		Exchange Rates				Acquisitions				Organic Growth				Total Change
Europe wholesale			(1	)%			1	%			4	%			4	%
Other international wholesale			1				4				7				12
Domestic wholesale			-				2				6				8
Direct to consumer			-				-				20				20
Total			-	%			2	%			7	%			9	%

 

European Wholesale Net Sales.   The following discussion excludes the impact on sales growth attributable to foreign currency rate changes and acquisitions as noted in the above table. European wholesale sales growth was driven by sales volume increases in FOSSIL jewelry and licensed watches.  These increases were partially offset by sales volume declines in FOSSIL watches.  The sales volume growth in FOSSIL jewelry was mainly attributable to further penetration of the line in Germany as well as recent expansion into new European markets, primarily Italy and the United Kingdom.  Net sales increases in licensed watches were primarily related to further penetration within existing markets as these brands continue to gain recognition.  FOSSIL watch sales decreases were primarily the result of declines in the sales of core styles and weak consumer response to new styles launched during 2005 and our belief that the watch category in general experienced declines during 2005.

 

Other International Wholesale Nets Sales.  The following discussion excludes the impact on sales growth attributable to foreign currency rate changes and acquisitions as noted in the above table. Growth from other international wholesale sales was led by sales volume increases in our licensed watch businesses primarily resulting from expansion of these brands into additional retail locations.  Fiscal 2005 net sales growth in our other international segment was negatively impacted by an approximate $4.7 million prior year special market sale that occurred in 2004.

 

Domestic Wholesale Net Sales.   Excluding the impact on sales growth attributable to acquisitions, domestic watch sales decreased 1.4% principally as a result of a 12.4% decline in FOSSIL watch sales and a 17.8% decline in RELIC watch sales.  These decreases were partially offset by growth in our mass market business that launched in mid-2004.  We believe that the decrease in sales of FOSSIL and RELIC watches was primarily due to a cyclical shift in consumer discretionary spending patterns away from the watch category during 2005.  During 2005, domestic sales of our accessory and sunglass businesses rose 18.5% resulting from sales volume growth in FOSSIL women’s and men’s leather products as well as RELIC sunglasses. The women’s handbag category was one of the benefactors of the shift in consumer discretionary spending in 2005 allowing us to not only experience increased sales in existing locations but also expand our presence in many other accessory product lines within the same customer base.

 

Direct to Consumer Net Sales.   Net sales from our retail stores worldwide increased 19.1% during the year as a result of a 20.4% increase in the average number of stores opened during the year and comparable store sales increases of 1.1%.   Net sales from our e-commerce business increased 16.7% as a result of sales volume growth in FOSSIL NCAA watches, MICHELE watches and FOSSIL leather products.  In comparison to the prior year, 2005 comparable store sales increases were negatively impacted by declines in our FOSSIL watch business, which has historically accounted for approximately 60% to 65% of our overall retail store sales.  Retail store sales were positively impacted by significant increases in sales from accessory products.   We operated 170 stores at the end of the year, consisting of 72 outlet, including one located oustide the United States,  and 98 full-price stores, consisting of 30 full-price stores located outside the United States.  This compares to 136 stores at the end of the prior year consisting of 60 outlet and 76 full-price stores, including 23 stores located outside the United States.  We opened 37 new stores and closed 3 stores during the year.

 

Gross Profit.   Gross profit margin decreased 120 basis points in 2005 to 51.3% compared to 52.5% in 2004. This margin decline can be attributed primarily to a sales mix shift between the different segments of our business.  As a percentage of consolidated net sales, 2005 net sales from our international and domestic wholesale watch segment declined by 300 basis points in comparison to 2004, while our domestic accessory segment experienced a sales mix increase of 170 basis points.  Historically, gross profit margins generated from our international segment and domestic watch segment are generally higher than those experienced in our domestic accessories segment.  In addition, we experienced higher freight cost as a percentage of net sales primarily due to fuel surcharges that were incurred during the second half of the year.  Partially offsetting these gross profit margin decreases were increased sales, as a percentage of total sales, from our higher margin producing direct to consumer segment.

 

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Operating Expenses.   Operating expenses increased approximately $54.7 million during 2005 and, as a percentage of net sales, increased to 40.9% of net sales compared to 38.8% for the prior year. Included in 2005 operating expenses is approximately $6.0 million related to operating expenses of businesses acquired in 2005. Excluding the operating expenses of acquired businesses, operating expense increases during 2005 primarily reflect increases in payroll related costs, advertising expense and depreciation and amortization expense.  Increased payroll costs were mainly related to additional headcount to support new initiatives, including the MARC JACOBS watch launch in 2005 and the ADIDAS watch and new DIESEL and MICHELE jewelry businesses launched in 2006.  Additional payroll cost increases were associated with the expansion of our European shared services center to support our SAP software solution roll-outs and increased headcount in our European headquarters office in Basel, Switzerland. Advertising expense increased to $82.4 million. As a percentage of net sales, advertising expense remained constant with 2004 at 7.7%. Depreciation and amortization expense increases were primarily related to leasehold improvements and in-store fixturing associated with new company-owned retail store openings during 2004 and 2005, additional hardware and software additions and depreciation related to the SAP implementations in Germany and France finalized in August 2004 and May  2005, respectively.

 

Operating Income.   Gross profit margin reductions and increased operating expenses as a percentage of net sales resulted in our operating profit margin decreasing to 10.4% in 2005 compared to 13.7% in the prior year.

 

Other Expense (Income) - Net.   During 2005, other expense (income) - net decreased unfavorably by approximately $11 million as a result of $3.8 million of currency losses incurred in 2005 compared to $6.9 million of currency gains experienced in 2004.

 

Income Taxes.  Our effective income tax rate decreased to 26.5% during 2005 compared to 34.3% in the prior year.  During 2005, pursuant to the American Jobs Creation Act of 2004, we were able to repatriate $165 million of subsidiary earnings which were not considered permanently invested and as a result received an 85% dividends received deduction for these eligible dividends.  Since we had previously provided for income taxes to be paid on these foreign earnings at the U.S. statutory rate of 35%, less appropriate foreign tax credits, we released approximately $18 million of our previously recorded deferred tax liabilities.  This reduction, offset by the actual taxes paid on these dividends, contributed earnings of approximately $0.17 per diluted share during 2005 that will not reoccur in 2006.  The repatriated funds will be used to invest in qualified expenditures in the United States in accordance with our approved Domestic Reinvestment Plan.

 

Effects of Inflation

 

We do not believe that inflation has had a material impact on results of operations for the periods presented. Substantial increases in costs, however, could have an impact on us and the industry. We believe that, to the extent inflation affects our costs in the future, we could generally offset inflation by increasing prices if competitive conditions permit.

 

Liquidity and Capital Resources

 

Historically, our general business operations have not required substantial cash needs during the first several months of our fiscal year. Generally, starting in the second quarter, our cash needs begin to increase, typically reaching a peak in the September-November time frame. Our cash holdings and securities available for sale as of the end of fiscal year 2006 increased to $140 million in comparison to $65 million at the end of the prior year. Of the $140 million of cash, cash equivalents and securities available for sale at fiscal year end 2006, $88.2 million is held in banks outside the United States.  The increase in cash holdings and securities available for sale is primarily the result of $148 million of net cash generated from operating activities less $61 million of cash used in investing activities and $20 million of cash used in financing activities. Cash flows generated from operating activities were primarily related to net income of $78 million, non-cash items of approximately $26 million, $24 million of cash from increased accrued expenses and $18 million of cash from decreased inventory balances partially offset by $19 million of increases in accounts receivable balances.  Cash flows used in investing activities were primarily related to fixed asset additions of $51 million.  Cash used in financing activities were primarily related to $26 million in repurchases of common stock and $3 million in distribution of minority interest earnings.  These items were partially offset by approximately $5 million of proceeds from the exercise of stock options and $2 million of debt borrowings.

 

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Aided by strong fourth quarter retail and web-based sales, accounts receivable at the end of 2006 increased by only 10.0%, well below our net sales growth rate of 20.5% for the fourth quarter, to $155 million compared to $141 million at the end of 2005. As a result, average day’s sales outstanding decreased to 45 days from 51 days in the prior year. Fiscal 2006 ending inventory of $228 million represents a 5% decrease compared to $241 million in the prior year and the composition of the inventory is more current. The decrease in inventories is mainly attributable to the implementation of two key initiatives.  First, we implemented strategies to adjust inventory purchases to match trailing trend results rather than purchasing inventory based on estimated but perhaps optimistic growth expectations.  Secondly, we took advantage of opportunities for the reduction in our excess inventory by selling increased amounts of discountinued product through alternative channels as well as our own outlet stores.

At the end of 2006, we had working capital of $358 million compared to working capital of $327 million at the end of the prior year. We had approximately $11 million of outstanding borrowings at the end of 2006 related to short term borrowings in the UK and Japan.  In the first quarter of 2006, our UK subsidiary entered into a revolving credit facility with its primary bank allowing borrowings of up to 4 million GBP.  Outstanding borrowings under the UK-based facility were $7.7 million USD at the end of 2006 and bear interest at the aggregate of the margin, London Interbank Offered Rate (“LIBOR”), and Mandatory Lending Agreement (“MLA”), costs, (6.17% on a combined basis at year end), due May 2007.  These borrowings were used to acquire a new facility for our U.K.-based operations.  The remaining $3.4 million in borrowings are under a short-term facility in Japan bearing interest at the Euroyen rate (approximately 1.38% at year-end), due in June 2007.  This facility is primarily utilized for working capital needs associated with our Japanese subsidiary.

 

At the end of 2006 we had no outstanding borrowings under our $100 million U.S. Short-Term Revolving Credit Facility which bears interest at our option of (i) the LIBOR base rate (5.32% at year-end) plus 50 basis points, or (ii) the lesser of (a) the higher of Wells Fargo’s prime rate (8.25% at year-end) less 1.0%, or 3.0%, or (b) the maximum rate allowed by law.  We have typically renewed this short-term credit facility in September each year.

 

During 2007, we anticipate capital expenditures of approximately $40 to $50 million to principally cover information technology additions, acquisition of facilities associated with our European headquarters in Basel, Switzerland, new company-owned retail store openings and other general maintenance requirements. We believe that cash flow from operations combined with existing cash on hand will be sufficient to fund our capital needs during 2007. We also have access to amounts available under our credit facilities should additional funds be required.

 

Contractual Obligations and Off-Balance Sheet Arrangements

 

The following table presents, as of January 6, 2007, a summary of our significant cash contractual obligations by payment date. Further discussion of the nature of each obligation is included in Note 8 and Note 11 to our Consolidated Financial Statements.

 

						Less than				1-3				3-5				More than
		Total				l Year				Years				Years				5 Years
		(in thousands)
Contractual Obligations
Short-term debt (1)		$	11,089			$	11,089			$	-			$	-			$	-
Minimum royalty payments (2)			115,763				40,535				55,239				14,963				5,026
Future minimum rental payments			160,744				32,115				50,556				33,978				44,095
Purchase obligations (3)			51,828				51,828				0				0				0
Total contractual cash obligations		$	339,424			$	135,567			$	105,795			$	48,941			$	49,121

 

(1)	Consists of short-term credit borrowings in the United Kingdom and Japan and excludes contractual interest.

 

(2)

Consists of primarily exclusive licenses to manufacture watches under trademarks not owned by us. Also includes amounts owed pursuant to various license and design service agreements under which we are obligated to pay the licensors a percentage of our net sales of these licensed products, subject to minimum scheduled royalty, design and advertising payments.

 

(3)	Consists primarily of outstanding letters of credit, which represent inventory purchase commitments that typically mature in one to eight months and open non-cancelable purchase orders.

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Selected Quarterly Financial Data

 

The table below sets forth selected quarterly financial information. The information is derived from our unaudited consolidated financial statements and includes, in the opinion of management, all normal and recurring adjustments that management considers necessary for a fair statement of results for such periods. The operating results for any quarter are not necessarily indicative of results for any future period. Certain line items presented in the tables below, when aggregated, may not agree to the corresponding line items on the Company's Consolidated Statements of Income and Comprehensive Income for fiscal years 2005 and 2004 due to rounding. 

 

Fiscal Year 2006		1st Qtr				2nd Qtr				3rd Qtr				4th Qtr
		AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA
Net sales		$	264,225			$	259,238			$	299,697			$	390,805
Gross profit			133,014				127,034				148,106				200,765
Operating expenses			116,022				110,838				115,153				143,581
Operating income			16,992				16,196				32,953				57,184
Income before income taxes			15,492				15,610				31,941				55,752
Provision for income taxes			5,776				4,372				10,400				20,665
Net income			9,716				11,238				21,541				35,087
Earnings per share:
Basic			0.14				0.17				0.32				0.52
Diluted			0.14				0.16				0.31				0.51
Gross profit as a percentage of net sales			50.3	%			49.0	%			49.4	%			51.4	%
Operating expenses as a percentage of net sales			43.9	%			42.8	%			38.4	%			36.7	%
Operating income as a percentage of net sales			6.4	%			6.2	%			11.0	%			14.6	%

 

Fiscal Year 2005		1st Qtr				2nd Qtr				3rd Qtr				4th Qtr
		AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA
														As Restated
														(1)
Net sales		$	232,510			$	226,235			$	260,171			$	324,203
Gross profit			121,162				117,252				136,210				160,514
Operating expenses			96,647				100,959				99,488				129,058
Operating income			24,515				16,293				36,722				31,456
Income before income taxes			21,912				13,881				34,385				32,770
Provision (benefit) for income taxes			(1,982	)			4,228				12,691				12,341
Net income			23,894				9,653				21,694				20,429
Earnings per share:
Basic			0.34				0.14				0.31				0.29
Diluted			0.32				0.13				0.30				0.29
Gross profit as a percentage of net sales			52.1	%			51.8	%			52.4	%			49.5	%
Operating expenses as a percentage of net sales			41.6	%			44.6	%			38.2	%			39.8	%
Operating income as a percentage of net sales			10.5	%			7.2	%			14.1	%			9.7	%

 

(1)	See Note 2 in the "Restatement of Consolidated Financial Statements" in Notes to Consolidated Financial Statements of this Form 10-K. The following table gives effect to adjustments related to stock-based compensation expense and the correction of other prior period errors:

 

Fourth Quarter- Fiscal Year 2005		As Reported				Adjustments				As Restated
Net sales		$	324,203			$	-			$	324,203
Gross profit			160,514				-				160,514
Operating expenses			127,129				1,929				129,058
Operating income			33,385				(1,929	)			31,456
Income before income taxes			34,699				(1,929	)			32,770
Provision for income taxes			12,534				(193	)			12,341
Net income			22,165				(1,736	)			20,429
Earnings per share:
Basic			0.32				(0.03	)			0.29
Diluted			0.31				(0.02	)			0.29
Gross profits as a percentage of sales			49.5	%							49.5	%
Operating expenses as a percentage of sales			39.2	%							39.8	%
Operating income as a percentage of sales			10.3	%							9.7	%

 

While the majority of our products are not seasonal in nature, a significant portion of our net sales and operating income is generally derived in the second half of the year. Our third and fourth quarters, which include the “back to school” and Christmas season, generated approximately 73% of our annual operating income for 2006. The amount of net sales and operating income generated during the first quarter is affected by the levels of inventory held by retailers at the end of the Christmas season, as well as general economic conditions and other factors beyond our control. In general, lower levels of inventory held by retailers at the end of the Christmas season may have a positive impact on our net sales and operating income in the first quarter of the following year as a result of higher levels of restocking orders placed by retailers. We currently believe that our inventory levels at our major customers at the end of 2006 were near their targeted inventory levels.

