Description

I’m writing up CROX as a long despite the fact that I expect this to get poor ratings and limited engagement.  This seems to be the case with all of my VIC write-ups even though all but one post (SFTBY) have worked out as well or better than I had expected.  I guess this is my niche.  CROX was last posted on VIC on 8/2/2020 at $36 with low ratings and no comments and exited 3 months later at around $57 (which, as of right now, looks like a good sale). Although an incredible result in 3 months (~+60%), with perfect hindsight, the exit could have been timed better as the stock ran to just north of $180 in 2021.  

QUICK PITCH: CROX is a name that many investors will not touch right now regardless of valuation for two reasons:

1) It’s a consumer discretionary business which investors want to avoid as we enter an inflation-driven recession.  Like other consumer discretionary businesses, it was a massive stimulus/covid/stay-at-home beneficiary as 2021 adj EPS was 4x its 2019 EPS.  Lastly, consensus estimates show strong continued growth which may be too optimistic (no one wants to buy into negative revisions).

2) Many view Crocs as a “fad” product which make it uninvestable for them. 

I am comfortable taking the other side of these “risks” as I’m confident in the durability of the cash flows and simply think the current price offers a very attractive margin of safety relative to the potential upside.  On its 1Q22 earnings call on 5/5, CROX increased its 2022E EPS guidance to $10.35 (compared to $10 previously).  CROX is currently trading at 4.8x this year’s earnings for a company with attractive earnings growth ahead.    

COMPANY HISTORY:

Crocs was founded in 2002, with the familiar loved/hated clog originally designed as a boat shoe.  The brand was named after crocodiles as the shoe is meant to perform well on both the land and the sea, just like its reptile namesake.  It went public in 2006 shortly after its founding on the back of explosive growth.  Aside from its recent acquisition of Hey Dude and expansion into sandals (both covered later), not much has changed over its 20 year history.  

The only notable acquisition (prior to Hey Dude) was its acquisition of Jibbitz (personalized charms one can stick into the holes in of Crocs) in 2006 for $10mm (plus $10mm earn-out if profitability metrics were hit).  It remains a limited SKU concept with clever methods of marketing and personalization  which drive a powerful and profitable business.  Jibbitz is a large part of Crocs profitability generating ~$160mm of sales at a ~90% gross margin.  Crocs has sold over 900 million pairs of shoes in its 20 year history and currently sells in more than 90 countries.  It is currently one of the most recognized brands in the world (generally loved or hated).

IS IT A FAD?

Sort of, but not really.  How many fads have endured for 20 years?  It has only had 2 years in its history with declining unit volumes (2008 and 2016).  See below a chart of annual sales and units going back to 2004:

Certainly not a linear for either metric but I think this shows the brand has durability.  The Hey Dude acquisition didn’t close until February 2022 so these are clean numbers for Crocs only.  

Units went from 6mm to 22mm to 47mm from 2005-2007 and sales from $109mm to $355mm to $847mm.  This was an 8x increase in 2 years.  Even with this astronomical growth and the entrance into the greatest recession since the Great Depression, units and sales only fell from its “fad peak” by 25% and 15%, respectively, and reverted back to growth the following year.  Even if Crocs sees the same 25% decline in units as back then (despite more benign conditions now vs. then), the two-year growth is substantial.   

WHY DID THE BUSINESS SPIKE IN 2021 AND WHY HAS THE STOCK CRASHED?

Crocs was clearly a covid-beneficiary, but as alluded to in the prior post, Andrew Rees who became CEO in 2017, deserves a lot of credit for improving the business.  While sales and volumes showed decent, steady growth from 2008-2017, the business still had issues with profitability.  Gross profits declined from 2013-2016.  Rees, formerly a consultant for the company, added much needed discipline and focus.  Sales in the Americas, previously in decline from 2012, experienced a resurgence starting in 2018 predominantly due to targeted marketing and celebrity/brand collaborations.  Sales in the Americas grew 33% from $480mm to $641mm from 2017-2019 (pre-covid).  It’s purely observational, but I see significant adoption from the younger millennial and Gen Z demographic, those that are focused purely on comfort and individuality (think of those that exclusively dress in athleisure for all occasions).  Covid turbo-charged this trend that I believe was already taking place.  The affordability and comfort make Crocs and ideal “work from home” shoe.

