Crocs (CROX): A wonderful company at a fair price

Crocs has very high returns on capital (~31%), is growing, and is trading at a P/E of around 11.98 (or 12.45 based on my adjustments).  They bought back shares in the past two quarters.

Brief history

Crocs makes shoes that have a reputation for being very comfortable and looking ugly.  😉  Ok ok, some people do find their shoes stylish.  In recent years, Crocs has put out more stylish shoes that are quite different from the original designs that made Crocs famous.  Some of the new styles look less like plastic shoes with bright colours and a lot more like traditional shoes.  Crocs’ shoes are popular among adults who want comfortable shoes at work and they are also popular among kids.

The stock IPOed in 2006 and became a Wall Street darling.  It grew revenues at an extreme rate and was fueled by constant equity raises.  Eventually it grew too fast and the company revealed accounting issues (appeals continue today though it looks like Crocs will win).  In Feb 2009, John Duerden became the CEO and was tasked with turning around the company.  In Feb 2010, Duerden passed the role to his COO, John McCarvel.  McCarvel is still the CEO today.  Ever since he took the helm, Crocs has become much more profitable.

A moat?

I believe that Crocs has a good brand as it has many imitators and has attracted many counterfeit products.  The manufacturing process for Croslite is a trade secret.  The brand and Croslite may constitute a weak moat for Crocs.  However, I believe that the quality of Crocs’ management is far more important as Crocs has lost money in the past due to mistakes by management.

Crocs is doing many difficult things at once

Retailing by itself is very difficult.  JC Penney and Sears are examples of smart people not making money in retail.  Retailing in several different countries is even harder- many of the very best retailers fail in their international expansion plans.  On top of that, Crocs is also in the manufacturing business as it owns manufacturing plants.

I believe the reason why Crocs is so ambitious is due to its former legacy of hyper growth.  They were rewarded for growth and public markets rewarded them with more capital regardless of profitability.  The company overreached, faced financial difficulty, and had to be turned around.  Going forward, I would keep an eye on how well Crocs is managing its empire.  Currently, its Europe business has seen a big drop  in operating income (-41.6%) from 2011 to 2012.  This may be a one-time problem that could eventually be solved.  It looks like Crocs has had fashion problems as its European business sold mostly clogs and the fad is wearing off.  Crocs’ American business has had the same problem with an oversaturation of clogs but Crocs has been introducing other designs and has seen its sales rebound.

Operating performance no longer improving as fast

YE2010 to YE2011 was a tremendous improvement for Crocs as EPS grew 63% and operating income grew 52.7% (constant currency).  (Similarly, YE2009 to YE2010 was a great year as Crocs went back to profitability.)  YE2011 to YE2012 doesn’t look as good in comparison as EPS grew only 16% and operating income grew 13.7% (constant currency).  If you take out the effect of a $5.9M contingency accrual in 2012, then the growth in operating income would be roughly 18.2%.

I believe that this slowdown has disappointed Wall Street and is the reason why this stock trades at a low P/E ratio.  However, these are still pretty good numbers and almost all retailers would be happy to see that level of growth.

Accounting Tidbits

Capitalized software

I think that this practice distorts Crocs’ true earnings as capitalizing software doesn’t make sense for retailers.  If it didn’t capitalize software costs, Crocs’ pre-tax earnings for YE2012 would be roughly $9.1M lower.

Legal matters / contingency accruals

In 2012, Crocs recorded a contingency accrual of $5.9M for the amount of money it estimates that it may lose due to legal matters.  I think that these accruals should be taken out when looking at the operational performance of the business.  The accrual was applied to the 2012 year even though the legal matters pertain to events that happened in the past several years.  It would make more sense to average out these legal costs over several years.

Taxes on foreign earnings / repatriation

Crocs has made money overseas in jurisdictions with a lower corporate tax rate than the US.  If it returns this money to the US, then it would have to pay taxes.  The YE2012 10-K states:

If the remaining $233.8 million were to be immediately repatriated to the U.S., we would be required to pay approximately $50.8 million in taxes that were not previously provided for in our consolidated statement of operations.

In my opinion, this is a hidden liability on Crocs’ books.  See this paper by PWC that explains the tax issues.

Overall tax rate

Because Crocs has lost money in certain jurisdictions, it has some deferred tax assets (DTAs) on its books.  Some of these DTAs may expire worthless if Crocs does not generate profit to use up these DTAs.  Crocs estimates how much of these DTAs will expire and record a corresponding valuation allowance.  In each year, these estimates can change and cause non-cash changes to reported earnings.  This muddies the picture as to the “true” earnings of Crocs’ business.

