Description

Crocs was written up here six months ago by abcd1234, who made a great stock call (up 110% in 6 months) and did a good job explaining the risk-reward skew in this stock. While the stock has done great and massively outperformed the market, I do think the skew still exists. While it isn’t as extreme as it was six months ago, it is still a really attractive set up. If management does what they say they are going to do by 2026, this stock will double or even triple in the next three to four years. But if the business cools down and growth normalizes on the Crocs brand to low single digits digits globally (this is expected for North America but not international) and margins contract somewhat, you are probably looking at 25% downside. I like that ratio of risk 1 to have a chance at making 4 to 8 in the intermediate term.  

I wouldn’t repost an idea that had been written up so recently if I didn’t think I had something to add, and in this case, what I have to add is historical perspective and industry specialization. I’ve covered Crocs since it went public in 2006 and as dangerous as these words are in investing, I feel quite confident that “it’s different this time” in terms of its boom/bust potential. This is a company that has, in my opinion, graduated from operating in the terrain of fads and has moved onto being a fashion staple that at times heats up in terms of trendiness and at times cools down, but enjoys an underlying steady base of replenishment demand, regardless of the fashion cycle. I would cite Uggs from Deckers (DECK) as a brand that enjoys similar characteristics (but at a higher price point).

History of a 20-year “Fad”

Crocs went through two sales busts, the first of which was an existential crisis where it almost went belly up. Sales contracted by 24% from 2007 to 2009, which led to earnings falling from $2.00 in 2007 to a loss of $1.30 in 2008. The stock lost 99% of its value from peak to trough. The cause of this first crisis was overdistribution to the wholesale channel. When the brand initially got hot, management sought to capitalize on that by selling to literally every retailer that was interested in carrying it. With the product overdistributed, discounting followed, hurting brand integrity at a time when generic, unbranded copycat plastic clogs were flooding the market. Gross margins fell from the discounting, and inventory write downs exacerbated the margin freefall. Gross margins contracted a whopping 2620 basis points in 2008, before rebounding materially in 2009.

The second business decline kicked off several years later and was driven more by lack of cost and ROI discipline than a drop in sales. From 2012 to 2015, gross margins came under pressure at the same time that SG&A exploded due to an ill-fated over-expansion of the owned retail network. When the company started to close stores and unwind the overexpansion, revenues fell – but much less this time – only about 15% over three years. The cause of the profit downturn was again overdistribution, but this time it was in the company’s own retail stores as opposed to in third party ones. Too many points of distribution again led to an oversupplied market and discounting and in turn gross margin pressure and loss of brand cache and integrity.

Both business declines were two different versions of the same problem: lack of brand management characterized by undisciplined inventory controls in the retail channel. Well-run footwear and apparel companies control where their product goes. Think Nike, Adidas, Uggs, every European luxury brand, etc. Controlling your wholesale distribution goes hand in hand with maintaining good vendor relationships where the cadence of promotions and discounts is mutually managed, in support of long-term brand health. This idea of brand management and cultivation was non-existent at Crocs in the years before current CEO Andrew Rees joined the company. (Rees joined in 2014 in conjunction with an investment made by Blackstone – they’ve since successfully exited. Rees was promoted to CEO in 2017).

The Rees Era: From Product Company to Brand

The first thing Rees did when he became CEO was clean house. He cut $80 million in costs, rationalized the owned store base, and made investments in systems and sourcing. Once the house was in order, he went on a growth mission. Beginning in 2019, Crocs began a growth campaign that was rooted in something the company never had in its first 15+ years of existence: active brand management. I’ll get into the details of what that entailed, but I’ll start with the punchline… the results have been fantastic. The Crocs brand has doubled in three years and seen significant margin expansion.

While some will dismiss this growth as the result of being a “Covid beneficiary”, there’s a lot more going on here that just a Covid benefit. A reason to believe that Crocs brand growth will prove sustainable is that the brand has already “comped the comp” so far this year, unlike countless Covid beneficiaries (from Pelton to Zoom) which have seen their windfall reverse already. Even confined to the world of retail (which got a Covid boost from stimulus checks and a margin boost from inventory shortages prompted by supply chain disruptions), you see companies ranging from Abercrombie to Gap to Target, which were overearning, see their top and bottom lines come back to earth.