The business exploded in the back half 2020 and the full year 2021.  Sales went from $1.2B in 2019 to $2.3B in 2021 and GAAP net income from $120mm to $725mm.  This obviously explains the stock price performance, but the stock peaked in November 2021, long before any deterioration has been presented in the financials.  While the stock was already trending lower, it announced the acquisition of Hey Dude for $2.5B just before Christmas which was not well received by the market.  The stock was down 12% on the day of the announcement and has been declining ever since.

One can debate the right price for Hey Dude but high growth companies are inherently hard to value (as the dispersion of outcomes is so wide).  Crocs market cap is down about $6B from its value prior to the Hey Dude acquisition, so from the perspective of earnings power from here, the earnings growth from the acquisition will be welcome insulation from potential normalization of Crocs sales (although management guidance still reflects growth from the Crocs products as well YoY).     

VALUATION

Crocs current valuation relative to management’s 5-year guidance might be the widest disparity I have ever seen.  In my experience, the market has more credibility than management, but let’s start with what a potential IRR could be if the company can hit the low end of their guidance (using overly conservative assumptions for that which does not have explicit guidance).

The company guides to $5B+ of revenues for Crocs by 2026 and $1B+ of revenues for Hey Dude by 2024 with an EBIT margin of 26%.  Hey Dude did $570mm of revenues in 2021 so this represents a 21% CAGR.  Even dropping this revenue growth down to 8% for 2025 and 2026 gets us to $1.2B of revenues for Hey Dude and total revenues of $6.2B.  26% get us to $1.6B of EBIT.  Cash flow generation for these 5 years will fully repay the debt and leave the company with greater than $1.2B of cash.  Some interest will be generated on this cash which we will ignore (in reality, the company will stop repaying debt when leverage is below 2x and will use the FCF to repurchase shares which will further juice the math) so taxed at 25% (cash tax rate is currently 22%), this results in $1.2B of net income, or $20/shr on the current share count.  At 15x, this is a $300 stock plus $20/shr of cash, or $320.  So on the low end of management guidance with conservative assumptions (on FCF generation and share count), this would be a 6.4x in 4 years, or a 60% IRR.

Before adjusting these growth rates lower, I would highlight that the company has some powerful growth engines that are driving this expected growth.  

First, the company actually may be being conservative with Hey Dude.  This is a very high growth company and thus difficult to forecast.  At $570mm of sales last year (more than 100% growth from 2020), it likely got a stimulus boost (like Crocs) and still has fad risk, but I’m confident sales could have been north of $1B if it had the benefit of Crocs’ scale and infrastructure. Despite gross margins lower than Crocs, Hey Dude has 40% EBIT margins.  This is due to limited marketing and a small geographic scale.  Crocs will immediately invest in the brand, bringing EBIT margins down closer to Crocs at 26%, which will certainly increase the growth trajectory.  

The first area of growth for Hey Dude is US geographic expansion.  Most of Hey Dude’s sales are in the Midwest and South and only recently gaining resonance in the Northeast and West Coast.  Crocs highlighted that this is the exact same growth trajectory they experienced so they have confidence this brand can travel nationwide.  They also only have 30% overlap in wholesale relationships.  As a highly popular product, Crocs has supplier power with its wholesale channels and should easily be able to gain shelf space in retailers that currently don’t carry Hey Dude shoes.  Crocs also has its own retail stores which it can easily drop in Hey Dude which will certainly drive sales.  Management said there is already significant overlap in the customer base so they do not think this will cannibalize sales much for Crocs. Lastly, Hey Dude’s share of kids sales is significantly lower than Crocs thus this is another area where they believe growth should be relatively easy with increased brand awareness. 