 

As we continue to grow in the watch, jewelry and direct to consumer segments, we believe we will continue to experience a greater percentage of our annual profits in the back half of the year. As a percent of sales, we believe operating expenses will be more significant in the first half of the year when due to seasonality, our sales volumes are lower while our carrying costs of stores, personnel and infrastructure costs incurred in the back half of the prior year carry into the following year. In addition, new product launches would generally augment the sales and operating expense levels in the quarter the product launch takes place. The results of operations for a particular quarter may also vary due to a number of factors, including retail, economic and monetary conditions, timing of orders or holidays and the mix of products sold by us.

 

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk

As a multinational enterprise, we are exposed to changes in foreign currency exchange rates. Our most significant foreign currency risk relates to the Euro, British Pound and, to a lesser extent, the Swiss Franc, as compared to the U.S. dollar. Due to our vertical nature whereby a significant portion of goods are sourced from our owned facilities, the foreign currency risks relate primarily to the necessary current settlement of intercompany inventory transactions. We employ a variety of practices to manage this market risk, including our operating and financing activities and, where deemed appropriate, the use of foreign currency forward contracts. The use of these instruments allows management to offset exposure to rate fluctuations because the gains or losses incurred on the derivative instruments will offset, in whole or in part, losses or gains on the underlying foreign currency exposure. We use derivative instruments only for risk management purposes and do not use them for speculation or for trading. There were no significant changes in how we managed foreign currency transactional exposure in 2006 and management does not anticipate any significant changes in such exposures or in the strategies we employ to manage such exposure in the near future.

 

At year-end we had outstanding foreign exchange contracts to sell 43.1 million Euro for approximately $56.2 million, expiring through December 2007 and approximately 3.6 million British Pounds for $7 million, expiring through June 2007. If we were to settle our Euro and British Pound based contracts at fiscal year-end 2006, the net result would be a net loss of approximately $338,000, net of taxes. Exclusive of these outstanding foreign exchange contracts or other operating or financing activities that may be employed by us, a measurement of the unfavorable impact of a 10 percent change in the Euro, British Pound and Swiss Franc as compared to the U.S. dollar would have on our operating profits and stockholders’ equity is presented in the following paragraph.

 

At fiscal year-end 2006, a 10 percent unfavorable change in the U.S. dollar against the Euro, British Pound and Swiss Franc involving balance sheet transactional exposures would have reduced net pre-tax income by $6.6 million. The translation of the balance sheets of our European, United Kingdom and Switzerland-based operations from their local currencies into U.S. dollars is also sensitive to changes in foreign currency exchange rates. At fiscal year-end 2006, a 10 percent unfavorable change in the exchange rate of the U.S. dollar against the Euro, British Pound and Swiss Franc would have reduced consolidated stockholders’ equity by approximately $15.8 million. In the view of management, the risks associated with exchange rate changes in other currencies we have exposure to are not material and these hypothetical losses resulting from these assumed changes in foreign currency exchange rates are not material to our consolidated financial position, results of operation or cash flows.

 

Item 8.  Financial Statements and Supplementary Data

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

Fossil, Inc.

Dallas, Texas

 

We have audited the accompanying consolidated balance sheets of Fossil, Inc. and subsidiaries (the “Company”) as of January 6, 2007 and December 31, 2005, and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended January 6, 2007.  Our audits also included the financial statement schedule listed in the Index at Item 15.  These financial statements and financial statement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Fossil, Inc. and subsidiaries at January 6, 2007 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended January 6, 2007, in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As discussed in Note 2, the accompanying 2005 and 2004 consolidated financial statements have been restated.  Also, as discussed in Note 1, as of January 1, 2006, the Company changed its method of accounting for employee stock-based compensation.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 6, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 7, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.

 

/s/  DELOITTE & TOUCHE LLP

Dallas, Texas

August 7, 2007

 

64

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CONSOLIDATED BALANCE SHEETS
AMOUNTS IN THOUSANDS
Fiscal Year		2006				2005
						As Restated -
						See Note 2
Assets
Current assets:
Cash and cash equivalents		$	133,304			$	58,222
Securities available for sale			6,894				6,553
Accounts receivable - net			155,236				141,193
Inventories - net			228,225				241,009
Deferred income tax assets			20,406				18,808
Prepaid expenses and other current assets			36,923				41,387
Total current assets			580,988				507,172
Investments			10,855				9,352
Property, plant and equipment - net			171,499				147,243
Goodwill			43,038				40,667
Intangible and other assets - net			46,217				40,708
Total assets		$	852,597			$	745,142
Liabilities and Stockholders' Equity
Current liabilities:
Short term debt		$	11,338			$	8,552
Accounts payable			53,306				60,628
Accrued expenses:
Compensation			28,896				22,259
Accrued accounts payable			23,562				20,028
Accrued royalties			14,265				8,316
Co-op advertising			11,554				15,178
Other			27,388				16,550
Income taxes payable			53,071				29,159
Total current liabilities			223,380				180,670
Deferred income tax liabilities			15,021				28,936
Other long term liabilities			7,893				6,692
Total long-term liabilities			22,914				35,628
Minority interest in subsidiaries			4,102				2,527
Stockholders' equity:
Common stock, 67,794 and 68,319 shares issued for 2006 and 2005, respectively			678				683
Additional paid-in capital			53,459				47,675
Retained earnings			529,376				475,504
Accumulated other comprehensive income			20,025				7,676
Treasury stock at cost, 69 shares			(1,337	)			-
Deferred compensation			-				(5,221	)
Total stockholders' equity			602,201				526,317
Total liabilities and stockholders' equity		$	852,597			$	745,142

 

See notes to the consolidated financial statements.

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CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA
Fiscal Year		2006				2005				2004
						As Restated -				As Restated -
						See Note 2				See Note 2
Net sales		$	1,213,965			$	1,043,120			$	957,309
Cost of sales			605,046				507,980				454,699
Gross profit			608,919				535,140				502,610
Operating expenses:
Selling and distribution			357,813				311,302				269,465
General and administrative			127,781				114,850				102,401
Total operating expenses			485,594				426,152				371,866
Operating income			123,325				108,988				130,744
Interest expense			3,554				321				32
Other (expense) income - net			(976	)			(5,719	)			5,496
Income before income taxes			118,795				102,948				136,208
Provision for income taxes			41,213				27,278				46,663
Net income		$	77,582			$	75,670			$	89,545
Other comprehensive income (loss), net of taxes:
Currency translation adjustment			13,758				(14,618	)			(1,825	)
Unrealized gain (loss) on marketable investments			47				372				(12	)
Forward contracts hedging intercompany foreign
currency payments - change in fair values			(1,456	)			2,478				796
Total comprehensive income		$	89,931			$	63,902			$	88,504
Earnings per share:
Basic		$	1.15			$	1.07			$	1.27
Diluted		$	1.13			$	1.04			$	1.23
Weighted average common shares outstanding:
Basic			67,177				70,476				70,367
Diluted			68,817				72,424				72,998

 

See notes to the consolidated financial statements.

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CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

AMOUNTS IN THOUSANDS

 

																		Accumulated other
																		comprehensive income (loss)
																						Unrealized				Unrealized
		Common stock								Additional								Cumulative				gain (loss) on				gain (loss)												Total
						Par				paid-in				Retained				translation				marketable				on forward				Treasury				Deferred				stockholders'
		Shares				value				capital				earnings				adjustment				investments				contracts				Stock				compensation				equity
Balance, January 3, 2004 as previously reported			46,628			$	466			$	25,881			$	379,354			$	23,513			$	(388	)		$	(2,156	)			-			$	(3,244	)		$	423,426
Adjustments to opening stockholders' equity			-				-				8,610				(8,180	)			(484	)			-				-				-				(398	)			(452	)
Balance, January 3, 2004 as restated (1)			46,628				466				34,491				371,174				23,029				(388	)			(2,156	)			-				(3,642	)			422,974
Common stock issued upon exercise of stock options			1,418				14				10,468				-				-				-				-				-				-				10,482
Tax benefit derived from stock-based compensation			-				-				6,006				-				-				-				-				-				-				6,006
Repurchase and retirement of common stock			(247	)			(2	)			(6,921	)			-				-				-				-				-				-				(6,923	)
Three-for-two stock split			23,300				233				(233	)			-				-				-				-				-				-				-
Restricted stock issued in connection with deferred compensation plan			-				-				3,202				-				-				-				-				-				(3,202	)			-
Stock-based compensation expense			-				-				2,090				-				-				-				-				-				-				2,090
Amortization of deferred compensation			-				-				-				-				-				-				-				-				1,142				1,142
Australia purchase			3				-				47				-				-				-				-				-				-				47
European stores purchase			7				-				104				-				-				-				-				-				-				104
Net income			-				-				-				89,545				-				-				-				-				-				89,545
Unrealized gain on marketable investments			-				-				-				-				-				(12	)			-				-				-				(12	)
Currency translation adjustment			-				-				-				-				(1,825	)			-				-				-				-				(1,825	)
Forward contracts hedging intercompany foreign currency payments - change in fair values			-				-				-				-				-				-				796				-				-				796
Balance, January 1, 2005 as restated (1)			71,109				711				49,254				460,719				21,204				(400	)			(1,360	)			-				(5,702	)			524,426
Common stock issued upon exercise of stock options			811				8				5,642				-				-				-				-				-				-				5,650
Tax benefit derived from stock-based compensation			-				-				3,379				-				-				-				-				-				-				3,379
Repurchase and retirement of common stock			(3,601	)			(36	)			(14,339	)			(60,885	)			-				-				-				-				-				(75,260	)
Restricted stock issued in connection with deferred compensation plan			-				-				1,162				-				-				-				-				-				(1,162	)			-
Stock-based compensation expense			-				-				2,577				-				-				-				-				-				-				2,577
Amortization of deferred compensation			-				-				-				-				-				-				-				-				1,643				1,643
Net income			-				-				-				75,670				-				-				-				-				-				75,670
Unrealized gain on marketable investments			-				-				-				-				-				372				-				-				-				372
Currency translation adjustment			-				-				-				-				(14,618	)			-				-				-				-				(14,618	)
Forward contracts hedging intercompany foreign currency payments - change in fair values			-				-				-				-				-				-				2,478				-				-				2,478
Balance, December 31, 2005 as restated (1)			68,319				683				47,675				475,504				6,586				(28	)			1,118				-				(5,221	)			526,317
Common stock issued upon exercise of stock options			710				7				5,109				-				-				-				-				-				-				5,116
Tax benefit derived from stock-based compensation			-				-				1,474				-				-				-				-				-				-				1,474
Repurchase and retirement of common stock			(1,312	)			(13	)			(2,207	)			(23,710	)			-				-				-				-				-				(25,930	)
Restricted stock issued in connection with deferred compensation plan			77				1				(1	)			-				-				-				-				-				-				-
Restricted stock forfeiture			-				-				1,337				-				-				-				-				(1,337	)			-				-
Stock-based compensation expense			-				-				5,293				-				-				-				-				-				-				5,293
Reclass due to SFAS No. 123R implementation			-				-				(5,221	)			-				-				-				-				-				5,221				-
Net income			-				-				-				77,582				-				-				-				-				-				77,582
Unrealized gain on marketable investments			-				-				-				-				-				47				-				-				-				47
Currency translation adjustment			-				-				-				-				13,758				-				-				-				-				13,758
Forward contracts hedging intercompany foreign currency payments - change in fair values			-				-				-				-				-				-				(1,456	)			-				-				(1,456	)
Balance, January 6, 2007			67,794			$	678			$	53,459			$	529,376			$	20,344			$	19			$	(338	)		$	(1,337	)		$	-			$	602,201

 

1) See Note 2, "Restatement of Consolidated Financial Statements" in Notes to Consolidated Financial Statements of this Form 10-K.

 

See notes to consolidated financial statements.

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS
AMOUNTS IN THOUSANDS
Fiscal Year		2006				2005				2004
						As Restated -				As Restated -
						See Note 2				See Note 2
Operating Activities:
Net income		$	77,582			$	75,670			$	89,545
Noncash items affecting net income:
Depreciation and amortization			32,049				26,510				23,339
Stock-based compensation			5,293				4,221				3,231
Minority interest in subsidiaries			4,382				4,343				4,054
Increase in allowance for returns - net of related inventory			3,126				1,544				547
Loss (gain) on disposal of assets			72				(727	)			(129	)
Impairment loss			318				-				863
Equity in income of joint venture			(685	)			(1,907	)			(1,515	)
Decrease in allowance for doubtful accounts			(1,254	)			(744	)			(1,216	)
Excess tax benefits from stock based compensation			(1,474	)			3,379				6,006
Deferred income taxes			(15,485	)			(17,082	)			(15,542	)
Changes in operating assets and liabilities, net of effects of acquisitions:
Income taxes payable			25,386				(16,115	)			23,781
Accrued expenses			24,349				3,441				12,266
Inventories			17,776				(57,392	)			(45,424	)
Prepaid expenses and other current assets			5,408				(9,999	)			(3,924	)
Accounts payable			(9,481	)			8,852				13,260
Accounts receivable			(18,903	)			10,555				(27,918	)
Net cash from operating activities			148,459				34,549				81,224
Investing Activities:
Additions to property, plant and equipment			(50,787	)			(53,202	)			(28,407	)
Business acquisitions, net of cash acquired			(7,227	)			(4,439	)			(47,863	)
Increase in intangible and other assets			(3,242	)			(2,032	)			(929	)
Purchase of short-term marketable investments			(287	)			(1,293	)			(298	)
Proceeds from sale of property, plant and equipment			151				525				1,217
Net cash used in investing activities			(61,392	)			(60,441	)			(76,280	)
Financing Activities:
Acquisition and retirement of common stock			(25,930	)			(75,260	)			(6,923	)
Distribution of minority interest earnings			(2,813	)			(8,006	)			(3,403	)
Excess tax benefits from stock-based compensation			1,474				-				-
Net borrowings (payments) on short-term debt			2,028				(18,155	)			23,629
Proceeds from exercise of stock options			5,116				5,650				10,482
Net cash (used in) from financing activities			(20,125	)			(95,771	)			23,785
Effect of exchange rate changes on cash and
cash equivalents			8,140				(5,545	)			(1,361	)
Net increase (decrease) in cash and cash equivalents			75,082				(127,208	)			27,368
Cash and cash equivalents:
Beginning of year			58,222				185,430				158,062
End of year		$	133,304			$	58,222			$	185,430

 

See notes to consolidated financial statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.	Significant Accounting Policies

Consolidated Financial Statements include the accounts of Fossil, Inc., a Delaware corporation and its subsidiaries (the “Company”). The Company reports on a fiscal year reflecting the retail-based calendar (containing 4-4-5 week calendar quarters). References to 2006, 2005, and 2004 are for the fiscal years ended January 6, 2007, December 31, 2005, and January 1, 2005, respectively. The Company noted that fiscal 2006 is a 53-week year as compared to a 52-week year in fiscal 2005 and 2004. For financial reporting purposes, this extra week was included in the first quarter of fiscal year 2006. All intercompany balances and transactions are eliminated in consolidation. The Company is a leader in the design, development, marketing and distribution of contemporary, high quality fashion accessories on a global basis. The Company’s products are sold primarily through department stores, specialty retailers and company-owned retail stores worldwide.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash Equivalents are considered all highly liquid investments with original maturities at date of purchase of three months or less.

