Coastal Contacts: Dominant, Growing, And Dirt Cheap

Dec.13.13 | About: Coastal Contacts (COA)

Author's Note: This article discusses a microcap stock. Please be advised of the risks associated with microcap stocks. Coastal Contacts Inc. had no input into the selection of the title of this article nor into the commentary that precedes the interview section. The text of the interview is an abridged transcription of a conversation between Lazarus Investment Partners LLLP and Coastal. Lazarus is a shareholder of Coastal and received no compensation for this article.

Introduction. The last time I needed glasses I went to the mall and tried on a pair of trendy Ray-Bans that would have set me back over $300. Amazed that a half ounce of plastic could cost so much, I went online and found the identical pair at coastal.com for around $100. After purchasing the glasses, I added to my fund's investment in Coastal Contacts (NASDAQ: COA) (TSX: COA.TO). We think the company right now is worth 2 to 3 times the current market cap, and can grow well beyond that if it's not acquired first.

Glasses are one of the next big industries to be disrupted by the internet. Frames are one of the greatest rip-offs around. There's no reason why such miniscule amounts of material have to cost so much money. Coastal is leading the way towards this disruption. To overcome consumer resistance to buying glasses in a new way, Coastal does everything from giving away the first pair free to offering a one-year, no hassle return policy.

The company was founded by Roger Hardy, still the CEO, in his basement in 2000. By September of 2012 Coastal surpassed $1 billion in cumulative sales. Coastal leads the market in both its home country of Canada as well as in the USA. Insiders own about 17% of the company, which keeps management motivated. Over the last twelve months Coastal recorded $215 million in sales. The company's market cap is $240 million and the balance sheet shows $26 million in cash and $7 million in debt.

Two segments. As evident by the company's name, Coastal Contacts has its roots in the contacts lens business, currently about three-quarters of sales. This segment is growing at 5-10% a year, and is profitable with recurring revenues from a loyal base of repeat customers. Contacts are a $7 billion global market, with around 16% online penetration in the US. We would call it a growing business; Coastal views it as their mature and stable segment.

Selling glasses is what Coastal views as the bigger growth opportunity. That market is 10x the size of the contact lens market, with only 3% online penetration in the US. Coastal's glasses division is growing at around a 25% annual rate and currently represents about one-quarter of company sales.

Competitive advantages. After Coastal's database of 5+ million vision correction customers, one of Coastal's most unique assets is its vertical integration. The company owns three eyeglass manufacturing facilities across the world, with some of the most technically advanced labs around. All orders are fulfilled internally. This gives the company control over its supply chain, squeezes out cost, and speeds order fulfillment.

Another competitive advantage of Coastal is that it owns some of its brands. Coastal brands are currently 44% of sales and offer the company both differentiated product and incremental margin.

Multiple ways to win. We see more than one way to win with an investment in Coastal. On a blended basis (which factors together the lower growth contact business and the higher growth glasses business) the top line is growing at a low double-digit rate. In order to continue to dominate the growing online glasses market, Coastal has been investing heavily in marketing and customer acquisition. These investments are paying off with repeat purchases and rising average order values (up 73% in glasses in Q3). It also means that the company is spending to build its franchise. Trailing EBITDA or net income metrics don't tell the true story of this company.

Coastal can be profitable any quarter it wants by dialing down the marketing spend. Management admits to this in the below interview. Therefore, to value the company using something below the revenue line, you need to consider it on a proforma basis. Management is targeting low to mid 20's EBITDA margins for the business long term, 21% for contacts and 24% for glasses to be specific. Grow the top line at just 10-11% and that implies EBITDA power for the company of over $50 million. At 10x--a conservative multiple for a dominant, growing, high margin business--you get to a valuation that's more than double where shares are priced today. But we think the upside is much higher if Coastal continues to execute on its business plan and maintains its market position in North America. For a comp that indicates the value of being a leading online optical company, look at what Wellpoint (NYSE: WLP) paid for 1800Contacts-more on that in a minute.

