Discount Glasses Oligopoly (OTCMKTS:ESLOF)

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Thesis

Typically, the intrinsic value of a business is derived by discounting the remaining life of future cash flows to present value. For this reason, I think it is essential to assess the sustainability of these the potential cash flows as well as the purchase price of the security in question.

EssilorLuxottica (OTCPK:ESLOF) is the world leader in the design, manufacture and distribution of lenses, frames and sunglasses. Not only does EssilorLuxottica control a dominant portion of the eyewear market share, but it also controls its entire vertical, from R&D and manufacturing to distribution network and insurance. A big reason I think their moat is so big is because of their portfolio of well-known brands, including proprietary brands like Ray-Ban and Oakley, as well as licensing deals with many designer brands. In my view, strong designer brands combined with the human need for prescription eyewear create a unique demand structure for EssilorLuxottica.

I believe this demand structure can continue to support positive free cash flow, which will lead to more substantial acquisitions, consistent dividends and reinvestment in the business to support organic growth. After trading down around 30% from all-time highs set late last year, EssilorLuxottica is currently trading at a free cash flow multiple comparable to the depths of 2008, providing a point of potentially advantageous entry.

Background

Industry

The global eyewear industry is estimated to be worth around $107 billion in annual consumer revenue and is expected to grow in the low to mid-range numbers for the foreseeable future. The industry is divided into five segments and the market share is shown in the table below:

Five Segments

EssilorLuxottica

The eyewear industry has historically been fragmented, with many different companies created over the past two centuries. Over time, EssilorLuxottica has taken significant market share through organic and M&A growth. Listed below is the history of mergers and acquisitions of the company:

History of mergers and acquisitions

EssilorLuxottica

Company

Throughout history, through organic business breakthroughs and industry consolidation, EssilorLuxottica has grown to where it is today. Instead of focusing on a specific industry niche, EssilorLuxottica controls the entire eyewear vertical value chain. From the design of iconic glasses and high quality contact lenses; the development of optical instruments; the manufacture of frames, lenses and laboratory equipment; dissemination; In insurance, this single company controls everything:

Value chain

EssilorLuxottica

Not only does EssilorLuxottica control the value chain, but they also have a portfolio of brands that I believe are loved by consumers around the world. Proprietary brands controlled by the company include names such as Ray-Ban, Oakley, Transitions and Kodak Lens. Prestigious licensed brands outside the corporate family also include Giorgio Armani, Bulgari, Burberry, Chanel, Coach, Dolce & Gabbana, Ferrari, Michael Kors, Prada, Ralph Lauren, Tiffany & Co., Tory Burch, Valentino and Versace. The company also produces lens surfacing and coating equipment for opticians, optometrists and ophthalmologists around the world with brands like Essilor Instruments and Satisloh.

It is also important to note that EssilorLuxottica’s distribution network includes approximately 18,000 stores worldwide that offer direct-to-consumer products as well as high-quality eye care. Stores under the company’s umbrella include an array of different physical and e-commerce platforms, including some of the most notable including Sunglass Hut, LensCrafters and Apollo.

Although EssilorLuxottica’s business model is large and complex in nature, I do not wish to fill this article exhaustively with information relating solely to their model. To learn more about their operational structure, value chain characteristics and trademark/licensing information; pages 10 to 50 of their annual report contain excellent consolidated information.

Organizational chart

EssilorLuxottica

Thesis support

Innovation

I believe that an important part of EssilorLuxottica’s business comes from the very beginning of the value chain, from research and development and new innovations. EssilorLuxottica is focused on organic product innovation through craftsmanship, new sustainable materials and breakthrough products with the goal of improving the livelihoods of millions of people. With more than 11,000 eyewear-related patents, the company continues to innovate and protect its intellectual property.

