This is an old writeup on Crocs from June 2023.
Disclaimer: None of what I write is a recommendation to buy or sell a stock. I am an internet stranger writing about random businesses with no successful track record in investing. This is a selfish endeavor to grow as an investor myself and to document my research as I do not have a good memory. Please do your own research before buying a stock.
If you like reading pdfs, here is a pdf version of this writeup.
INTRODUCTION
Crocs Inc. is a casual footwear company, based in Colorado, famous for its unique “clogs” (plastic shoes with holes and an open back, which many people find ugly). The company majorly sells products, under the ‘Crocs’ brand, made of a material called “Croslite”, a proprietary molded footwear product. The company recently purchased another casual footwear brand – ‘HeyDude’ in 2022.
Today, 75% of its revenues come from the Crocs brand, which consists of 2 molded footwear product lines, clogs (80% of Crocs brand revenues) and sandals(10% of crocs brand revenues). Jibbitz(8% of Crocs brand revenues), which are small charms which one can clip onto the holes on crocs shoes to personalize. The remaining 25% of Crocs’ revenues come from the HeyDude brand.
BUSINESS HISTORY
Initial High Growth & Overexpansion(2002 - 2009):
Crocs was founded in 2002 by 3 friends who came up with the idea on a vacation in the Caribbean. Crocs was named after crocodiles as the shoe was meant to perform well on both land and water. One of them was wearing a slip resistant clog produced by a Canadian company “Foam Creations”, the other 2 friends thought they were ugly but loved their functionality. They licensed the technology from Foam Creations, calling it “Croslite” (Crocs eventually bought Foam Creations in 2004) and started producing clogs. These shoes debuted at the Fort Lauderdale International Boat Show in 2002 and were an instant hit. Sales went up explosively from then till 2007(Crocs IPO-ed in 2006). The company forecasted demand to keep going up at the same rate and expanded too widely by selling to every retailer possible. When demand started to slow down from 2007(sales dropped 24% from 2007-09), this over-distribution hit the company hard. Discounting followed to get rid of too much inventory, earnings dropped (Crocs lost money in 2008-09) and stock lost 99% of its value. This was the first boom-bust cycle the company experienced.
Second Overexpansion(2010 - 2015):
The company experienced another boom-bust cycle in 2012-15, although this was not as bad as the last one. This time, the problem was overexpansion in Crocs’ own retail stores (company operated stores). It had also lost its focus by foraying into footwear segments other than its molded croslite products which affected margins. Revenues fell 15% over 2012-15. Both these overexpansion mistakes were caused by overexpansion and too much discounting, hurting brand image.
Turnaround(2016 - Present):
Andrew Rees, who became CEO in 2017, has managed to successfully turn around the company, by bringing in best brand management practices and investing in marketing (He had joined the company in 2014 after Blackstone took a 13% stake in the company with a $200M investment. He served as president before becoming CEO. Blackstone still owns 11.5% of the company). He is vastly experienced in consumer products branding and marketing. He has done a great job with capital allocation since he took over the company. He has constantly invested in marketing even during the pandemic, closed/transferred under-performing company operated retail stores(reduced company store count by over 30% from 2017 to 2018), improved quality of revenues by exiting low margin footwear categories(non-molded products) that earlier management had forayed into, started focusing on clogs which was Crocs’ signature product and put in place policies to control product distribution. Company has bought back large number of shares outstanding(share count reduced by 16% since 2018) as the share prices have traded at a large discount(management understands difference between good and bad value in buybacks, without buying back shares at any price).
The RoCE in 2022 is optically low, hiding the true profitability of the underlying business due to accounting effects of the HeyDude acquisition. HeyDude brand is fundamentally highly profitable, similar to the Crocs brand(HeyDude had operating margins of 30% on revenues of $500 million prior to acquisition - with no physical retail stores owned by HeyDude, RoCE of HeyDude brand standalone, should have been greater than or equal to the Crocs brand).
The true gross margins are also hidden as the company reports distribution/logistics costs under cost of goods sold, unlike competitors, who report it in SG&A. In Q1 2023, Crocs revealed distribution costs to be 12% of revenues, which indicates economic gross margins to be 12% higher than those reported in above financials(After accounting for this, adjusted gross margins are an average of 66% from 2019-2023).
