Crocs Clogs Are Good, But The Stock Is Even Better (NASDAQ:CROX)

Investment thesis

As a consumer who appreciates the durability and comfort offered by Crocs (NASDAQ:CROX) clogs at a reasonable price, my enthusiasm extends beyond the product to the stock’s investment potential. The company demonstrates substantial pricing power, leading to a remarkable twofold increase in operating margin from pre-pandemic levels, even amid the unprecedented inflation of 2021 and 2022. While North American revenue growth is slowing, Crocs has bright growth prospects in Asia, where 60% of the global population resides. Furthermore, the stock’s current undervaluation of around 40% presents a compelling investment opportunity, earning it a “Strong Buy” recommendation.

Company information

Crocs and its subsidiaries are designing, developing, worldwide marketing, distributing, and selling casual lifestyle footwear and accessories for women, men, and children.

The company’s fiscal year ends on December 31. Crocs disaggregates revenues by brands and geographic areas. According to the latest 10-K report, the HEYDUDE brand has been acquired in February 2022.

Financials

The company’s financial performance over the last decade has been solid, with revenue compounding at an impressive 13% CAGR. As the business scaled up, CROX demonstrated firm operating leverage as the operating margin expanded from 6.7% to 25.3%. The business is not very capital intensive, and CROX does not pay dividends to shareholders, which allows the company to generate a wide free cash flow [FCF] ex-stock-based compensation [ex-SBC] margin. The dip in the FY2022 FCF margin should not mislead readers because there was a $2 billion acquisition of a HEYDUDE footwear brand.

A consistently positive FCF margin and widening operating profitability allow CROX to sustain a healthy balance sheet. Liquidity is in excellent shape, and I am also comfortable with the covered ratio despite the high leverage ratio. I want to emphasize that the lion’s part of the total debt, $1.9 billion, matures in 2029 and 2031. That said, the high leverage ratio is the company’s advantage and not a weakness. I consider the high leverage advantageous in this context, primarily due to the extended duration of the company’s liabilities, set to mature after a five-year period, coupled with the benefit of a locked-in interest rate of 4.25%.

The latest quarterly earnings were released on November 2, when the company topped consensus estimates. Revenue demonstrated solid dynamics with a 6% YoY growth, and the bottom line followed accordingly; the adjusted EPS expanded from $2.97 to $3.25 on a YoY basis. It’s crucial to underscore that the expansion in EPS was not primarily a result of enhanced operating leverage but rather stemmed from relatively assertive stock buybacks in Q3. It’s essential to note, however, that the overall financial performance remained robust, aligning well with the increase in revenue, with both gross and operating margins showcasing stability year-over-year. I emphasize the point about stock buybacks to make sure readers are not misled, especially considering that profitability metrics remained relatively flat during this period.

Earnings for the upcoming quarter are scheduled for release on February 16. Consensus estimates forecast Q4 revenue at $957 million, which means that the YoY growth is expected to be modest at 1.1%. The adjusted EPS is expected to shrink from $2.65 to $2.35. EPS projections look pessimistic given that the operating margin has been relatively resilient in 2023, and no revenue decline is expected. The substantial pessimism is underscored by the fact that there were 12 EPS downgrades in the last 90 days. I am optimistic about the company’s ability to deliver positive surprises, given that consensus estimates are very conservative. On the other hand, the pessimism expressed in 12 EPS downgrades might indicate that there will be a cautious FY 2024 guidance from the management, which might hurt the stock price after the earnings release.

Now, let me move on to a more strategic and longer-term perspective. The company’s widely recognized brand is a strong strategic advantage, and best-in-class profitability suggests that Crocs executes well to absorb its solid brand loyalty and pricing power. The business is susceptible to the impacts of inflation, particularly regarding the volatility in raw material prices. However, given Crocs’ robust brand strength, I am confident that the company will be able to maintain its solid pricing power. The resilience of the brand, coupled with effective management, positions Crocs to navigate through potential cost fluctuations, ensuring the ability to sustain competitive pricing in the market.

