Description

Introduction

The optics of Crocs – seemingly faddy brand traction suspiciously correlated with CV after a decade of stagnation, a clear covid beneficiary being ugly but comfortable (and thus ideal stay at home wear), coupled with ludicrous and seemingly unsustainable operating margin expansion from anaemic to 30% - all from the same old foam plastic clog, made it on first glance appear like one of the most obvious short candidates out the back of covid. However, having started scratching away in 2021 with an interest on the short side, I discovered the optics here are deeply misleading, and a thorough analysis leads one to much more positive conclusions on the sustainability of their post CV trajectory. After another violent sell off following their 2Q23 results, the risk / reward skew today on the long side looks exceptional – perhaps as good as it’s been since CV. I believe this name offers line of sight to an achievable 3x in the next 2-3 yrs, whilst offering significant downside protection – you have to really torture the destination assumptions to justify the current valuation. Mr Mkt has a demonstrated history of making some very peculiar calls on Crocs over the past few years – I believe we are back to being offered a terrific (if not completely free) lunch at current prices. With heavy insider buying resuming (Chairman recently purchased another $1.2m shares), and the expectation of taking the safety switch off their $1bn share buyback bazooka over the NTM (15% of mkt cap), not to mention significant upside to consensus earnings, there are numerous engines working to drive this long thesis.

Crocs has been written up twice in the past 14 months

• First in Jun-22 by abcd1234 https://valueinvestorsclub.com/idea/CROCS_INC/5502068857
• Then in Dec-22 by baileyb906 https://valueinvestorsclub.com/idea/CROCS_INC/0705207450

Quick history recap – untangling CV19

• The previous write ups do a great job at covering the history of the business so I’ll try to make this brief
• What I’d like to spend a little more time on is looking at how Crocs was valued in the past, and show that the market, both on the upside and the down, has offered in my view highly irrational prices on Crocs shares, based on reasonable expectations at the time
• First the history
• 2011 – 2017: Static business with global sales ~$1bn; no growth, anemic margins
• The big picture here is Crocs was a static business for half a decade preceding the current CEO’s appointment in 2017 (having joined as president in 2014)
• 2011 sales: $1.00bn; 2017 sales: $1.02bn
• 2018 – 2019: Some traction, sales climb to $1.4bn in 2019, OP margin improves to 12% (an 8 year high)
• The change in strategy from the CEO hinged on 2 major pillars:
• Ignite the brand
• In his own words, CEO recognised Crocs didn’t have an awareness problem – recognition of the Crocs brand globally was very high
• They had a relevance problem – no one wanted the shoes
• So they changed they marketing approach
• Started using celeb collaborations and endorsements
• Came out with all sorts of funky designs and prints to drive interest
• Some highlights include my personal favourite – the KFC Crocs that are actually scented of fried chicken, along with Justin Bieber collaborations etc – you get the picture
• Tighten distribution
• At the same time as driving relevance through mkting, the company set out to consolidate distribution, aware that loose distribution had killed the brand post GFC, as countless pairs of Crocs wound up in gas stations around the country post 2008 at severely discounted prices, and Crocs were not able to control their margins
• With increasing relevance, and a tighter control on what prices their retailers were selling Crocs, the company was able to improve their operating margin substantially, reaching 12% in 2019
• 2020-2022: Covid
• Through CV the business really takes off – sales ~2x to $2.3bn in 2021, then on to $2.7bn in 2022
• Meanwhile the margins exploded, from 12% adj OPM in 2019 to 30% in 2022
• Here’s the sales and OP charts from 2011 to get a sense for the scale of the changes that the business saw through CV:
• Sales
•  
• 
• Operating profits
• 
• So what was going on through CV19?!
• Let’s first look at the share price to get a sense for how the market was treating this
• Crocs shares up 20x from the CV low of $9/sh to the CV peak (Oct-21) of ~$180/sh in 18 short months
• 
• The optics here all looked rather nuts… by late 2021 the market was putting a full multiple (15x EV/ EBIT +1) on earnings benefiting from a perfect storm
• Through CV, on top of the apparent WFH benefit, Crocs brand caught fire as a teen fashion staple in the US
• Through 2021 I gather Crocs became ‘the brand’ to wear in high schools up and down the country
• A large proportion of teenage girls owned multiple pairs – it got to the point where you weren’t cool in school unless you had Crocs
• At the same time numerous celebs (inc Justin Beiber and Kanye West – before his melt down) were voluntarily wearing Crocs on the red carpet
• Crocs released collabs that included
• $750 Balenciaga stiletto Croc
• KFC fried chicken inspired shoe – with insertible ‘jibitz’ that were actually scented of KFC’s fried chicken (which sells 2^nd hand for hundreds of $s)

