I've started to realize that the real fun in maintaining a blog is the interaction with readers. My postings on Crocs Inc. ("CROX" or the "Company") - see 'Why I'm Shorting Crocs' and my post-earnings followup - resulted in quite a bit of feedback. This mostly came through email, including quite a few hate emails regarding the 'weak analysis' I put forth on CROX. At any rate, I wanted to address a few common questions I received and throw out a few takeaways from CROX's Q3 results.
Hedging with Options: I received a few emails on why I bought calls and the reason is to offset some of my short exposure. CROX is a high octane stock and the calls are insurance; I don't expect to make any money off the calls and in fact the calls I own have been vaporized. Some people prefer hedging with in-the-money ("ITM") options but I prefer to go with out-of-the-money ("OTM") options for a company like CROX mainly because more "protection" kicks in if CROX rockets up due to the option delta approaching one as it gets closer to being ITM. With ITM options the delta is already one but with slightly OTM options you can get the benefit of delta cranking up if the stock takes off on you. In either case, the purpose isn't to fully hedge the position and if a stock goes against you, you're still losing quite a bit. If the stock "works" for you, you make money albeit less the cost of the hedge.
CROX Street Research: Some emails from CROX longs took issue with my view that the Street is wrong with CROX and that the sellside is in constant contact with CROX so they must be correct on their analysis and valuation. I'll admit that many longs and many CROX analysts may know far more about the overall product line for CROX but I take a very pragmatic if not skeptical approach to the sellside, especially with CROX. I feel the sellside has no shame and hyped CROX stock in the weeks leading to Q3 results. A variety of management meetings with the Street in September led to increased "confidence" by the sellside that CROX is a great investment story and Q3 would be a strong quarter. Any investor - institutional or retail - that placed any significance on the research of these firms has lost 30+% since that time. What's worse, since the stock's implosion after Q3, the sellside continues to release bullish research on the Company. I'd have no problem if the most bullish sellside analysts were not conflicted but the reality is if one goes here and looks at the CROX Secondary Offering Prospectus cover, the underwriters tend to be some of the most bullish analysts for the Company. I can't say I'm shocked that Piper Jaffray, lead underwriter for the secondary, continues to maintain an Outperform on the stock given the fees it raked in as lead underwriter. In addition, CROX's Q3 EPS of $0.66 incorporated the lowest tax rate for its current fiscal year. If the tax rate for Q1 or Q2 was used, EPS would have been $0.61-$0.65 per diluted share.
Inventory: I was asked what my take on inventory levels were considering a small percentage was in the U.S. and that high inventory really shouldn't be an issue. I tend to disagree for a few reasons. The first is that despite what management's long-term target for product mix is, CROX offers seasonal products and missing out on those deliveries results in potentially out-of-season/stale products that may need to be sold for a discount to push through to retailers. Further, the majority of inventory as per the Q3 Conference Call transcript is in the classics, and management expects sales of classics to decelerate in foreign markets as they have in the U.S. To me, this means they're stuck with a lot of inventory that may be out of fashion in the next 3-6 months when the product is in-season again. In addition, demand for core style sell-through is decelerating in the U.S. which also raises the question of what type of provisions are in place for put-backs by retailers?
That's one concern in regards to inventory but my other focus is on the sequential growth in inventory and a disconnect between the financial statements and what management has stated in the past. In Q2, inventory grew by 25% over Q1 to meet international demand. But now in Q3, inventory has grown considerably over Q2 to address the same issue in Q2 - international demand. That doesn't make that much sense to me because in the Q3 call management stated that international launches have been mainly focused on classics, the high-volume high velocity products. Going back to the Q2 conference call transcript, management states that the inventory balance is skewed towards classics, touts its "just in time" ability to shift between models quickly, and more importantly states that CROX has excess capacity for high-volume products, meaning the Company should be able to handle high demand for its classic lines. The following is the excerpt from the Q2 call regarding inventory management. I've bolded what I feel are the key points:
Jim Duffy - Thomas Weisel Partners - Analyst: Okay. And couple more if I may. As the skew count increases, there's more complexity here. Can you speak to the components of the inventory, kind of classics versus other styles? You're typically not as aggressive with your newer style from an inventory standpoint. Does your balance of inventory reflect the balance of sales, or is there a difference during the (inaudible)?
Ron Snyder - Crocs, Inc. - President and CEO: Our balance of inventory would be more skewed to classics, to the stuff that sells everywhere in the world, our Caymans, our Beaches, our Mary Janes, obviously the Athens during the season where flip-flops are popular, and then we'd weed off the rest of that inventory into the southern hemisphere - now Brazil and South Africa and Australia and all throughout the Southeast Asia, of course, buys the product all year long, Hawaii, Puerto Rico. So we would typically - our model would be to have more of that inventory that sells everywhere. There's really no risk in having excess inventory of our high-volume products, where the new products we want to have excess capacity in place where, when a given style takes off in a season, we can quickly ramp up and take advantage of that new style.
Jim Duffy - Thomas Weisel Partners - Analyst: So that leads to the question of your six-million-pair capacity. What's the split of that between classics and new styles, or how easy is it to shift from one to the other?
Ron Snyder - Crocs, Inc. - President and CEO: It's pretty easy to shift between one and the other. We have excess capacity of all of our high-volume stuff, certainly more so than we would of new styles, but even when we're coming up with new styles, we put in the capacity for both machines, as well as molds, gluing lines, sewing lines, whatever's required for a given new model. We'll put in excess capacity in anticipation that that particular line would take off. If that one doesn't, then another one that uses those same machines and equipment would pick up that excess capacity we put in place.
Given these comments, it seems strange that the Company's inventory levels continued to expand substantially. We know that Q3 international demand was high and that international demand consists mostly of classic lines. We also know that in Q2, there was $119MM in inventory which was skewed towards classic lines. So to go from Q2 inventory of $119M to Q3 inventory of $195MM when management has previously discussed how fast and efficient the production process is and more importantly when the bulk of that demand was in core models that were in stock based on Q2 inventory looks questionable to me.
Buyback: I found it interesting that CROX management went with a 1MM share repurchase plan. At current prices that would amount to about $43MM or 70% of its existing cash balance. Property and equipment expanded by about $37MM in the past 9 months and management stated it underestimated some of the demand for CROX products yet it feels confident enough to utilize 70% of its cash balance to fund a share repurchase rather than utilize cash for expansion projects?
International Sales: I've received some emails saying I don't understand the international demand for CROX products. I'll admit I don't but I would also wager my lack of visibility on future international sales contributions is along the same lines of the sellside. However, the Street continues to push the idea of international growth as a significant opportunity for CROX and has no problem in assigning a high valuation to far from certain growth in markets where analysts have far less visibility. Further, the U.S. market should not be discounted and what I've seen in my local areas suggests CROX sales and interest may be slowing. For example, the Macy's at the Landmark Square Mall in Stamford, CT carries CROX, the bulk of which are classics and they are marked down from $30 to $15 per pair. There is considerable inventory at this Macy's despite the price cut. There's also a Payless Shoe Store in the same mall which sells identical Airwalks for $14.99. Take it as just one data point but in this localized market, the CROX brand is worth about $0.01 more than a generic. So to some investors that emailed me suggesting CROX could be a Nike ("NKE") type brand, I haven't found too many Nike products selling for a few pennies more than private label.
DISCLOSURE: AUTHOR MANAGES A HEDGE FUND THAT IS SHORT CROX AND LONG CROX CALL OPTIONS