March 2020 was one of the most volatile months in the history of the stock market. The S&P500's decline of 12% on Monday the 16th of March was the 3rd worst single day decline in the index's history and it was the 2nd worst day for the Dow, ever! The market's peak-to-trough decline of 34% occurred with unprecedented speed - just four weeks or 20 trading sessions.
This is scary stuff for investors, but for those willing to take a long term view and holding a reserve of cash, the market offered up minority stakes in some terrific businesses at quite reasonable prices. We availed ourselves of several opportunities. Stock prices could decline further and we will have been too early, but that's ok. Our time horizon is measured in decades, not next month.
One of those companies is EssilorLuxxotica (‘EL’), the world's largest eyewear company. It was formed in 2018 through the merger of French lens maker Essilor and Italian frames maker and eyewear retailer Luxxotica. Essilor is the company behind the first multi-focal lens developed in the 1950s and through a series of acquisitions over the past two decades has emerged as the producer of nearly one out of every two prescription lenses globally. Luxxotica is a leading producer of glasses frames, with plants in Italy, the US and China and owner or licensee of some of the most powerful brands in eyewear: Ray-Ban, Sunglass Hut, Oliver Peoples, Vogue, Prada, LensCrafters and OPSM, just to name a few.
In the first full year as a combined company, EL reported revenue of EUR 17.4bn, operating profit of EUR 2.8bn and EUR 1.9bn in profit after tax. It generated a similar amount of free cash flow, of roughly EUR 1.8bn. The combined entity had no net debt until it issued EUR 5bn in bonds in November and the 3-year debt they issued had a coupon of 0%. It priced above par, i.e for more than 100 cents on the dollar, and thus carried a negative yield - extraordinary! EL shareholders were literally gifted money to invest at no nominal cost. With the full integration of these two businesses, organic growth plus bolt-on acquisitions, I expect free cash flow to rise toward EUR 3bn within three years. If I am right, this would equate to 14 times free cash flow on the value at which we acquired shares in the business in March.
What attracted us to the business are the underlying characteristics of the eyewear market and EL’s remarkably strong position in that industry.
The eyewear industry is large, with around EUR 100bn in revenue, and a solid long-term growth outlook. Nearly every person on the planet will probably need some form of vision correction during their lifetime, especially as they age. By 2050 around 40% of the global population will be affected by presbyopia (age-related near sight degeneration).
Demand for eyewear has 1) inherent stability, 2) shows good defensive qualities while 3) offering good long-term growth. These are traits we look for.
The key thing that attracts us to this industry is pricing power. Even the most expensive set of lenses and frames probably costs $50-$100 to produce, and yet retail prices are multiples of that and are not subject to any price regulation. That makes the eyewear business a very profitable one, and one that generates a lot of cash and good returns on capital. In the case of EL, in its first combined year the group generated gross profit margins of 63% and operating margins of 16%.
What allows eyewear companies to earn those kinds of margins?
Firstly, glasses meet a genuine medical need and this has several important effects. The consumer is dealing with the “person in the white coat”, where an optometrist or optician provides a diagnosis. Studies show how we tend to trust authority figures. Many health insurance schemes also offer some level of cover or reimbursement for the cost of prescription glasses, which also reduces the out-of-pocket cost. Opticians typically practice in a retail setting, and that has another effect. It offers convenience. You can purchase your prescription glasses on the spot.
In Britain, the result is a “capture rate”, or number of eye tests that turn into sales, of around 60%. We think the rate is similar in other markets.
Just as important, however, is that glasses are a fashion accessory. A pair of glasses can signal status, identity, intelligence, belonging, differentiation, attractiveness, self-expression and other highly subjective and yet powerful emotive forces. What does buying a cheap, unattractive pair of glasses say about you as a person?
As Sam Knight in the Guardian writes: And spectacles are unusual things. It is hard to think of another object in our society which is both a medical device that you don’t want and a fashion accessory which you do.
Strong pricing power leads to high returns on capital, which in EL’s case stands at around 36%. These returns on capital are protected by EL’s scale, the barriers to entry in the lens business (including decades of knowledge and research into lens design, customization and production), the power of the group’s brands, and the influence EL has over the distribution channel.
It is difficult to over-emphasize the importance of this last factor. Educating optometrists and opticians about your products and getting them to recommend them is key as they are the consumer touch-point. The lens laboratories are the crucial link in the supply chain as they provide the technical capability to deliver highly customized products to consumers in a timely fashion. EL has amassed significant market power over both points in the value chain.
As an industry insider wrote of the battle for the US lens market:
In 1996 Essilor made a major strategic move when it decided to enter the US lab business in purchasing the lab network Southern Optical in Greensboro, North Carolina and the Omega Group in Dallas. This decision was taken under the responsibility of the Essilor chairman Gerard Cottet and not without risk because Essilor was now in competition with its customers. This was the beginning of Essilor Laboratories of America which under the management of Hubert Sagnières developed to the biggest lab organization in the USA and gave Essilor the advantage to control distribution and quality of its own products...
The potential synergies from the merger of Essilor and Luxxotica are compelling: cross-selling, in-sourcing of lens procurement, and rationalization of manufacturing and supply chain overlap.
In the longer term a vertically integrated EL will be in a unique position to push the envelope of the industry’s antiquated supply chain with production of complete pairs of branded, integrated frames and lenses with faster delivery times. EL will also be in a unique position to attack the omnichannel space, with the ability to offer customers a range of brands, lenses, customer service levels and delivery times that no rival can match. It will provide enormous customer value, customer lock-in and provide a powerful economic ‘moat’.
It is a great business in an attractive industry and we think we were able to acquire it at a fair price during March. But where could things go wrong?
The biggest issues facing the combined group is the potential battle for control, which may inhibit the integration and realization of synergies and the ability to capitalize on the strategic advantages of a combined EL.
Leonardo del Vecchio is the Italian founder and controlling shareholder of Luxxotica and by all accounts he is a tough operator. After retiring from Luxxotica for a few years (he is currently 84), he returned to running the company and ousting his long-serving number two, who subsequently left the business. He has a number of children although none are actively involved in the business and according to reports part of the motivation to merge with Essilor was ensuring the combined group is too large for any of them to influence.
Yet his investment company is the largest individual shareholder of the combined group with around 31%. He is co-executive Chairman of EL with equal powers alongside the CEO of Essilor, Herbert Sagnières. Tensions between Sagnières and del Vecchio arose within months of the merger being completed.
The board of the combined company is split evenly between appointees of the two former entities. The arrangement of joint-control, strong personalities, companies with long and proud histories and their own unique cultures is typically a recipe for trouble and a brewing battle for ultimate control is likely to come to a head at a board meeting in early 2021. At that meeting all directors must stand for re-election. I am not certain what will transpire between now and then, but it is likely to create headlines and some volatility in the share price. In the long term, however, the logic of the merger is compelling. Nobody wins by allowing the opportunities to go to waste.