• Combining the WFH CV impact, the high school craze and the whirlwind of celebrity endorsements and special collabs – the earnings looked the definition of unsustainable
• US footwear retailer’s view in 2021
• Doing channel checks with large nationwide retailers through late 2021 – there was a rough consensus that they’d seen this movie before (2007) with Crocs, and they thought it was indeed unsustainable
• Of course timing this would be difficult – they thought Crocs would have to deflate close to pre CV performance at some point, but not clear how long the apparent fad would last or run for
• Then the event that catalysed the shares collapse – Crocs acquire Hey Dude (announced Dec-21, closed Feb-22)
• At the time Hey Dude was a little known footwear brand, which they surprised everyone by paying $2.5bn for (15x EBITDA at the time)
• Crucially – Hey Dude at the time of acquisition was running around $500m sales, but was doing $20m in sales just 4 years prior, so had seen extraordinary growth themselves
• If there was one footwear brand’s fire burning even brighter than Crocs, it was Hey Dude!
• And suddenly the question quickly became – had Crocs just paid up to become a ‘fad squared’, all sitting on 3.5x leverage
• The sustainability of both brands suddenly was called into question, and the market violently sold off – down ~-75% by mid 2022
• 
• Fast forward to 2022
• Crocs brand starts to show surprising signs of stability
• By mid 2022 Crocs was doing something I would not have predicted a year earlier – it was somehow managing to continue to grow it’s sales, even in North America, where the 2021 base was supposed to have been peak fashion fad AND peak CV… how were they doing this?
• Talking to footwear retailers – they were all starting to say something quite interesting – yes the teenage girl isn’t coming into the shop to buy several pairs anymore, but now the brother buys a pair, now the mum has a pair
• They thought Crocs had broadened it’s customer base and essentially ‘normalised’ wearing them in public
• Because of the stability they were seeing in their sales, they mostly adjusted their expectations – a collapse in the Crocs brand sales was no one longer their base case expectation, it was now for stability at the new level
• Hey Dude – even better than expectations
• What was even more surprising was the feedback on HeyDude
• Far from fading, the feedback at the time from one nationwide retailer with >1000 stores was in 20 yrs in the footwear business he’d never seen brand interest like it
• He didn’t even stock hey Dude yet, and yet hey dude was the most searched brand on his website
• The view was that worse case, even if this is faddy, at the time only 1 in 10 people in the US had ever heard of Hey Dude… this looked like it would burn for another 3-4 years in in the worst case, and wasn’t likely to about course and start shrinking any time soon
• Latest update in 2023
• Crocs brand – going from strength to strength
• Crocs brand has now comped the comp the comp – everything, everywhere, all at once
• They have turned in positive growth in all 3 regions, every single Q since the start of 2021 – it’s really quite impressive, who could have expected this in 2021?!
• 
• Hey Dude – some turbulence and cause for mkt concern
• Growth stalls – falling from ~+100% YoY in 2022 to now just +3% YoY in 2Q23
• Meanwhile Crocs mgmt reduced their FY23 Hey Dude sales guidance by -7.5%, or -9% for 2H23
• These Hey Dude concerns are dealt with in further detail in the dedicated ‘Deeper dive into Hey Dude’ section below
• 

