Skeptics Will Not Stop Crocs

Pop quiz. In its most recent quarter, a company grows revenue 162% and earnings 205%. Domestic revenues are up 99%, and international revenues are up about 400%. It trades at a 4x forward revenue multiple, and a 27x forward earnings multiple. Its EBIT margin is in excess of 30%. Guess how IAG votes?

Normally, you would have to do some thinking to answer the question. Sit down, actually determine what type of growth rates and margins this company will earn. Determine how fast the size of its market and overall market share will grow. Not an easy task when the growth rates are so high, so you would have to look at relevent metrics of performance, in the case of a retailer: door growth, revenue growth, gross margin expansion, operating margin expansion, market penetration. You would have to put the metrics in perspective given the size of the company, the size of the market, its business strategy, and its competition. How does this company sustain a competitive advantage? Now you have to look at its revenue breakdown: what percentage is coming from what products, what markets, etc. Compare all of this against comparable companies. Hint: Comparable companies doesn't necessarily mean companies that sell the same product.

Before you start crunching numbers, or doing months of industry research as I have, remember that we are in IAG. All of this is unnecessary when you have a growth company. What exactly is a growth company you ask? This is a company where there is a certain level of uncertainty in the future. This is a company with an impressive, but short operating history, which creates senstivity to near-term earnings or projections. And of course, given the strength of its business, this is usually a company at the fearful, dreadful, absolutely and utterly terrifying level known to most as the "52-week high."

Now guess how IAG votes. Pass by an overwhelming majority that shocked even me. 6 vote play. And nearly 100 students on the other side. Though it is tempting for me after losing the battle on Crocs (CROX) to berate the decision of the members, IAG is mostly a young club still learning the ins and outs of the market. I have always been impressed by how quickly the members have been able to analyze the typical "value plays" in the market. It usually doesn't take members long to see the rationale in investing in a company with a strong and long operating history, healthy margins, and low multiples (especially when the multiples are relevant to cash flow). IAG does very well in this arena and I believe it is because of former great PMs teaching the philosophy of value investing.

However, when it comes to growth, IAG usually screws up big. Whether they were ultimately voted pass or play, great companies like Google (GOOG), Wynn Resorts (WYNN), Chipotle Mexican Grill (CMG), Blue Nile (NILE), and now Crocs have had a very difficult time making it into the IAG portfolio, even while one is supposed to resemble a "growth" portfolio.

Why? I asked several IAG alum the same question and we agreed the problem is that IAG members are not conditioned to analyzing these types of companies. They see a stock go up 500% or trading at 50x earnings and they simply wonder, how can this company keep possibly going up. Even if they take the next step and look at the fundamentals of the company, they see triple-digit growth rates, and cannot see how that business can keep growthing at a fast clip.

Then, in come the DCF enthusiasts, whom I have been criticizing for almost a year now for the arrogance and lack of reasoning employed in their projections. The Crocs "DCF" dropped revenue growth from 135% for 2007 to 25% for 2008. Given the numbers stated above, anyone would agree that this is absurd. How do we compensate for the lack of intuition in the model? Let's just plot 25% revenue growth for the next five years so we don't have to analyze the company's expansion strategy. Let's keep EBIT margins constant so we don't have to do any research on how they may improve or decline. Let's pay absolutely no attention to near-term analyst projections.

The DCFs are pretty terrible when it comes to companies like Crocs, but sometimes the relatives don't get any better. Last year, a presentation on Palm (PALM) showed a bar graph with forward earnings multiples on Palm and its competitors. "Research in Motion (RIMM) has a 67x multiple while Palm's is only 14x! Buy buy buy Palm! Sell sell sell RIMM!" The reasoning behind my oppenent's CROX relative wasn't much better. It compared Crocs to companies like NIKE (NKE), Sketchers (SKX), Heely's (HLYS) and the average of the footwear industry. Guess who's multiples are going to be the highest? Sketchers is the only one I would call a comparable, but even that is a stretch given its slow growth expecations. But who cares? If they make shoes then we're close in enough.