Securities Available for Sale consists of debt securities with original maturities exceeding three months and mutual fund investments. By policy, the Company invests primarily in high-grade marketable securities. Unrealized holding gains (losses) are included in accumulated other comprehensive income (loss) as a component of stockholders’ equity.

Accounts Receivable are stated net of allowances of approximately $38.3 million and $32.1 million for estimated customer returns and approximately $9.8 million and $11.1 million for doubtful accounts at the close of fiscal years 2006 and 2005, respectively.

Inventories are stated at the lower of average cost, including any applicable duty and freight charges, or market.

Investments in which the Company has significant influence over the investee are accounted for utilizing the equity method. If the Company does not have significant influence over the investee, the cost method is utilized.

Property, Plant and Equipment is stated at cost less accumulated depreciation and amortization. Depreciation is provided using the straight-line method over the estimated useful lives of the assets of thirty years for buildings, five years for furniture and fixtures and three to six years for computer equipment and software. Leasehold improvements are amortized over the shorter of the lease term or the asset’s useful life.

Property, equipment and other long-lived assets are evaluated for impairment whenever events or conditions indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows related to the asset. Impairment losses related to under-performing Company-owned retail stores of approximately $318,000 and $863,000 were recorded in 2006 and 2004, respectively, and are included in selling and distribution expense. There was no impairment loss recorded in 2005.

Goodwill and Other Intangible Assets include the cost in excess of net tangible assets acquired (goodwill), trademarks, tradenames, customer lists and patents. Trademarks, customer lists and patents are amortized using the straight-line method over the estimated useful lives of generally seven to twenty years. Goodwill and other indefinite-lived intangible assets such as tradenames related to business combinations are tested at least annually for impairment rather than amortized. Impairment testing compares the carrying amount of the asset with its fair value.  Fair value is estimated based on the market approach and discounted cash flows.  When the carrying amount of the asset exceeds its fair value, an impairment charge would be recorded.  The Company completed the required annual testing for impairment as of fiscal year-end 2006 and 2005 and has determined none of its goodwill or indefinite-lived intangible assets are impaired.

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Cumulative Translation Adjustment is included as a component of other comprehensive income (loss) and reflects the adjustments resulting from translating the financial statements of foreign subsidiaries. The functional currency of the Company’s foreign subsidiaries is the local currency of the country. Accordingly, assets and liabilities of the foreign subsidiaries are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at the average rates prevailing during the year. Changes in exchange rates that affect cash flows and the related receivables or payables are recognized as transaction gains and losses in the determination of net income. The Company incurred net foreign currency transaction gains of approximately $2.0 million, losses of $3.8 million and gains of $6.9 million for fiscal years 2006, 2005 and 2004, respectively, which have been included in other (expense) income - net.

Forward Contracts are entered into by the Company principally to hedge the future payment of intercompany inventory transactions by its non-U.S. subsidiaries. These cash flow hedges are stated at estimated fair value and changes in fair value are reported as a component of other comprehensive income (loss). At January 6, 2007, the Company had hedge contracts to sell 43.1 million Euro for approximately $56.2 million, expiring through December 2007 and 3.6 million British Pounds for approximately $7 million, expiring through June 2007. If the Company were to settle its Euro and British Pound based contracts at fiscal year-end 2006, the net result would be a loss of approximately $338,000, net of taxes. This unrealized loss is recognized in other comprehensive income (loss). The net decrease in fair value of approximately $1.5 million during fiscal 2006 is reported as other comprehensive loss and consisted of net losses from these hedges of $338,000 plus $1.1 million of net gains reclassified into earnings.

Revenues are recognized at the point the goods leave the Company’s distribution center for the customer. Because the majority of the Company’s customers pay freight and do not have stated rights of inspection, title transfers at the point in time the goods leave the Company’s dock. The Company accepts limited returns and may request that a customer return a product if the customer has an excess of any style that the Company has identified as being a poor performer for that customer or geographic location. The Company continually monitors returns and maintains a provision for estimated returns based upon historical experience and any specific issues identified. While returns have historically been within management’s expectations and the provisions established, future return rates may differ from those experienced in the past.  In the event that the Company’s products are performing poorly in the retail market and/or it experiences product damages or defects at a rate significantly higher than our historical rate, the resulting credit returns could have an adverse impact on the operating results for the period or periods in which such returns materialize.

Cost of Sales includes raw material costs, assembly labor, assembly overhead including depreciation expense, assembly warehousing costs and shipping and handling costs related to the movement of finished goods from assembly locations to sales distribution centers and from sales distribution centers to customer locations.  Additionally, cost of sales includes customs duties, product packaging cost, royalty cost associated with sales of licensed products, the cost of molding and tooling and inventory shrink and damages.

Selling, Distribution and Administrative Expenses includes sales and distribution labor costs, distribution costs from sales distribution centers to customer locations, sales distribution center warehouse costs, depreciation expense related to sales centers, point-of-sale expenses, advertising expenses and administrative support labor and “back office” or support costs such as treasury, legal, information services, accounting, internal audit, human resources and executive management costs.

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Advertising Costs for in-store and media advertising as well as co-op advertising, catalog costs, product displays, show/exhibit costs, advertising royalty related to the sales of licensed brands, internet costs associated with affiliation fees, printing and promotional allowances are expensed as incurred. Advertising expenses were approximately $83.3 million, $82.4 million and $73.5 million for fiscal years 2006, 2005 and 2004, respectively.

Minority Interest in Subsidiaries, included within other expense (income)-net represents the minority stockholders’ share of the net income (loss) of various consolidated subsidiaries. The minority interest in the consolidated balance sheets reflects the minority owner’s proportionate interest in the equity of the various consolidated subsidiaries.

 

Earnings Per Share (“EPS”). Basic EPS is based on the weighted average number of common shares during each period. Diluted EPS includes the effects of dilutive stock options outstanding during each period using the treasury stock method.

The following table reconciles the numerators and denominators used in the computations of both basic and diluted EPS:

 

Fiscal Year		2006				2005				2004
IN THOUSANDS, EXCEPT PER SHARE DATA
Numerator:
Net income		$	77,582			$	75,670			$	89,545
Denominator:
Basic EPS computations:
Weighted average common shares outstanding			67,177				70,476				46,911
Three-for-two stock splits			-				-				23,456
			67,177				70,476				70,367
Basic EPS		$	1.15			$	1.07			$	1.27
Diluted EPS computation:
Basic weighted average common shares outstanding			67,177				70,476				70,367
Stock options and restricted stock			1,640				1,948				2,631
			68,817				72,424				72,998
Diluted EPS		$	1.13			$	1.04			$	1.23

 

Antidilutive stock options to purchase approximately 907,000, 805,000, and 31,000 common shares were not included in the EPS computations in 2006, 2005 and 2004, respectively, because the exercise prices of these options were greater than the average market price of the Company’s common stock for the respective years.

Common Share and Per Share Data in these notes to consolidated financial statements have been presented on a retroactive basis for all stock splits.

Deferred Income Taxes are provided for under the asset and liability method for temporary differences in the recognition of certain revenues and expenses for tax and financial reporting purposes.

Fair Value of Financial Instruments is estimated to approximate the related book values unless otherwise indicated, based on market information available to the Company.

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Newly Issued Accounting Standards.  In February 2007, the Financial Accounting Standards Board (“FASB”), issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115, (“SFA 159”). The fair value option permits entities to choose to measure eligible financial instruments at fair value at specified election dates. The entity will report unrealized gains and losses on the items on which it has elected the fair value option in earnings. SFAS 159 is effective beginning in fiscal year 2008. The Company is currently evaluating the effect of adopting SFAS 159, but does not expect it to have a material impact on its consolidated results of operations or financial condition.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”).  SFAS 157 provides guidance for using fair value to measure assets and liabilities. Under SFAS 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. This standard primarily applies to those assets or liabilities that do not have a quoted market price. SFAS 157 is effective beginning in fiscal year 2008 and is required to be adopted beginning January 6, 2008. The Company is currently evaluating the effect of adopting SFAS 157, but does not expect it to have a material impact on its consolidated results of operations or financial condition.

 

In June 2006, the FASB released Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 supplements FASB Statement No. 109, Accounting for Income Taxes, by defining the threshold for recognizing the benefits of tax return positions in the financial statements as "more-likely-than not" to be sustained by the taxing authority.  Tax benefits associated with positions taken or to be taken on tax returns where there is uncertainty as to whether the position will be challenged by the taxing authorities will be impacted by FIN 48.

 

FIN 48 is effective beginning in fiscal year 2007.  FIN 48 establishes a two-step process for the recognition and measurement of the amount of benefit to be recorded in the financial statements for tax positions taken or expected to be taken in a tax return.  This process requires the enterprise first to determine whether is it more likely than not that the tax position taken will be sustained upon examination by the taxing authority, including resolution of any appeals or litigation, on the basis of the technical merits of the position.  FIN 48 requires that an enterprise measure the amount of recognizable tax benefit for each tax position meeting the recognition threshold as the largest amount that is greater than 50 percent likely to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information.  The cumulative effects of applying FIN 48 will be affected as a change in accounting principle and result in a decrease of $6.1 million to the fiscal year 2007 opening balance of retained earnings.

 

In June 2006 The Emerging Issues Task Force (“EITF”) issued Issue 06-3, How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should be Presented in the Income Statement (That Is, Gross Versus Net Presentation (“EITF 06-3”)). Questions have arisen whether various non-income taxes assessed by governmental authorities should be presented gross or net in an entity’s income statement.  Non-income taxes include sales tax, use tax, excise tax, value added tax, and various taxes related to specific industries.  This issue was added to the EITF’s agenda, and the EITF was asked to determine the approach that should be taken in determining whether some or all of these taxes should be presented gross or net in an entity’s income statement.  The consensuses in EITF 06-3 are effective beginning in fiscal year 2007.  The adoption of EITF 06-3 will not have a material impact on the Company’s consolidated results of operations or financial condition.

 

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Newly Adopted Accounting Standards. In December 2004, FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which replaces SFAS 123 and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB No. 25). SFAS 123R requires all share-based payments, including grants of employee stock options, to be recognized in the financial statements based on their fair values.  Under SFAS 123R, public companies are required to measure the cost of services received in exchange for stock options and similar awards based on the grant-date fair value of the award and recognize this cost in the income statement over the period during which an award recipient is required to provide service in exchange for the award.  The pro forma disclosures previously permitted under SFAS 123 are no longer an alternative to financial statement recognition.

Effective January 1, 2006, the Company adopted SFAS 123R using the modified prospective method and as such, results for prior periods have not been restated  as a result of this implementation.  Under this transition method, the measurement and the method of amortization of costs for share-based payments granted prior to, but not vested as of January 1, 2006, will be based on the same estimate of the grant-date fair value and primarily the same amortization method that was previously used in the SFAS 123 pro forma disclosure. For equity awards granted after the date of adoption, the Company will amortize share-based compensation expense on a straight-line basis over the vesting term.  Compensation expense is recognized only for share-based payments expected to vest. The Company estimates forfeitures at the date of grant based on historical experience and future expectations. Prior to the adoption of SFAS 123R, the Company utilized the intrinsic-value based method of accounting under APB No. 25, and related interpretations, and adopted the disclosure requirements of SFAS 123.  The effect of forfeitures on the pro forma expense amounts was recognized based on actual forfeitures.  The adoption of SFAS 123R resulted in share-based compensation expense of approximately $5.3 million ($3.4 million net of tax), or approximately $0.05 for both basic and diluted earnings per share for fiscal year 2006. Included in the $5.3 million was a benefit of approximately $165,000 resulting from the cumulative effect of changing from recognizing forfeitures on an actual basis to an estimated basis. In conjunction with the implementation of SFAS 123R, $5.2 million of deferred compensation, previously recorded as a separate component of stockholders’ equity, was reclassified into additional paid-in capital.

 

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (“SFAS 154”).  This standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. This standard requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle. SFAS 154 also states that a change in the method of depreciating a long-lived asset be accounted for as a change in estimate that was effected by a change in accounting principle. Also, an error correction from previously issued financial statements should be called a “restatement”. SFAS 154 was adopted in fiscal year 2006 and the Company believes these consolidated financial statements comply with the requirements of SFAS 154.

2.	Restatement of Consolidated Financial Statements

 

Restatement Adjustments

 

Following an internal review into the Company’s equity granting practices during the period from 1993 through 2006, the Company and its Audit Committee concluded that the Company’s consolidated financial statements and selected financial data for each of the fiscal years ended December 31, 2005, January 1, 2005, January 3, 2004 and January 4, 2003, should be restated to record additional stock-based compensation and related tax effects resulting from equity grants awarded during fiscal years 1993 through 2005 that were incorrectly accounted for under generally accepted accounting principles in the United States of America. This decision was based on the determination that the equity grant dates were selected in error because the grant price and the number of shares individual employees were entitled to receive were not determined with finality on the original grant date and therefore the revised measurement dates as defined by APB No. 25 for determining the accounting treatment of certain equity grants differed from the equity grant dates originally used by the Company in preparing its consolidated financial statements.  In analyzing the historical annual mass grant process, new hire grants and other equity grants from fiscal years 1993 through 2006, the Company reviewed historical circumstances and patterns related to its equity granting practices, the requirements of its LTIP, Board of Directors meeting minutes, the minutes of its Compensation Committee or resolutions related to actions taken by the Compensation Committee, Form 4’s, payroll information and other evidence including Company e-mail and related correspondence to determine the most appropriate measurement dates.  After comparing the newly determined most appropriate measurement dates to the original grant dates used in preparing its historical consolidated financial statements, the Company determined that certain equity grants were awarded at exercise prices below the fair market value of its common stock on the measurement date.  As a result, it has recorded additional pre-tax stock-based compensation expense of approximately $2.4 million and $1.9 million to restate its consolidated statements of income and comprehensive income for fiscal years ended December 31, 2005 and January 1, 2005, respectively.  In addition, the Company is also restating its beginning retained earnings balance for the year ended January 1, 2005 by approximately $8.2 million, for which $7.3 million relates to the cumulative impact of the additional compensation expense, for fiscal years 1993 through 2003 and $900,000 relates to the correction of other errors.

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The summary of evidence the Company relied upon to determine the most appropriate measurement dates for stock option grants to employees from 1993 to 2006 is detailed below.

