CRCT - Cricut: Nothing Has Changed Over The Past Few Quarters

2023-12-12 02:19:01 ET

Summary

• I recommend a neutral rating due to ongoing challenges impacting its growth outlook.
• User engagement rates and paid user growth are declining, indicating potential issues with the existing user base.
• The Accessories and Materials segment is still in a transformation phase, hindering near-term recovery. Macro factors like high interest rates and consumer spending constraints further contribute to subdued growth.

Overview

My recommendation for Cricut Inc. ( CRCT ) is a neutral rating, as I remain negative on the business's near-term growth outlook and the timing for normalized growth to return. Various operating metrics and macro factors continue to point to growth headwinds in the near term, making it extremely difficult to model near-term performance. Instead of modeling for false precision, I am avoiding the stock for now. Note that I previously gave a neutral rating for CRCT (6 ^th April 2023) as there were too many uncertainties regarding the near-term outlook. I found it impossible to forecast the business performance as there was little clarity as to when the demand environment would normalize. The weak consumer demand backdrop and declining margins due to promotional efforts were not positive either.

My key updates are:

1. CRCT performance since my last post
2. Weak engagement rate and paid users growth pointing to headwinds ahead
3. Weak macro headwinds post a challenge to CRCT growth recovery.

Recent results & updates

On 8 ^th November 2023, CRCT reported total revenue of $174.9 million in 3Q23 (a -1.2% decline), driven by weak Accessories & Materials and Subscriptions revenue. On the bright side, gross profit came in at $81.9 million, reflecting stronger margins at 46.8%, driven largely by solid Connected Machine margins. The impact of the expansion in gross margin was also felt at the EBITDA margin line, which expanded by 500bps to 19.3%.

8 months since I wrote an update, while the reported figures point to gradual stabilization (revenue decline improving from -26% in 1Q23 to -1.2% in 3Q23), I believe the situation at CRCT has not shown any major signs of improvement. In my opinion, many of the challenges CRCT has faced year-to-date persisted in 3Q, primarily on the engagement side. This is a major issue as it impacts the long-term growth trajectory of the business.

The first data point that suggests ongoing headwinds is user engagement rate, which has continued its streak of decline to a low of 40% as of 3Q23. This is the worst it has ever been since March 2020. The bigger worry here is that churn might be a lot worse than it seems because CRCT is still adding users (as seen by the total number of users). If the assumption is that the new users are likely to be engaged users, this suggests a very high churn from the existing base of users, which is a big red flag.

Engagement continues to be a headwind because when consumers are cutting less they're using fewer materials and that puts pressure on their demand. from: 3Q2023 earnings call

The second data point that points to weakening growth is that the number of paid users sequential growth has dipped to a negative region for the first time ever. This further proves my point that there might be something bigger brewing underneath that is impacting the existing base of users. If we combine the fact that engagement rates continue to decelerate and paid user growth is slowing, I find it hard to see any potential for growth to accelerate in the near term, let alone the timing when growth will reach normalized levels.

Furthermore, from a top-line growth perspective, ~30% of the business is going to continue facing headwinds and is still in restructuring mode. The Accessories and Materials segment is unlikely to recover anytime soon, as management reiterates that it is still in the two-year transformation phase. In the near term, in order to ensure the segment remains competitive, management intends to continue its promotional strategy to stay price competitive. I expect this to be a drag on further margin expansion.

Another point to note regarding growth is that the macro situation is showing no signs of normalization anytime soon. Consumer spending power continues to get squeezed by the high cost environment. Fed rates remain high at 5+%, mortgage rates touched 8% , and the US unemployment rate remains near a 30-year low, suggesting no reason for the Fed to cut rates. All of these should continue to drive consumers to cut discretionary spending, which is not a good sign for this upcoming holiday season as retailers are likely to be cautious about restocking.

I believe management is already seeing such data flowing through their periodic reporting, as they are guiding for 2H23 revenue to be below historical seasonality, with 4Q specifically likely to grow below normal seasonality and net new users to decline in FY23. The underlying implication is that CRCT needs to increase promotional spending in order to stay competitive in 4Q23, which means margins are going to see headwinds.

Overall, 3Q23 showed a continuation of the challenging demand trends from past quarters, and I believe the uncertainty in the growth outlook and timing of normalized growth remain. I reiterate my neutral rating, as I think it is best to avoid the stock for now given the difficulty in modeling the near-term performance of the business.

Valuation

I believe the market is already pricing in the weak growth prospects ahead for CRCT, judging from how the forward PE has de-rated. Historically, CRCT trades within the range of 19x to 35x PE. However, when growth started to decline at a rapid rate (-45%) in 2Q22, valuation dropped to a trough of ~12x forward PE. Now, CRCT growth has clearly recovered from that -45% to just -1.2% in 3Q23. However, I think the headwinds I noted above are likely to hurt growth again, as valuation should continue to derate from here. Suppose CRCT trades down to 19x forward PE (the low end of its trading range) from the current 22x, the near-term fair value is probably worth $6.

Summary

In summary, my take on CRCT remains neutral due to ongoing challenges impacting its growth outlook. Despite marginal improvements in certain financial metrics, the fundamental issues persist, signaling continued difficulties in user engagement and paid user growth. Notably, the decline in user engagement rates and the first-time dip in paid user growth are concerning indicators of potential underlying issues affecting the existing user base. Furthermore, a substantial portion of CRCT's business, particularly the Accessories and Materials segment, continues its two-year transformation, likely impeding near-term recovery. Macro factors like high interest rates and consumer spending constraints also add to the subdued growth environment.

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