Description

Cricut

Executive Summary: Cricut shares recently sold off following the release of their Q4 2021 results. They are now 45% below their March 2021 $20 IPO listing price and 77% below their 52 week-high, as the market remains wary of ‘covid winners’ lapping tough comparables, whilst Cricut implicitly provided weak guidance for the first half of 2022, citing pull-forward of demand of its connected machines and increased promotional activity. However, the fundamental drivers of growth that saw their revenues cagr at >40% in the years leading up to covid (namely, 1) Cricut’s dominant market position and 2) the company’s strong moat based on network effects and switching costs) remain in place, and the company still has a large TAM to penetrate (particularly overseas). For investors willing to look past the uncertain near-term outlook, it is possible to underwrite a three-year 20% IRR under very reasonable assumptions, and a clear return to secular growth of  >20% would result in a multibagger.

Company history:

·         Cricut can trace its roots back to its beginnings as Provo Craft, a Utah-based company that sold supplies to the avid scrapbooking hobbyists that resided in the state (likely due to the Mormon fascination with genealogy). Provo Craft released the original Cricut Personal Electronic Cutting machine in the early noughties. The machine cut various letters and designs for scrapbooking paper projects and card-making, with an extremely high degree of intricacy and precision, that would be almost impossible to achieve with regular scissors or a precision knife. Customers were limited to cutting designs on preloaded Cricut cartridges, whilst there were a limited number of materials it could cut (primarily paper-based).

·         In 2012, the company recruited Ashish Arora, a well-regarded executive from Logitech, in order to lead a refurbishment of the Cricut’s product line. During his tenure, he invested heavily in R&D and successfully executed a number of hardware and software releases that massively improved both the performance and scope of the die cutting machines. Gone were the cartridges, and now customers used Cricut’s proprietary cloud-based Design Space software to upload and create designs, as well as purchase several projects, designs and fonts via subscription. The cutting machines also became more powerful, being able to cut a wider range of materials (including various types of metals and woods), with greater accuracy and precision. With the aid of tools, the machines were capable of not only cutting but even drawing, writing, scoring and embossing, engraving etc.

·         As a result of 1) the improved machine capabilities, 2) the increasing user-friendliness and learning resources and 3) the creative possibilities the Design Space software offered, the appeal of Cricut machines expanded from the original scrapbooking and crafting communities to a wider audience. The products were now also popular with prosumers, who would use Cricut machines to make various crafted items to sell in Etsy stores.

·         Between 2013 and 2021, Cricut revenues increased at a CAGR of >40%. The company currently generates $1.3bn in revenue and has a user base of 6.4mn users.

·         In March 2021, the company IPO-ed on the NASDAQ. The company issued 15.3mm Class A shares (lower voting rights compared to Class B shares), with the existing owners retaining the majority of economic interest and voting rights, making Cricut a controlled company.  The majority of IPO proceeds were used to shore up the company’s cash position, with insiders (mainly management) only selling a small proportion of their shares, whilst majority shareholder (Petrus Asset Management – Ross Perot’s family office), retained all its shares. 

Business Model:

 Cricut operates three complementary business lines – 1) Connected Machines, 2) Subscriptions and 3) Accessories & Materials. The company operates a razor-razor blade business model, where customers purchase one of their connected die cutting machines at a relatively low margin with the hope that the customer will then be ‘locked’ into the Cricut ecosystem of higher margin software subscriptions and accessories/materials.

Connected Machines

Cricut currently sell three main types of connected die cutting machines, with progressively higher capabilities and price points (from the Cricut Joy, which is a small unit mainly used for basic scrapbooking and crafting, to the flagship Cricut Maker which is capable of cutting several materials and has several other capabilities with the correct tools):

Source: Cricut website

Subscriptions

The Design Space software that is used with the Cricut machine is free to users. However, to make the most of the software requires a subscription. Cricut offers two types of subscription, Cricut Access and Cricut Access Premium. There is also the option of purchasing various projects and designs on an a la carte basis.

Source: Cricut website

Accessories and Materials

Cricut offers several SKUs of accessories and materials that are used in conjunction with die cutting machines. These can range from materials like foil transfer sheets, iron-on, vinyls to machine and handheld tools.

Note: Engagement is defined as user has used Cricut machine to create a project in last 90 days 

Investment Strengths:

·         Market position: Whilst it is difficult to get market share data, whether looking at social media presence, product range or the respective floor space that crafting specialty stores dedicate, it is clear that Cricut is the dominant market leader in electronic die-cutting machines, operating in an effective duopoly with Silhouette (a distant second). Cricut is very much the ‘Apple’ of the crafting world, with aesthetically pleasing hardware and easy-to-use, intuitive software (in fact several reviews comparing Cricut to Silhouette, usually contrast the easy-to-use but simplistic Cricut software versus the more complicated, but greater flexibility/functionality of Silhouette - analogous to an iOS vs Android decision). Their latest range of products rate very high in most independent consumer electronic publications and crafting blogs/videos and are considered best-in-class. 

·         Social Media/Network Effects: Cricut has a prolific following on social media, whether looking at Instagram (1.6mn), Facebook (2.6mn), Youtube (473k), Pinterest (400k) or Tiktok  (+2bn video views). This is also only looking at official channels, and not counting the countless affiliate or independent channels or groups with large followings that provide educational content. This provides a virtuous cycle for Cricut, as several new users look to this content both for inspiration for new projects and for educational tips on how to get the most out of their machines. Also, as Cricut’s Design Space is cloud-based software, Cricut has an incredible data-set to see users’ preferences and behaviors that it can use to improve the user experience and track/improve engagement.

