2023-12-18 10:56:44 ET
Summary
- Crocs stock has soared by 27% since the my previous article, but Q3 earnings were underwhelming.
- Management incentives, including significant share ownership, suggest a strong personal motivation to improve the company's performance.
- My updated valuation takes into account the uncertain growth trajectory of the HEYDUDE brand, resulting in a downgrade to a buy rating.
- In the base case, there is an opportunity here.
- This is a risk-reward game.
Following my recent Crocs article
In October, I wrote an article about Crocs ( CROX ), grading it as a strong buy. I addressed the critical question regarding Crocs' future: its brand reliance. Since then, the market has experienced a massive rally, with the stock soaring by 27%. However, in November, the Q3 earnings were released, and, in my view, they weren't positive. In this article, I will explain why I believe the combination of the higher price and uncertain outlook is sufficient to downgrade the stock to a buy.
I will provide an updated valuation and take a closer look at management incentives, a factor I did not include in my last article.
Management
Overall, Andrew Rees, as the leader, has orchestrated an incredible run since assuming the role in 2017. He holds approximately 950,000 shares of the company, most likely constituting a significant portion of his net worth, especially considering his prior absence from a major CEO position before Crocs. This suggests strong personal incentives for him to enhance the company's performance and, consequently, the stock price.
The incentive system in place is robust, with almost 90% of the CEO's compensation at risk, and around 70% of the total compensation in the form of equity. Other NEOs, including the CFO and COO, allocate about two-thirds of their compensation on a performance basis, with half of it in equity. Directors also have more than 50% of their compensation tied to equity.
It's worth mentioning that in around August, both the CFO and one of the directors made direct purchases of the stock at prices of $101 and $94, respectively—not far from the current valuation.
Q3 and updated valuation
In summary, I am not impressed with HEYDUDE's performance; it has declined by 9% YOY in Q3 and is projected to further decrease in FY23. While the brand remains strong, the disconnect between its strength and actual sales raises questions for me regarding the management's M&A initiatives. This uncertainty casts doubt on future growth rates, fundamentally altering the valuation. Now, a 5% growth rate does not seem out of reach.
For FY 23, management has updated their guidance, forecasting a top-line growth of 10-11%, amounting to around $3.9 billion. This represents a decrease from the previously stated 12-14% guidance. The revision is primarily attributed to weak sales in HEYDUDE, while the guidance for the Crocs brand remains unchanged.
HEYDUDE sales are projected to decline by 4-6%, as indicated by pro forma projections. These figures appear inconsistent with the brand power that Crocs claims HEYDUDE possesses. Notably, the brand has experienced a significant increase in brand awareness, rising from 18% to 32% in just 5 months. Furthermore, HEYDUDE has achieved a notable ranking as the 7th favorite footwear brand.
Although the company exhibits quality, as evidenced by high returns on capital, the surge in price and the complexities surrounding the HEYDUDE brand have significantly altered the valuation landscape.
In comparing my recent valuation with the new ones, I'm placing particular emphasis on the growth rates. Initially, I considered a 4% growth rate to be overly pessimistic, but given the weakened HEYDUDE sales, I am now reconsidering this perspective. The current situation suggests that a more cautious approach might be warranted.
Additionally, I believe that my wacc calculation is now more accurate. It's essential to acknowledge that while perfection is unattainable in such calculations and they are subject to continuous change, the adjustments made contribute to a more precise evaluation in the present context.
Currently, with a 12% FCF yield for a business with a high ROCE, it still appears cheap, but the questionable growth trajectory poses a challenge. Assum ing analyst estimates of 7% EPS growth next year, we end up with a 1.3 PEG ratio, which doesn't position it as a bargain.
Considering the discounted cash flow, I believe it is more accurate. I used the 17% free cash flow margin from the last year, factoring in a 2% terminal growth rate and an updated 11.3% wacc. Assuming a 7% growth rate, which aligns with analyst EPS growth estimates for the next three years, the stock appears undervalued by 22%. However, these assumptions are contingent on the growth of HEYDUDE or, conversely, a much higher growth from the Crocs brand.
In a more optimistic scenario where HEYDUDE's popularity translates into substantial sales (assuming a 10% growth), we see a 39% undervaluation. Conversely, if things worsen from HEYDUDE's perspective and growth slows to the 4-5% range, the stock would be fairly valued. This is acceptable if you believe in the high quality of the business, but I don't consider it to be the highest quality, given the associated risks.
Conclusions
Considering the price surge since my last article and the underwhelming results from HEYDUDE, I believe the more appropriate rating for Crocs, in my view, is a buy, downgrading from a strong buy.
I maintain the expectation that the company will continue to outperform, especially considering the relatively low current price. The viability of this outlook hinges on the company's ability to sustain growth in the higher single digits. However, the key risk, in my assessment, lies in the performance of HEYDUDE. This factor will be closely monitored moving forward.
The potential upside is significant if the growth aligns with the brand power asserted by the management. However, due to the inherent risks that this might not materialize, I am reevaluating the investment's strength, and it no longer qualifies as a strong buy in my assessment.
I would like to hear your opinion on this risk/reward play.
For further details see:
Crocs: Downgrading After Q3 Rally And Earnings Surge