Implications for Mr Mkt

• From Jan-15 to Dec-21, Crocs’ avg EV / EBIT +1 was 16.4x
• Remarkably, despite Crocs Adj OP moving from $143m in 2019 to in Oct-21 an expected FY22E Adj OP of $750m… the market was content to put the same ~15x fwd multiple on what looked at the time (as explored above in the history recap) to be peak fad, peak CV, peak fashion bubble - peak everything!
•  
• Conversely, by mid 2022 – just as both Crocs and Hey Dude sales and earnings were surprising with strong signs of stability – surely ahead of any reasonable expectations 1 year prior, the shares had collapsed to $50/sh or 4x P/E (EV/EBIT 6x given the leverage)
• This is all in the past – why is this relevant?
• Because in recognising the absurd extremes Crocs valuation has oscillated between over the past 2 years, I think it adds plausibility to the claim that Crocs shares can be once again deeply mispriced
• An irrational mkt is an insufficient condition to make money, but it is a necessary one – here I’m just trying to show that Croc’s price has in recent times often met this necessary condition of blatant inefficiency

So what’s the recent drama – why are the shares down again? Mkt concerned with Hey Dude

• 2Q23 results
• Crocs beat the group sales and profit guidance and street estimate (street tend to match guidance fairly precisely)
• But missed 2Q23 Hey Dude consensus sales expectations by -7%
• More problematic - Crocs reduced the FY23 Hey Dude sales guidance by -7%, or -9% in 2H23
• They simultaneously lifted Crocs brand guidance (+4% FY23 sales, +3% 2H23), with the aggregative effect being a very slight group guidance raise (+1% FY23, +0.1% 2H23)
• For context, it is quite rare for Crocs to either miss their numbers or reduce guidance, as they tend to guide conservatively then beat and raise through the year
• Since Crocs started offering guidance under the new CEO from 2018, aside from 2020 when they initially pulled their guide, they have never missed their initial FY sales guide, and only reduced FY expectations quarter to quarter once since 2018:
• FY sales guide in top box ($m), % change in FY guide through the year in the bottom box:
• 
• Yes this was an aggregate guide up, but the market spat the dummy, choosing to focus on the Hey Dude disappointment rather than the Crocs brand strength and sold off -15%