In the most recently reported third quarter, the Crocs brand grew 20% in constant currency, despite it having grown 72% in the third quarter of 2021. In North America, where the comps were toughest (95% growth in 3Q21), the Crocs brand eked out 2% growth. Its DTC business in North America was even stronger, with comps of +13%, reflecting that sales continue to shift to the company’s captive distribution channel. The “Covid winner” short thesis has gotten long in the tooth at this point, given how many companies in the same sector have already seen temporary tailwinds reverse.

That isn’t to say there wasn’t a Covid benefit to Crocs, but there was one that was more enduring. The pandemic era was great for selling comfy apparel and footwear that was perfect for working at home. But the trend to casualization hasn’t totally reversed – and it won’t. While people have returned to the office, many more than before are working from home, at least part of the time. And in order to lure people back to the office, many offices are more casual than they were pre-pandemic. This isn’t that radical of a shift, as casualization and athleisure were already decade-or-more long trends before the pandemic even started. Going back to that first bust for Crocs, around the time of the Global Financial Crisis… wearing a plastic clog to most offices would have been laughable. Now, 14 years later, I would say it would be acceptable in more spaces than not. So, all that helps the TAM here.

But beyond just being at the right place selling the right kind of product at the right time, there were meticulous efforts towards brand elevation through prudent merchandising, retail strategy, and marketing over the last 3 years. Not only did Rees rationalize the number of stores that Crocs operates from 624 to 353 currently, but he also rationalized the number of SKUs. He ended the product over-assortment that led to too many low-selling styles that ended up on discount. Instead, Crocs homed in on just a few key silhouettes, primary among them the core clog. Love it or hate it for its clunky ugliness, the Crocs clog is iconic, and immediately recognizable. Real brands - especially in footwear - have signature, instantly recognizable evergreen key styles. For Crocs, that’s the clog.

Beyond the clog and variations on that signature silhouette, most merchandising investment has been confined to sandals and personalization. I would say the jury is out still on sandals (slides and double straps), but personalization has been a home run. The company’s Jibbitz charms are very on-trend and in-line with the Gen Z/Millennial preference for customization and projecting personal interests. Just like a graphic T allows the wearer to broadcast their favorite movie/band/sports team/TV show/travel destination, so does a Jibbitz. And they are 90% margin. So, whether your jam is Disney characters, the Wu-Tang Clan, or a spin bike… there’s a Jibbitz out there for you to advertise that affinity to the world (at high margin).

The core tenets of brand elevation include controlled distribution and strong marketing execution. In terms of distribution, allocations to wholesale have been tighter (in terms of number of stores as well as breadth of product). Owned points of distribution have been cut by more than 40%, and emphasis has been put into getting customers to shop online at Crocs’ own website. Sales are now nearly 40% digital (which includes its own website as well as third party sites like Zappos, Amazon, and Tmall).

In terms of marketing execution, the company – not unlike successful streetwear and athletic footwear brands – has leaned hard into collaborations and limited drops, many of which sell out fast. Below are examples of collaborations with an American streetwear designer (Salehe Bembury designs footwear for luxury brand Versace), a Japanese streetwear brand, and an iconic and kitsch-y fast food brand….

These limited offerings add brand heat, and once they sell out, often sell for multiples of the original price on secondary market sites.

Crocs has also turned up the brand heat through collaborations with luxury brands (Balenciaga) and recording artists (such as Luke Combs, Post Malone, and SZA). Crocs has also benefited from celebrities posting themselves in the product (pics below are an Instagram shot from noted Crocs-lover Justin Bieber, a press photo of Questlove on the Oscar red carpet, and more Instagram shots from Ariana Grande, and one of Kardashian-Jenners – Kendall? Kylie? – I forget which is which).