 

Evidence Relied Upon		Number of Grants				Percent of Total				Number of Options				Percent of Total
Payroll information			2,794				44.8	%			6,714,275				34.4	%
Board of Directors meeting minutes			1,212				19.4	%			6,138,796				31.4	%
Company e-mail			1,209				19.4	%			2,862,825				14.6	%
Compensation Committee meeting minutes			458				7.4	%			555,735				2.8	%
International management meetings			275				4.4	%			732,236				3.7	%
Company equity grant administration database			81				1.3	%			271,842				1.4	%
Form 4			27				0.4	%			815,093				4.2	%
All other evidence			183				2.9	%			1,454,112				7.5	%
Total			6,239				100.00	%			19,544,914				100.0	%

 

In addition to the correction of errors related to stock-based compensation discussed above, the Company is correcting other errors in its prior year financial statements.  These errors were not previously recorded as the Company believed the amounts of these errors, both individually and in the aggregate, were not material to its consolidated financial statements.  Accordingly, the Company has restated its consolidated statements of income and comprehensive income and cash flows for the year ended December 31, 2005 to include:  (i) an approximate $442,000 decrease in pre-tax income related to additional employer and employee FICA taxes due, including interest thereon,  in connection with the correction of classifying certain incentive stock options to non-qualified stock options,  (ii) an approximate $979,000 increase in pre-tax income to reverse the impact of certain sales returns recorded in fiscal year 2005 that should have been recorded in fiscal year 2004, which had an effect of increasing net sales, cost of sales and selling and distribution expenses by approximately $2.7 million, $1.2 million and $454,000, respectively, (iii) an approximate $207,000 decrease in pre-tax income to adjust accrued liabilities related to certain management fees that should have been eliminated at the end of fiscal year 2004, (iv) an approximate $1.5 million increase in pre-tax income related to the correction of an error in its analysis for store-impairment related to an improper application of FASB Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which had the effect of reducing depreciation and amortization expense and loss on disposal of assets by $700,000 and $756,000, respectively, (v) a decrease in income tax expense of approximately $600,000 to reduce an accrual for tax penalties, (vi) an approximate $2.4 million increase in income tax expense to increase certain tax contingency reserves released in fiscal year 2005 that should have been released in fiscal year 2004, primarily related to foreign tax liabilities previously recorded for potential tax exposure related to the Company's reorganization of its German subsidiary in fiscal year 2004, and (vii) an approximate $48,000 decrease in income tax expense resulting from the impact of the pre-tax adjustments on additional stock-based compensation expense and other adjustments described in items (i) through (iv) above.

For its previously disclosed basic weighted average common shares outstanding included in the Company’s consolidated statements of income and comprehensive income for the fiscal years ended December 31, 2005 and January 1, 2005, the Company’s restatement includes an approximate 358,000 share and 305,000 share reduction, respectively, to correct an error related to the improper inclusion of unvested restricted shares in such previously reported amounts.

 

The Company is restating its consolidated balance sheet at December 31, 2005 to include:  (i) an increase in cash and cash equivalents and a decrease in accounts receivable-net of $765,000 to correct an error related to the timing of posting certain credit card settlement payments, (ii) a $1.3 million increase to deferred income tax assets, a $1.1 million decrease to income taxes payable and a $114,000 decrease to deferred income tax liabilities related to the tax effect of additional stock-based compensation expense from fiscal year 1993 through fiscal year 2005 and the net impact of expenses related to the correction of other errors and adjustments to certain tax contingency reserves from fiscal year 2001 through fiscal year 2005, (iii) a $907,000 decrease in property, plant and equipment-net and a $900,000 decrease in accrued expenses related to the correction of an error in the Company’s analysis for store impairment, (iv) a $2.3 million increase in accrued expenses related to additional employer and employee FICA taxes due, including interest thereon, in connection with the Company's correction of reclassifying certain incentive stock options to non-qualified stock options, (v) a $12.5 million increase in additional paid-in capital and a $755,000 decrease in deferred compensation related to the impact of adjustments to additional stock-based compensation expense, (vi) an adjustment from other current liabilities to other long term liabilities of approximately $5.5 million related to deferred rent, and (vii) a $11.6 million adjustment to retained earnings relating to the after-tax impact of additional stock-based compensation expense and the net impact of expenses related to the correction of other errors from fiscal year 1993 through fiscal year 2005.

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For fiscal years 2005 and 2004, the Company is restating for approximately $3.5 million and $5.8 million, respectively, of expenses previously disclosed as selling and distribution expense to general and administrative expense.  These expenses were comprised of certain administrative expenses related to the Company's Direct to Consumer segment.  

 

In connection with the Company’s review of its historical equity granting practices and the resulting correction of grant dates for certain equity awards, the Company reviewed the implications of Section 162(m) which prohibits tax deductions for non-performance based compensation paid to its chief executive officer and the four highest compensated officers in excess of one million dollars in a taxable year.  It concluded that no adjustments are required to its previously filed financial statements in connection with the provisions of Section 162(m).

 

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CONSOLIDATED BALANCE SHEETS
AMOUNTS IN THOUSANDS
Fiscal Year		2005
Assets		As Reported				Adjustments				As Restated
Current assets:
Cash and cash equivalents		$	57,457			$	765			$	58,222
Securities available for sale			6,553				-				6,553
Accounts receivable - net			141,958				(765	)			141,193
Inventories - net			241,009				-				241,009
Deferred income tax assets			17,505				1,303				18,808
Prepaid expenses and other current assets			41,387				-				41,387
Total current assets			505,869				1,303				507,172
Investments			9,352				-				9,352
Property, plant and equipment - net			148,150				(907	)			147,243
Goodwill			40,667				-				40,667
Intangible and other assets - net			40,708				-				40,708
Total assets		$	744,746			$	396			$	745,142
Liabilities and Stockholders' Equity
Current liabilities:
Short-term debt		$	8,552			$	-			$	8,552
Accounts payable			60,628			-					60,628
Accrued expenses:
Compensation			19,956				2,303				22,259
Accrued accounts payable			20,928				(900	)			20,028
Accrued royalties			8,316				-				8,316
Co-op advertising			15,178				-				15,178
Other			22,014				(5,464	)			16,550
Income taxes payable			30,228				(1,069	)			29,159
Total current liabilities			185,800				(5,130	)			180,670
Deferred income tax liabilities			29,050				(114	)			28,936
Other long term liabilities			1,220				5,472				6,692
Total long-term liabilities			30,270				5,358				35,628
Minority interest in subsidiaries			2,527				-				2,527
Stockholders' equity:
Common stock, 68,319 shares issued for 2005			683				-				683
Additional paid-in capital			35,161				12,514				47,675
Retained earnings			487,097				(11,593	)			475,504
Accumulated other comprehensive income			7,675				1				7,676
Deferred compensation			(4,467	)			(754	)			(5,221	)
Total stockholders' equity			526,149				168				526,317
Total liabilities and stockholders' equity		$	744,746			$	396			$	745,142

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The impact to beginning retained earnings at January 3, 2004, by fiscal year, for adjustments related to stock-based compensation expense and the correction of other prior period errors is as follows:

 

		Stock Based Compensation								Correction of Other Errors
Amounts in thousands		Pre-Tax				Income Tax				Pre-Tax				Income Tax
		Amount				Effect				Amount				Effect
Effect of restatement on net income by fiscal year:
1993		$	(4	)		$	1			$	-			$	-			$	(3	)
1994			(147	)			36				-				-				(111	)
1995			(498	)			130				-				-				(368	)
1996			(715	)			187				-				-				(528	)
1997			(714	)			187				-				-				(527	)
1998			(912	)			239				-				-				(673	)
1999			(971	)			254				-				-				(717	)
2000			(1,315	)			343				-				-				(972	)
2001			(1,140	)			298				-				(1	)			(843	)
2002			(1,520	)			308				220				(187	)			(1,179	)
2003			(1,643	)			339				(1,336	)			381				(2,259	)
Total effect of restatement on beginning retained earnings at January 3, 2004		$	(9,579	)		$	2,322			$	(1,116	)		$	193			$	(8,180	)

 

For fiscal year 1993 through fiscal year 2001, adjustments to stock-based compensation presented above, net of taxes, represent all of the stock-based compensation included in the Company’s net income for the respective periods.  The Company’s net income for fiscal years 2002, 2003, 2004 and 2005 includes stock-based compensation, net of tax, of $1.5 million, $2.0 million, $2.4 million and $3.1 million, respectively, inclusive of the amounts of stock-based compensation, net of taxes, presented in the table above.

 

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CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA

 

		2005
		As Reported				Adjustments				As Restated
Net sales		$	1,040,468			$	2,652			$	1,043,120
Cost of sales			506,761				1,219				507,980
Gross profit			533,707				1,433				535,140
Operating expenses:
Selling and distribution			315,045				(3,743	)			311,302
General and administrative			109,270				5,580				114,850
Total operating expenses			424,315				1,837				426,152
Operating income			109,392				(404	)			108,988
Interest expense			316				5				321
Other (expense) income - net			(5,512	)			(207	)			(5,719	)
Income before income taxes			103,564				(616	)			102,948
Provision for income taxes			25,505				1,773				27,278
Net income		$	78,059			$	(2,389	)		$	75,670
Other comprehensive income (loss), net of taxes:
Currency translation adjustment			(14,622	)			4				(14,618	)
Unrealized gain on marketable investments			372				-				372
Forward contracts hedging intercompany foreign currency payments - change in fair values			2,478				-				2,478
Total comprehensive income		$	66,287			$	(2,385	)		$	63,902
Earnings per share:
Basic		$	1.10				n/a			$	1.07
Diluted		$	1.07				n/a			$	1.04
Weighted average common shares outstanding:
Basic			70,834				(358	)			70,476
Diluted			73,209				(785	)			72,424

 

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CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA

 

		2004
		As Reported				Adjustments				As Restated
Net sales		$	959,960			$	(2,651	)		$	957,309
Cost of sales			455,919				(1,220	)			454,699
Gross profit			504,041				(1,431	)			502,610
Operating expenses:
Selling and distribution			274,842				(5,377	)			269,465
General and administrative			93,840				8,561				102,401
Total operating expenses			368,682				3,184				371,866
Operating income			135,359				(4,615	)			130,744
Interest expense			30				2				32
Other (expense) income - net			5,773				(277	)			5,496
Income before income taxes			141,102				(4,894	)			136,208
Provision for income taxes			50,533				(3,870	)			46,663
Net income		$	90,569			$	(1,024	)		$	89,545
Other comprehensive income (loss), net of taxes:
Currency translation adjustment			(2,306	)			481				(1,825	)
Unrealized gain on marketable investments			(12	)			-				(12	)
Forward contracts hedging intercompany foreign currency payments - change in fair values			796				-				796
Total comprehensive income		$	89,047			$	(543	)		$	88,504
Earnings per share:
Basic		$	1.28				n/a			$	1.27
Diluted		$	1.22				n/a			$	1.23
Weighted average common shares outstanding:
Basic			70,672				(305	)			70,367
Diluted			74,462				(1,464	)			72,998

 

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CONSOLIDATED STATEMENT OF CASH FLOWS

AMOUNTS IN THOUSANDS

---

 

Fiscal Year		2005
		As Reported				Adjustments				As Restated
Operating Activities:
Net income		$	78,059			$	(2,389	)		$	75,670
Noncash items affecting net income:
Depreciation and amortization			27,210				(700	)			26,510
Stock-based compensation			1,821				2,400				4,221
Minority interest in subsidiaries			4,343				-				4,343
Increase in allowance for returns - net of related inventory			1,544				-				1,544
Loss (gain) on disposal of assets			29				(756	)			(727	)
Equity in income of joint venture			(1,907	)			-				(1,907	)
Decrease in allowance for doubtful accounts			(744	)			-				(744	)
Excess tax benefits from stock based compensation			3,651				(272	)			3,379
Deferred income taxes			(16,888	)			(194	)			(17,082	)
Changes in operating assets and liabilities, net of effects of acquisitions:
Income taxes payable			(18,356	)			2,241				(16,115	)
Accrued expenses			1,528				1,913				3,441
Inventories			(58,612	)			1,220				(57,392	)
Prepaid expenses and other current assets			(9,999	)			-				(9,999	)
Accounts payable			8,852				-				8,852
Accounts receivable			13,257				(2,702	)			10,555
Net cash from operating activities			33,788				761				34,549
Investing Activities:
Additions to property, plant and equipment			(53,202	)			-				(53,202	)
Business acquisitions, net of cash acquired			(4,439	)			-				(4,439	)
Increase in intangible and other assets			(2,032	)			-				(2,032	)
Purchase of short-term marketable investments			(1,293	)			-				(1,293	)
Proceeds from sales of property, plant and equipment			525				-				525
Net cash used in investing activities			(60,441	)			-				(60,441	)
Financing Activities:
Proceeds from exercise of stock options			5,650				-				5,650
Acquisition and retirement of common stock			(75,260	)			-				(75,260	)
Distribution of minority interest earnings			(8,006	)			-				(8,006	)
Net payments on short-term debt			(18,155	)			-				(18,155	)
Net cash used in financing activities			(95,771	)		-					(95,771	)
Effect of exchange rate changes on cash and cash equivalents			(5,549	)			4				(5,545	)
Net decrease in cash and cash equivalents			(127,973	)			765				(127,208	)
Cash and cash equivalents:
Beginning of year			185,430				-				185,430
End of year		$	57,457			$	765			$	58,222

 

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CONSOLIDATED STATEMENT OF CASH FLOWS

AMOUNTS IN THOUSANDS

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Fiscal Year		2004
		As Reported				Adjustments				As Restated
Operating Activities:
Net income		$	90,569			$	(1,024	)		$	89,545
Noncash items affecting net income:
Depreciation and amortization			23,339				-				23,339
Stock-based compensation			1,320				1,911				3,231
Minority interest in subsidiaries			4,054				-				4,054
Increase in allowance for returns - net of related inventory			547								547
Gain on disposal of assets			(129	)			-				(129	)
Impairment loss			-				863				863
Equity in income of joint venture			(1,515	)			-				(1,515	)
Decrease in allowance for doubtful accounts			(1,216	)			-				(1,216	)
Excess tax benefits from stock based compensation			6,497				(491	)			6,006
Deferred income taxes			(14,688	)			(854	)			(15,542	)
Changes in operating assets and liabilities, net of effects of acquisitions:
Income taxes payable			26,306				(2,525	)			23,781
Accrued expenses			12,871				(605	)			12,266
Inventories			(44,204	)			(1,220	)			(45,424	)
Prepaid expenses and other current assets			(3,924	)			-				(3,924	)
Accounts payable			13,260				-				13,260
Accounts receivable			(31,384	)			3,466				(27,918	)
Net cash from operating activities			81,703				(479	)			81,224
Investing Activities:
Additions to property, plant and equipment			(28,407	)			-				(28,407	)
Business acquisitions, net of cash acquired			(47,863	)			-				(47,863	)
Increase in intangible and other assets			(929	)			-				(929	)
Purchase of short-term marketable investments			(298	)			-				(298	)
Proceeds from sales of property, plant and equipment			1,217				-				1,217
Net cash from investing activities			(76,280	)			-				(76,280	)
Financing Activities:
Acquisition and retirement of common stock			(6,923	)		-					(6,923	)
Distribution of minority interest earnings			(3,403	)			-				(3,403	)
Net payments on short-term debt			23,629				-				23,629
Proceeds from exercise of stock options			10,482				-				10,482
Net cash used in financing activities			23,785			-					23,785
Effect of exchange rate changes on cash and cash equivalents			(1,840	)			479				(1,361	)
Net decrease in cash and cash equivalents			27,368			-					27,368
Cash and cash equivalents:
Beginning of year			158,062				-				158,062
End of year		$	185,430			$	-			$	185,430

 

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3.	Acquisitions

In February 2006, Fossil International Holdings, Inc. (“FIH”), a wholly owned subsidiary of the Company, contributed approximately $4.3 million to Fossil Mexico, Sociedad Anonima de Capital Variable (“Fossil Mexico”), a newly-formed entity that is 51% owned by FIH.  On February 1, 2006, Fossil Mexico acquired certain fixed assets, intangible assets and inventory from Grupo Japme, S.A. de C.V.(“Grupo Japme”), the Company’s distributor in Mexico, for a cash purchase price of approximately $7.2 million.  The terms of this transaction include an earnout payment to Grupo Japme in an amount of $1.3 million in the event that defined earnings objectives are achieved within the twelve months following the acquisition date.  The acquisition was recorded as a purchase and resulted in goodwill of approximately $1.0 million.  In 2007, the Company paid an additional $1.3 million in connection with the achievement of the earnout objectives and such amount was recorded as additional goodwill.