Deeper dive into Hey Dude

• So what’s going on with Hey Dude
• On first glance, the reported growth from Hey Dude has plummeted, from ~100% YoY last year, to only +3% YoY in 2Q23
• Within this +3%, wholesale sales were -8% YoY, with DTC +30%
• 
• The trend appears to show an alarming slowdown, suggesting to some that it’s maxed out and possibly about to hit reverse
• It’s all about Pipeline fill
• In fact to understand what’s going on under the hood, we need to talk about Pipeline fill
• In 2022 Crocs quickly started plugging Hey Dude distribution into many of the same channels and large nationwide footwear retailers which Crocs brand sells through
• This meant they rapidly expanded the doors, driving the 80% -100% growth last year
• What we need to appreciate is that as Crocs doubled their distribution, a large amount of sales – Crocs claim $220m worth (so 22% of FY22 Hey Dude pro forma sales) – was achieved by simply filling the initial inventory that the retailers need to order to first start selling Hey Dude
• This $220m initial fill in will not be repeated this year, and so makes the sell-in compares very tough
• Look to Sell out
• To try and look through this one off sell-in comp challenge, Crocs give us 2Q23 Hey Dude sell out: +27% YoY
• Sell out growth defined as increase in $s spent by consumers on Hey Dude YoY
• Given DTC was +30%, and DTC is ~1/3 of the business, implication that wholesale sell out was ~+21% YoY (rough maths)
• Adjusted sell in trend
• If we take Crocs disclosure at face value, and remove 100% of the claimed non comp pipeline fill from their reported wholesale sales in 2021:
• Clean growth rates for Q1 and Q2 both trending ~+40% YoY
• 
• However I’m inclined to push back on this face value interpretation a little, as without wanting to get too far into the weeds, in fact a portion of Crocs disclosed ‘non-comp’ figure includes some closed non-strategic accounts, which have simply been reallocated to larger nationwide accounts
• I wouldn’t include this as non-comp, in my mind it’s comp sales that have simply been reallocated
• Having discussed this point with mgmt, I believe this component of the their claimed non-comp piece is the minority – perhaps ~25% of the $220m
• So if we want to include the reallocated sales in our base, and just remove the pure pipeline fill, I would guestimate we should retain ~75% of the 220m:
• Happily this produces a best guess clean non comp sell in of ~+30% YoY – very similar to the disclosed +27% sell out
• 
• Conclusion: however you cut it, Hey Dude’s true brand growth trajectory is really much smoother than the sell in figures would suggest
• Clean growth without pipeline tailwind last year ~+50%, clean growth without headwind this year ~+30% - a much more reasonable and healthy trajectory than +100% in FY22 going to zero
• 
• BUT it’s not all plain sailing
• There are some other genuine issues around Hey Dude that need addressing
• Amazon discounting
• If you go on Amazon today and search for Hey Dude shoes, you will find hundreds of pairs, nearly all at steep discounts
• This is hurting Crocs ability to defend their margin – and mostly to blame for the -5ppt YoY in Hey Dude OPM (2Q23)
• How is this inventory there, esp given Crocs mgmt claimed laser focus on controlling distribution?
• Mgmt have told us that when they bought the Hey Dude brand, they cancelled a bunch of international distributors
• These distributors quickly dumped their stock, and it’s now wound up discounted on Amazon
• Timeline to resolve: year end 2023
• Mgmt have now set up systems to monitor how this is tracking
• Given the finite amount of liquidated inventory from those cut distributors in 2022, mgmt estimate this issue will be mostly solved by year end 2023
• Conclusion: not ideal but in principal this issue has a finite timeline and should get resolved
• Heavy inventory and weaker sell thru feedback from channel checks
• Given the frenzied excitement and demand for Hey Dude last year, many retailers went balls to the wall with their ordering plans for Hey Dude in 2022
• These orders then shipped late given the supply chain issues through 2022, with a lot of the inventory turning up late in the year
• At the same time, as access to the brand rapidly expanded from niche stores to nationwide chains, the brand heat cooled – not stalled – it’s now running in the ‘good not great’ category
• The combined effect is the retailers are now over inventoried in Hey Dude, and have been for most of the year
• I don’t see this as a terminal issue, for the following reasons:
• This is the main reason Crocs have pulled down the Hey Dude guide, as retailers reduced their planned orders ahead of season – so it’s now mostly in the numbers
• There will have been a large but one off dilutive impact on per-store demand which will have resulted from the distribution expansion, but which retailers may not have properly baked into their planned orders – explaining the heavy inventory
• Crocs are only just beginning their tried and tested mkting collaborations and endorsements approach with Hey Dude, having launched two collaboration over the past summer months
• Likewise Crocs mgmt’s own product and design is only just filtering through, with a lot of the shoes being sold up till early to mid-2023 coming from the previous owner
• AND Crocs have new models being launched throughout the back half of 2023
• When the above is combined with Crocs mgmt exceptional track record of cultivating a thriving Crocs brand out of the same ugly plastic shoe, I wouldn’t want to bet against them not doing the same with Hey Dude
• Not to say we have a crystal ball here, the destination book ends are quite wide on Hey Dude, but there are plenty of reasons to be optimistic, it’s not all doom and gloom
• Finally – the international Hey Dude launch is still to come
• ~40% of Crocs brand sales come from Intl (ex US) mkts
• Crocs mgmt have said they plan to roll out Hey Dude distribution through all the same channels they use for Crocs brand
• Assuming the same ratio of intl for Hey Dude, at current Hey Dude US run rate of ~$1bn sales, that would imply a further ~$700m intl sale to come
• Of course, Hey Dude is still a growing brand – mgmt have no intension of letting US sales stop at $1bn, and so the true destination internationally is likely significantly larger than $700m
• So far in 2023 Hey Dude has launched in very small size in 2 European mkts I believe, but currently it’s still in ‘test and learn’ phase…
• The hope will be for a more material contribution to total sales in 2024 and beyond