I believe that Crocs’ YE2012 earnings are a little higher than what they would normally.  To adjust for tax issues:

  • Pre-tax income was $145.5M.
  • Subtract $9.1M for capitalized software costs.  ($136.4M)
  • I will assume that Crocs’ “normal” effective tax rate is 21%.  (It paid $29.3M in cash taxes, which corresponds to a tax rate of ~21.5%.)
  • Adjusted earnings are $107.8M.  GAAP earnings are $131.3M.

Excess cash, Crocs’ P/E ratio does not seem distorted

Crocs has $294.3M in cash and cash equivalents as of YE2012.  Its credit facility requires it to have $100M in cash on hand before it is allowed to repurchase shares.  This leaves $194.3M in excess cash.

At $17.44, Crocs has a market cap of $1,536.8M.  Subtracting $194.3M in excess cash leaves $1342.5M.  Adjusting the P/E further gives an adjusted P/E of 12.45.  Without the adjustments, the P/E ratio would be 11.7.

I don’t believe that Crocs’ stated earnings distort its underlying business by much.  I used YE2012 earnings instead of the trailing twelve months.  Crocs’ TTM P/E ratio is 11.9, so it doesn’t change things much.

Capital allocation

Management’s capital allocation is good (though not amazing).  It could be better if it put its excess capital to better use.  It could/should repatriate its excess cash and aggressively repurchase its shares.

I think that this is the reason why Warren Buffett prefers to buy a controlling position in a business rather than just a fractional share of it.  By controlling the business, he has access to its excess cash and can reinvest it as he sees fit.  This is better than having the excess cash sit there and earn little interest (or to receive earnings in the form of tax-inefficient dividends).

Return on capital

Adjusted after-tax earnings / (PP&E + Inventory + $100M cash)

= $107.8M / ($82.2M + $164.8 + $100M)

= 31%

Comments by management

Sometimes, some of the things that they say don’t make sense.

Management has started to state non-GAAP EPS in its earnings releases (e.g. this one).  I disagree with their use of non-GAAP earnings as it adds back items that are supposedly one-time but probably aren’t.  I think that they will ultimately upgrade their ERP system in the future again.  I believe that in this day and age, retailers will constantly need to upgrade their technology systems just to keep pace with the competition.

Management has integrity

Looking at the DEF 14A filing, it seems that management has failed to hit most of their targets for 2012.  Surprisingly, they declined the one bonus they were eligible for:

However, in keeping with our pay for performance philosophy, our named executive officers informed the Committee that they intended to decline any annual cash incentive award because of the Company’s overall performance versus plan in 2012. Therefore, the Committee did not award our named executive officers a bonus under the annual incentive plan in 2012.

Overall

Crocs checks off the key things I want to see:

  1. Good economics.  Returns on capital are very high.
  2. Great management.  They are good at what they do and have integrity.
  3. Reasonable valuation.

*Disclosure:  I do not own any CROX at the moment.

Links

http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/87829

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3 thoughts on “Crocs (CROX): A wonderful company at a fair price

  1. I like this idea. Trading at 12x FCF seems pretty reasonable and the company is much more diverse than it was five years ago.

    The only thing I don’t like about it is that in the past five years there has been exactly one insider buying. On the other hand, the officers are selling pretty decent chunks of stock every time the window opens and the CEO sold a big chunk last year after they cut guidance. I would have much more confidence buying if the insiders were joining in. Any thoughts?

    • Sometimes there are legitimate reasons for insiders to sell.

      1- Not everybody is a hoarder. Some high-income individuals have low or negative net worth because they spend all their money. Some people have credit card debt.
      2- They may be conservative. Maybe they want to diversify. (On the other hand, if insiders cite diversification as a defense for insider selling, it’s usually a red flag for me.)
      3- Bill Gates is selling his Microsoft stock to fund his charity work and perhaps partly to diversify (Gates owns stocks other than Microsoft). I don’t see it as a bearish sign on Microsoft.
      4- John Malone sold at a very low price, likely due to a margin call. If you took the opposite side of his trade, you would have made an absolute killing.

      I usually look at insider buying/selling when I screen companies. Sometimes insiders sell low. Sometimes insiders always sell stock… it doesn’t mean much. Sometimes insiders aren’t the greatest capital allocators. Some even buy high and sell low (e.g. Pinetree). I don’t see insider buying/selling as an entirely reliable signal.

      The important thing is that you deal with people with integrity. This is how Buffett can buy great companies and not end up on the wrong side of insider selling. Not everybody in the world is all about money. Buffett has said that selling your own wonderful company is not a good financial move; but if you want to do it and you want a buyer who won’t destroy your baby, then he wants to buy your company.

  2. Pingback: Crocs Q2 2013 earnings | Glenn Chan's Random Notes on Investing

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