2023-11-13 13:38:33 ET
Summary
- Crocs' simple design and an efficient manufacturing process leads itself to a favorable value cycle compared to competitors.
- CROX is valued as if they are going to decline to an industry-median EBIT margin and grow at an industry-standard rate because of a "fad" scare.
- The market does understand the advantage that CROX has over competitors and is currently pricing it with a 29% upside.
Preview
Crocs, Inc. ( CROX ), is down ~25% YTD and seems to have entered extreme value territory. I believe this sell-off is because of two reasons:
- Underperformance of the HEYDUDE acquisition.
- The market believes CROX is a fad and will elicit declining margins towards an industry median.
In this article,
- I will explain why CROX deserves a premium in margins over competition due to their manufacturing processes.
- I will value CROX using an Unlevered Discounted Free Cash Flow "DCF" analysis, using WACC as a discount factor. A Bearish Case, Base Case, and Bullish Case Scenario will be calculated using reasonable assumptions based on preemptive research.
- I will also provide a Bonus Case Scenario, simulating a continuation of under-performance from HEYDUDE, and a decline in margins to an industry median.
- I will provide my personal opinion on the price target and upside potential.
The Value Cycle
One of my favorite aspects of CROX is the efficient manufacturing process of the clog and how it leads itself to an incredible value cycle. Fashion trends are difficult to predict, so the winners will be the ones who can adapt quickly.
Design
The first step in the value cycle is designing the product. Designers at CROX most likely use 3D modeling software to create new designs to test out. They will then use this model to help manufacturers CNC "Computer Numerical Control" machine the shoe mold, which is used in a highly automated injection molding process. This means a big investment for CROX is the shoe mold itself, also called "tooling" in other industries. This is usually made by machining aluminum billet into the desired shape. To get a good return on investment "ROI" on this tooling, the design has to be demanded by the public - but we'll get into this more in the sales and marketing segment. I've included an example of a shoe mold below
Manufacturing
After the mold is manufactured, it can be used in a mass production setting through an injection molding process using their patented Croslite™ and LiteRide™ raw materials. Essentially, machines will heat up these raw materials until it's semi-liquid, and then inject it into the mold using high pressure. Once the raw materials cool and freeze into shape, the Croc can be ejected and sent down the line. Crocs have no fabrics, laces, or any interdependent materials for the most part. It is a very simple product which means it is subject to high automation capabilities which limits manual labor and drives higher margins. To help explain this, I've included a simple diagram of a sample process.
Shoe Making Machine (Shoe Making Machine Website)
Sales and Marketing Feedback
After the clog has been manufactured and sold to the public, CROX employees get to understand what works and doesn't work through raw sales, social media interaction and general marketing trends. CROX is very active on social media and I've included a post from their Instagram account that amassed nearly 1 million likes for the Shrek-themed Crocs.
What's great about the simple nature of the Croc, is the adaptability of the process. Let's say, for example, the Shrek-themed Croc doesn't sell - Then the design team can use this feedback to try something new, create new tooling and repeat the cycle until something sticks. But on the other hand, if the Shrek-themed Crocs are a sellout, then their process is ready for full throttle to make as many as they can efficiently. This process is pretty much industry standard, but I believe CROX can get more out of it because of the simple injection molding process as opposed to traditional textile processing. They can afford to try wacky and risky ideas that help set them apart from competitors. Although theory aside, it seems this value cycle has helped the marketing team tremendously. Worldwide, Crocs has been on a steady increase using Google Trends.
Crocs Google Trends (Google Trends)
Valuation
The valuation segment will consist of an unlevered discounted cash flow analysis using the Weighted Average Cost of Capital "WACC" as a discount factor. Assumptions on Revenue Growth and Earnings Before Interest and Taxes "EBIT" will be made based on some preemptive research. A Bear Case, Base Case, and Bull Case and a Bonus Case Scenario will be presented.
Preemptive Research
Proper assumptions require some research so the following section is dedicated to my reasonings.
CROX lists the following companies as competitors in their 10-K :
- (NKE ) NIKE, Inc.
- (ADDYY ) adidas AG.
- (DECK ) Deckers Outdoor Corporation.
- ( SKX ) Skechers U.S.A., Inc.
- (SHOO ) Steven Madden, Ltd.
- (WWW ) Wolverine World Wide, Inc.
- (VFC ) V.F. Corporation.
I think an important aspect to focus on is EBIT margins. As of now, CROX is sitting around 25% margins which is 5% higher than DECK at 20% margins. I would say industry median is around 10%. Although I am a fan of CROX manufacturing process, I still think it's reasonable to expect a reversion to the mean for margins. Modeling this will be reflected in my DCF assumption.
Furthermore, I think it's reasonable to assume growth in line with expected industry CAGR research. I found some values to get us started: 3.29 , 4.8 , 5.25 . I think a reasonable range is around 3.25%-5.25% for CROX growth, especially seeing how the HEYDUDE acquisition is working out for them.
Crocs Q3 Earnings (Crocs Website)
The HEYDUDE brand has declined in growth by 8.5% and is expected to fall further next quarter around 20-25% after management provided weak guidance. This is most likely one of the main reasons the stock has fallen because the HEYDUDE brand comprises 25% of the total revenue. I will use this information in my DCF assumptions as well.
Crocs Revenue Breakdown (Crocs Website)
WACC
One last step before assumptions is the WACC calculation. This was calculated using the Capital Asset Pricing Model "CAPM", with interest expense, debt, and effective tax rate values coming from Seeking Alpha. The Risk-Free Rate, which is the current 10-year treasury yield, and Beta came from Yahoo Finance. The Market Risk Premium came from Damodaran Online . I calculated a WACC of 11% which will be used as the discount rate.
WACC CROX (Author)
DCF Assumptions
The following DCF uses assumptions in tan boxes with switches for Sales Growth and EBIT margins. Since WACC already contains the debt structure, I will be looking at the "Before Debt" fair value. Since the HEYDUDE acquisition, the debt structure skews the fair value when debt is added. Besides, CROX has mentioned their strategy to reduce leverage over the quarters and I believe this is very plausible given the healthy margins and safe Net Debt/EBITDA margin of ~2.
Crocs DCF (Author using Seeking Alpha Values)
Bear Case
Result: Fair Value of $59 with a -35% upside.
Sales Switch: 3
- Initial Revenue growth of 4.3% in 2024, matching analysts' estimates from Seeking Alpha. Then, HEYDUDE falls off the map and we lose a staggering 25% revenue growth in 2025. This value was picked since HEYDUDE is currently 25% of CROX sales. Following this, continued growth relative to the low end the Shoe industry CAGR of 3.25%.
Margins Switch: 3
- Following the demise of Hey Dude, the Crocs Fad is true, and margins gradually contract to the low end of 10%.
Base Case
Result: Fair Value of $113 with a 29% upside.
Sales Switch:1
- Initial Revenue growth of 4.3% in 2024, matching analysts' estimates from Seeking Alpha. Then we are going to assume Hey Dude does not necessarily fall off the map, but sells as a normal shoe without too much brand strength. We are going to assume this for CROX as well and the culmination of the brands lends to the middle range of shoes CAGR of 4.25%.
Margins Switch:1
- HEYDUDE brand strength declines, but CROX sells on the higher demand similar to that of DECK of around 15% EBIT margins.
Bull Case
Result: Fair Value of $154 with a 48% upside.
Sales Switch: 2
- Similar to the Base Case, but we have a little more brand awareness and CROX sales grow at the higher end of the shoe industry CAGR of 5.25%.
For further details see:
Crocs: Leader Of The Swamp With 29% Upside