Author: Zaheer

WACC, which stands for Weighted Average Cost of Capital, is something taught in finance or business schools pretty ubiquitously these days. It is essentially meant to reflect the rate which is paid by a business to finance its assets.

Having recently passed the CFA level 1 exam, I can testify that the sacred text (curriculum) contains the WACC gospel in all its glory. Judging by a recent experience, it appears as though devotion to, and faith in WACC is quite strong. Blasphemous as it may be, I’m about to make the case that WACC is the work of the devil, and will lead you astray.

When evaluating an investment opportunity, one typically looks out into the future and estimates a few things:

1. What cash will this investment generate?
2. How sure am I about this?
3. What rate must I discount this cash at to arrive at its present value today?

That last one is the sticking point. Curiously, while explaining the time value of money, the clergy at the CFA institute will refer to such a discount rate as relating to forgone interest. Essentially they’d say that 100bucks today would grow to 100x(1+r) in a year where ‘r’ is the rate of return you can get on the 100 bucks. And by the same logic, if offered 100 bucks one year from now, one would calculate the amount needed today, which you can grow at ‘r’ to arrive at 100 bucks one year from now, and call that number the present value of the 100 bucks coming to you in a year.

Later in the texts however, cash flows generated by a business must be discounted at the WACC of the business. This is puzzling.

Let’s assume we’re looking at a strong business which generates enormous cash flows, and will never again need to issue shares to raise capital. Does this business have a “cost of equity”? One might argue that if shareholders don’t get a reasonable return on their investment they would either sell their shares, or vote for change in the board/management of the business to better reflect their wishes for returns. Both these outcomes seem like self-correcting events to me.

So how exactly does the WACC relate to, interact with, or impact upon the cash that a business can generate and pay out? I really don’t know. This heretical question seems to not cross the minds of those applying WACC in their investment decisions.

This is not to suggest that capital is free, just that WACC isn’t the answer to the fundamental question. Not having a clear-cut answer is likely the reason for the popularity of WACC. It’s easier to live with an incorrect answer than to live with uncertainty.

Some might argue that the riskiness of an investment should be reflected in an increased discount rate. I’d argue that the time value of money is not impacted by whether or not you forecasted the cash flows correctly. The rate at which one discounts a cash flow has nothing to do with the certainty of the cash flow. Expected value measurement (using weighted probabilities) of an uncertain cash flow may be appropriate to measure that cash flow, but to imply that because you can’t see into the future of business x, the rate at which your money could grow elsewhere changes is to conflate two very different concepts.

Further, using as an input the expectations of other investors in your calculations of a rate at which to discount cash is similarly erroneous. The expectations embedded in the valuations made by other investors do not affect at what rate your cash could grow elsewhere.

Clearly what I’m describing is “opportunity cost” which in economics simply refers to your best alternative option. Thinking in terms of opportunity cost is what I deem appropriate. I’m ready to be burned at the stake.

Crocs is an extremely well recognized brand globally. The clog originated as a product with a practical use case that was for a shoe that works both on land and in water (hence the name Crocs) and the company was founded in the early 2000s.

In 2014, Blackstone invested in Crocs through a PIPE deal and simultaneously brought a number of key executives on board. The redeemable shares that were issued to Blackstone have since been redeemed, so the only remaining equity is common shares.

The turnaround in the Crocs business is quite clear from historic financials: The margins improved, production was entirely outsourced, distribution was better controlled and working capital requirements were reduced quite substantially. The brand was repositioned as a trendy, luxury leisure brand whereas it was previously the sort of thing you bought at the petrol station.

Today Crocs has outrageously strong gross margins in the 50%+ range and generates a lot of free cash flow, reflecting the repositioning of the brand and its popularity among consumers. The Jibbitz Charms that Crocs sells alongside its clogs lean heavily into the self-expression and personalization that is the new normal for today’s consumer. It’s no secret that they also are enormously profitable.

