Discover more from Unconventional Value
Investment Idea #2: Crocs (NASDAQ: CROX)
Two durable brands. Capable management. Industry-leading profitability. Cheap valuation.
This is the second edition of Investment Ideas, a segment where I share actionable stock ideas intended for a multi-year horizon. The performance of every idea (updated monthly) is here. Keep in mind these are ideas, not advice.
CROCS — CROX 0.00%↑
Stock price (as of August 15, 2023): $97.80
Shares outstanding (as of July 20, 2023): 61,644,258
Market cap: $6.0 billion
Enterprise value: $7.9 billion
An investment in Crocs is a multi-year bet on the strength of two casual footwear brands and management’s ability to execute on a global opportunity. For those short on time, the thesis is quite simple:
Management are capable operators and capital allocators who share ownership and are incentivized to create shareholder value.
Both brands are durable franchises, with the most promising growth avenues being Asia, sandals, and Hey Dude international.
The business should maintain industry-leading operating margins north of 25% while consistently converting earnings into cash.
The business is priced at ~9x earnings or a ~9% free cash flow yield while guiding for double digit growth over the next three years.
Some backstory is necessary to understand the quality of leadership.
Crocs was founded in 2002. By 2007, it was a public company with sales of almost $850 million — quite the start for an ugly shoe company. Nevertheless, rapid growth can be difficult to manage. At Crocs, it was severely mismanaged.
Company-operated stores exploded from 94 in 2006 to 619 in 2013 while operating margins collapsed from 27% to 5%. Stores lagged expectations, non-core products diluted the brand, and growth turned counterproductive — it failed to produce profits.
In 2014, Blackstone invested $200 million and overhauled the management team. Andrew Rees (current CEO) joined as President, Michelle Poole (current President) joined to lead product and merchandising, and a host of regional executives with extensive industry experience (something the previous management sorely lacked) entered the fold.
During this period — roughly 2014 to 2018 — the company was transformed. Manufacturing, product, marketing, distribution, digital — everything changed. The company exited non-core business lines and closed underperforming stores. It switched to distribution centers from direct factory shipments. And it closed all company-owned factories in favor of outsourced manufacturing.
On the product side, Crocs returned to its roots — molded footwear — and used the flexibility afforded by injection molding to stay on the leading edge of trends and test adjacent styles. It cut SKU count in half and unified brand messaging globally; previously, marketing efforts differed by region, which negatively impacted the brand’s presence, product sell-through, and supply chain efficiency.
The full transformation story is worthy of its own article (perhaps I’ll tackle that in another post), but the takeaway for the purpose of this write-up is simple: management is directly responsible for the brand’s success since 2014.
It’s also worth highlighting a few things with respect to capital allocation.
First, management has repurchased over $1.6 billion worth of shares at an average price of ~$38, leading to a ~30% decline in shares outstanding since year end 2013. As an opportunistic exercise instead of a rote method of “offsetting dilution,” this has been an extremely value-accretive strategy for shareholders.
Second, management is transparent about capital allocation priorities and have executed on their word. After leveraging up to 3.1x for the Hey Dude acquisition, share repurchases were paused to pay down debt, with a target of under 2.0x leverage by Q2 2023. When the Q2 report came out last month, leverage stood at 1.8x after paying down ~$850 million of debt since the acquisition. And in July, the company resumed share repurchases.
Third, while a frequent subject of criticism, I view the Hey Dude acquisition as an excellent use of capital. It lies directly in management’s sweet spot (brand building) while diversifying the company and expanding its addressable market. The $2.5 billion price tag is often a point of contention, but it represents only 8.4x Hey Dude’s trailing-12-month operating income (and this is during a stretch of elevated investment). In all, I expect the Hey Dude acquisition to be praised in hindsight. (More on this later.)
Management is also invested alongside shareholders. Andrew Rees owns ~1.5% of the company (a market value of ~$100 million and in my estimation, the vast majority of his net worth) with other directors/officers bringing the total to ~2.7% ownership. All managers are required to own shares equal to at least 3x their base salary (5x for Rees). And roughly two thirds of equity compensation is in the form of 3-year PSUs, granted based on achievement of (a) cumulative 3-year revenue and (b) adjusted EBITDA margin targets. The other third is time-based RSUs, which vest based on continued employment.