INDUSTRY ANALYSIS
The footwear industry can be divided into 3 major categories:
1. Companies who manufacture the physical product(factories)
2. Companies that design, market and distribute footwear products
3. Retailers
First category companies are low-cost manufacturers in low wage countries like China/Vietnam. There is no differentiation between them and typically have poor economics. Retailers(Category 3) also do not have much differentiation between them – it majorly comes down to who operates more efficiently. With respect to Porter’s forces, companies in the second category(bigger and well known brands like Nike, Adidas etc) seem to be the most well positioned relative to the other 2 categories(even though it is also highly fragmented and competitive). For footwear brands, there is some overlap between categories 2 and 3, as companies like Nike, Adidas etc, have company operated retail stores, apart from selling to multi brand retail stores.
The second category is highly competitive with a large degree of fragmentation. High fragmentation indicates low barriers to entry. Competition is generally based on brand awareness, product functionality, design(fashion trends, design newness), quality and pricing. Economics have improved for footwear brands with the rise of outsourced manufacturing in low wage countries like China, Vietnam – they have become capital light, however, this has reduced the barriers to entry as well. The industry is subject to rapidly changing consumer demand preferences, fashion trends and general economic conditions.
Casual Footwear Industry
Casual footwear segment is also highly fragmented - top 3 players are Skechers, Crocs and Deckers (Ugg, Hoka brands). Skechers has revenues of $7.7 billion, Crocs and Deckers have revenues of $3.5 billion each in 2022. Skechers earned $550 million, Deckers earned $650 million and Crocs earned $850 million in operating income. Crocs has been growing revenues fastest amongst these three in last few years. Casual footwear industry’s size is $300 billion, so the level of fragmentation is very high.
Crocs has much higher gross margins, operating margins and RoCE as compared to peers(Skechers has RoCE of 12%, Deckers 25%, Crocs 75%). In the clogs segment($8 billion) which make up majority of the revenues for Crocs, it has 25% market share – it is a leader in molded footwear category.
COMPETITIVE ADVANTAGES
Cost Advantages
Crocs benefits from its proprietary molded footwear, which has a much lower cost to manufacture – its product is very simple(mostly no assembly required) as compared to competitors whose products have large number of parts, which need to be manually assembled, which in turn involves labor. This shows up in Crocs’ superior gross margins of 65% (47% for Skechers, 50% for Deckers, 45% for Nike). This, combined with lower price points for its products(typically $40-$50 for Crocs vs $100+ for say a Nike shoe) creates a great combination of lower prices to consumers, yet higher profitability for the business. Due to the manufacturing simplicity, they also have a lower turnaround time which helps in getting new designs and colors to customers faster than competition. The company’s production process differentiation also allows intricate designs to be printed with ease, which are not possible in traditional footwear.
Customer Captivity - Why are Crocs’ customers extremely loyal?
Crocs’ Croslite technology has several advantages – comfort(respond to body heat by softening and conforming to wearer’s feet), light weight, easy on and off, easy to clean, odor resistant(closed cell nature of Croslite makes it resistant to bacteria/fungus that cause foot odor).
Crocs’ customers are known to be extremely loyal and simply love the brand. Crocs has a National Croc Day created by fans themselves. The brand has become very popular among teenagers/youngsters – many of them grew up wearing crocs when they were young(Crocs was founded in 2002 and its initial high growth was in 2002-2006), hence identify with the brand. Also, the fact that they are seen by people as ugly worked in their favor where people started wearing them as a sign of telling the world that they don’t change for the outside world, as a self-expression of authenticity, individuality, not conforming to conventions and that their comfort is what matters(Crocs’ marketing tagline – “Come as you are”).
Jibbitz(small charms attachable to clogs/sandals with 90% Gross Margins) allow customers to personalize, which is also very much valued by their customers as they can create their own unique shoe. There are long term trends of customers moving towards more casualization, comfort and personalization (especially among teens, Gen Z) which are working in Crocs’ favor.
Management Execution
Management execution has also been very pivotal in the success of the company. Crocs gets constant feedback from customers and constantly gives them new designs, colors. They continuously stay on top of fashion trends and give product newness which is very important in the footwear industry. Collaborations are a way that they try to generate buzz and increase brand relevance, partnering with celebrities like Justin Bieber, Post Malone, Priyanka Chopra etc, working with these artists to release limited edition clog designs which sell out extremely quickly. These celebrity collaborations are all organic – the celebrities themselves are fans and users of crocs branded footwear before the collaboration.
The management has also put in place best brand management practices, like MAP(Minimum Advertised Price) – setting minimum prices that retailers can sell the product for(prevents price competition among retailers, improves customer trust as they won’t see prices dropping drastically after they have bought at a higher price, prevents deterioration of brand value in eyes of customer) and fixed wholesale allocation policies to prevent too much inventory buildup in retailers (controlling supply).