International is the other source of relatively easy growth for Hey Dude.  Currently less than 5% of Hey Dude sales are outside the US compared to Crocs at 32%.  Hey Dude grew sales 81% in 1Q22 and current guidance for the full year is 36% growth (after greater than 100% growth in 2021).  This growth remains entirely in the US as a focus on international is not targeted until 2023 or later.  Even at just Hey Dude’s 2022 US sales and Crocs global mix of US/International would generate the $1.2B of sales referenced above.

Moving to core Crocs, I believe low hanging fruit remains here as well.  While not only reinvigorating the classic clog (mostly with creative marketing), Rees has created an added focus on sandals as well. They last disclosed Sandals as representing 16% of sales in 2021, but the growth plan of getting the Crocs brand to $5B+ by 2026 involves growing the sandals business by 4x from 2020.  Who knows if they can hit this target but achieving significant growth from a relatively new product rather than relying on continued astronomical growth from the clog feels more credible to me.

Their other major growth driver is China.  Currently China is only 5% of revenues and they believe they get this to 10% by 2026.  China is the second largest shoe market in the world so getting China to 10% of sales in 5 years does not seem like such a heavy lift to me.  The extreme sales growth and brand awareness in the US over the past two years I also think bodes well to this trend making its way to China.

MORE MUTED EXPECTATIONS:

We were already 5 months through the year when full year guidance was last given so let’s assume the company whiffs on their back half of the year by $150mm (for Crocs only), or 10%, which gets us to $2.6B of revenues.  They increased full year Hey Dude guidance by $130mm from 1Q to 2Q so this brand is clearly doing far better than they had expected.  Let’s still assume they miss the full year by $50mm at the midpoint which puts full year Hey Dude revenue at $725mm.  This brings total company revenues for 2022 to $3.325B.  Let’s then assume that Crocs revenues drop by 15% in 2023 (recall revenues only dropped 15% in 2008 during the financial crisis after sales had previously 8x’ed the two years prior) and Hey Dude only grows by 5% (essentially the same 15% drop for the legacy Hey Dude offset by 20% “growth synergies” associated with Crocs).

Crocs revenue CAGR’ed at 6.7% from 2009-2019 so let’s assume the same rate for the next three years to 2026 for both brands.  Thus sales are the following:  

                   2022         2023                  2024         2025                2026

Crocs          2,600         2,210          2,357         2,514         2,682 

Hey Dude                  725                 761                 812                 866                 924 

Sales          3,325         2,971          3,169         3,380         3,605 

We won’t go into every assumption under this scenario in detail, but if we then assume that EBIT margins drop to 20% and linearly increase to 22% by 2026 (400 bps below their LT target), we get to almost $800mm of EBIT in 2026.  If we then assume once leverage drops to below 2x, FCF generation is used for share buybacks at $80/shr, CROX will do $11.2/shr in EPS.  At 10x PE, this is a $112 stock in 4 years or a 22% IRR.

CONCLUSION

This has already gotten longer than I expected, but I think there is great asymmetry in price of CROX at the current valuation.  So long as one believes Crocs (and to lesser extent Hey Dude) will not fall into perpetual decline (and eventual obscurity), I think the downside is limited.

On the upside, I actually think the stock would perform better than illustrated in the beginning of the valuation section above (6x upside seemed enough for that purpose) if management actually delivers on their long-term guidance.  At sub 5x earnings and a long growth runway, CROX has the “twin engines” (to quote Chris Mayer) to become a historically powerful stock.  If they execute on this Hey Dude acquisition as they anticipate, it obviously not only diversifies their product mix, but also demonstrates to the market their ability to make intelligent acquisitions as well as their platform value.  This could justify a premium multiple on a significantly higher EPS than today.  

Catalyst

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