I won’t belabor my point: the Crocs leadership team is highly capable and are incentivized to create long-term shareholder value. They orchestrated a successful turnaround, returned capital to shareholders appropriately, and set the company up for sustained profitable growth. They are a major asset.
Since reporting Q2 earnings, CFO Anne Mehlman has purchased ~$200,000 of stock; Director Douglas Treff has purchased ~$200,000; and Director Thomas Smach has purchased over $1.2 million of shares. All purchases occurred in the $101-105 range.
2. Brand Durability & Growth
There are plenty of ways to grow the Crocs enterprise. Both Crocs and Hey Dude are (1) distinctive, (2) extensible, and (3) affordable brands operating in a $160+ billion global category, of which the two command less than 5% share combined.
For Crocs, the brand’s polarization is an advantage. Michelle Poole understands this: “You love us or hate us. That’s okay, because that means you’re paying attention to us.” Haters don’t lose Crocs money, but lovers make Crocs quite a bit of money. Really, the fervor leads to one thing: lower customer acquisition costs, which partially explains the rapid improvement in profitability since doubling down on the core brand.
Hey Dude, while not as polarizing, is a similarly distinctive silhouette with avid fans, evident from the average customer owning four pairs. The volume of repeat purchases is a clear sign the brand resonates with customers. Further, Hey Dude’s growth prior to acquisition was achieved on a barebones marketing budget; the prominence of word of mouth also points to the brand’s strength.
The extensibility of both brands is another part of the story. Frequent new colors, new styles, and collaborations with organizations and individuals as varied as Post Malone, Balenciaga, Taco Bell, Salehe Bembury, the Grateful Dead, Bad Bunny, KFC, Justin Bieber, 7-Eleven — the list goes on — ensure the brand remains fresh in the eyes of the consumer and appeals to a variety of interests.
Hey Dude is similarly extensible but has yet to deploy the collaboration playbook to its full extent. Its first collaboration with outdoors brand Mossy Oak launched in Q2 to a positive reception, but it remains (very) early days. I anticipate many more collaborations in the pipeline.
Like Crocs, Hey Dude also launches new color and pattern schemes targeted at specific wearing occasions for holidays, events, etc. The Americana collection, launched for Memorial Day and the 4th of July, was one of the brand’s best-selling collections in Q2.
Affordability is also a central component in the success of both brands. Crocs’ classic clog retails for ~$50, and there is never a shortage of discounts. Even at such an approachable price point (and accounting for discounts), the brand boasts industry-leading gross margins. Hey Dude is similarly inexpensive, retailing in the $50-70 range and also reporting respectable gross margins.
These three attributes — distinctive, extensible, and affordable — underlie my belief in the enduring brand value of both Crocs and Hey Dude.
That said, three specific growth avenues appear particularly worthy of monitoring: (1) Crocs Asia, (2) Crocs sandals, and (3) Hey Dude international.
Asia is a promising land for Crocs as home to two of the three largest footwear markets in the world. For the sake of brevity, we’ll focus on China, where the brand remains significantly underpenetrated. China represents ~20% of global footwear sales and tends to account for a similar proportion of competing brands’ sales. However, it accounts for only ~5% of Crocs sales; this gap is expected to narrow in the coming years.
More importantly, recent evidence suggests the brand resonates with the Chinese consumer with sales growing over 100% for two consecutive quarters. During the mid-year festival, Crocs was the second best-selling casual footwear brand on Tmall and the first on Douyin (Chinese TikTok). This is the fruit of a repeatable brand building playbook executed diligently over the last few years.
Sandals, a highly fragmented $30 billion market, is another promising category and a natural extension of the molded footwear brand (lightweight, affordable, easy to take on/off, and comes in a variety of colors/patterns).
Again, recent results points to the success of the brand’s strategy. Core franchises such as the Classic and Brooklyn continue to grow as collaborations like the Pollex slide (with Salehe Bembury) sell out instantly. Sandals was a $310 million business in 2022; management expects it to reach $400 million this year and over $1 billion in 2026.
Hey Dude may be the most exciting growth engine, provided management’s playbook can replicate its success. Although still relatively unknown, it has incredibly positive brand momentum. Circana, a real-time data provider for the consumer market, noted that Hey Dude was the fastest growing brand in U.S. wholesale in 2022 and moved up from #15 to #8 in casual footwear brand rankings. This is after just one year of Crocs’ ownership.
