The stock market slammed foam clog manufacturer Crocs (CROX -0.81%) with a double-digit percentage drop in share price after it announced its intention to buy out Italian plastic shoe company Hey Dude on Dec. 23. Shares fell more than 16% at one point and ended trading down about 10%, despite the company saying the deal will be accretive to revenue.
The market's initial take suggests it isn't too happy with the deal, but there are at least three reasons Crocs decision may have been a smart one.
Image source: Getty Images.
1. Hey Dude appears to be popular and profitable
The plastic or canvas shoes made by Hey Dude appear to be a good match to the Gen Z, or zoomer, demographic Crocs sells much of its own footwear to. The shoes focus on comfort and light weight, with the lightest models weighing in at just five ounces. Hey Dude's estimated revenue for 2021 is $570 million, and Crocs expects the deal to be "immediately accretive" to its own revenue, margins, and earnings. In short, it expects the deal to be positive from the top line to the bottom line.
Crocs management says the acquisition should provide a boost of $700 million to $750 million to its 2022 revenue. An analyst at Piper Sandler also turned bullish on Crocs' acquisition despite the stock market's strong negative reaction, noting Hey Dude ranked 54th in its "Taking Stock With Teens" survey in 2019 and has since risen to 8th place while describing Hey Dude as "one of the fastest-rising brands."
Hey Dude's shoes seem to be verifiably popular on major retail websites. While it is hardly sophisticated market research, Hey Dude's "Wally Sox" canvas loafers are listed as the "#1 best seller" in the category of "Men's Loafers & Slip-Ons" on Amazon. Turning to customer reviews, the loafers have an average 4.8 stars out of 5 from over 50,000 global ratings, indicating a high level of satisfaction among purchasers through this major retail platform. While this is just one source, it is at least some confirmation of a positive reception for Hey Dude products.
2. Inflation is on Crocs' side
Out of the $2.5 billion Crocs is spending on Hey Dude, $2.05 billion is in cash raised through borrowing, and the remaining $450 million will be paid for with Crocs shares. While borrowing such a large amount seems quite risky, there is likely solid reasoning behind the decision and the risk is really a lot lower than it appears on the surface.
For one thing, if Crocs' assertions about Hey Dude being accretive to both its top and bottom lines are fairly accurate, paying down the debt rapidly should be possible. As Crocs itself said in the acquisition press release, it expects "the combined business to generate significant free cash flow, enabling us to quickly deleverage while investing to support future growth."
Perhaps more importantly, the U.S. economy is experiencing elevated price inflation. How long this inflation will last is a matter of sharp debate among analysts, though it is currently at a 40-year high of 6.9% according to Kiplinger, with the possibility of easing to 2% to 3% during 2022. Other sources claim government spending plans, combined with massive federal debt and a wage-price spiral, may keep inflation high for much longer. In a classic case of inflation benefiting the borrower, Crocs may be able to pay off its loan more readily if it raises prices to match inflation in the future, while enjoying the benefits of having Hey Dude added to its operations and revenue sources immediately. In short, inflation is currently making debt cheaper, and thus less risky, for Crocs and other borrowers.
Simultaneously, Crocs management said it is using relatively little stock for the purchase. If its Hey Dude acquisition is as much of a positive boost as it claims, its stock value is likely to increase sharply. Shares are therefore a more valuable resource for the future than inflation-eroded cash, reinforcing the idea that Crocs put careful thought into the acquisition. The large loan remains a gamble but arguably looks like a rationally calculated one.
3. Crocs is getting more than just shoes
Buying out Hey Dude is also getting Crocs more than just another revenue stream, assuming it manages to smoothly integrate the two companies' operations. It is also gaining Hey Dude's distribution network, market presence, manufacturing capacity, and properties both physical and intellectual. According to the presentation shown at the buyout announcement, the merger "more than quadruples total addressable market" for the two companies to $160 billion. Management also says it anticipates expanding Hey Dude to a brand worth more than $1 billion by 2024.
Both companies also have high digital penetration (the percentage of sales made through each company's website), 37% for Crocs and 43% for Hey Dude, making both competitive in the ever-more digitized marketplace. This also raises the possibility of easy, low-friction cross-selling between the two platforms and the customer base each has built up. Hey Dude will keep its own leadership team under Rick Blackshaw, but the Crocs International wholesale and distribution network will be put at Hey Dude's disposal to increase the latter's product availability in Europe, Asia, and the Middle East. Since, according to the presentation, 95% of Hey Dude's revenue is currently being generated in the U.S. only, expanding worldwide could be a major step toward realizing the billion-dollar goal.
Of course, in the real world, mergers frequently don't work out quite as perfectly or profitably as upbeat corporate projections would have investors believe. It is often more difficult than anticipated to get two companies' operations working in tandem, to maximum efficiency and profit, than executives think when shaking hands on the initial deal. Crocs and Hey Dude could theoretically run into unexpected roadblocks in the process of combining into one entity, missing cash flow projections as a result, and thus having trouble servicing the $2 billion in new debt.
However, in this case, I think the two enterprises are extremely similar in their products and target market, making it quite likely the integration will be relatively trouble-free and raising the chance of meeting the company's objectives.
The Crocs plunge: Boomer market, zoomer enterprise?
The steep drop in Crocs' share value in response to its Hey Dude acquisition almost looks like a generational stereotype playing out on Wall Street. The market, playing the role of stodgy elder, simply sees the acquisition as a huge debt to acquire another maker of flimsy canvas shoes. Crocs, meanwhile, attuned to the latest trends, is branching agilely out into a popular market appreciated by young purchasers, ignoring Wall Street's disapproving harrumph while zeroing in on a trendy profit opportunity.
Taking on this much debt just to get another shoe brand is undeniably a risky move. However, backed up by avid demand, and with its borrowing potentially cushioned by inflation, Crocs looks like one of the more bullish shoe stocks following its Hey Dude acquisition and is worth considering for your own portfolio -- and consider the current stock market drop as a buying opportunity.
