Crocs (NASDAQ:CROX) investors, both longs and shorts,
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Its current valuation seems to suggest that a beat is already priced into the stock. While it won’t surprise me to see a short term gain if positive Q3 results are released, I suspect that many institutional longs will take the opportunity to lock in gains for 2007, particularly when it comes to an overvalued,
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I generally prefer to short companies that have the potential to be "broken" which has led me to companies like Downey Financial Corp (NYSE:DSL), and Jo Ann Stores (NYSE:JAS) in the past. Shorting momentum stocks like CROX requires expensive, and time consuming hedging via options, but I believe the short case on CROX is so compelling over the coming 12 months that it’s well worth shorting, and sustaining any short term losses. It’s not a significant portion of my portfolio because I want to give myself room for error and more importantly, if the short side does provide a material gain, I won’t need a massive position to make a contribution to my long biased portfolio.

CROX has grown tremendously in recent years as the Company has penetrated new doors worldwide. The Company has expanded its product offerings to include apparel, and has upscaled its footwear offerings with the limited launch of You by Crocs. However, the main growth driver has been door growth and current fashion acceptance for its clogs. Despite offering a variety of "models" such as the Mary Jane, Capri,
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At its current valuation, investors are paying an extremely expensive price for management to execute its new initiatives. will moderate in 2008, so growth in door count is unlikely to grow at 25+% as it did in Q2 when it had 12,000 doors at the end of Q2 2007 which was up from 10,
Original Price For Sale Georgetown 11s Fast Delivery To Your Door,000 in Q2 2006, or even the triple digit growth from 2005 to 2006. New products may be accepted by a larger customer base but with CROX’s valuation, the speed of new product acceptance and the size of new product revenue must be enormous in order to avoid a large correction. sales, and more than 30% of international sales according to a September 2007 research report by Cowen Company. Children can be notoriously fickle regarding their tastes, and product reversals in children’s categories are often times violent, and quick. This simply means that CROX may need to fill a $240 $300MM revenue gap (assuming CROX achieves sales of $800 $900MM in 2007) if children’s appetite for CROX footwear ebbs heading into 2008. Investors should also keep in mind that CROX has generated second order revenue from its current popularity with children through CROX backpacks and Jibbitz. In addition, the Mary Jane is generally targeted to teenage girls, and is vulnerable to changes in fashion trends that may result in reduced interest in that product line.

Why does this matter? Well, CROX may become even more dependent on its children’s product sales than investors and the Street realize. The Q2 2007 Shoe Carnival (NASDAQ:SCVL) conference call shed some interesting light on Crocs sales when CEO Mark Lemond stated: It’s (Crocs) working very well in the kid’s business,
Where Can i Buy Georgetown 11s Low Is a Good Choice For You, kid’s department, very well. And it’s working okay in the women’s department. It’s selling through at about half the rate in women’s that it’s selling through in kids.

Management knows that its children’s revenues will eventually be vulnerable and in an attempt to diversify have gone into apparel,
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CROX commands some lofty multiples and what’s interesting is the two sided game that is occurring with the Street and CROX management. Management specifically stated that after 2007 gross margins will trend to around 55% during its Q2 2007 conference call and even as recently as its September 2007 investor conferences. Street research for 2008 projections by Cowen Company (Sept 2007), Baird Company (Aug 2007), Think Equity (Aug 2007), and Wedbush Morgan (Sept 2007) all incorporate gross margins of 58.6 59+% for their 2008 estimates despite management specifically providing 55% gross margin guidance. The Street may just be guessing and using 2007 numbers to come up with 2008 estimates because they’ve routinely underestimed CROX’s growth. In response to underestimating a company’s growth, the Street inevitably creates a hurdle rate that can’t be exceeded and shares correct. In this case, while CROX management is being specific about its guidance, the Street is largely ignoring it, possibly because CROX management has historically been conservative in its guidance.

So having spoken about CROX’s valuation, here are some real numbers. Table I presents comparable peer multiples for CROX,
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TABLE I: CROX PUBLIC COMPARABLES

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Valuation premiums are earned for high growth and CROX has grown very rapidly but that growth is not as certain as it was just 1 2 years ago when the Company’s growth could be driven by new door penetration. Further, current prices seem to impound truly best case scenarious for CROX into perpetuity. Table II is a discounted cash flow analysis based on what the Street is using 59% gross margins, and takes that into the future. This is an aggressive analysis assuming 25% annual revenue growth, sustained 59% gross margins, significant achievement of operating leverage, and a static share count resulting in over 30% EPS growth annually. In addition,
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Table II: DISCOUNTED CASH FLOW ANALYSIS 59% GROSS PROFIT MARGINS

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Table II makes some very aggressive assumptions. The discount rate used to value CROX’s cash flows was 16% based on a risk free rate of 4.75%, a risk premium of 4.25%, a CROX beta of 2.6, and 0 debt alongside a 4% perpetual growth rate. Even with these aggressive, perfect world assumptions, CROX can be valued at roughly $7 billion.

Table III takes all of the same assumptions as in Table II but uses management’s 55% gross profit guidance to derive a valuation for CROX.

TABLE III: DISCOUNTED CASH FLOW ANALYSIS 55% GROSS PROFIT MARGINS

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As Table III illustrates, a change in gross profit margins can have a very material impact on the Company’s valuation. Further, Table III like Table II still incorporates optimistic long term revenue growth,
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Ultimately, CROX investors are forgoing allocating capital to some premiere brands/companies that still offer tremendous growth (WBD for example) for a rubber shoe company with little competitive advantage that is prone to a significant adverse change in interest for the bulk of its products. Some may cite the patented Croslite and the litigation threat, but comparing the Cali line from SKX along with imitations available at Collective Brands (NYSE:PSS),
Order Authentic Georgetown 11s Low Extra 50% Off Clearance Items, and mass market retailers suggests that the threat of litigation is doing little to prevent the inflow of cheap imitations. Some would cite the comfort factor and appeal to healthcare workers and cooks, and the closed hole line of shoes as new "models."

Ultimately,
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