Insider buying

• Previously large and well timed insider purchases are resuming: Chairman just bought another $1.2m post 2Q23
• Here’s the full insider buying picture since 2020
• 
• Mar – May 2022
• 8 different insiders bought a total of $4.5m stock
• 
• Post 2Q23: Chairman purchases another $1.2m

Capital allocation - $1bn buy back to come

• Crocs has a demonstrated history of share buy backs
• 
• They have authorisation for another $1bn buy back
• The same level they deployed, in its entirety, in 2021
• So far they haven’t been able to deploy the buyback due to debt covenant restrictions
• Specifically their TLB facility requires Crocs to bring gross debt / Adj EBITDA (TTM) < 2.0x before they can start the buy backs
• This 2Q23 was the first Q since they raised the TLB (to fund Hey Dude purchase in 1Q22) that they’ve been under 2x (currently now 1.8x)
• Debt pay down
• At the same time, Crocs have a long term net leverage target of 1.0x – 1.5x EBITDA
• Currently they are 1.7x net leverage
• Crocs mgmt plan going forward
• They have told us on the earnings call, they will balance continued debt pay down while resuming ‘opportunistic’ share repurchases
• Speaking with the company, they add that on their maths they see the repurchases as far more value accretive, but that investor feedback has taken issue with Crocs high leverage for a retailer, and so they are keen to manage down their leverage simultaneously
• Conclusion
• The simple conclusion is I expect about $500m excess FCF to be generated of 2H23, o/w would guess 50/50 split on buybacks so $250m on repurchases in H2
• But more importantly – in FY24 on my numbers the business will generate ~$1bn FCF
• And if they spend the full remaining $750m approval on buybacks, and a little debt paydown, with modest EBITDA expansion they will be well inside their target leverage – say around 1.2x
• Crocs have a strong demonstrated history of aggressive buybacks, and in the next 18months will be fully able to spend their full allocation – this should be our base case
• Given the mkt cap today of $6.2bn – this is 16% of the mkt cap being bought back over the next 18 months, at a valuation that accretes huge value to the remaining shareholders
• Not to mention that beyond 2024, the business will continue to chuck off FCF >$1bn /yr, and something will need to be done with the capital

Destination scenarios

• Let’s run some scenarios and see what we’re paying today for these future outcomes
• To add some context I’ve included the historical trajectory in sales and OP

• Mgmt LT guidance
• ’26 Crocs brand sales >$5bn
• ’26 LT group OPM >26%
• Hey dude – they haven’t formally given LT guidance (their past number is stale as they’ve already surpassed it)
• But my sense is mgmt think Hey Dude can be bigger than Crocs LT, given the market size is far larger and the growth trajectory has been explosive
• Here I’ve conservatively used $2bn for a guess at a mgmt equivalent Hey Dude ’26 guidance
• OK so what’s in the price – not very much!
• The first scenario labelled ‘mkt’ runs some assumptions that you need to believe to get to the current price:
• Crocs brand sales stop dead in their tracks indefinitely
• Hey Dude sales stop dead in their tracks indefinitely
• This one is particularly silly given the Intl roll out is still to come
• Margins compress
• Crocs moves down to 25% - still strong but below the 28% currently
• Hey Dude margin gets halved to 15%
• Apply 8.5x EBIT multiple – roughly half its historical avg since ’16 of 16x
• This gets you to the current price…
• Every single one of these assumptions is ludicrous
• Another disaster scenario B to drive it home
• Delete Hey Dude
• Crocs sales stops dead in its tracks
• Group margins take a huge compression to 20%
• Apply Croc’s own avg multiple of 15x…
• Get’s you to $123 / sh, or 22% above the current price
• Base case
• Any sensible multiple on ’23 – ’25 earnings…
• Gets you to 160% to 250% above the current price
• That’s with base case assumptions that lean conservative and are quite beatable
• Mgmt case: $540/sh, +435%
• Conclusion: the skew on this name is extraordinary
• Very hard to cook up a credible worst case scenario where you lose money from here
• Very easy to see +250% or a 3.5x by ‘25
• Of course, there’s no getting away from the extreme volatility and mark to mark losses you could find yourself sitting on in the interim, but talking about fundamental downside after a couple of years – very limited in my view