Collaborations have turned the heat up on the Crocs brand where multiple huge brands, designers, artists, and everything in between wants a piece of the action. These limited edition runs have been selling out in minutes, and have a somewhat cult-like following. The margins are, of course, amazing on these collabs and them selling out rapidly certainly helps inventory management too. Some of the limited edition runs are selling in the aftermarket at multiples of the original retail price, illustrating the rise of Crocs to a level akin to Nike when it drops Air Jordans or whatever else.

The fly in the ointment for Crocs has largely been HeyDude; Crocs acquired the business in 2021 paying 20 times earnings, which might be explained by the following

1. Crocs management likely felt fear regarding the narrow scope of the business, dealing only in foam clog products
2. HeyDude was growing at a triple digit clip and
3. The HeyDude brand kinda fit in with the casual leisure vibe that Crocs had cultivated for itself.

While the (substantial) debt related to the acquisition has been paid down to levels that management is comfortable with, HeyDude has seen negative growth for the last few quarters (and in the negative double digit %s at that) resulting in a pretty strong selloff in the CROX stock. The slower growth of the Crocs brand compared with the previous few years has also contributed to the selloff bringing the price down to ~$100.

I would argue that the stock is a buy here under $110 for several reasons.

First, let’s have a look at revenues for the 9 months ending September 2023 vs 2024 specifically for the Crocs brand:

While the North American (NA) market has been the stronghold of the Crocs brand, the International segment has been growing at a decent clip (17% QoQ in Q3 ’24) and still makes up less than half of the revenue for the brand. The Direct To Consumer (DTC) segment both in NA and internationally has been growing a bit faster than has the wholesale(WH) segment. While revenue growth as a whole has slowed, it is not declining.

Second, the runway for growth in the international markets is exceptionally long; China, India and Korea are likely candidates for success, while management also includes Japan and Western Europe as “tier 1” targets for growth. Japanese culture, in my view, probably doesn’t mesh too well with the Crocs image and I would suspect China, India, and Korea present the best opportunity.

Revenue isn’t disclosed by geography specifically, but you can look at store count as a proxy + from earnings calls and some investor presentations slides one can pick up that revenues out of China grew 90% in the 2023 period and for example still grew a healthy circa 20% in Q3 ’24. India has presented some regulatory trouble for Crocs which has resulted in them needing to begin producing product inside of India, which they have done but expect to be running at full tilt only in 2025.

Collaborations with K-Pop stars have begun in Korea and given the quality of the marketing team at Crocs, I’d argue that they stand a good chance of success. Given success in even 1 of the “tier 1” targets would mean we’re off to the races.

HeyDude is the elephant in the room and perhaps should get a post all on its own. Suffice it to say that management is aware that things aren’t going according to plan with the brand and are actively trying to address this. Terrence Reilly who can be credited with much of the success of the Crocs marketing since 2015 is back and in charge of HeyDude, after leaving for Stanley in 2020. He casually took Stanley (a 100+ year old brand) from ~$70m to >$700m in revenue through his marketing genius. I’d not bet against him at HeyDude. He’s brough Sydney Sweeney onboard as “Director of Dudes” as he believes that youth female culture shapes culture as a whole. Other marketing shifts abound; the move from performance to brand marketing, the opening of the HeyDude TikTok shop (already generating massive heat) and other moves from the team seem promising. I would add the caveat that I think HeyDude shoes lack a fundamental x-factor but again, I would not bet against Reilly.

The increased marketing spend on HeyDude will show up as an increase in SG&A and whether shareholders see a return on that investment requires a gander into a crystal ball, which I unfortunately don’t have.

Third I’d point to brand loyalty, quality of marketing team, returns on invested capital and both absolute and relative value.

Overall then, the situation looks something like this to me:

Assumptions in the above DCF are:

• Low single-digits growth
• 21% tax
• 11% discount rate
• 13x multiple on terminal FCF

Just for context, here are some comparison statistics:

Cheap, right? The major concerns I consider worth keeping an eye on are:

• Management not cutting losses on HeyDude if it comes down to it
• A further diworsifcation acquisition
• True change in consumer preferences

But overall, I’ve loaded up (bought a nice tranch under $100) and am pretty darn bullish (if that wasn’t abundantly clear.)

For an overview of the business performance, I suggest referring to https://www.roic.ai/quote/CROX/classic