Crocs’ robust brand and global recognition create a solid foundation for the company’s international expansion endeavors. Although revenue growth is naturally decelerating in North America, where the brand has a long-standing history and high penetration, the company is experiencing noteworthy growth in Asia. Recognizing Asia as a pivotal long-term growth driver is a strategic move by Crocs’ management, and I align with this perspective, especially considering that almost 60% of the global population resides in this dynamic region. Crocs’ Asia Pacific revenues compounded at a staggering 30% over the last three full fiscal years, and Q3 2023 TTM also demonstrated the above 20% growth compared to FY 2022.

A significant catalyst for potential revenue growth and enhanced profitability at CROX could stem from the increased penetration of digital sales in the overall revenue mix. According to the latest earnings presentation, digital sales currently account for 38% of the total revenue, indicating considerable room for further improvement and expansion. The anticipated compound annual CAGR of 12.2% in the global e-commerce market by 2030 presents a substantial tailwind. Crocs is well-positioned to capitalize on this trend, given its proven track record of success. Furthermore, the e-commerce platform is a potent tool for Crocs to extend its presence beyond North America without spending on opening its stores.

Beyond the massive brand and promising growth opportunities in the Asia Pacific region, it’s crucial to highlight the strategic and marketing agility of Crocs’ management. The proficiency in securing numerous collaborations with popular franchises and celebrities is stellar. A glance at the company’s official website reveals a diverse array of partnerships, showcasing the brand’s adaptability and broad appeal. From Russian pop band Little Big to South Korean sensation PSY, Hollywood icon Drew Barrymore, and collaborations with entities like Pixar’s Cars and Levi’s, Crocs has successfully navigated varied markets and demographics, solidifying its position as a versatile and globally recognized brand.

Valuation

CROX price plunged by 12% over the last twelve months, substantially lagging behind the broader U.S. stock market. The stock has an attractive “B” valuation grade from Seeking Alpha Quant. Indeed, most of the valuation ratios are substantially lower than the sector median and the company’s historical averages.

The company does not pay out dividends, so the discounted cash flow [DCF] simulation looks like the only option to proceed with. I use an 11.4% rate for discounting, which is a WACC recommended by Gurufocus. Consensus revenue estimates are available up to FY2027. For the years beyond, I have used a 10% revenue CAGR, which looks fair enough given the acquisition of the HEYDUDE brand, growth prospects in Asia Pacific, and the ability to demonstrate marketing flexibility with a wide array of collaborations with well-known names and brands. Moreover, I want to emphasize that the mix of consensus estimates and my revenue growth projection after FY 2027 gives a 6% CAGR for the whole decade, which is very conservative compared to the past decade’s 13% CAGR. I use a TTM 8.6% FCF ex-SBC margin and expect a half-a-percentage point yearly expansion.

My simulation shows the business’s fair value is $8.8 billion. This is 41% higher than the current market cap and looks like a very attractive valuation to me.

Risks to consider

Crocs has enjoyed notable success in recent years; however, its prosperity is tightly linked to prevailing fashion trends. Given the dynamic nature of consumer preferences, any shift away from the current priority on comfort-focused footwear could significantly undermine the brand’s positioning, adversely affecting the company’s financial performance. This vulnerability can be proactively mitigated if the management can efficiently diversify the portfolio with complementary brands that will not directly compete with Crocs. Such a strategic move would help safeguard against fluctuations in fashion trends and contribute to a more resilient position within the ever-evolving fashion industry.

While the popularity of Crocs presents a clear advantage, it simultaneously poses a potential risk. The brand’s widespread popularity makes its products susceptible to illegal replication, often sold at much cheaper prices by smaller manufacturers in regions with lower labor costs. This might undermine Crocs’ market position and popularity in countries producing these unauthorized replicas.

Significant uncertainty surrounds Crocs’ ability to fully unlock the potential synergies from the HEYDUDE acquisition. The substantial $2 billion investment, particularly notable for a company of Crocs’ scale, raises concerns about the successful integration. The failure to absorb all planned benefits could potentially result in a massive disappointment among investors. Such an outcome may have prolonged implications, requiring several quarters for Crocs to rebuild investor confidence in the stock.

Bottom line

To conclude, Crocs’ stock is a “Strong Buy”. The company has a massive brand recognition, which results in solid pricing power. This helps expand and sustain comprehensive operating profitability, ultimately likely improving the company’s FCF. I like the capital allocation approach with a fortress balance sheet and long-term debt repayable only in 2029 and after that. Furthermore, my valuation analysis suggests that the stock is massively undervalued.