After spending so much time on errant DCFs, the quality of understanding of the company and industry usually suffers. This was very evident to me last night having experience looking at consumer stocks. Insider selling? Book value? Competition in a market that has only penetrated 2%. The entire reasoning was very flawed. Yes, Sketchers and Nike can make a Crocs-like shoe. But at this stage, that would only expand the growth of the market of those types of shoes rather than slow Crocs's growth. Think of Crocs as Red Bull energy drink. Coke (KO) and Pepsi (PEP) were very eager to enter the energy drink market that Red Bull dominated. But that only made the energy drink market that much bigger. Red Bull lost sizeable market share, but the market grew by such an astonishing rate that it isn't even material anymore.

To be fair for my part of the presentation, in a solid relative, you should have more than one other company to base your judgments. I only included one: Under Armour (UA) because its is without a doubt the most and only comparable to Crocs. There are similar market capitalization, growth estimates, revenue. Moreover, both companies have a similar business strategy in the retail market: trying to expand their business through a hit product. The only difference is that Crocs has much better margins and a much lower earnings multiple. I tried to reconcile those differences, but eventually proposed the market was underestimating Crocs's potential while full appreciating Under Armour. Either way, Crocs is certainly not trading at an unreasonable level. The PEG multiple on CROX is 1.2 trailing (60x/50%), with a forward PEG about .77 (27x/35%).

I believe Crocs is at a very attractive risk/reward level and will continue to perform in measures that a beyond the scope of reasoning currently in IAG. Our presentation on Blue Nile was met with harsh criticism and the stock went up 170% on the fruition of our thesis. Crocs is 5x the size of Blue Nile, but there is still plenty of upside left. It is now my top pick, and I believe I will once again have pitched the best performing stock of the school year. At the same time, I will try to continue to teach members how to invest in growth stocks:

1. Determine on the fundamental growth drivers of the company at hand.
2. Make judgements based on the information (metrics) you have available.
3. Put the market valuation (multiples) in the context of what you learn in 1 & 2.
4. Make a thesis.
5. Reevaluate your thesis as more information becomes available.

Watch Crocs and stay tuned.

Neal Sangani

Disclosures: I own calls on CROX. My comments are for educational purposes only and are solely my opinions.

VMW's Valuation Disconnect With EMC

"The market can stay irrational longer than you can stay solvent."

True, but you would think that market's would start becoming a little smarter after the major collapses of the dot-com bubble. I of course was still in high school; but no business education is complete without learning about some great collapses. 3Com (COMS) spun off Palm (PALM) with an IPO that generated a significant amount of hype. While 3Com held a major stake in the company, Palm shares were driven so high that they accounted for more than 3Com's entire market value. In other words, the market valuation of Palm implied 3Com's core business (ex-Palm) was worth less than zero. Obviously, we know exactly where Palm went when the bubble popped.

The typical corporate finance interview question for this case is usually: "Does this violate the expectations of market efficiency?" One might be tempted to answer yes, but the answer is no. Right after an IPO it is nearly impossible to short shares. Intelligent market participants could not profit from the absurdity of the situation.

Fast forward about 7 years to VMWare (VMW) and EMC (EMC). Again we have a much hyped spinoff that has risen from an IPO price of $29 to $107 in about one month. At current prices, if VMW represents approximately 75% of EMC's market capitalization. If VMW were to outperform EMC by another 30%, EMC's core business would have an implied value of zero. Again, it is very difficult to short shares given the small float of VMW shares (EMC holds 86%). However, options are traded and intelligent investors can buy puts or short calls.

A number of sources including Seekingalpha and Barron's have pointed out the disconnect and I am looking for opportunities to make some fast money. There are only two possible explanations here: EMC is grossly undervalued, or VMW is grossly overvalued. If we were to take on a simple hedge, we would short .75 shares of VMW for every 1 share of EMC we bought, and then short a competitor of EMC for the remaining .25.

The AllStar Portfolio has taken a large bet that VMW is about to take a significant fall as the market assumes a state of rationality. The fact that the company is at a market cap of $42 billion at 116x forward earnings is not even core to our thesis. Obviously, we have thus far, and expect to continue to take heavy losses as VMW shares are on a tear. However, the valuation disconnect is too enticing to ignore. As a mock portfolio, we do not face the risk of margin calls that would occur in the real world with a trade like this. Yet, we also have a much shorter time horizon for this trade to pay off. VMW reports earnings on Oct. 24. More importantly, the lockup period will expire 180 days after the IPO. Stay tuned.

Neal Sangani

Disclosures: I purchased puts on VMW today. My comments are for educational purposes only.