While celebrity heat can come and go, it is extremely effective for brand building when it occurs (Uggs may have never blown up had they not graced Sarah Jessica Parker's feet at peak Sex and the City, 20 or so years ago).

None of these campaigns, collabs, limited runs happened in the previous fashion cycles, nor was the product gracing so many celebrity feet (all I can remember is the orange ones favored by now-canceled celeb chef Mario Batali).

All this is a lot of qualitative context to explain it isn’t an accident that Crocs brand sales went from just over $1 billion in 2018 to around $2.5 billion today. This has gone from a business that chased demand and prioritized short-term results to one that is managed strategically with the long-term brand health always in mind.

While growth in the U.S. is slowing down (tough comps and law of large numbers), international which accounts for around 40% of sales, roughly evenly broken up between Europe/Middle East/Africa/Latin America (mostly Europe) and Asia-Pacific – is really starting to pick up. Obviously, the post-Covid retail recovery has been meaningfully delayed in large swaths of Asia (especially China) given the more cautious approach to dropping pandemic mitigation measures. Reopening will be a tailwind there for 2023, and things are already picking up. In Q3, the Crocs brand grew 82% constant currency (66% reported) in the Asia Pacific region and 46% constant currency (26% reported) in EMEALA. And both Asia-Pacific and EMEALA are a couple of years behind North America in terms of marketing programs such as collaborations and endorsements… I think we are just now starting to see the impact of several years of marketing investment in these regions.

While the torrid pace of double-digit Crocs brand growth in the U.S. is behind them, the recently acquired Hey Dude loafer business is far less mature than the legacy Crocs business and should be a driver of North American growth for years to come.

The Controversial Hey Dude Acquisition

Investors hated this deal because it took them by surprise last year. Management had expressed no intention to do a big deal, then they surprised the market with an optically expensive deal two days before Christmas in 2021, when people were heading on vacation and looking to lock down their P&Ls for the year. Not a good way to make friends and influence people when it comes to investor relations.

The deal looked expensive – 15x EBITDA – and was large: $2.5 billion. It brought leverage up to 3.5x at a point when investors were worried that the consumer was about to roll over. Fast forward a year, and the deal price looks a lot more reasonable - around 8x EBITDA on 2022 numbers, because Hey Dude is on fire and has almost doubled its sales this year. Operating margins on this business are also very high – around 30%, despite the business not being fully scaled. With the benefit of hindsight, this deal wasn’t so expensive after all. As for how it went down, somehow Crocs management caught wind of an investment bank running an auction where only private equity bidders were participating (don’t ask me why the bank was running it that way – doesn’t make intuitive sense). A strategic buyer with levers to pull on the cost side (sourcing) and the revenue side (distribution relationships) should be able to outbid private equity – and Crocs did.

Like Crocs, the Hey Dude product is comfortable and well-suited to a casualized world. The loafers also suit a wider range of occasions than plastic Crocs do. The acquisition has been outperforming all guidance from the time of the deal, and I think we are still in the early innings here, as Hey Dude is much more penetrated at retail and enjoys much better brand recognition in the Midwest and South than it does on the coasts.

The Upside Case for Crocs

Management has guided the Crocs brand to double again – to $5 billion in revenues by 2026. To get there, they aim to have digital revenue penetration reach 50% of Crocs brand revenue (seems achievable), double Jibbitz revenues (also seems achievable), get Asia to 25% of brand sales (it was 15% in 2021 and 19% in the most recent quarter – seems doable), and grow China from <5% to around 10% (also seems reasonable). The biggest stretch goal here is growing sandals from around $300 million in revenue now to $1.2 billion in 2026. If they did all this and had even 15% annual growth at Hey Dude (which is a major low ball given the brand’s momentum and immaturity), the company would make north of $20 in 2026 and likely trade for $200-$300.

That’s a lot of upside. But what if there is a hard landing on the Crocs brand?