In January 2005, Fossil Europe B.V., Ltd. (“Fossil B.V.”) a wholly owned subsidiary of the Company, acquired 100% of the capital stock of IWG Independent Watch Group Scandinavia AB, the Company’s distributor in Sweden, for a cash purchase price of approximately $3.0 million. The acquisition was recorded as a purchase and resulted in goodwill of approximately $1.0 million.

In January 2005, Fossil (Asia) Holdings Limited, a majority controlled subsidiary of the Company, acquired certain assets from Protime Watch Co., Ltd., the Company’s distributor in Taiwan, for a cash purchase price of $2.9 million. The acquisition was recorded as a purchase and resulted in goodwill of $1.3 million.

Effective October 2004, Fossil (East) Limited (“Fossil East”), a wholly-owned subsidiary of the Company, increased its equity interest in Fossil Time Malaysia Sdn. Bhd. to 100% by acquiring 18% of the capital stock from its minority interest holders and increased its equity interest in Fossil Singapore Ptd. Ltd. to 100% by acquiring an additional 19% of the capital stock from its minority interest holders in exchange for cash in the aggregate amount of $770,000. Both of these acquisitions were recorded as purchases and approximately $334,000 of goodwill was recorded in connection with these transactions.

In April 2004, FMW Acquisition, Inc., a wholly-owned subsidiary of the Company, acquired 100% of the outstanding shares of Tempus International Corp. (d/b/a Michele Watches), (“Tempus”) based in Miami, Florida for approximately $50 million in cash. Tempus manufactured, marketed and distributed watches under the MW^® and MW Michele brand labels. This acquisition was recorded as a purchase and the results of Tempus’ operations were included in the Company’s 2004 consolidated statements of operations from the date of aquisition. Total consideration exceeded the fair value of net assets acquired by $51.1 million which is made up of the following: $21.8 million for goodwill, $24 million for tradenames; and $5.3 million for customer lists.  FMW Acquisition, Inc. and Tempus International Corp. were merged into the Company in June 2005 and July 2005, respectively. The underlying non-intellectual property assets associated with such merger were contributed by the Company to Fossil Partners, L.P.

In January 2004, Fossil East acquired 20% of the issued and outstanding shares (the “Shares”) of Fossil (Australia) Pty. Limited. Consideration for the Shares consisted of 2,475 shares of common stock of Fossil, Inc., par value $0.01 per share, and approximately $26,400 in cash. The total value of the transaction was approximately $73,900. Upon closing, Fossil East owned 100% of the issued and outstanding shares of Fossil (Australia) Pty. Limited.  No additional goodwill was recorded as a result of this transaction.

The results of business combinations completed in fiscal 2006 and prior are included in the accompanying consolidated financial statements since the dates of their acquisition. The pro forma effects, as if transactions had occurred at the beginning of the years presented, are not significant.

 

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Goodwill. The changes in the carrying amount of goodwill, which is not subject to amortization, are as follows:

		United								Other				Direct to
IN THOUSANDS		States				Europe				International				Consumer				Total
Balance at January 1, 2005		$	21,097			$	17,213			$	1,502			$	-			$	39,812
Acquisitions		-					994				1,303			-					2,297
Currency			702				(2,079	)			(65	)			-				(1,442	)
Balance at December 31, 2005			21,799				16,128				2,740				-				40,667
Acquisitions			-				-				1,026				-				1,026
Currency			-				1,390				(45	)			-				1,345
Balance at January 6, 2007		$	21,799			$	17,518			$	3,721			$	-			$	43,038

4.	Investments

The Company maintains a 50% equity interest in Fossil Spain, S.A. (“Fossil Spain”) pursuant to a joint venture agreement with Sucesores de A. Cardarso for the marketing, distribution and sale of the Company’s products in Spain and Portugal. The Company has accounted for the investment based upon the equity method from the effective date of the transaction and as of fiscal year-end 2006 the investment was approximately $9.5 million. The Company’s equity in Fossil Spain’s net income was $706,000, $1.9 million, and $1.5 million for fiscal 2006, 2005 and 2004, respectively, and is included in other (expense) income-net.

Fossil East holds 363,624 shares of Crew BOS, an India stock exchange listed company at an original aggregate cost of $1 million. The Company’s ownership represents less than 1% of Crew BOS’s total outstanding shares. The investment has been accounted for under the cost method.

5.	Inventories

Inventories - net consist of the following:

 

Fiscal Year		2006				2005
		IN THOUSANDS
Components and parts		$	9,786			$	14,763
Work-in-process			1,691				4,807
Finished merchandise on hand			175,519				192,121
Merchandise at Company stores			31,807				23,206
Merchandise from estimated customer returns			21,496				18,509
			240,299				253,406
Inventory reserve for obsolescence			(12,074	)			(12,397	)
Inventories - net		$	228,225			$	241,009

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6.	Property, Plant and Equipment

Property, plant and equipment - net consist of the following:

 

Fiscal Year		2006				2005
		IN THOUSANDS
Land		$	15,979			$	14,307
Buildings			72,334				54,112
Furniture and fixtures			66,996				54,507
Computer equipment and software			68,375				62,024
Leasehold improvements			43,637				30,484
Construction in progress			13,361				15,615
			280,682				231,049
Less accumulated depreciation and amortization			109,183				83,806
Property, plant, and equipment - net		$	171,499			$	147,243

 

7.	Intangibles and Other Assets

Intangibles and other assets - net consist of the following:

 

			2006								2005
	Useful		Carrying				Accumulated				Carrying				Accumulated
Fiscal Year	Lives		Amount				Amortization				Amount				Amortization
			IN THOUSANDS
Intangibles - subject to amortization:
Trademarks	10 yrs.		$	2,015			$	1,202			$	1,890			$	1,072
Customer list	9 yrs.			8,274				2,472				5,300				1,325
Patents	14 -20 yrs.			713				174				644				133
Other	7-20 yrs.			194				142				118				113
Total intangibles - subject to amortization				11,196				3,990				7,952				2,643
Intangibles - not subject to amortization:
Tradenames				29,263				-				28,947				-
Other assets:
Deposits				4,020				-				2,788				-
Cash surrender value of life insurance				3,050				-				2,689				-
Other				2,814				136				1,051				76
Total other assets				9,884				136				6,528				76
Total intangibles and other assets			$	50,343			$	4,126			$	43,427			$	2,719
Net of amortization							$	46,217							$	40,708

 

Amortization expense for intangible assets was approximately $1,356,000, $946,000 and $740,000 for fiscal 2006, 2005 and 2004, respectively. Amortization expense related to existing intangibles is estimated to be approximately $1.3 million for each of the years 2007, 2008, 2009 and 2010 and $673,000 for 2011.

 

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8.	Short Term Debt

Banks: U.S.-based:  On September 21, 2006, the Company executed the renewal of its Loan Agreement and Revolving Line of Credit (the “Revolver”) with its primary bank, Wells Fargo Bank (“Wells Fargo”), dated September 23, 2004, whereby Wells Fargo will provide a revolving line of credit of up to $100 million.  The Revolver is secured by 65% of the issued and outstanding shares of certain subsidiaries of the Company pursuant to an Amended and Restated Stock Pledge Agreement entered into as of September 21, 2006.  The Revolver requires the maintenance of net worth, quarterly income, working capital and certain financial ratios.  Borrowings under the Revolver bear interest at the option of the Company (i) at the London Interbank Offer Rate, (“LIBOR”), base rate (5.32% at year-end) plus 50 basis points, or (ii) at the lesser of (a) the higher of Wells Fargo’s prime rate (8.25% at year-end) less 1.0% or 3.0%, or (b) the maximum rate allowed by law.  The Company may prepay the Revolver without penalty.  Wells Fargo may accelerate the note to be immediately due and payable if the Company fails to pay any part of the principal or interest of the Revolver, or upon an Event of Default.  The Company intends to use the proceeds for working capital needs, potential acquisitions and for general corporate purposes, including potential common stock repurchases.  The Loan Agreement and the Revolver expire on September 20, 2007.  There were $5 million in borrowings outstanding under the Revolver as of fiscal year-end 2005.  There were no outstanding borrowings as of fiscal year-end 2006. The Company incurred approximately $3 million, $239,000 and $7,000 of interest expense related to outstanding borrowings under the credit facility for fiscal years 2006, 2005 and 2004, respectively.

On December 21, 2006, the Company and Wells Fargo executed a Fourth Amendment to the Revolver that modified certain financial and non-financial covenants, including a restriction on the Company relating to future common stock repurchases.  The Company anticipates this restriction to be lifted contemporaneously with its filing of this Form 10-K.  The Company is in compliance with all covenants related to its amended Loan Agreement as of January 6, 2007.

At fiscal year-end 2006 and 2005, the Company had outstanding letters of credit of approximately $15.9 million and $17.7 million, respectively, to vendors for the purchase of merchandise, which amounts reduced availability of borrowings under the Revolver.

Banks: Foreign-based: During March 2006, Fossil U.K. Ltd. (“Fossil UK”) entered into a revolving credit facility with its primary bank allowing borrowings of up to 4 million GBP. All outstanding borrowings under the facility bear interest at the aggregate of the Margin, LIBOR and Mandatory Lending Agreement (“MLA”), costs (6.17% on a combined basis at fiscal year-end). In connection with the financing agreement, Fossil U.K. pays an unused fee of 0.32% per year. U.K.-based borrowings, in U.S. dollars, under the facility were approximately $7.7 million at fiscal year-end 2006.  Borrowings made under this credit facility were used to acquire a new facility for the Company’s U.K.-based operations.  The Company’s Japanese subsidiary, Fossil Japan, maintains a short-term credit facility allowing for borrowings of up to 400 million yen, bearing interest based upon the Euroyen rate which was 1.38% as of fiscal year-end 2006. In connection with the financing agreement, Fossil Japan pays an unused fee of 0.3% per year. Any outstanding borrowings under the Japan facility reduce the amount of borrowings available under the Revolver. Japan-based borrowings, in U.S. dollars, under the facility were approximately $3.4 million for both fiscal year-end 2006 and 2005 and were primarily used for working capital purposes.

 

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9.	Other (Expense) Income – Net

Other (expense) income – net consists of the following:

 

Fiscal Year		2006				2005				2004
		IN THOUSANDS
Minority interest expense		$	(4,382	)		$	(4,343	)		$	(4,054	)
Equity in the earnings of joint venture			706				1,856				1,873
Interest income			1,113				1,590				1,283
Currency gains (losses)			2,039				(3,780	)			6,943
Royalty income			415				510				302
Other gains (losses)			(867	)			(1,552	)			(851	)
		$	(976	)		$	(5,719	)		$	5,496

 

10.

Taxes

Income Taxes

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of the consolidated deferred tax assets and liabilities were:

 

Fiscal Year		2006				2005
		IN THOUSANDS
Current deferred tax assets (liabilities):
Bad debt allowance		$	3,550			$	4,008
Returns allowance			8,841				7,245
Inventory			4,187				1,940
Compensation			4,778				4,625
Accrued liabilities			3,117				2,679
In-transit returns inventory			(5,413	)			(5,421	)
Deferred rent			281				2,236
Loss carry-forwards			2,320				-
Other			845				1,496
Total current deferred tax assets			22,506				18,808
Valuation allowance			(2,100	)			-
Net current deferred tax assets			20,406				18,808
Long-term deferred tax assets (liabilities):
Fixed assets			(6,606	)			(4,228	)
Trade-names and customer list			(9,792	)			(10,382	)
Compensation			453				335
Deferred rent			2,453				-
Loss carry-forwards			882				2,692
Undistributed earnings of certain foreign subsidiaries			(2,154	)			(13,280	)
Tax deductible foreign reserves			(1,482	)			(828	)
Unrealized exchange gain			(830	)			(856	)
Other			2,937				303
Total deferred tax liabilities			(14,139	)			(26,244	)
Valuation allowance			(882	)			(2,692	)
Net long-term deferred tax liabilities		$	(15,021	)		$	(28,936	)

 

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The current deferred tax asset for loss carry-forwards includes a $6 million U.S. capital loss carry-forward that expires in 2007 and $1.1 million of net operating losses of foreign subsidiaries that expire at various dates for the years indicated. Valuation allowances have been recorded to reflect the estimated amount of deferred tax assets that may not be realized on these losses.

 

Capital loss carry-forwards:
		(IN THOUSANDS)
Expires 2007		$	6,000
Expires 2008			8
Expires 2009			15
Expires 2010			-
Expires 2011			2
Expires thereafter			1,075
Total capital loss carry-forward		$	7,100

 

 

The following table identifies earnings before income taxes for the Company’s U.S. and non-U.S. based operations for the years indicated.

 

Fiscal Year		2006				2005				2004
		IN THOUSANDS
U.S		$	40,129			$	20,721			$	27,286
Non-U.S.			78,666				82,227				108,922
Total		$	118,795			$	102,948			$	136,208

 

The Company’s provision for income taxes consists of the following for the years indicated:

Fiscal Year		2006				2005				2004
		IN THOUSANDS
Current provision:
U.S. Federal		$	37,128			$	19,443			$	26,359
Non-U.S.			16,377				19,101				27,081
State and local			1,427				2,437				2,760
Total current			54,932				40,981				56,200
Deferred provision
U.S. Federal			(15,580	)			(16,046	)			(8,432	)
Non-U.S.			199				(983	)			(6,138	)
State and local			(104	)			(53	)			(973	)
Total deferred			(15,485	)			(17,082	)			(15,543	)
Tax equivalent related to exercise of stock options
(credited to additional paid-in capital)			1,766				3,379				6,006
Provision for income taxes		$	41,213			$	27,278			$	46,663
Tax (benefit) expense related to other comprehensive (loss) income		$	(28	)		$	799			$	523

 

The Company was granted a 100% tax holiday for its watch assembly activities in Switzerland for tax years 2003 through 2007 which will decrease to a 60% holiday from 2008 through 2012.  After 2012, the Company will pay the full Swiss tax rate on its watch assembly activities.  This holiday had the effect of reducing current foreign income taxes by $400,000, $1.2 million and $300,000 in fiscal years 2006, 2005 and 2004. 

