WWW - 3 Risks A Crocs Inc. Investor Should Know

2023-06-12 23:54:03 ET

Summary

• Crocs appears undervalued with a forward PE ratio of 10, but investors should consider liquidity, development, and valuation risks.
• The acquisition of HEYDUDE adds significant debt to Crocs' balance sheet, but the company's expanding cash flow and refinancing ability make liquidity risk low.
• Despite lowered guidance for FQ2 2023, Crocs' diversified business and growth prospects from the HEYDUDE acquisition suggest the stock is a sound investment with a "Buy" rating.

Crocs Inc. ( CROX ) looks dirt cheap at first sight.

CROX is a stock with excellent profitability. Its revenue tripled, and EPS turned from a loss to $8.82 in just five years. Yet, it dropped over 20% from its recent high, and its forward PE ratio fell to 10, falling short of its 5-year average by around 50%. For a company with significant growth prospects, this valuation is unreasonably cheap.

But hold on. There are three risks that you should understand before you make your decision to invest in CROX: liquidity risk, development risk and valuation risk.

HEYDUDE Acquisition

Let's start with the acquisition of HEYDUDE, a casual footwear brand.

Crocs acquired the privately-owned Italian brand in February 2022 for $2.5B, funded by $2.05B in cash and $450M in company's shares. HEYDUDE was acquired for under 15x EV/EBITDA (4.4x sales). Crocs and Wall Street were quite optimistic about the deal:

We think the Hey Dude acquisition may accelerate the overall growth rate given CROX's ability to sell the brand into its legacy distribution.

( Loop Capital Markets )

The acquisition looks like a very good fit as the financial algorithm is accretive to Crocs. The brand is aligned with global trends and the purchase multiple compares very favorably to other high growth footwear companies such as Allbirds and On.

( Monness Crespi Hardt )

With the acquisition of HEYDUDE, we are thrilled to add another high-growth, highly profitable brand to our portfolio.

( Crocs )

By the end of FY2022, HEYDUDE added $895.9 million in revenue, about one-fourth of Crocs' total revenue. In the latest financial quarter, approximately 71% and 30.1% of its sales are attributable to the wholesale and digital channels, respectively.

1. Liquidity Risk (Risk Level: Low)

The acquisition of HEYDUDE added a significant amount of debt for Crocs, despite its asset size tripling. The below table compares the balance sheet before and after the acquisition of the Italian footwear brand.

CROX's liquidity may be concerning as the acquisition move added a considerable amount of debt to its balance sheet. The company has $125.7 million cash or equivalent, which is incomparable to over $2,200 million debt.

First, in the short term, CROX should have no liquidity issue to resolve. Its current ratio also exceeds 1 (at 1.76), implying the current assets can pay down the short-term liabilities without the need to raise additional capital. And the company has no maturity of senior notes and term loan until 2029, despite a $5 million amount of principal that has to be repaid quarterly.

Over a longer-term horizon, 2029 will be a challenging year for Crocs Inc. as a $350 million redeemable senior notes and the $2 billion term loan facility will mature. It is estimated that in Q1 2029, the company will need to repay not more than $1.8 billion of debt, equivalent to about half CROX's yearly revenue or three times its cash flow from operations.

It is too early to predict if the CROX will have liquidity issues in 2029. But I opine the risk is low due to its expanding cash flow from operation (see below) and undoubted refinancing ability.

2. Development Risk (Risk Level: Mid-Low)

Leisure footwear is a semi-discretionary product.

As inflationary pressure remains and economists anticipate an economic recession, consumer sentiment remains low. The University of Michigan Consumer Sentiment Index shows that U.S. consumers are still pessimistic about the economic outlook and unwilling to spend. The Index plummeted by 6.8% in May 2023 from April 2023.

Besides the gloomy broader market, Crocs Inc. lowered its guidance for the current financial quarter (FQ2 2023). The company forecasted diluted earnings per share of $2.83 to $2.98 fell well short of the $3.29 consensus, and it missed the revenue consensus by a slight margin as well. This put the Street in disappointment.

Companies like Peloton ( PTON ) fails to grow their sales post-pandemic. But Crocs does not belong to this category.

Although CROX had a history of plateauing sales in the 2010s, it continues its strength after the pandemic hype. It sold over 30 million pairs of Crocs Brand shoes in Q1 2023, which increased 19.7% on a yearly basis. It also sold 8.9 million pairs of HEYDUDE shoes within the same timeframe, which doubled compared with the Partial Period (Feb 17 to Mar 31) in 2022.

The acquisition of HEYDUDE brings diversification to its business as the growth of Crocs may slow down. The Italian brand is still in its growth stage, which drives promising growth prospects for the company. It is expected that the revenue of HEYDUDE will surge by mid-20%.

However, HEYDUDE's margins are much lower than Crocs. In 2022, the gross margin for the Crocs Brand was 56.3%, while the gross margin for HEYDUDE Brand was 40.8%.

3. Valuation Risk (Risk Level: Low)

As HEYDUDE brings a considerable amount of income to Crocs' revenue stream, which is about one-fourth of total revenue, using CROX's previous 5-year average PE ratio to value the company may be inaccurate.

Crocs Inc. acquired HEYDUDE at approximately 15 times EV/EBITDA, which coincides with CROX's 5-year EV/EBITDA average. The multiple is also similar to the industry average. So that, I think using 15 times EV/EBITDA to evaluate the company is appropriate.

(Source: Seeking Alpha, compiled by Author)

The stock is trading at 9.28 times EV/EBITDA, which is 38% lower than its fair value. As Ben Graham advocates, a stock shall return to its fair value in the long term. Crocs Inc. shall likely have a 20%+ upside, matching my investment strategy of searching for 20%+ return opportunities.

Also, it is worth noting that the acquisition of HEYDUDE comprises $2.0 billion in cash and 2,852,280 Crocs, Inc. shares. The latter increases the shares outstanding by about 5% and thus diluted the "per share" metrics (including PE ratio).

But approximately $1.05 billion is available for share repurchasing under the share repurchase authorization. So, the share count shall decrease over the long term, and the negative effect will be wiped out.

Investors were concerned about the heavy indebtedness of Crocs Inc. and doubted its growth potential, but I think the risks are low. Thus, Crocs Inc. is a sound investment to consider at its current valuation, and I initiate a "Buy" rating on the stock.

Please feel free to leave a comment below to share your view. Thanks for reading.

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