Crocs Inc. Financial Policy Analysis: Structure & Strategy

Introduction and Company Overview

Crocs Inc. is a manufacturer and marketer of footwear. Their core product utilizes a patented resin that molds well to the foot, making the product more comfortable than most shoes. Crocs became a defining fashion trend of the 2000s. The company, which launched in 2002, went public in 2006. The IPO raised $208 million in a 9.9 million share offering at $21 per share. On the day of the IPO, the price rose above $31 (Denver Business Journal, 2006). The share price had originally been slated for the $13–$15 range prior to the IPO (Reeves, 2006), but this was changed at the last minute. The stock price shot up as high as $75 before collapsing to the $1–$4 range, where it remained for several months.

As a young company, Crocs does not have any legacy issues. This makes it an excellent case for the study of financial policy, as it presents a simple set of contrasting forces. The absence of legacy issues means that the current management team is entirely responsible for the company's current financial policy. Contrasting this is the fact that the company has grown rapidly, which can add an element of chaos to financial planning. Such companies can find themselves with a given financial structure before they have had time to formulate a coherent policy. This paper examines the case of Crocs and investigates the financial policies the firm has exhibited during its young history.

The analysis is conducted in the context of the firm's rapid growth and competitive operating environment. The firm has suffered a downturn in revenues not unlike many firms in the apparel industry. However, the newness and fashion-driven nature of Crocs means that the revenue decline may be entirely unrelated to the broader economic context. There has been limited competitive response to Crocs, which operate largely in their own sub-category with very little direct competition. The footwear market overall is, of course, highly competitive. Whether the niche that Crocs has carved out for itself is sustainable depends on the whims of fashion rather than the actions of competitors or the influence of the economy.

An organization's financial policies can be described by analyzing seven elements: the mix of capital; maturity structure; basis of coupon and dividend payments; currency issues; preference for financial innovation; external control; and distribution of value.

Financial Policy Description: Seven Elements

1. Mix of Capital. Analysis of this element seeks to ascertain the degree to which the firm relies on different classes of capital. At Crocs, the current debt-to-equity ratio is 58.7%. In 2007 it was 41.2%, and in 2006 it was 43.7%. The company has little long-term debt. The bulk of its liabilities are current liabilities, spread across different classes, the largest being accounts payable and "other." The company had a nominal amount of long-term debt prior to its IPO but has since eliminated that from the balance sheet. Since the IPO, long-term liabilities at Crocs have consisted mainly of "other."

The majority of the firm's equity derives from the IPO. In 2007 Crocs had a higher debt-to-equity ratio than in 2008, the result of having higher retained earnings. The company's earnings have been highly volatile during the past few years. When earnings were high, they flowed into retained earnings. In the most recent year, when the company recorded a substantial loss, retained earnings were similarly reduced. The company did not take on debt to cover these losses. An analysis of the Statement of Cash Flows reveals that capital expenditures were financed by cash flow from operations in 2008, the latter being positive despite the accounting loss.

The firm's limited reliance on debt is reasonable at this point in its life cycle and for the business in which it is engaged. Crocs is barely two years removed from its initial public offering, meaning that equity financing is available to fund operations and expansion. An analysis of the firm's environment reveals that Crocs faces a difficult operating environment, even without considering the impact of the global economic crisis. The Crocs product has characteristics of a fad, albeit one with some legitimate traction in the marketplace. The company faces intense competition from a wide range of suppliers. Perhaps the most significant environmental threat concerns intellectual property rights. Crocs depends on rights relating to both the resin used in production and its sandal designs, in addition to the usual rights relating to branding. Protection of these rights is essential because Crocs charges relatively premium prices for its shoes ($30–$60), given its production costs. These margins must be protected, but cannot be if knockoffs are permitted to enter the market. Defending the Crocs technology and design against myriad threats is going to be a difficult, expensive proposition (Reeves, 2006), complicated by management's decision to offshore some production to China — a move that virtually guarantees the production of knockoffs.

Given these risks, Crocs is wise to limit its use of leverage. Leverage will increase volatility at a firm whose operations are already highly volatile. The current economic downturn has significantly suppressed revenues and earnings. Had Crocs been leveraged going into 2008, its situation would be dire, whereas it is merely bad at present. This conservatism has given the company a chance to pull through the crisis.

2. Maturity Structure. A risk-neutral position with regard to maturity is one where the life of the firm's assets equals the life of the firm's liabilities. For Crocs, the liabilities are almost entirely current. The current portion of long-term liabilities on the balance sheet has been used more extensively in 2008, a function of lower than expected revenues. This consists of a revolving credit facility priced in relation to either the Fed Funds rate or LIBOR, at the company's option. The agreement was amended several times throughout 2008, and by year-end the rate was 12.25% and did not allow for new borrowings. There are also rental commitments through 2013 and beyond.

The life of the financing is weighed against the life of the firm's assets. Property, plant, and equipment is the largest non-current component of total assets. A significant proportion of capital equipment was leased in previous years, but the firm has reduced that to $9,000. Another asset class is intangibles. These are considered to have finite lives ranging from 5 to 10 years, with most falling in the 7-year category. The 10-year category consists of the patents — perhaps the most important intangible asset category.

The interpretation of maturity structure is that the firm must choose between a preference for refinancing risk or reinvestment risk. The maturities and assets are not matched at Crocs. The company appears to strongly prefer reinvestment risk, since it is plowing funds back into capital investments. This is especially evident in the way the company has eliminated its long-term debt. Crocs' managers are therefore placing their bets that continued growth through expansion of products and markets is better for the company's long-term success. Refinancing is seen as riskier, possibly because increased refinancing risk would undermine the company's ability to continue growing as it sees fit.

