Use the podcast player below to listen to our discussion on Crocs and its Q3’22 result, which accompanies the detailed write-up below:

(Date of report: 15 December 2022)

You might not like Crocs, but the group sold over 30 million shoes this quarter. It was a record quarter for revenue and full year guidance has been raised. Clearly, there are enough people out there who like the shoes to make this a potent business.

Sitting at the centre of trends like casualisation and direct-to-consumer, the immense share price performance over 5 years is far less polarising than the shoes. Can the company keep it up, or is this just a fad?

Elevator pitch

Lucky charms?

Crocs is such an interesting business, with a history going back to 2002 and an IPO in 2006. Shortly thereafter, the company acquired Jibbitz, bringing charms to the shoes that allow consumers to express themselves. This tells you a lot about the DNA of the company: smart acquisitions and whacky styles.

With a turnaround story that started in 2014, the current management team brings refreshing honesty to discussions with analysts. They are quick to point out current failings and where the previous management team got it wrong between 2008 and 2013.

The share price was trading at around $15 in 2014. Now trading at around $95, this is a return of over 6.3x in less than a decade. This is the stuff of dreams.

For many, the shoes are the stuff of nightmares. It doesn’t matter what you think of the style though – they sold over 30 million shoes this quarter alone! You may not want to wear the adult size Lightning McQueen shoes, but you won’t complain about getting a slice of the profits.

With a current sales level of $2.5 billion and a plan to double it in the next few years, there are lofty ambitions here that need to be supported by a plan. Luckily, there is a plan and a good one at that, with the acquisition of a business called HEYDUDE delivering a proper growth platform to Crocs shareholders.

Differentiated, but less polarising

The management team somehow estimates a $160 billion total addressable market across the “occasions” on which you would wear either Crocs or HEYDUDEs. It’s debatable whether there’s ever an occasion to wear Crocs unless you are younger than five, but the HEYDUDEs look decent and are interesting without being polarising. They are all about comfort, a good thing in a more casual environment.

Overall, this deal delivers diversification without cannabilisation. It also brings a great opportunity for international distribution, as only 5% of HEYDUDE’s revenue is generated outside of the US. By plugging into Crocs’ global distribution network, HEYDUDE has a great runway ahead that the founder could never have achieved alone.

Of course, nothing is ever normal with this group. One of the major HEYDUDE designs is called the Wally, which is arguably what people look like in Crocs!

With a diversifying product set under the Crocs banner, like sandals which add to the “clog” silhouette that the business has been built around, there won’t be a shortage of controversial fashion. It’s good news for shareholders though, with manufacturing efficiencies based on the colours and compounds they use for the clogs. Target markets for the sandals include India, Southeast Asia and the Middle East.

This differentiated offering lends itself well to direct-to-consumer, a theme we unpacked on previous shows like Nike (here) and Lululemon (here). This is part of why the margins are so strong in Crocs.

Speaking of margins, Crocs achieves an incredible EBIT margin. Recently running at over 30%, the guidance is for 26% out to 2026 as revenue doubles from here (in theory). The plan also includes free cash flow margin of around 20%, which is incredibly strong.

Bull Box vs. Bear Box

In the Bull Box, we can’t help but be impressed with the growth story, the product strategy and the way in which management approaches the world:

The Bear Box acknowledges how fickle fashion is, along with the associated reputational risks. We also touch on operational risks and the balance sheet.

Management and leadership

This is a business that has transitioned well beyond its founders. The three founders, Lyndon “Duke” Hanson, Scott Seamans and George Boedecker, have all subsequently moved on and today the company is largely owned by the big asset managers and institutional shareholders.

The current CEO is Andrew Rees, who has been in charge since 2017. His previous experience at Reebok and other retail businesses is an asset. At around a 2% stake, Rees has a substantial shareholding in the company insofar as management alignment with shareholders goes.

Looking at the rest of the leadership team, there appears to be varying tenures with some experienced leaders and some new blood. While board linkages aren’t as impressive as we have seen at other companies we’ve covered, the board is reasonably well-tenured with a diverse mix of experiences.

A risk flag is the fact that insiders have mostly been sellers over the last twelve months and more so recently given the rally in the stock price. While this may be some profit taking on stock-based compensation, it still warrants a mention as a concern.

Competitors and other players to consider

We’ve covered apparel several times in Magic Markets Premium before. In addition to the Lululemon and Nike shows mentioned earlier, we’ve also covered Levi’s. The fashion and apparel industry is a bloody red ocean (i.e. full of competitors) and to the extent you can differentiate your offering, you can survive or thrive.

Whilst Crocs shoes are certainly an acquired taste, competitors like Skechers ($SKX, with a similar market cap around $6bn) cater to a similar demographic. There is also Decker’s Outdoor ($DECK). Athough this name may be unfamiliar to subscribers, Decker’s is the owner of brands like UGG’s which manufactures similarly polarising footwear and in doing so, caters to niche fashion and lifestyle consumers.

Larger brands like Nike ($NKE), Adidas ($ADDY), or even fashion retail like Guess ($GES) would also come into play. An exhaustive list is not possible, but the key point is that in fashion and apparel, investors and consumers are spoilt for choice.

