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We Won't Get Fooled Again!

When I start to forecast financials for a stock and arrive at a target value that just doesn't add up, I tend to look at a historical chart with a price-to-earnings overlay to get a better feel for how the market has treated that stock. I believe in this instance that there is more to learn from investors' sentiment and what they are willing to pay for earnings than what the analysis of cash flows would predict. Crocs Inc. (CROX) is a perfect example. The Crocs IPO in 2006 came to market at $21 per share, and on a split adjusted basis, climbed 355% to an all time high in 2007. I recall the hysteria that surrounded the shoes in 2007. I worked at a retail store that sold Crocs in the early days. When customers would call to inquire about their availability, it became commonplace to tell customers "Check back with us in a week. We should have some in stock by then." I knew well it would be weeks before a shipment would arrive since the company couldn't keep pace with feverish demand. As a result of fast sales growth, investors were pumping money into the shares and volatility ensued, leaving the stock sensitive to anything but stellar EPS results. Based upon the fact that the shares traded at a low of $1.19 just over a year later, we know that the results were far below expectations and the stock was relatively overvalued by a long shot.

Well, as Roger Daltrey of The Who once chimed "I get down on my knees and pray we don't get fooled again." I hope the market doesn't get fooled again. Traditional valuation methods would suggest a one year price target of $28.36 for CROX using a blended approach of equally weighting price targets as seen in the table below.

Price Target

Weight

Forward PE

19.91

25%

EV/EBITDA

28.32

25%

EV/Revenue

19.93

25%

DCF

45.28

25%

1 Year Target Price

$ 28.36

Other Key Forecasted Financials

Millions except EPS

2012e

2013e

2014e

2015e

2016e

Revenue

1,201

1,441

1,657

1,657

1,657

Free Cash Flow

75

160

188

201

202

Core EPS

1.51

1.81

2.08

2.08

2.08

ROIC

24%

23%

21%

17%

15%

ROE

21%

20%

19%

16%

14%

Normally, I'd be happy with a 28% premium for any of my investments, yet you won't find me purchasing shares. Here's why. CROX is grossly overvalued again compared to its competitors. Now this is slightly warranted as revenue has grown 27% YOY, far outpacing the industry average. But, Deckers Inc. (DECK), a close competitor of CROX with 40% YOY revenue growth, trades at a trailing PE ratio of 13.52 and CROX currently trades at a trailing PE ratio of 17.74. We have a similar situation to 2007 when the numbers look good, but it just doesn't add up to further share appreciation. Forward PE projections further demonstrate how CROX is overvalued. The industry average forward PE ratio would predict a discount to current trading at a $19.91 price target. In the case where a stock is so heavily driven by changes in consumer sentiment, relative valuation metrics such as PE and enterprise multiples provide a much clearer picture of how the market will price a stock.

I agree that based upon historical revenue growth and forecasted margins, the stock could be worth what a discounted cash flow analysis would predict at $45.28, yet this assumes investors would be willing to pay 30 times my forecasted 2012 EPS. I don't see a situation where this would occur as investors recall the stock declined 98.5% in 2007. Additionally, global factors in Europe and in China have contributed to an overall decline in market sentiment. The ability for CROX to increase will be further hampered by the market's unwillingness to pay even more for volatile earnings.

Beyond market sentiment, CROX also has some numbers buried in its financial statements that have added to EPS volatility historically and they must be accounted for when forecasting EPS. The company enacted an aggressive restructuring plan to better react to customer demands and diversify its product portfolio in 2007. Additionally, CROX contributes a portion of profits before tax to charitable organizations. This is an admirable endeavor for a company, yet the reported EPS numbers don't accurately represent earnings attributable to selling core products. In sum, the restructuring charges and charitable contributions amount to nearly $62 million in the past three years. The table below further details the yearly income statement adjustments that were reversed.

Nonrecurring Items

Millions

2009

2010

2011

Pre-Tax

Nonrecurring expense/(income) in COGS

7.1

1.3

0

Nonrecurring expense/(income) in SG&A

41.2

3.5

2.6

Nonrecurring expense/(income) in non-operating (income)/loss

0.0

0.0

0.0

After-Tax

Nonrecurring items in COGS

0.0

0.0

0.0

Nonrecurring items in SG&A

0.0

0.0

0.0

Nonrecurring items in non-operating (income)/loss

(4.1)

(0.4)

(1.0)

Taxes would've increased tremendously in 2009 by $50 million when the tax shield from charitable contributions is removed. Such adjustments provide a clearer picture of CROX and its core business of selling to retail customers. It is worth noting that when backing out restructuring charges and charitable contributions that annual EPS improves minimally.

All said, the steep price decline in 2007 still rings loud in my head and the lack of confidence in core EPS numbers contributes to a further unwillingness to pay more for CROX earnings. CROX will likely continue to outpace the industry in terms of top line and bottom line growth, yet this stock is a classic case of a company with good prospects who is relatively overvalued and will likely underperform the market in the year to come.

Source: Crocs: Relatively Overvalued With Volatile EPS