To summarize, production cost advantages, customer captivity and management execution have been keys to the company’s success.
HEYDUDE ACQUISITION
Crocs bought HeyDude, a shoe company started in 2008, focusing on casual, comfort led footwear, similar to crocs’ DNA, for $2.5 billion($2.05 billion debt + $450 million in crocs shares). The shoes are known for being extremely lightweight(starts at 130g for a pair vs avg shoe weight of 500-600g), flexible, and soft, with design and functional flexibility for convenience. HeyDude expands Crocs’ TAM to $160 billion from $40 billion. HeyDude had about $500 million in revenues and was also highly profitable (30% operating margins) prior to the acquisition. HeyDude also seems to have high customer loyalty - An average HeyDude customer owns 4 pairs. Management plans to use similar brand management playbook as it has been doing with Crocs to grow the brand.
Crocs’ shares dropped 12% on this acquisition news since the company was taking on debt in an uncertain environment. However, HeyDude has performed very well, with the company reaching prorated revenues of about $1 billion in 2022. The company has also paid down $550 million of debt in 2022. With both Crocs and HeyDude generating large amounts of cash, the company plans to deleverage quickly and resume share buybacks in the near to medium term (company paused buybacks after HeyDude acquisition to bring down debt to reasonable levels).
OPPORTUNITY & DOWNSIDE PROTECTION
Crocs’ earned $850 million operating earnings on $3.5 billion of revenues(before interest, taxes). Owner earnings before interest and taxes, should approximate operating earnings as the business is capital light(Inventory is major use of capital. Other than inventory, company owns few retail locations, distribution centers). The company targets $5 billion of Crocs brand revenue by FY2026, through international growth(particularly Asia), growth in sandal revenues and focusing on growing digital portion of revenues. Management expects an operating margin of 26% in FY2026. Company should generate enough cash to pay down debt completely by then. HeyDude is also growing fast, with the brand achieving $1 billion run rate in 2022(which was originally forecast for 2024). HeyDude should also be significantly larger in 2026 – HeyDude has potential to expand in other regions in the US and internationally as well(currently, HeyDude has only been distributed in middle and southern parts of the US with very little international revenues(5%)). Assuming $6 billion total revenues($5 billion of crocs brand + $1 billion in HeyDude) and 26% margins, at current prices($6.8 billion market cap as of 6/4/2023), business is trading at 5-6x PE based on future earnings(currently trading at 11-12 times trailing pre-tax earnings). This seems to be a very low PE for a quality business with great management.
Even if we assume no growth and company maintains current revenues, it is still trading at a very cheap valuation based on trailing earnings which gives good downside protection. Overall, I believe it provides excellent value for long-term investors.
PRE-MORTEM
Debt: If interest rates increase drastically, demand falls due to high inflation/interest rate increases(macroeconomic environment), and revenues go down from 2022 levels into 2028/29, earnings will also go down and interest outgo increases, company may struggle to pay back debt.
HeyDude: Not a lot is known about HeyDude at this point, one needs to trust management on this acquisition. HeyDude is different from the crocs brand(both clogs/sandals) in that there is no jibbitz that allows personalization. Will the management be able to grow the business successfully? Does HeyDude have a durable competitive advantage? And will it maintain margins as it grows?
If above 2 risks play out, assuming HeyDude revenues go to 0, Crocs revenues drop by 20% to $2B, and OM drops to 15%, Crocs will make $300M in cashflows/year – current interest payment is $170M/year(which is probably increasing over next few years)(this interest payment maybe lower than $170M as management is expected to pay back debt this year with a long term net debt to EBITDA target of 1-1.5 from current levels of greater than 2.2).
Huge sales increase from 2020 to 2021 during covid, proves transitory and sales start to fall towards pre-2020 levels as people go back to offices.
Short term successful track record(turnaround since 2017/18)
Fashion is fickle: Consumers turn out to be less sticky and move onto other latest fashion trends.
Absence of owner operator(Crocs’ CEO, Andrew Rees, owns 1.5% of the company; Top management cumulatively owns 2.7%).
Their molded products are non-biodegradable which environmentally conscious Gen Z’ers/millenials would not appreciate.
Management’s past execution maybe affected(especially their goal in growing Crocs brand to $5B by FY26) due to attention shift caused by the HeyDude acquisition.
Disclosure: Long CROX