Description

Crocs today is a solid value play, trading under 9x earnings, generating 25% ROEs, and growing revenue in the high single digits.  With a net cash balance sheet of $3 per share, the stock trades at a 10.3% FCF yield on TTM figures, and almost 12% on 2013 FCF (that is including growth capex too).  CROX’s 9.4x forward P/E ratio is substantially lower than its peers who trade today on average at 15.6x 2013 numbers, despite better margins and higher ROEs at CROX.

Overview:

Background:

From the website:

“Celebrating its 10th anniversary in 2012, Crocs, Inc. is a world leader in innovative casual footwear for men, women and children. Crocs offers several distinct shoe collections with more than 300 four-season footwear styles. All Crocs™ shoes feature Croslite™ material, a proprietary, revolutionary technology that gives each pair of shoes the soft, comfortable, lightweight, non-marking and odor-resistant qualities that Crocs fans know and love. Crocs fans "Get Crocs Inside" every pair of shoes, from the iconic clog to new sneakers, sandals, boots and heels. Since its inception in 2002, Crocs has sold more than 200 million pairs of shoes in more than 90 countries around the world. The brand celebrated reaching $1 billion in annual sales in 2011.”

Croc’s sells roughly 48mm pairs (or units) of shoes per year.  It’s an asset light business model today, with almost 80% of manufacturing outsourced, much to China and all in low cost countries.  Crocs cost roughly $9 per unit to manufacture, with average selling prices around $22.  Contrary to popular belief, Crocs is no longer a fad company, with sales of the classic clog representing only 16% of units today.  The clog shape accounts for less than half of revenue (46%), and in total the company sells over 300 different styles of footwear.  A significant number of units are sold to the healthcare industry as well including over 1,350 podiatry offices.

As far as distribution, the company sells it footwear through 3 channels:  1) wholesale (e.g. to Dicks Sporting Goods, doctor’s offices), 2) the Internet, and 3) company operated stores & outlets.  Crocs operates 500 locations today, which account for 38% of sales.  The wholesale channel accounts 52% of revenue, with web based sales accounting for the 9% balance.   Generally the company earns 50% incremental EBITDA margins through the wholesale channel, and approximately 70-75% margins through its operated retail stores. 

Given the margin disparity and the ability to broaden the product offering through company operated locations, management has been building out its store base over the past two years, with impressive results.  2008 and 2009 saw terrible declines in revenue under prior management, as too much focus on the clog footwear product, as well as heavy reliance upon the wholesale channel (who cut inventory to the bone during the crisis), caused revenue to drop from a peak of $847mm in 2007, to $646mm in 2009. 

Today, there is a much wider assortment of product, and lower margin wholesale channel revenue has declined from 91% of revenue in 2007, to 53% in the most recent quarter.  EBITDA margins have improved from 2% in 2009 to almost 17% for 2012.

Given the mishaps that brought the stock from a peak of $70 a share to $1.50 amidst the great recession, management has been revamped with John McCarvel named CEO in March 2010.  Since then, the company has been closing its US kiosk locations and opening high traffic mall type store locations, particularly in Asia as well as a handful in the US and Europe.  Management also continues to migrate customers to higher average per unit priced goods. 

The price range of their products is generally in the inexpensive $20 to $50 per unit range, with an average selling price of $22.77 in the September quarter.  That compares to 2010 average pricing of $17.69.  Next year, management is expecting ASPs to increase by 8%, partly from mix and partly from higher prices.

Third Quarter and 2013

Q3 was a disappointment to the street, despite a 3% increase in ASPs and a 6% increase in unit sales.  For Q4, management guided to 9% constant currency growth, again lighter than Street figures.  The stock is in the classic transition phase away from growth investors, who were buying this at 20x+ earnings with topline growing at 27% in 2011, to the value crowd who I assume likes a stock growing at 8-12% at 9x earnings.

Overall, expectations are for a flat EPS number for Q4, which isn’t too surprising given that CROX seasonality is the opposite of most retailers who make their money in Q4. Also of note, with 35-40 new stores opening in Q4, the cost base, but not the revenue is hitting the P&L.  Inventory is up 24% yoy too, but explained easily by 1) the new stores, 2) higher ASPs than a year ago, and 3) some earlier shipments that the company received compared to 2011.

Croc’s also sell better in the warmer months.  Sales tend to weaken with rainy and cool weather too, meaning some lumpiness for example in the Americas, where comp store growth was up 9.3% in Q1 (warm winter), down 1.2% in Q2 (rainy, sales pulled forward to Q1), and up 5.5% in Q3 (decent weather).  

For the full year 2012, adjusting out certain tax benefits recognized in Q3, EPS should end up around $1.38.  FCF / share using normalized tax rates, including all capex looks to be around $1.34.  Backing out the $3 per share in cash (NET of repatriation taxes which on a PV basis are far lower than the $38mm I assumed), implies that investors are only paying 8.7x earnings, and investing in the business at a healthy 11.2% FCF yield. 