Trademark application

Through acquisitions and organic innovation, EssilorLuxottica has built a portfolio of eyewear brands that rank among the highest levels of consumer satisfaction. The total portfolio of proprietary brands and license agreements is as follows:

Brand portfolio

EssilorLuxottica

While the company has said internally that its brands are highly ranked, two online surveys show that the company controls an average of 75% of the top 20 rated brands. Both polls had Ray-Ban ranked first, an exclusive EssilorLuxottica brand. Continued customer satisfaction and high regard for the brands in their portfolio will, in my view, be the key to continued future growth.

Secular trends

According to the Vision Council of America, approximately 75% of adults in the United States use glasses (64%) or contact lenses (11%). For context of growth, the total US adult population wearing goggles in 1965 was approximately 45%. This number also increases with age. While 59% of Americans between the ages of 25 and 39 wear corrective glasses, that number jumps to 93% for those between the ages of 65 and 75. In addition to corrective glasses, 85% of the population uses sunglasses.

I believe that if the world’s population continues to grow, technology and accessibility to corrective eyewear increases, and the need for multipurpose eyewear (readers, driving-specific eyewear, transition lenses) increases, EssilorLuxottica will benefit from potential secular trends . Additionally, as life expectancy increases globally and the potential need for corrective eyewear increases due to the negative effects of screen time on our eyes, EssilorLuxottica may experience some long-term tailwinds. .

According to data collected on Statista, the value of the global eyewear market will grow at a CAGR of 5% per year until 2027:

Global Eyewear Value

Statistical

Although these statistics are based on the United States and EssilorLuxottica is a global company, I still think this is a good indicator of global eyewear statistics because the United States is the largest retail market.

finance

Discounted cash flow

After analyzing the fundamental business behind the company’s cash flows, I performed a discounted cash flow [DCF] analysis to determine the intrinsic value of EssilorLuxottica. Below I have attached my intrinsic value calculation, my DCF sensitivity table, the weighted average cost of capital [WACC] calculations, and DCF inputs:

Intrinsic value

Created by author

Sensitivity table

Created by author

WACC calculations

Created by author

DCF inputs

Created by author

Evaluation

Not only do I think EssilorLuxottica is discounted to its potential future cash flows, but it is trading at a historically low part of its market capitalization. / FCF range:

Price / MNT FCF

Koyfin

Historically, buying company stock below 18x LTM FCF has provided excellent returns to shareholders going forward.

Risk / Reward

Even if EssilorLuxottica’s free cash flow multiple contracted to the previous all-time low set in 2003 (13.5x) and free cash flow remained constant, this would place the downside potential at -23% from compared to current levels. Comparing this bearish case to the possible 252% discount derived from my DCF, I think EssilorLuxottica is currently trading with a high margin of safety.

Risks

Competition

I think one of the main reasons EssilorLuxottica has had a positive performance over the past decade is that its market share in the eyewear industry as a whole continues to grow, which benefits its economies. of scale. Recently, competition from companies like Warby Parker has been pushing hard to take market share from EssilorLuxottica. If successful, a decline in EssilorLuxottica’s market share could have adverse effects.

Multiple deletion

If EssilorLuxottica sees competitive pressure eating away at its growing market share, I think the company could see its valuation multiples contract, as the stock may be less attractive to investors. Declining market share in an industry expected to grow to a CAGR of 5% over the next five years may also continue to weigh on declining ROI [ROIC]. Historically, the company’s return on investment has remained between 10 and 12.5%, but has recently declined following the merger between Essilor and Luxottica, where it currently sits below 4%.

ROIC

Koyfin

While free cash flow may continue to support future dividends and acquisitions, the decline in profitability could, in my view, remove the multiples driving the stock price down.

Summary

By controlling their entire vertical, having a well-known brand portfolio and creating demand from luxury and medical customers, I believe EssilorLuxottica’s future cash flow is very sustainable. With over 11,000 patents, 2,350 designs and 3,460 trademarks, I also believe they have the intellectual property to further underpin their moat in the eyewear industry. With Essilor and Luxottica finalizing their combination at the end of 2018, I still believe that the potential synergies as a product of the merger are not fully reflected, particularly in the share price currently.