On the acquisition call, management outlined an expectation for $700-750 million in pro-forma revenue for 2022 and $1 billion by 2024. Actual pro forma revenue in 2022 totaled $986 million. And despite a reduction in 2023 guidance, the brand is still set to reach the $1 billion target a year ahead of schedule.
Notably, the issues behind the slowdown this year are temporary and limited to the wholesale business. The DTC business grew 30% in Q2. On the call, management remained incredibly upbeat about the brand trajectory and emphasized how they continue to make the necessary investments to grow the brand over the long-term.
Specifically, two major initiatives are currently underway — a new ERP system and a new distribution center in Nevada. These should be completed by year end, which will set Hey Dude up for a return to 20%+ growth in 2024.
Hey Dude’s international business is in its infancy and represents a huge area of whitespace. Less than 5% of Hey Dude sales are international compared to ~40% for Crocs. Over time, management plans to match Hey Dude’s distribution to that of Crocs. This year, it began to test the brand internationally and shipped its first orders out of a Netherlands distribution center. This marks the beginning of a multi-year effort to expand into Europe and the Middle East, followed by Asia. Given management’s expertise in building a global brand, this exercise is likely to create significant shareholder value over time.
In all, there are two major aspects to think about when it comes to growth. First, the fad argument against Crocs stands on weak footing. All regions and segments (clogs, sandals, jibbitz) continue to grow at above-market rates. The brand has been around for over 20 years now. And its recent success is the direct result of a conscious strategy diligently implemented over years.
Second, Hey Dude adds another high-growth brand with an opportunity to improve marketing, extend the product, and expand distribution globally. The team has demonstrated success in all three areas previously; I see little reason why they will be unsuccessful this time.
Crocs is a highly profitable, asset light business with strong cash flows.
Molded products are simpler and less labor intensive to manufacture than traditional footwear. DTC and digital sales also comprise a significant portion of the combined business, resulting in industry-leading gross margins.
Further, a subtle accounting difference understates Crocs’ advantage. While most footwear companies exclude distribution and logistics from cost of sales, Crocs includes it. Calculated on a like-for-like basis, Crocs’ gross margin was 69% in the most recent quarter, compared to 58% reported. (The breakdown of distribution costs included in cost of sales is a new disclosure and unavailable prior to Q1 2023.)
This level of structural profitability grants Crocs an advantage which trickles down to industry-leading operating margins.
Of course, a reasonable investor should question the sustainability of these margins given Crocs’ extraordinary growth in the last three years. The flexibility of its cost structure provides some comfort here. Marketing represents almost 26% of SG&A, up from 8% in 2014; if returns on this spend were to decline, the company would be able to pull some levers to preserve profitability.
Perhaps most importantly, Crocs sees its profits in cash. Free cash flow margins also outpace the industry and have increased from —6% in 2014 to 14% in 2022.
In 2023, free cash flow margins have resumed their upward trend, reaching 19% in the twelve months ended Q2.
Given the continued momentum of the business and management’s proven operational chops, I see little reason to believe the company’s profitability is a fluke. Management has consistently reiterated its expectation for operating margins to remain above 26% over the long-term, and these profits are likely to convert into cash in line with history.
Crocs is cheap no matter which way you look at it. To gauge a rough estimate of the expectations embedded in the stock price, I used the following assumptions as part of a simplified reverse DCF:
Starting free cash flow: $500 million
5-year growth rate: 4%
Terminal growth rate: 3%
Discount rate: 10%
Essentially, the market believes Crocs will grow roughly in line with GDP. That makes little sense to me given the growth opportunities ahead. I expect Crocs to grow at or near double digits for at least the next five years.
Compared to peers, Crocs also trades at a significant discount despite delivering faster growth and higher profits.
There appears to be a severe disconnect between the fundamentals of the business and the stock price. When Andrew Rees was prompted about this disconnect in mid-2022, he responded (lightly edited for clarity):
I think given what we see as the financial performance of the company and the growth prospects we see for the company, even relative to our guidance for this year, we're certainly not getting recognition in the stock price. I think what we need to focus on is just continuing to execute. And that's what we focus the teams on each and every day. Keep executing.
This heads-down mentality is exactly why I am content to sit back, be patient, and wait for the market to understand the results and opportunity at Crocs.
If you made it this far, please consider subscribing or sharing with a friend. Your support means a great deal. Thank you.