A reconciliation of income tax computed at the U.S. federal statutory income tax rate of 35% to the provision for income taxes is as follows:

Fiscal Year		2006				2005				2004
Tax at statutory rate			35.0	%			35.0	%			35.0	%
State, net of federal tax benefit			0.7	%			0.8	%			0.9	%
Foreign rate differential			(9.2	)%			(9.8	)%			(12.5	)%
U.S. tax on foreign income			9.0	%			12.3	%			10.1	%
Dividends received deduction			-				(11.8	)%			-
Other			(.8	)%			-				0.8	%
Provision for income taxes			34.7	%			26.5	%			34.3	%

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The lower effective tax rate in 2005 was the result of the Company’s ability, pursuant to the American Jobs Creation Act of 2004, to reduce previously recorded deferred tax liabilities by repatriating foreign earnings at an effective tax rate substantially below the statutory rate at which these deferred tax liabilities were established.

 

Deferred U.S. federal income taxes are not provided on undistributed earnings of certain foreign subsidiaries where management plans to continue reinvesting these earnings outside the United States. Determination of such tax amounts that would be payable if earnings were distributed to the U.S. Company is not practical because potential offsets of foreign tax credits would be available under various assumptions involving the tax calculation.

 

The Internal Revenue Service (“IRS”) has substantially completed a field audit of the Company’s federal income tax returns for the years 2003 and 2004 and proposed certain adjustments. The Company has filed a protest of these adjustments through the IRS Office of Appeals. In addition, the Company is subject to audits by state, local, and foreign tax authorities. The Company believes that adequate provisions have been made for any adjustments that may result from tax examinations, however, audit outcomes and the timing of audit settlements are subject to significant uncertainty.  Should any issues addressed in the Company’s tax audits be resolved in a manner not consistent with its expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs.

 

Other Taxes

The Company also reviewed the consequences of issuing in-the-money stock options under Section 409A.  The Company plans to reimburse its employees for any tax liability, including interest and penalties, arising under Section 409A relating to in-the-money stock options exercised by such employees subsequent to December 31, 2005 up to a certain date.  The Company estimates such reimbursement to employees will approximate $766,000 and expects to record this charge in fiscal year 2007.  The Company intends to offer option holders the opportunity to amend certain vested and un-exercised options that were granted in-the-money to avoid any future adverse tax consequences under Section 409A.  The Company also anticipates giving such option holders (excluding executive officers) a cash bonus for the increase in the exercise price.  The Company estimates it will make cash payments totaling approximately $2.0 million in fiscal year 2008 to option holders.  The Company will record such bonuses as additional compensation expense in fiscal year 2007.  The Company will account for any modification of stock options in accordance with SFAS 123R.  The financial impact of this modification is not yet known but is expected to be recorded in fiscal year 2007.  The Company is also reviewing “in-the-money” option grants to its non-U.S.-based employees to determine what additional tax liabilities, if any, the Company or its employees may incur in connection with such “in-the-money” grants.  

 

Unrelated to the Special Committee’s review of the Company’s equity granting practices, the Company identified that certain grants previously awarded to employees as incentive stock options should have been treated as non-qualified stock options.  Due to different tax requirements associated with the exercise of an incentive stock option versus a non-qualified stock option, it has determined that certain employer and employee FICA taxes and employee withholding taxes were not properly withheld at the time such options were exercised by its employees.  The Company has determined that for any amounts due from the beginning of fiscal year 2004 through the current date, it will indemnify its employees’ FICA amounts that are required to be paid, as a result of the now non-qualified status of these stock option grants.  The Company estimates that amounts to be paid related to the delinquent FICA taxes and similar social taxes related to certain international subsidiaries, including the employer and employee portion, including interest thereon, will approximate $1.8 million of which $1.4 million  was recorded as part of its restatement.  

 

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11.	Commitments

License Agreements. The Company has various license agreements to market watches bearing certain trademarks or patents owned by various entities. In accordance with these agreements, the Company incurred royalty expense of approximately $44.1 million, $34.6 million and $32.9 million in fiscal years 2006, 2005 and 2004, respectively. These amounts are included in the Company’s cost of sales and selling and distribution expenses. The Company has various agreements in effect at the end of fiscal year 2006 which expire on various dates between 2007 and 2012 and such agreements also require the Company to pay royalties ranging from 3.0% to 20.0% of defined net sales. Future minimum royalty commitments under such license agreements at the close of fiscal year 2006 are as follows (amounts in thousands):

 

2007		$	40,535
2008			37,618
2009			17,621
2010			9,937
2011			5,026
Thereafter			5,026
		$	115,763

 

Leases. The Company leases its retail and outlet store facilities as well as certain of its office facilities and equipment under non-cancelable operating leases and capital leases. Most of the retail store leases provide for contingent rental based on operating results and require the payment of taxes, insurance and other costs applicable to the property. Generally, these leases include renewal options for various periods at stipulated rates. Rent expense under these agreements was approximately $38.0 million, $31.5 million and $29.8 million for fiscal years 2006, 2005 and 2004, respectively. Contingent rent expense has been immaterial in each of the last three fiscal years. Future minimum rental commitments under such non-cancelable leases at the close of fiscal year 2006 are as follows (amounts in thousands):

 

		Operating				Capital
2007		$	32,115				277
2008			27,124				277
2009			23,432				277
2010			19,678				277
2011			14,300				277
Thereafter			44,095				622
		$	160,744				2,007
Less amounts representing interest							(171	)
Capital lease obligations , included in short-term debt and in other long-term liabilities							1,836

 

The Company has entered into a sublease agreement with a third party related to one of its retail store locations pursuant to which future sublease income is expected to be approximately $1.1 million for each of the years 2007, 2008, 2009, and 2010 and $623,000 in 2011.

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From time to time the Company is involved in litigation, most of which is incidental to its business. In the Company’s opinion, no litigation to which the Company currently is a party is likely to have a material adverse effect on the Company’s results of operations, financial condition or cash flows.

 

12.	Stockholders’ Equity and Benefit Plans

Common and Preferred Stock.  On March 12, 2004, the Board of Directors declared a three-for-two stock split (“2004 Stock Split”) of the Company’s common stock, par value $0.01 (the “Common Stock”), which was effected in the form of a stock dividend which was paid on April 8, 2004 to stockholders of record on March 26, 2004. Retroactive effect on prior years was given to the 2004 Stock Split in all share and per share data in these consolidated financial statements and notes.

The Company has 100,000,000 shares of authorized $0.01 par value Common Stock, with 67,793,918 and 68,318,730 shares issued at the close of fiscal years 2006 and 2005, respectively. The Company has 1,000,000 shares of authorized $0.01 par value preferred stock with none issued or outstanding. Rights, preferences and other terms of preferred stock will be determined by the Board of Directors at the time of issuance.

Common Stock Repurchase Programs. During fiscal years 2005 and 2004, the Company’s Board of Directors approved stock repurchase programs, pursuant to which up to 4,500,000 and 667,000 shares, respectively, of its Common Stock may be repurchased.  During fiscal years 2006, 2005 and 2004, the Company repurchased and retired 1.3 million, 3.6 million and 247,000 shares, respectively, of its Common Stock under these repurchase programs at a cost of approximately $25.9 million, $75.3 million and $6.9 million, respectively. All authorized purchases under such programs were completed in April 2006.

Deferred Compensation and Savings Plans. The Company has a savings plan in the form of a defined contribution plan (the “401(k) Plan”) for substantially all U.S. based full-time employees of the Company. After one year of service (minimum of 1,000 hours worked), the Company matches 50% of employee contributions up to 3% of their compensation and 25% of the employee contributions between 4% and 6% of their compensation. The Company also has the right to make certain additional matching contributions not to exceed 15% of employee compensation. The Company has not made any additional matching contributions during fiscal years 2006, 2005 and 2004.  The Company’s common stock is one of several investment alternatives available under the 401(k) Plan. Matching contributions made by the Company to the 401(k) Plan totaled approximately $850,000, $842,000 and $633,000 for fiscal years 2006, 2005 and 2004, respectively.

In December 1998, the Company adopted the Fossil, Inc. and Affiliates Deferred Compensation Plan (the “Deferred Plan”). Eligible participants may elect to defer up to 50% of their salary pursuant to the terms and conditions of the Deferred Plan.  In addition, the Company may make employer contributions to participants under the Deferred Plan from time to time. The Company made no contributions to the Deferred Plan during fiscal years 2006, 2005 and 2004.

Stock-Based Compensation Plans. In December 2004, the FASB issued SFAS 123R, which requires all share-based payments, including grants of employee stock options, to be recognized in the financial statements based on their fair values.  Under SFAS 123R, public companies are required to measure the cost of services received in exchange for stock options and similar awards based on the grant-date fair value of the award and recognize this cost in the income statement over the period during which an award recipient is required to provide service in exchange for the award.  The pro forma disclosures previously permitted under SFAS 123 are no longer an alternative to financial statement recognition.

 

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Restricted Stock Plan. The 2002 Restricted Stock Plan of the Company is intended to advance the best interests of the Company, its subsidiaries and its stockholders in order to attract, retain and motivate key employees by providing them with additional incentives through the award of shares of restricted stock. To date, shares awarded under the Restricted Stock Plan have been funded with shares contributed to the Company from a significant stockholder. During 2006, 2005 and 2004, 44,200, 53,800 and 137,200 shares, respectively, of stock were contributed to the Restricted Stock Plan by the stockholder and reissued by the Company to the employees. At fiscal year-end 2006, 69,000 shares issued to employees were forfeited and are held in the Company treasury to be issued as future awards are granted.  The restricted shares outstanding have original vesting periods that predominantly range from one to five years. These shares were accounted for at fair value at the date of grant.  At fiscal year-end 2006, the Company has available 626,550 common shares for future issuances under the Restricted Stock Plan.

 

Long Term Incentive Plan.   An aggregate of 5,821,875 shares of common stock were initially reserved for issuance pursuant to the Long Term Incentive Plan (“LTIP”), adopted April 1993. An additional 3,037,500 shares were reserved in each of fiscal years 1995, 1998, 2001 and 2003 for issuance under the LTIP. Designated employees of the Company, including officers and directors, are eligible to receive (i) stock options, (ii) stock appreciation rights, (iii) restricted or non-restricted stock awards, (iv) restricted stock units, (v) cash awards, or (vi) any combination of the foregoing. The LTIP is administered by the Compensation Committee of the Company’s Board of Directors (the “Compensation Committee”). Each award issued under the LTIP terminates at the time designated by the Compensation Committee, not to exceed ten years. The current options, stock appreciation rights, restricted stock and restricted stock units outstanding have original vesting periods that predominately range from three to five years.  All stock appreciation rights and restricted stock units are settled in shares of Company common stock.

 

Nonemployee Director Stock Option Plan. An aggregate of 506,250 shares of common stock were reserved for issuance pursuant to the Nonemployee Director Stock Option Plan, adopted April 1993. An additional 112,500 shares were reserved in fiscal year 2002 for issuance under this plan. During the first year individuals are elected as nonemployee directors of the Company, they receive a grant of 5,000 nonqualified stock options. In addition, on the first day of each subsequent calendar year, each nonemployee director automatically receives a grant of an additional 4,000 nonqualified stock options as long as the individual is serving as a nonemployee director. Pursuant to this plan, 50% of the options granted will become exercisable on the first anniversary of the date of grant and in two additional installments of 25% on the second and third anniversaries. The exercise prices of options granted under this plan were not less than the fair market value of the Company’s common stock at the date of grant.

 

Pro forma disclosures as if the Company had adopted the fair value recognition requirements under SFAS 123 for stock option awards in fiscal years 2005 and 2004, respectively, are presented in the following table.

Fiscal Year		2005				2004
		(In thousands, except per share data)
Net income, as reported		$	75,670			$	89,545
Add: Stock-based employee compensation included in reported net income, net of tax			3,101				2,365
Deduct fair value based compensation expense, net of tax			(21,182	)			(7,640	)
Pro forma net income		$	57,589			$	84,270
Basic earnings per share:
As reported		$	1.07			$	1.27
Pro forma under SFAS 123		$	0.82			$	1.20
Diluted earnings per share:
As reported		$	1.04			$	1.23
Pro forma under SFAS 123		$	0.80			$	1.15

 

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As of January 6, 2007, there was approximately $13.1 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the incentive plans. This cost is expected to be recognized over a weighted-average period of approximately 2 years.

Stock options and stock appreciation rights.  The fair value of stock options and stock appreciation rights granted under the Company’s stock-based compensation plans was estimated on the date of grant using the Black-Scholes option-pricing model.  The table below outlines the weighted average assumptions for these award grants:

		2006				2005				2004
Risk-free interest rate			4.71	%			4.16	%			2.95	%
Expected term (in years)			5.53				5.00				4.50
Expected volatility			57.98	%			58.83	%			60.37	%
Expected dividend yield			-	%			-	%			-	%
Estimated fair value per option/ stock appreciation right granted			10.12				13.72				12.66

The expected term of the options represent the estimated period of time until exercise and is based on historical experience of similar awards.  Expected stock price volatility is based on the historical volatility of the Company’s common stock.  The risk-free rate is based on the implied yield available on U.S. Treasury issues with an equivalent remaining term.

The Company receives a tax deduction for certain stock option exercises/restricted stock vestings when the options/restricted shares are exercised/vested. Generally for options, the tax deduction is related to the excess of the stock price at the time the options are sold over the exercise price of the options. For restricted shares, the tax deduction is the fair market value of the stock on the date the restricted shares vest. Prior to the adoption of SFAS 123R, the Company presented all tax benefits resulting from the exercise of stock options and the vesting of restricted shares as operating cash inflows in the Consolidated Statements of Cash Flows. SFAS 123R requires the benefits of tax deductions in excess of the grant-date fair value for those options and restricted shares to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis. This amount is shown as “Excess tax benefits from stock-based compensation” on the Consolidated Statements of Cash Flows and for 2006 amounted to approximately $1.5 million.

