Is the Crocs Stock Growth Thesis Now Busted?

Large swaths of the stock market continue to get clobbered by a myriad of issues related to inflation, higher interest rates, and the general aftermath from pandemic-disrupted supply chains in the recent past.

Crocs (CROX 1.53%) is one of those companies the market is dragging through the mud. Unfortunately, investors do have a point. Its execution in the last couple of years hasn't been ideal, and the balance sheet is still messy after the $2 billion acquisition of once-fast-growing casual shoe brand HeyDude in early 2022.

With business overall now staring down a period of contraction, is the investment thesis in Crocs stock busted?

Crocs stay reasonably hot

The company's namesake foam clogs are still doing quite well. When excluding negative currency exchange rate effects, Crocs revenue rose 11% in Q3 2023. Total pairs of foam clogs sold slightly declined from 2022, but average selling price rose.

The thesis I outlined back in 2021 before I began accumulating shares in 2022 remains intact. Growth in Asia, where Crocs still has a very small presence, continues apace. Sales rose nearly 29%, excluding currency exchange rates. Despite ongoing economic issues, sales in China specifically rocketed over 90% higher.

And on a stand-alone basis, the Crocs brand continues to generate best-in-class profitability. Its adjusted operating margin was 37.4%, up from 33.1% in Q3 2022. That's helped Crocs pay down corporate debt (now $1.9 billion, compared to $2.3 billion at the beginning of 2023) and make share repurchases ($150 million in Q3 alone).

Meanwhile, the company has been combating "gray market sales" (when a wholesale distributor diverts inventory to be sold in a market they have no agreement to sell to). Specifically, a wholesale distributor in Africa was believed to be diverting its allocated inventory to the U.S. for sale on marketplaces like Amazon. Crocs has closed this account, and is realizing some growth headwinds as a result.

HeyDude losing its cool factor?

In a nutshell, the HeyDude brand doesn't seem to be losing its appeal with young people. Management reported that by some metrics, brand awareness continues to rise, especially among younger consumers that HeyDude is targeting. Direct-to-consumer and online revenue increased 15% and 9%, respectively, holding on to last year's epic run after the Crocs acquisition. 

But what is less than cool is trying to navigate accounting blips due to brand overexpansion last year after the acquisition, which led to the overall 9% decline in HeyDude sales in Q3. What gives?

It has to do with sell-out (the final sale of a product from a retailer to the consumer). Sell-out from strategic wholesale accounts (the sale of large quantities of product which later gets sold via retail) did increase 28% last quarter. However, Crocs has been closing out non-strategic wholesale accounts to better align the HeyDude brand with the foam clogs supply chain. Additionally, many of its distribution partners have been cautious in building new inventory as of late as global economic worry crops up.

In short, HeyDude growth is reversing, and revenue is expected to fall a further 20% to 25% in Q4 2023 -- which is likely to bring down Crocs' revenue overall by a mid-single-digit percentage in Q4 2023. The pain could continue through the first half of 2024. HeyDude profit margins are headed lower as a result (20.1% in Q3, compared to 29.3% last year). What happened?

Management was candid in admitting that it flooded the market with HeyDude shoes after the acquisition last year to try and increase brand awareness and future growth potential. Brand awareness has indeed risen. But now the after-effects of those actions are causing some growing pains as HeyDude shoe distribution needs to be rightsized for current demand.

Management does still think HeyDude will be a $1 billion-plus business in 2024 despite the current headwinds, which would keep the brand in growth mode if it pulls it off.

Is Crocs a busted stock?

It's been a rough couple of quarters for Crocs as its HeyDude prize has seemingly turned against it, and more turbulence could be on the way. That said, I see no reason to be hasty with writing this one off. The current management team (CEO Andrew Rees and CFO Anne Mehlman) took over in 2017 and 2018 and revitalized the business after years of stagnation, and I remain confident they can navigate Crocs through this downturn too -- which is partially self-inflicted, but also driven by the current state of global consumer health.

And while a "cheap" valuation could deteriorate if sales and profitability decline in the coming quarters, it is worth noting that the stock currently trades for a meager sum of less than 8 times trailing-12-month earnings and just over 6 times trailing-12-month free cash flow. That could provide a margin of safety, as the market seems to be pricing in quite a bit of negativity.

For now, Crocs is no longer in growth mode. However, my original thesis for buying this top shoe stock last year remains intact for now. Stay tuned in the coming quarters.