·         Switching costs:  Firstly, there is a learning curve associated with using the Design Space software for a user to get the most out of their machines. Once they have invested time learning various tips and tricks and building a certain preference for certain projects/designs offered by the software, this is going to create an element of stickiness in the existing user base. Secondly, users will typically have several Cricut accessories and materials, making them more plugged into the Cricut ecosystem of machines. 

·         Large underpenetrated SAM/TAM: Cricut currently has 6.4mm users. Prior to IPO, Cricut commissioned a study to ascertain their service addressable market across eleven markets. This SAM consisted of individuals surveyed who had made at least one creative project in the past twelve months in a category that was addressed by Cricut’s current product line. Their SAM in US and Canada was 85mn, whilst they are barely scratching the surface of the international opportunity (44mn in the other nine target markets surveyed) . Furthermore, they noted their TAM (essentially potential creative users, but with needs not addressed by Cricut’s current product line, was more than 2x the TAM – both domestically and internationally).   Whilst I’m generally way of bombastic TAM proclamations by management, there are a number of supporting factors that Cricut can continue to penetrate this market, including 1) Cricut’s track record of revenue and user growth to date, 2) international growth is very strong (>100% yoy), and still only remains 11% of overall Cricut sales and 3) Cricut’s demonstrated track record in product development and increasing the TAM of their products (from the earlier expansion from the scrapbooking and crafting community, to the more recent push at products aimed at prosumer market)

·          Management: Cricut’s CEO, Ashish Arora has successfully presided over the last decade of the company's transformation from basic electronic cutting machines targeting scrapbookers to cutting-edge line of products and software/accessories ecosystem and the resultant revenue growth and Cricut’s dominant market position. He is still relatively young (early 50s) and has plenty of skin in the game, owning a small eight figure sum of shares.

·         Fortress Balance Sheet: The company currently maintains a healthy net cash position of >$200 mn and negligible debt, minimizing the risk of a dilutive equity raise should there be any pressure on near-term profitability. 

Possible reasons for the opportunity:

·         Covid pull-forward: Cricut was clearly a beneficiary of covid-19. The lock-downs and stay-at-home provisions bred the ideal environment for crafters to increase their output and/or for someone to take up a side hustle. This was clearly evident as Cricut saw a surge in connected machine sales, whilst engagement levels on machines increased from historic norms and people consumed a higher level of accessories and materials, with more projects being completed. As the world returns to normal, many of these covid winners have been brought down to earth as consumption patterns mean revert and companies deal with the hangover following a pull-forward in sales, with investors struggling to normalize what future consumption looks like and scared of stepping in front of a weak near term print. Like many covid winners, Cricut has been trading very weakly for the last 8-9 months, and sold off another 30% immediately following the release of its Q4 results. Whilst there was a natural normalizing in engagement and materials ARPU, the market was caught off-guard by the extent of the margin contraction in connected machine sales. This was mainly caused by 1) over-production to minimize potential supply chain concerns and 2) some channel issues with retail partners over-ordering and subsequently engaging in promotional activity to work down inventories. Furthermore, management provided a very weak implicit guide for the first half of 2022, driven by 1) an expected near-term pullback in connected machine sales, given the recent pull forward, 2) expectations of return to weaker seasonal first-half, which didn’t happen in 2021 due to covid and 3) ramp up in some R&D/G&A expenses that were suspended during covid. They also alluded to the fact that their LT operating margin target of 15-19% may not be met in 2022. This scared an already nervous and skeptical market on these types of names. However, the longer-term thesis remains intact. Remember, Cricut was growing >40% pre-covid and whilst the near term numbers will be under pressure, the drivers for secular growth remain intact, with the subscription business and overall engagement remaining healthy. 

·         Misunderstood by investors: It’s difficult to value Cricut as it has no direct tradable comparables (its closest comparable Silhouette, has a Japanese parent company). Most sell-side analysts seem to use a group of consumer electronic comparables and slap on a group average multiple, which when combined with the uncertain near-term outlook is resulting in low price targets by the houses that currently cover it. However, I believe Cricut is a higher quality company than this peer group for a number of reasons – 1) Cricut’s dominant market position is like few of its peer group (market share relative to #2 player, switching costs of DesignSpace software) , 2) Cricut was growing revenues at >40% CAGR pre-covid, whilst still being in an earlier stage of international expansion than peers and 3) Cricut derives >80% gross profits from the more stable subscription and accessories & materials businesses, which are more recurring in nature.

·         Target market is predominantly women: I remember a year or two ago, a thread in the VIC topics section around the under-representation of women and minorities in the funds management space, which may cause a blind spot around companies that aren’t on the radar of urban, white males between the ages of say 25-50. Given Cricut’s historical target market has been menopausal women with a scrapbooking hobby, this may well be a factor here.

·         Low free float: Cricut only has a free-float of <$250mn and ADV of ~375k shares, which would make it difficult for larger funds to accumulate a meaningful position (having said that, Abdiel has been an active acquirer of shares and hold a chunky position). 

Valuation

For investors that are able to look past the weak near-term outlook and have a >1-2 year time horizon, I believe Cricut’s current valuation possesses a very asymmetric risk-reward.

To derive a three-year IRR of 20%, you would only need to assume that Cricut could achieve a 15% CAGR on revenues and achieve the bottom-end of its long-term target operating margin guidance (15-19%), with an exit multiple of 14x. All three of these underlying assumptions strike me as being quite conservative, assuming Cricut can continue to maintain its dominant market position and get back on track to even a fraction of its pre-Covid growth momentum, which I believe is very achievable.

If the company was able to get back to >20%+ growth (noting, its pre-covid revenue growth of >40%, track record of execution and largely under-penetrated TAM) and achieve a >20x exit multiple at the more mid-point of the margin guidance, you start to get some silly upside longer-term on a valuation basis.

Catalyst

Return to growth, following the laping of tough comparables