The stock has sold off from a high of $22.30 in April 2012, to its current level around $15.  EPS was $1.24 last year (2011), will be around $1.38 in 2012, and I expect $1.60+ in EPS in 2013, somewhat higher than the Street based on share buybacks and 10% growth overall.  Given the low multiple on the stock today, and the declining share count, I do not believe that CROX at 9x earnings is really pricing any meaningful growth in 2013. 

Bank Facility/Buybacks

The company amended their credit facility last month, raising borrowing capacity from $75mm to $100mm, with the potential to add another $25mm.  Borrowing costs were reduced by 50bps to L+125, and Crocs can also utilize up to $75mm of drawings on the revolver to buy back shares.  Given that most of their cash is held overseas, management is smartly borrowing at exceptionally low rates to avoid a costly repatriation tax.  Covenants are extremely loose at 3.25x D/EBITDA given that the company is in a net cash position.  The facility now matures in December 2017.

Since 2007, CROX has had a 5.5mm buyback program in place.  As far as I could tell, the program was not utilized until Q4 this year when management bought back 1.1mm shares, leaving 4.4mm remaining.  A 4-5% reduction in the share base, at what I deem to be attractive prices, will be well deployed capital in addition to the company’s growth plans for stores.  I do not believe that a reduction to share count has been factored into street estimates for 2013.

It is also noteworthy that Jeff Lasher, the CFO, spent 5 years at AutoNation, a company notorious for its heavy share buybacks.

Store Economics

Generally, it costs $240,000 to open a store in the US, and $140,000 in Asia.  Management expects to open 70 to 95 stores in 2013 (down from 100 in 2012), which should cost $13-18mm depending on the store’s size/locations.  US stores average 1500 sqft, Asian stores a bit over 1000 sqft.  Revenue should reach 750k/store year by year 3, at 20% operating margins.  That is $155k in EBIT by year 3.  Management expects that in they can generate well over 35% ROIs on new stores. 

Comps / Valuation

I get it that CROX can be viewed as a fad stock, not for the long term, and subject to fashion trends that can change yearly (or monthly).  However, Croc’s has evolved from a fashion statement to a comfort brand.  They are appealing to anyone that wants a shoe that is easy to wear, wash, and lasts a long time.  While competition from non-branded clog shoes exists, consumers will seem happy to pay $20-30 for a real, well-designed Crocs shoe that lasts a long time.  The moat here is in the brand, and Croc’s knockoffs have been around for years now, unlikely to add to margin pressure or take share.

With a fad $200+ shoe company like Deckers trading at 10.5x next years EPS, I ask the question, is CROX really worse than DECK (whose revenue was down 9% in the Sept quarter)?  The consumer value proposition is important, particularly in tough economic times, and for that reason I think Croc’s is a brand that will continue to appeal to a wide audience, with really less fashion volatility.

Here are the comps:

From a valuation perspective, if the company executes on its 2013 plans, then it seems plausible the stock can trade to a 15x P/E level, which with cash would imply a $25 stock (I added $2.65 in cash per share after buybacks, down from $3).  $10 upside or 65%.  It is noteworthy that just 18 months ago CROX traded as high as 24x current year earnings, at $30 per share.

The downside I view as a missed 2013 number, at say $1.40 to $1.50 in EPS, and a terrible 7.5x P/E multiple.  That equates to a $12.50-13.50 stock, down $2 from today’s levels. 

Other Notes:

-          Europe represents only 2% of company’s operating earnings, despite the fact that it represents 13% of revenue.  There is a turnaround story perhaps if Europe ever pulls out of its recession, although admittedly it’s hard to see the light at the end of that tunnel.

-          2013 EBITDA I used $220mm, which is roughly 10% higher than its TTM EBITDA of $200mm.  New stores coming online in Q4 should add 4-6mm of EBITDA, ASPs should be up 3-5% (although management has suggested 8%), and unit growth ex new stores (comp stores) should be in the 1-3% range, similar to trend.

-          Against $220 of EBITDA for 2013, I assume $27mm of maintenance capex next year, $16mm of growth capex, $2mm of interest expense, and $36mm of taxes (20% tax rate per management).  That is $138mm in FCF or $1.62 in FCF/share.  Using only maintenance capex, I get $1.71 in FCF/share for 2013, which seemingly should support a $17-20 stock price today.

-          Backlog is booked by wholesale buyers, and was up 33% at the end of September compared to Sept 2011.  While early ordering likely added 10-15% to this, at least the wholesale channel appears to be healthy still despite fiscal cliff concerns impacting consumer spending in the US.

-          Risks include fashion trends, which as MJS27 pointed out in his write up on DECK, are impossible to predict longer term.  Consumer spending in Asia could slow, and a recession here (or anywhere for that matter) could cause revenue and earnings to fall. 

Catalyst