In assessing downside risk, it’s important to remember that the sales drawdowns – even in tough times – were manageable… it was lack of distribution and cost discipline that really sunk earnings. Even in the near-death experience of 2007 to 2009, sales only fell about 24%. The bigger problem was excess inventory which led to discounting, gross margin pressure, and inventory write downs (gross margins went from 59% in 2007 to 33% in 2008). The business is much more weighted to its own retail and internet operations this time, and the product is much more tightly controlled. We are unlikely to see this kind of gross margin blood bath again. However, acknowledging that 2021 was probably peak margins and brand heat, my downside case contemplates a 20% drawdown on Crocs brand revenues and a 700-basis point margin contraction on the Crocs business from 2021 levels. When you factor in about 20% annual growth from Hey Dude, which I deem to be a conservative estimate for next year, you land at around $8 in EPS in a hard landing scenario, which would likely lead to a stock price in the $64 to $96 range using 8x to 12x P/E (or downside between 10% and 40% from today’s quote). Will I risk a third of my capital to potentially double or triple it? The answer to that question is almost always yes (exception would be companies flirting with bankruptcy/financial distress, where I want an even more skewed risk-reward).

The Macro Elephant in the Room

Why buy a consumer stock when there are macro headwinds… inflation, rising rates, potentially increasing unemployment, etc.? There are plenty of generalists who absolutely will not touch a consumer stock in a degrading consumer environment. But I would argue that consumer spending is not a zero-sum game… share of wallet is always shifting, and there will be companies who get a larger slice of a shrinking pie thus can still grow. The last consumer stock I put up on VIC – Academy Sports & Outdoors (ASO) roughly a year ago – is up about 20% this year in a tape where the Russell is down 23% and the retail index (XRT) is down 35%. The retail/apparel/footwear sector always has wide dispersion with performance outliers, and I think Crocs will be one given its brand heat, accessible/affordable price points, and substantial international exposure in countries where the cycle is lagging that of the U.S. (although FX will be a headwind there).

People still need shoes, even in tough times, and these are cheap ones, with core clogs generally priced $49.99 to $59.99, sandals $29.99 to $49.99, and Jibbitz generally $4 to $5 apiece. A big part of the short case in earlier cycles was that unbranded, generic plastic clogs and slides from China would eat into Crocs’ share. No one really talks about this anymore, because Crocs is a brand now… and a $30-$50 price point is attainable to such a large addressable market, why wear fakes when you can wear the real thing?

While tougher times may make the real thing a little father out of reach when it comes to a handbag from Gucci or even Michael Kors, $50 on a durable pair of shoes is very affordable for something that is truly branded, and changing up the color, pattern, or Jibbitz on your Crocs is a pretty low-ticket way to freshen up your look, versus other available options.

Ugly Shoes/Attractive Stock

Summing it up, I think Crocs is a company that has professionalized the way it runs its business, much to the benefit of brand integrity, and ultimately, I believe business volatility. There is no sign of the brand rolling over in the U.S., although it is decelerating, but that slowdown is offset by international markets taking off. The extremely unpopular Hey Dude acquisition looks like a real winner with the benefit of hindsight. The company should deleverage from that acquisition through cash flow generation, and restrictions on share buybacks will probably go away in two to three quarters. While the phenomenal financial results of the last few years are well-known, the management actions that got the company here are less universally understood. There are also a lot of investors out there who treat consumer stocks with reversion to the mean bias. Reversion to the mean is a great strategy for commodities and financials… but I am not sure it works on brand-driven, fashion-driven consumer companies.

This management team has executed like champs, but no one believes the long-term guidance, because if they did, the stock is 5x 2026 earnings. This is the opportunity. If that 2026 guidance proves too aggressive, this could still be a 10%+ compounder, because Hey Dude alone can drive that much earnings growth. And if I am totally wrong, I still think the stock is worth about $80, assuming the whole market doesn’t blow up (always a key caveat). The upside case is at least 3x the downside case here, and maybe closer to 5x to 6x. That – plus a lot of non-believers – makes CROX shares a good bet to me.

Catalyst

• Soft landing for Crocs brand in North America while international growth accelerates
• Continued double-digit top and bottomline growth for Hey Dude brand in 2023 and 2024
• Resumption of stock buybacks in mid-2023