Unpacking the numbers

To give some context to how far this group has come, we only need to look back to 2016 to find operating losses:

The growth story for Crocs is exciting, with the turnaround having created a sustainable business that is strongly cash generative. When you consider the current revenue profile and where the opportunities lie, it’s hard not to believe in this story:

Looking at the latest quarter, you’ll see a huge revenue number because of the HEYDUDE acquisition which isn’t in the base. So for year-on-year numbers, it’s better to just look at Crocs instead, which was up 20% in constant currency in the latest quarter.

Volumes were 19.2% higher and the average selling price was flat in constant currency, which leaves some question marks around pricing power. At least volume growth more than makes up for it.

Consolidated gross margin fell severely by 910 basis points to 55.1%. Half of that is HEYDUDE dilution and the rest is supply chain and inflationary pressures, which is what you expect to see when selling prices are flat. This has also been a far more promotional quarter than in the comparable year because stock levels have recovered across the market

Adjusted EPS increased by 20% in the latest quarter.

EBIT margin was over 30% last year and is now at around 27%. The management team believes that over 26% is possible, even with doubling the revenue from here.

What makes this interesting is that operating leverage doesn’t seem likely from here, despite such strong revenue growth. This means that expense growth will be high. They are historically good at managing margins, so we don’t think we would see a tech company story here where costs go out of control, but it’s just surprising to see no expectation of operating leverage on a high-teen revenue growth rate.

Looking at working capital, Crocs inventory is up 52.6% vs. last year because the prior year was a period of extremely low stock. HEYDUDE has $190m inventory and Crocs has $324m. Crocs generates nearly 2.7x the sales of HEYDUDE with 1.7x the inventory, so you can see that the supply chain efficiency and working capital management in HEYDUDE is nowhere near the level of Crocs. This is what you would expect to see and the room for improvement is part of the upside case.

The remaining capex pressure is on investment in distribution and supply chain for HEYDUDE and some IT investment as well. After that, the focus is on a strong balance sheet that needs to be delevered to below 2x. Once that is achieved, there would be share buybacks with an open repurchase authorisation from the board of $1bn. This seems like a very sensible capital allocation strategy.

The net debt story around the HEYDUDE acquisition is quite something. They went from 0.8x net debt to adjusted EBITDA to a pro-forma 3.1x including HEYDUDE at year end 2021. Now running at 2.5x, the company expects to be below 2x by mid-year 2023. That’s a very impressive story.

Trading overview

As with any investment, timing can be everything. If you invested at the peak of over $180 in November ’21, by June your portfolio was arguably as ugly as the clogs with heels. The stock seems to have bottomed in the mid $40’s in June and is now up to around the $100 mark – an impressive rally.

Zooming out, the stock ran away from its trend, so the correction was merely pulling back to the 200-week moving average. This is a great example of why we look at the 200-week moving average for long term trends, as it proved supportive and the stock has bounced off this level strongly. The 20-week moving average has just crossed above the 50-week moving average. On dailies, the 20/50- and 200-day moving averages have all just crossed bullish in November.

The upside momentum seems to be building. Daily momentum is neutral but weekly is slightly more extended.

On a short-term basis, traders could wait for a correction to the bottom of the rising channel. There is a confluence of support around this level including the ‘20’21 and ’22 consolidation ranges, the ’07 peaks and the current confluence of the 20/50-week moving averages. However, longer term players may not want the FOMO to bite and could consider a long position if the investment horizon is long enough.

To the upside, we believe the ‘R1’ resistance level could be reached in the near term but may prove stickier and may require more time to surmount.

Investing overview

So here we are: ugly shoes but pretty profits!

We have a candid CEO who says it as it is, a clear focus on proper capital allocation and a global growth story that simply makes sense. There are double-digit growth numbers being delivered by a diversified product range.

This growth strategy is built on all the right stuff, like market penetration and improving supply chain, rather than a plan to do further deals.

If you’re looking for where the catch is, then there are question marks remaining around the margin story. Although there has been some leverage in Selling, General & Administrative expenses (down from 31.2% of revenue to 27.2% of revenue), management’s guidance is for consistent margins despite revenue doubling from here.

This makes it sound like a growth machine with limited pricing power, running a race against input cost pressures and hoping that consumer demand keeps the machine ticking over. That works extremely well, until it doesn’t. This would be a very bearish view though and one that could miss out on serious returns even if it is proven to be correct one day.

The market has been worried about the pricing of the HEYDUDE deal, which didn’t come cheap at $2.5 billion. The valuation multiple was a forward revenue multiple of 4x and around 80% of the price was paid in cash, with a fifth in Crocs shares. It sounded very expensive at the time but the strategy seems sound.

A year down the line from that news, the share price is still down 40%. Over 6 months, it’s up nearly 75%. These are huge swings as the market digests the story.

On an EBITDA multiple of 9.4x, it really doesn’t seem expensive for this growth. The Price/Earnings multiple is 10.3x. The free cash flow multiple has blown out somewhat, but that’s to be expected in this environment of reopening.

With an objective view on the numbers and the drivers of growth, Crocs is appealing as an investment rather than an addition to the shoe cupboard. The management team has pulled off an incredible story over nearly a decade and there’s no obvious reason why the story cannot continue.

This is arguably the most positive surprise (relative to our initial expectations) we’ve received from any company we’ve looked at in Magic Markets Premium!