The following table summarizes stock option and stock appreciation right activity:

 

										Weighted
										Average
						Weighted				Remaining				Aggregate
						Average				Contractual				Intrinsic
Options and stock appreciation rights		Shares				Exercise Price				Term (years)				Value
		IN THOUSANDS												IN THOUSANDS
Outstanding at January 3, 2004			6,252			$	8.01				5.0			$	50,074
Granted			1,201			$	20.62
Exercised			(1,420	)		$	7.13							$	25,079
Forfeited or expired			(303	)		$	11.85
Outstanding at January 1, 2005			5,730			$	10.67				5.0			$	61,121
Granted			823			$	25.45
Exercised			(810	)		$	6.97							$	12,697
Forfeited or expired			(303	)		$	14.60
Outstanding at December 31, 2005			5,440			$	13.23				5.1			$	71,983
Granted			441			$	19.02
Exercised			(710	)		$	7.21							$	8,456
Forfeited or expired			(247	)		$	19.97
Outstanding at January 6, 2007			4,924			$	14.28				5.0			$	70,324
Exercisable at January 1, 2005			2,458			$	6.67				3.7			$	16,403
Exercisable at December 31, 2005			4,390			$	13.53				5.0			$	59,405
Exercisable at January 6, 2007			4,104			$	14.03				4.7			$	57,561
Nonvested at January 6, 2007			820			$	15.56				6.6			$	12,763
Expected to vest			738			$	15.56				6.6			$	11,487

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The aggregate intrinsic value in the table above is before income taxes and is based on the exercise price for outstanding and exercisable options/rights at January 6, 2007 and based on the fair market value of the Company’s common stock on the exercise date for options/rights that have been exercised during the fiscal year.  

 

Options and Stock Appreciation Rights Outstanding and Exercisable.  The following table summarizes information with respect to options and stock appreciation rights outstanding and exercisable at January 6, 2007 (share amounts are in thousands of dollars):

 

Options and Stock Appreciation Rights Outstanding																Options and Stock Appreciation Rights Exercisable
												Weighted-
								Weighted-				Average								Weighted-
								Average				Remaining								Average
Range of				Number of				Exercise				Contractual				Number of				Exercise
Exercise Prices				Shares				Price				Life (Yrs.)				Shares				Price
$0.00 - $3.14					74.8				2.47				0.1				74.8			$	2.47
3.14 - 6.28					455.4				4.70				1.9				455.4				4.70
6.28 - 9.42					1,481.9				8.31				3.5				1,369.7				8.23
9.42 - 12.56					690.5				11.57				5.4				455.4				11.54
12.56 - 15.70					99.6				13.33				5.6				81.4				13.29
15.70 - 18.83					400.2				18.26				6.8				93.2				17.83
18.83 - 21.97					837.8				19.26				6.4				740.1				19.18
21.97 - 25.11					93.4				23.43				7.2				45.5				23.76
25.11 - 28.25					700.4				25.82				7.0				698.2				25.82
28.25 - 31.39					90.2				29.47				7.5				90.2				29.47
					4,924.2				14.28				5.0				4,103.9				14.03

 

The Company has elected to apply the long-form method to determine the hypothetical additional paid-in capital (“APIC”) pool provided by FASB Staff Position SFAS 123R - 3, (Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards).  The Company had determined that a hypothetical pool of excess tax benefits existed in APIC as of January 1, 2006, the date of adoption of SFAS 123R, related to historical stock option exercises.  In future periods, excess tax benefits resulting from stock option exercises will be recognized as additions to APIC in the period the benefit is realized.  In the event of a shortfall (that is, the tax benefit realized is less than the amount previously recognized through periodic stock compensation expense recognition and related deferred tax accounting), the shortfall would be charged against APIC to the extent of previous excess benefits, if any, including the hypothetical APIC pool, and then to tax expense.

Restricted Stock and Restricted Stock Units. The following table summarizes restricted stock and restricted stock unit activity:

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Restricted Stock and Restricted Stock Units		Shares				Weighted Average Grant-Date Fair Value
		IN THOUSANDS
Nonvested at January 3, 2004			341			$	12.67
Granted			137			$	25.39
Vested			(55	)		$	13.21
Forfeited			(14	)		$	14.29
Nonvested at January 1, 2005			409			$	16.81
Granted			54			$	25.77
Vested			(77	)		$	16.62
Forfeited			-			$	20.42
Nonvested at December 31, 2005			386			$	18.03
Granted			206			$	19.35
Vested			(88	)		$	17.74
Forfeited			(69	)		$	18.69
Nonvested at January 6, 2007			435			$	18.62
Expected to vest			392			$	18.62

 

    The total fair value of shares/units vested during 2006, 2005 and 2004 was $1.6 million, $1.8 million and $1.2 million, respectively.

 

13.	Supplemental Cash Flow Information

 

Fiscal Year		2006				2005				2004
		IN THOUSANDS
Cash paid during the year for:
Interest		$	3,471			$	315			$	30
Income taxes		$	29,858			$	59,774			$	33,110

Supplemental disclosures of non-cash investing and financing activities:

 

Purchase of property for capital lease
obligation		$	4			$	47			$	1,560
Additions to property, plant and equipment
included in accounts payable		$	1,794			$	2,821			$	1,266

14.	Major Customer, Segment and Geographic Information

    In accordance with Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, the Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments.

 

    The Company manages its business primarily on a geographic basis. The Company’s reportable segments are comprised of the United States, Europe, Other International and Direct to Consumer. The United States, Europe, and Other International reportable segments do not include activities related to the Direct to Consumer segment.   The Europe segment primarily includes sales to wholesale or distributor customers based in European countries as well as the Middle East and Africa.  The Other International segment primarily includes sales to wholesale or distributor customers based in Australia, Canada, China (including the Company’s assembly and procurement operations), Indonesia, Japan, Korea, Malaysia, Mexico, Singapore, South America and Taiwan. The Direct to Consumer segment includes company-owned retail stores and e-commerce sales.  Each reportable geographic segment provides similar products and services, and the accounting policies of the various segments are the same as those described in Note 1, “Significant Accounting Policies”.

 

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    The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of the customers. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment.  Operating income for each segment includes intercompany profits associated with the sale of products by one segment to another.  For segment presentation, due to the Company’s diversified business model, it is impractical to eliminate such intercompany profits and include them in the respective segment that ultimately sells the product to an unrelated third party.  However, in evaluating the performance of each segment, management considers the impact that such profits have on each reportable segment.  Costs associated with various corporate expenses are not allocated to the various segments but are included in the United States segment. Intercompany sales of products between segments are referred to as intersegment items. Corporate assets including cash, short-term investments and certain intangible assets are included in the United States segment.  Summary information by operating segment follows:

 

SEGMENT INFORMATION

 

		Fiscal Year 2006
		Net Sales				Operating Income				Long-lived Assets				Total Assets
IN THOUSANDS
United States - wholesale:										$	128,709			$	387,532
External customers		$	442,753			$	(11,762	)
Intersegment			118,638				-
Direct to consumer			220,782				21,591				40,247				92,473
Europe - wholesale:											87,459				275,340
External customers			378,650				39,798
Intersegment			215,281				-
Other international - wholesale:											15,194				97,252
External customers			171,780				73,698
Intergsegment			335,613				-
Intersegment items			(669,532	)			-
Consolidated		$	1,213,965			$	123,325			$	271,609			$	852,597

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		Fiscal Year 2005
		Net Sales				Operating Income				Long-lived Assets				Total Assets
IN THOUSANDS
United States - wholesale:										$	137,264			$	385,985
External customers		$	411,735			$	(19,640	)
Intersegment			103,293				-
Direct to consumer			172,969				12,491				28,986				67,086
Europe - wholesale:											61,203				211,162
External customers			316,353				31,239
Intersegment			181,417				-
Other international - wholesale:											10,517				80,909
External customers			142,063				84,898
Intersegment			336,619				-
Intersegment items			(621,329	)		-
Consolidated		$	1,043,120			$	108,988			$	237,970			$	745,142

 

		Fiscal Year 2004
		Net Sales				Operating Income				Long-lived Assets				Total Assets
IN THOUSANDS
United States - wholesale:										$	127,877			$	332,290
External customers		$	381,574			$	15,798
Intersegment			163,383				-
Direct to consumer			144,223				7,996				18,523				54,101
Europe - wholesale:											53,542				215,803
External customers			304,285				28,353
Intersegment			78,935				-
Other international - wholesale:											7,653				181,228
External customers			127,227				78,988
Intersegment			310,124				-
Intersegment items			(552,442	)			-
Consolidated		$	957,309			$	131,135			$	207,595			$	783,422

 

GEOGRAPHIC INFORMATION

Customers of the Company consist principally of major department stores and specialty retail stores located throughout the world.  In connection with Federated Department Store Inc.’s acquisition of May Department Stores Co. in 2005, net sales to this combined entity would approximate 9%, 10% and 11% for fiscal years 2006, 2005 and 2004.  Net sales, operating income and long-lived assets related to the Company’s operations in the U.S., Europe and Other International markets are as follows:

 

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		Fiscal Year 2006
		Net Sales				Operating Income				Long-lived Assets
IN THOUSANDS
United States		$	632,431			$	7,961			$	163,060
Europe			397,922				40,301				91,024
Other international			183,612				75,063				17,525
Consolidated		$	1,213,965			$	123,325			$	271,609

 

		Fiscal Year 2005
		Net Sales				Operating Income				Long-lived Assets
IN THOUSANDS
United States		$	568,586			$	(7,678	)		$	163,235
Europe			325,101				30,147				62,463
Other international			149,433				86,519				12,272
Consolidated		$	1,043,120			$	108,988			$	237,970

 

		Fiscal Year 2004
		Net Sales				Operating Income				Long-lived Assets
IN THOUSANDS
United States		$	511,411			$	23,289			$	144,050
Europe			313,325				27,975				55,494
Other international			132,573				79,871				8,051
Consolidated		$	957,309			$	131,135			$	207,595

 

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

We have had no changes in or disagreements with our accountants to report under this item.

Item 9A.  Controls and Procedures

Controls Evaluation and Related CEO and CFO Certifications

We conducted an evaluation of the effectiveness of the design and operation of the “disclosure controls and procedures” (“Disclosure Controls”), as defined by Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), as of the end of the period covered by this Annual Report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).

Attached as exhibits to this Annual Report are certifications of the CEO and the CFO, which are required in accordance with Rule 13a-14 of the Exchange Act. This “Controls and Procedures” section includes the information concerning the controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Definition of Disclosure Controls

Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed in the reports filed under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our Disclosure Controls include components of internal control over financial reporting, which consists of control processes designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles in the United States. To the extent that components of our internal control over financial reporting are included within our Disclosure Controls, they are included in the scope of the quarterly controls evaluation.

 

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Limitations on the Effectiveness of Controls

Our management, including the CEO and CFO, does not expect that the Disclosure Controls or internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Scope of the Controls Evaluation

The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, our implementation of the Disclosure Controls and the effect of the controls on the information generated for use in this Annual Report. In the course of the controls evaluation, we sought to identify data errors, control problems or acts of fraud and confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the Disclosure Controls can be reported in our Quarterly Reports on Form 10-Q and to supplement the disclosures made in our Annual Report on Form 10-K. Many of the components of the Disclosure Controls are also evaluated on an ongoing basis by the Internal Audit Department and by other personnel in the finance department. The overall goals of these various evaluation activities are to monitor our Disclosure Controls, and to modify them as necessary. Our intent is to maintain the Disclosure Controls as dynamic systems that change as conditions warrant.

Among other matters, we also considered whether the evaluation identified any “significant deficiencies” or “material weaknesses” in internal control over financial reporting, and whether we had identified any acts of fraud involving personnel with a significant role in our internal control over financial reporting. This information was important both for the controls evaluation generally, and because Item 5 in the certifications of the CEO and CFO requires that the CEO and CFO disclose that information to our Board’s Audit Committee and to our independent registered public accountants. In the PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements,” a “significant deficiency” is referred to as a control deficiency, or combination of control deficiencies, that adversely affect our ability to initiate, authorize, record, process or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of our annual or interim financial statements that is more than inconsequential will not be prevented or detected. A “material weakness” is referred to as a significant deficiency or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. We also sought to address other controls matters in the controls evaluation, and if a problem was identified, we considered what revision, improvement and/or correction to make in accordance with its ongoing procedures.

 

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Restatement

We have restated all prior period financial statements included in this Form 10-K for the effects of errors in accounting for stock-based compensation.  We have concluded that the restatement is a result of the material weakness in internal control over financial reporting.

Evaluation of Disclosure Controls and Procedures

 

In connection with the filing of our Annual Report on Form 10-K for the year ended January 6, 2007, our management, with participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our Disclosure Controls and procedures and concluded that, because of the material weakness in our internal control over financial reporting relating to equity grant administration and accounting for and disclosure of equity grants discussed below, our Disclosure Controls and procedures were not effective as of January 6, 2007.

The Public Company Accounting Oversight Board’s Auditing Standard No. 2 defines a material weakness as a significant deficiency, or a combination of significant deficiencies, that results in there being a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.  Specifically, we did not design and implement controls necessary to provide reasonable assurance that the grant dates we used for equity grants were appropriately determined in accordance with the provisions of APB No. 25.

Management’s Report on Internal Control Over Financial Reporting

We are responsible for establishing and maintaining adequate internal control over the Company’s financial reporting. There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal controls can provide only reasonable assurances with respect to financial statement preparation. Further because of changes in conditions, the effectiveness of internal control may vary over time.

 

We assessed the effectiveness of our internal control over financial reporting as of January 6, 2007. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework.

The following material weakness has been identified and included in management's assessment. The Company did not design and implement controls necessary to provide reasonable assurance that the measurement date for stock option grants was appropriately determined.  As a result, the measurement date used for certain option grants was not appropriate and such grants were not accounted for in accordance with generally accepted accounting principles. 

 

As a result of the above material weakness, we concluded that, as of January 6, 2007, our internal control over financial reporting was not effective.

 

Our independent registered public accounting firm, Deloitte & Touche LLP, has issued a report on our management’s assessment of our internal control over financial reporting. The report is included herein.

 

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Changes in Internal Control over Financial Reporting

No change in internal control over financial occurred during the quarter ended January 6, 2007 that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting. Subsequent to January 6, 2007 and as a result of identifying a material weakness in our internal control over financial reporting, we have adopted certain recommendations of the Special Committee and have taken certain actions concerning corporate governance to enhance the process for granting equity-based compensation awards in the future, and we have implemented and are in the process of implementing, additional remedial actions including, but not limited to, the following:

 

·

We will institute internal audit procedures relating to the equity-based compensation awards approval and documentation process; engage an independent compensation consultant and/or independent counsel (at least for a transitional period) and focus on improving the Compensation Committee approval and oversight process; designate specific members of in-house legal, accounting, and human resources staffs to oversee documentation, accounting and disclosure of all equity-based compensation awards; widely distribute and explain enhanced equity grant processes and documentation requirements; increase automation of the equity grant record keeping process; improve process and controls regarding delegated grant authority; and improve training and education designed to ensure that all relevant personnel involved in the administration of equity-based compensation awards understand relevant policies and requirements.

 

·

Annual grants will be determined in connection with annual performance reviews of employees, including executives.  Generally, one annual grant date will apply to all annual grants to United States’ employees, and another annual grant date will apply to all annual grants to employees outside of United States.

 

We are continuing to implement the recommendations of the Special Committee and intend to take additional actions at a later date.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Fossil, Inc.

Dallas, Texas

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting that Fossil, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of January 6, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.  Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.  The following material weakness has been identified and included in management’s assessment.  The Company did not design and implement controls necessary to provide reasonable assurance that the measurement date for stock option grants was appropriately determined.  As a result, the measurement date used for certain option grants was not appropriate and such grants were not accounted for in accordance with generally accepted accounting principles.  This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the Company’s consolidated financial statements as of and for the year ended January 6, 2007, and this report does not affect our report on such consolidated financial statements and financial statement schedules.