If you’re still with me – let’s recap in plain terms, what is at it’s core a very simple thesis…

Recap

• Right now the market seems panicked about Crocs for 2 reasons
• Lingering questions around Crocs resurgent success being faddy and thus unsustainable
• Of more concern over past 3 months – the mkt is now worried about Hey Dude’s performance, seeing sell in numbers fall from close to +100% YoY last year, to close to flat today (+3% 2Q23)
• Both of these fears are…
• 1) Misplaced
• 2) Overly (entirely) discounted in the current price anyway
• Why misplaced?
• Crocs brand
• Expect stabilisation and growth from here (US still growing, Intl business getting more traction, margins stable)
• How – because the performance so far has actually had far more to do with the new (2017) CEO’s strategy gaining traction, than it did about CV – this is much clearer now looking back than it was in 2021
• In a nut shell, the strategy that’s been working so well and continues to do so, first in the US but more recently catching on internationally as well:
• 1) Ignite the brand with creative mkting, celeb endorsements and funky collaborations – and capitalise on the high awareness that Crocs brand already has
• 2) Tighten distribution to control discounting, supporting margins whilst simultaneously avoiding the negative brand image of low pricing
• Hey Dude
• The headline sell in growth deterioration from ~+100% last year to now zero is misleading
• Because last year HD doubled sales through rapid distribution expansion, meaning about 20% of the sales were sold to fill retailer inventories and pipelines – the initial first stock up
• This year that same one time ‘stock up’ is a comps headwind
• Cleaning the growth, the 100% to zero, in reality is about 50% to 30% clean sell in
• Likewise sell out was +27% YoY in 2Q23 – the American consumer is continuing to buy more Hey Dude shoes
• AND mgmt haven’t materially launched internationally with Hey Dude yet – something which can add another 70% of sales if it sells intl in the same ratio as Crocs brand
• Lastly, we have to recognise mgmt’s track record of success with the Crocs brand – they plan on repeating the same play book with Hey Dude
• If they can take an ugly irrelevant foam shoe and make it a fashion staple around the world, I wouldn’t bet against them breathing life into the Hey Dude brand
• Luckily it’s not a bet we need to take either way – no positive developments on Hey Dude are priced in anyway
• Valuation skew on destination scenarios
• Table says it all
• Very hard to cook up a credible worst case scenario where you lose money from here over the medium term
• Very easy to see +250% or a 3.5x by ‘25
• 
• Other triangulations on this thing being mispriced
• Heavy insider buying
• Insiders bought the Mar-Jun 22 lows to the tune of $4.5m – in what proved a mostly well timed series of purchases
• This has now resumed post 2Q23 – in August the Chairman bought another $1.2m of stock
• Crocs share price has a history of trading at non sensical valuations, both on the upside and the down
• In Oct 2021, when Crocs appeared to be benefiting from a covid and fashion whirlwind (sales ~2x pre CV, margins ~3x = earnings ~>6x)… the mkt was happy to fully capitalise these surely super normal earnings into perpetuity by applying Crocs’s historical avg EBIT multiple of 15x
• By June 2022, when Crocs sales were doing the impossible by continuing to grow off their CV base, and Hey Dude was growing 100% YoY – both vastly ahead of reasonable expectations – Crocs had collapsed to 6x EBIT or 4x P/E, with the mkt value essentially moving in the exact opposite direction to what any sensible observer would have estimated as fair value at these 2 points in time
• The final bazooka: $1bn share buybacks
• $1bn buyback lined up, expected to be deployed over the next 18 months, likely with more to follow
• At $1bn we’re talking about 16% of the current mkt cap
• Netnet
• If you can stomach the vol and potential for big swings in the market to market position value, the fundamental risk / reward skew on this over a couple of years look extremely attractive

Catalyst

See above summary