3. Basis for Coupon and Dividend Payments. Crocs does not pay dividends (MSN Moneycentral, 2009). This is consistent with behavior typical of young, growing firms — partly because of the emphasis such firms place on growth, and partly because of the volatile nature of earnings in young firms, for whom dividend payments would represent a risky ongoing obligation.

In late 2007, Crocs entered into its revolving credit facility, which is based on a floating rate (Fed Funds, LIBOR, or prevailing bank rate). This indicates that management took the view that interest rates were going down — which they did. Being a new company, management would have had little indication of how Crocs would respond to changes in the macroeconomic environment. It was reasonable to assume that strong growth would continue; however, that has not been the case. By accepting a floating rate, the company saw its interest payments decline as rates dropped at the beginning of 2008. This coincided with a drop in revenues as the financial crisis worsened. Thus, the floating rate was incidentally matched with the firm's revenue streams. Management did not know that revenues would drop as a result of macroeconomic weakness — their slow response on cost-cutting resulted in steep losses and inventory write-downs in 2008. It can therefore be inferred that the floating rate's alignment with revenue streams was largely coincidental. The decision to utilize a floating rate was more likely driven by an accurate assessment of the future direction of interest rates, which was predictable given that the subprime crisis was beginning to emerge when the credit facility was established.

4. Currency Policy. Crocs has some limited international operations. The firm began by utilizing technology from a Canadian firm, which was later absorbed into the company. It has undertaken overseas production in Brazil, Mexico, Romania, and China, and has applied for patent protections in over 36 countries worldwide (Reeves, 2006).

Crocs sells in over 70 countries, with international expansion beginning in earnest in 2006. After just one year, international sales had increased from $8.2 million in 2005 to $78.4 million in 2006, accounting for approximately one-third of total sales (Pierce, 2007). This growth has been facilitated by setting up distribution centers where manufacturing takes place — the operating hedge — which has become the cornerstone of Crocs' foreign currency policy.

The company had, until the previous year (Blick, 2008), an operating hedge in its Quebec City facility, offsetting its largest foreign currency exposure: the Canadian dollar. Crocs also matches manufacturing facilities with sales in Mexico and China. Otherwise, its production is U.S.-dollar denominated, eliminating the need for hedges. Aside from these operating hedges, Crocs does not actively hedge its foreign currency exposure.

It is unknown whether this is a deliberate policy based on careful analysis of currency markets or an incidental policy resulting from insufficient analysis of the issue — both are plausible given the youth and inexperience of the firm. The firm's foreign currency exposure is growing, and it will not be able to establish operating hedges in every country. Indeed, it remains to be seen how Crocs will hedge its Canadian dollar exposure now that it has closed the Quebec City facility. In terms of financing, Crocs obtains all of its capital domestically — through the NASDAQ for equity financing and through a U.S.-based line of credit. It remains to be seen if this strategy will be maintained as exposure to foreign markets grows.

5. Preference for Financial Innovation. The use of exotic financing instruments can reflect management's creativity and opportunism. With respect to Crocs, there is little financial innovation. The firm's main sources of capital are its line of credit and its equity financing — both are straightforward. This reflects two important points. First, there is little operational complexity at Crocs at this stage. Second, it reflects the relative inexperience of the Crocs management team, which is essentially comprised of the same entrepreneurs who launched the company. They are learning on the job and are therefore averse to exotic financial instruments. The new CEO as of 2008 is Russell C. Hammer, a former finance executive at Motorola (Forbes, 2009). As he brings more experience to the finance team, it will be interesting to observe whether there is a shift toward greater use of complex financial instruments, though there is no indication of this to date.

6. External Control. Equity in Crocs still lies largely with the founding shareholders. In 2006, 9,900 shares were issued publicly, but these represent less than 15% of the total public shares even today. That year also saw the exercise of 31,726 preferred shares into common shares, giving those shareholders increased say over the company's operations. Since then, further shares have been issued, albeit mainly to management.

With respect to debt, 2008 saw a consistent increase in outside control. Crocs was found on several occasions to have been in violation of financial covenants within its revolving credit facility agreement. This resulted in fees, and the bank required the company to lower its borrowing. Further amendments in 2008 reduced the amount borrowed in exchange for the removal of all remaining covenants.

The revolving credit facility is an example of Crocs' management asserting control over its situation. The creditor, Union Bank, had enforced covenants against Crocs, which caused the company to reduce its obligations to Union Bank and thereby limit external control. This indicates that Crocs has adopted a stance of actively defending against outside control.

7. Distribution. This element reflects the way the company markets its securities and delivers value to investors. The only form of public capital that Crocs has is its common stock. At present, the firm has been hesitant to leverage itself, indicating that management possibly believes its business is sufficiently risky as it stands, and that taking on more risk could potentially lead the firm to ruin.

Crocs does not issue dividends, preferring to deliver value via capital gains. This policy is consistent with young, growing companies and reflects management's belief that cash flows are not sufficiently established and stable to justify a dividend, and that reinvesting capital as retained earnings will allow the company to build its operations and generate greater profit for shareholders in the future. Crocs was growing rapidly until 2008, when growth stagnated. This resulted in steep declines not just in profitability but in shareholder value, as the stock price plummeted from $75 in the autumn of 2007 to $0.79 during the depths of the global economic crisis — a 99% loss of value. This will make it difficult for the company to raise further equity capital, which will constrain its growth prospects going forward.

These seven elements constitute the description component of Crocs' financial profile. For the most part, they are consistent with what would be expected of a small, young, and rapidly growing company. Management has an aversion to debt, which may serve them well going forward since they may ultimately be forced to rely on debt financing — it is therefore advantageous that they are not yet overleveraged. The firm remains subject to high volatility, and has benefited from its relatively conservative financial outlook.