 

In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of January 6, 2007, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of January 6, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended January 6, 2007, of the Company and our report dated August 7, 2007 expressed an unqualified opinion on those financial statements and financial statement schedule and includes an explanatory paragraph relating to the restatement and the change in accounting for employee stock-based compensation, described in Note 2 and Note 1, respectively.

 

/s/ DELOITTE & TOUCHE LLP

Dallas, Texas

August 7, 2007

 

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Item 9B.  Other Information

None.

PART III

Item 10.  Directors, Executive Officers and Corporate Governance

Directors

The following table and text set forth the name, age and positions of each Director.

 

Name		Age		Position
Elaine Agather		51		Director
Kenneth W. Anderson		75		Director
Michael W. Barnes		47		Director and President and Chief Operating Officer
Alan J. Gold		73		Director
Kosta N. Kartsotis		54		Director and Chief Executive Officer
Tom Kartsotis		48		Director and Chairman of the Board
Jal S. Shroff		70		Director and Managing Director of Fossil (East) Limited
Michael Steinberg		78		Director
Donald J. Stone		78		Director and Lead Independent Director
Caden Wang		55		Director

 

Elaine Agather was appointed to the Board of Directors on February 8, 2007, effective February 12, 2007.  Ms. Agather is currently a member of the Company’s Audit Committee and Chairperson of the Compensation Committee.  Since 1999, Ms. Agather has served as Chairperson and Chief Executive Officer of Chase-Dallas.  She also has served as South Region Head and Managing Director of JPMorgan Private Bank since 2001. From 1992 until 1999, she served as Chairperson of Texas Commerce Bank in Fort Worth, Texas.

 

Kenneth W. Anderson has been a director of the Company since April 1993.  Mr. Anderson is currently the Chairman of the Company’s Audit Committee and a member of the Company’s Compensation Committee.  Mr. Anderson was a co-founder of Blockbuster Entertainment Corporation, a video rental company, and served as its President from 1985 until 1987. From 1987 to 1991, Mr. Anderson served in various positions with Amtech Corporation, a remote electronic identification technology company, which he co-founded, including the position of Chairman of its Executive Committee.

 

Michael W. Barnes has served as President and Chief Operating Officer of the Company since January 1, 2007.  Mr. Barnes served as President, International and Special Markets Division from October 2000 to December 2006.  Mr. Barnes served as Executive Vice President from 1995 until October 2000 and has been a director of the Company since February 1993.

 

Alan J. Gold has been a director of the Company since April 1993.  Mr. Gold is currently a member of the Company’s Audit Committee and Compensation Committee.  Mr. Gold was the founder of Accessory Lady, a women’s fashion accessory retail chain, and served as its President until 1992. Mr. Gold is currently President of Goldcor Investments.

 

Kosta N. Kartsotis has served as Chief Executive Officer since October 2000.  Mr. Kartsotis also served as President of the Company from December 1991 to December 2006 and as Chief Operating Officer from December 1991 until October 2000. Mr. Kosta Kartsotis joined the Company in 1988. He has been a director of the Company since 1990.

 

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Tom Kartsotis has served as Chairman of the Board since December 1991. Mr. Tom Kartsotis founded the Company in 1984 and served as its President until December 1991 and as Chief Executive Officer until October 2000. He has been a director of the Company since 1984.

 

Jal S. Shroff has served as Managing Director of Fossil (East) Limited since January 1991 and has been a director of the Company since April 1993.

 

Michael Steinberg has been a director of the Company since March 2000.  Mr. Steinberg is currently a member of the Company’s Compensation Committee and Nominating and Corporate Governance Committee.  Mr. Steinberg served as Chairman and Chief Executive Officer of Macy’s West, a Division of Federated Department Stores, Inc., from which he retired in January 2000.

 

Donald J. Stone has been a director of the Company since April 1993.  Mr. Stone is currently the Chairman of the Company’s Nominating and Corporate Governance Committee and a member of the Company’s Audit Committee and Compensation Committee.  Mr. Stone is also currently the Lead  Independent Director, effective May 2007.  Mr. Stone served as Vice Chairman of Federated Department Stores until February 1988, at which time he retired.

 

Caden Wang has been a director of the Company since August 2005.  Mr. Wang is currently a member of the Company’s Audit Committee and Nominating and Corporate Governance Committee.  From 1999 to 2001, Mr. Wang served as Executive Vice President and Chief Financial Officer of LVMH Selective Retailing Group, which included various international retail holdings such as DFS, Sephora, and Miami Cruiseline Services. He has also served as the Chief Financial Officer of DFS, Gump’s and Cost Plus.  Mr. Wang is a Certified Public Accountant. Since April 2005, Mr. Wang has served on the Board of Directors of LeapFrog Enterprises, Inc. and is a member of its audit committee and nominating and corporate governance committee.  Since October 2003, Mr. Wang has served on the Board of Directors of bebe Stores, Inc. He is currently the chairman of its audit committee and a member of its nominating and corporate governance committee.

 

Mr. Tom Kartsotis and Mr. Kosta N. Kartsotis are brothers. There are no other family relationships among any of the directors or executive officers of the Company.

 

Executive Officers

The name, age, current position with the Company, and principal occupation during the last five years of executive officers Messrs. Tom Kartsotis, Kosta N. Kartsotis and Michael W. Barnes and the year each first became an executive officer of the Company is set forth above under the caption “Directors,” and with respect to each remaining executive officer is set forth in the following table and text:

 

Name		Age		Position
Harold S. Brooks		56		President, Fashion Watch Division
Livio Galanti		39		Executive Vice President
Mike L. Kovar		45		Senior Vice President, Chief Financial Officer and Treasurer
Jennifer Pritchard		48		President, Retail Division
Mark D. Quick		58		Vice Chairman

 

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Harold S. Brooks has served as President, Fashion Watch Division since October 2004.   From December 2003 until October 2004, Mr. Brooks served as President and Chief Executive Officer of Koret, a division of Kellwood, a marketer of apparel.  From 2000 to 2003, Mr. Brooks held the position of Director of International Expansion, Planning and Allocation at Build-A-Bear Workshop, a retailer of customized stuffed animals.   Prior to his employment with Build-A-Bear, Mr. Brooks served as President and Chief Executive Officer of Famous-Barr, a division of May Department Stores.

 

Livio Galanti has served as Executive Vice President since August 2007.  Mr. Galanti served as Senior Vice President of Luxury Brands from December 2006 until July 2007.  From November 2004 to November 2006, Mr. Galanti served as Senior Vice President of the Sports Division. Prior to joining the Company, Mr. Galanti served for three years as General Manager and joint venture partner in Timex Group Italia, a watch distribution, design and development company.

 

Mike L. Kovar has served as Senior Vice President, Chief Financial Officer and Treasurer since October 2000.  Mr. Kovar served as Senior Vice President, Finance from March 2000 until October 2000.  From November 1997 until March 2000, Mr. Kovar served as Vice President and Chief Financial Officer for BearCom Group, Inc., a wholesaler of two-way radios, and as Controller from July 1996 to November 1997.

Jennifer Pritchard has served as President of the Retail Division since September 2006.  From January 2004 until March 2006 she served as President of Arden B., a division of Wet Seal, a specialty retailer of apparel and accessory items.  Prior to that, from October 2002 until January 2004 Ms. Pritchard served as President of Zutopia, another division of Wet Seal, and from April 2001 until October 2002 she served as Executive Vice President Product Development and Marketing of Tex 38, LLC, a Hong-Kong based design and production company.

Mark D. Quick has served as Vice Chairman of the Company since January 1, 2007.  Mr. Quick served as President, Fashion Accessories from October 2000 until December 2006 and President, Stores Division from March 2003 until September 2006.  Mr. Quick served as Executive Vice President from March 1997 until October 2000. From November 1995 until March 1997, he served as Senior Vice President-Accessories.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Exchange Act requires the Company’s officers and directors, and persons who own more than 10% of a registered class of the Company’s equity securities (the “10% Stockholders”), to file reports of ownership and changes of ownership with the SEC.  Officers, directors and 10% Stockholders of the Company are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms so filed. Based solely on review of copies of such forms received, the Company believes that, during the last fiscal year, all filing requirements under Section 16(a) applicable to its officers, directors and 10% Stockholders were timely met, except for the following: one Form 4 filed by each of Messrs. Barnes, Bock, Brooks, Kercho, Kovar and Quick relating to three transactions; and one Form 4 filed by Mr. Shroff relating to two transactions.

Board Committees and Meetings

 

The Board of Directors has established three standing committees: the Audit Committee, the Compensation Committee and the Nominating and Corporate Governance Committee. Ms. Agather and Messrs. Anderson (Chairman), Gold, Stone and Wang serve on the Audit Committee; Ms. Agather (Chairperson) and Messrs. Anderson, Gold, Steinberg and Stone serve on the Compensation Committee; and Messrs. Steinberg, Stone (Chairman) and Wang serve on the Nominating and Corporate Governance Committee.

 

Audit Committee.  The functions of the Audit Committee are to appoint the Company’s independent registered public accounting firms, to review the plan and scope of any audit of the Company’s financial statements and to review the Company’s significant accounting policies and other related matters. Deloitte & Touche LLP, the Company’s principal independent registered public accounting firm, reports directly to the Audit Committee. The Audit Committee, consistent with the Sarbanes-Oxley Act of 2002 and the rules adopted thereunder, meets with management and the Company’s independent registered public accounting firm prior to the filing of officers’ certifications with the SEC to receive information concerning, among other things, significant deficiencies in the design or operation of internal controls over financial reporting. The Audit Committee has adopted a procedure that enables confidential and anonymous reporting to the Audit Committee of concerns regarding questionable accounting or auditing matters.  The Company’s internal audit group reports directly to the Audit Committee on a quarterly basis. The Audit Committee held a total of eleven meetings during the fiscal year ended January 6, 2007.

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All members of the Audit Committee have been determined to be financially literate and to meet the appropriate NASDAQ and SEC standards for independence. See “Director Independence.” The Audit Committee includes two independent directors, Mr. Anderson and Mr. Wang, who have been determined by the Board of Directors to meet the qualifications of an “audit committee financial expert” in accordance with SEC rules. The Audit Committee operates under a formal charter adopted by the Board of Directors that governs its duties and conduct.  Copies of the charter can be obtained free of charge from the Company’s web site, www.fossil.com, or by contacting the Company at 2280 N. Greenville Avenue, Richardson, Texas 75082, to the attention of Investor Relations, or by telephone at (972) 234-2525.

Compensation Committee.  The functions of the Compensation Committee are to make recommendations to the Board of Directors regarding the compensation of Company executives, to produce annual reports on executive compensation for inclusion in the Company’s proxy statement, to oversee and advise the Board of Directors on the adoption of policies that govern the Company’s compensation programs, including stock and benefit plans, and to administer the 2004 Long-Term Incentive Plan (the “Incentive Plan”) and the 2002 Restricted Stock Plan (the “Restricted Stock Plan”).  The Compensation Committee held three meetings during the fiscal year ended January 6, 2007.

All members of the Compensation Committee have been determined to meet the appropriate NASDAQ standards for independence. See “Director Independence.” Further, each member of the Compensation Committee is a “Non-Employee Director” as defined in Rule 16b-3 under the Securities Exchange Act of 1934 and an “outside director” as defined for purposes of 162(m) of the Internal Revenue Code of 1986, as amended.  Copies of the Compensation Committee Charter can be obtained free of charge from the Company’s web site, www.fossil.com, or by contacting the Company at 2280 N. Greenville Avenue, Richardson, Texas 75082, to the attention of Investor Relations, or by telephone at (972) 234-2525.

Nominating and Corporate Governance Committee. In August 2005, the Board of Directors established the Nominating and Corporate Governance Committee.  The functions of the Nominating and Corporate Governance Committee are to: (a) identify qualified individuals for membership on the Board of Directors; (b) recommend to the Board of Directors the director nominees for the next annual meeting of shareholders; (c) develop and recommend to the Board of Directors a set of corporate governance guidelines; and (d) oversee the corporate governance affairs of the Board of Directors and the Company.  The Nominating and Corporate Governance Committee’s role includes periodically reviewing the compensation paid to non-employee directors, and making recommendations to the Board for any adjustments. In addition, the Nominating and Corporate Governance Committee conducts an annual review of the Company’s succession plans relating to the Chairman and Chief Executive Officer positions.  The Nominating and Corporate Governance Committee regularly reviews the purposes of the Board committees, recommends to the Board of Directors any necessary or desired changes to the purposes of such committees and whether any committees should be created or discontinued.

The specific responsibilities and functions of the Nominating and Corporate Governance Committee are delineated in the Nominating and Corporate Governance Committee Charter.   Copies of the charter can be obtained free of charge from the Company’s web site, www.fossil.com, or by contacting the Company at 2280 N. Greenville Avenue, Richardson, Texas 75082, to the attention of Investor Relations, or by telephone at (972) 234-2525.

The Nominating and Corporate Governance Committee held three meetings during the fiscal year ended January 6, 2007.  All members of the Nominating and Corporate Governance Committee have been determined to meet the appropriate Nasdaq standards for independence. See “Director Independence.”

The Board of Directors held six meetings during the fiscal year ended January 6, 2007.  During 2006, each director attended 75% or more of the meetings of the Board of Directors and the meetings held by all committees of the Board on which such director served.  The Board of Directors strongly encourages that directors make a reasonable effort to attend the Company’s Annual Meeting of Stockholders. All of the members of the Board of Directors attended the Company’s 2006 Annual Meeting of Stockholders.

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Special Committee.  A Special Committee of independent directors of the Board of Directors was formed on November 11, 2006 to undertake a voluntary review of the Company’s equity granting practices.  The findings of the Special Committee were reported by the Company on May 7, 2007.  The Special Committee was terminated effective July 31, 2007.

Codes of Business Conduct and Ethics

The Company has adopted a Code of Conduct and Ethics that applies to directors, officers and other employees of the Company and its subsidiaries.  In addition, the Company has adopted a Code of Ethics for Senior Financial Officers, which includes the Company’s principal executive officer, principal financial officer, and principal accounting officer.  Violations of these codes may be reported to the Audit Committee. Copies of the codes can be obtained free of charge from the Company’s web site, www.fossil.com, or by contacting the Company at 2280 N. Greenville Avenue, Richardson, Texas 75082, to the attention of Investor Relations, or by telephone at (972) 234-2525. The Company intends to post any amendments to, or waivers from, its Code of Ethics that apply to its Senior Financial Officers on its web site at www.fossil.com.

Item 11.  Executive Compensation

 

COMPENSATION DISCUSSION AND ANALYSIS

 

This section contains a discussion of the material elements of compensation awarded to, earned by or paid to our Chief Executive Officer, our Chief Financial Officer, our three other most highly compensated executive officers who were serving as executive officers as of January 6, 2007 and one additional employee, Stephen Bock, who would have been one of our three most highly compensated individuals had he been serving as an executive officer as of January 6, 2007. These individuals are referred to as the “Named Executive Officers.”