A free, little-noticed call option. You'll read in the interview how Coastal is pursuing multiple managed care relationships. These relationships have the potential to bring millions of customers to Coastal's door. The company described some of these conversations as in the "late innings," so we see possible 2014 announcements of managed care deals as an investment catalyst that few are anticipating.

Takeout potential. Coastal is the only public, pure play online retailer of contact lenses and glasses. That gives it tremendous scarcity value. It's the trophy asset for any large optical player that wants to get into the space, or that has a retail franchise to defend. When Amazon wanted to get into shoes, they paid nearly $1 billion for Zappos, which we heard was 35-40x EBITDA (although a lower price/sales multiple).

We read that online glasses retailer Warby Parker raised money at a valuation of over $100 million when they had about 100,000 pairs of glasses sold in the prior year. Coastal has sold over 2 million pairs of glasses in the past four years, has leading market share, yet has a market cap of only $240 million. Coastal's glasses business alone could be worth more than Coastal's market cap, and glasses are only 25% of Coastal's sales.

1800Contacts was sold twice. In 2007 Fenway Partners bought it for $340 million, when the business was net income negative and after doing $249 million in 2006 sales. That's 1.37x trailing sales. Coastal has $157 million in trailing twelve month sales in its contacts segment. At the same multiple, you get to a valuation of $215 million. Add in net cash and you have almost the entire market cap accounted for, with no value ascribed to nearly $60 million of annual glasses sales, growing at 25% and the #1 market position in the most important market in the world.

In 2012 Fenway Partners sold 1800Contacts to WellPoint for $900 million when 1800Contacts had close to $400 million in revenue (2.25x sales). Applying that multiple to Coastal's contact lens segment gets you a valuation of around $350 million, almost 50% above today's price-just for the contacts business. The glasses business and net cash are free. At the time the WellPoint deal was announced, 1800Contacts had 3.3 million customers. Coastal has today over 5.2 million customers. We think this stock is dirt cheap. Coastal management comments below on the topics of valuation and takeout potential are worth noting.

Key investment risks. What can go wrong? It's possible that buying glasses online won't continue to grow in the way we are anticipating. Perhaps current growth rates are supported by early adopters, but what happens when those get exhausted? There's also the risk of traditional optical retail changing course and slashing prices. Once you approach price parity between online and retail, the advantages of traditional retail (in person try on, consultative sale) will become more significant. As always, there's competition. We see it as just a matter of time until some of the optical giants awake and invest more heavily in ecommerce. And as cheap as Coastal's prices are, vendors selling unbranded, made in China frames will still price lower.

Our biggest criticism of the company, however, is that even at a quarterly run rate of over $50 million in sales, they are only expecting to be EBITDA neutral in 2014. We understand that this is by choice, as the company is prioritizing customer acquisition over profitability, otherwise the cash would be "welling up through the floorboards," as Coastal's President put it. We picked on this point a bit in the interview, and you'll soon hear management make the case for why customer acquisition is so valuable.

Management Interview. To best hear the Coastal story, it's worth reading our conversation below with Gary Collins, Coastal's President and Terry Vanderkruyk, VP of Corporate Development. We thank them both for taking the time to address our questions. (If you've had your fill of reading about Coastal and just want to hear about their free glasses offer, go to http://www.coastal.com/firstpairfree).

Coastal operates in one industry, vision, correction, but it has two segments with different growth profiles. Could you elaborate?

Gary: About 75% of the business is a mature contact lens business, which is very profitable, with very consistent growth, very consistent profitability and stable customers that tend to repeat very regularly.

The eyeglasses business, which is the newer part of the business, is growing much more quickly. About 25% growth in the last quarter. That's a business that we've been working on for the last three or four years. We started it in Canada, our home jurisdiction, and it's gone very well for us. It's now EBITDA neutral even with an aggressive marketing spend. And, in the last couple of years, we've been growing that business here in the US, acquiring more than one million unique eyeglass customers, and we're starting to see those customers come back with strong average order values on those returning orders. And we're very excited about where it's headed.

Why would glasses be a growth business but lenses be more stable?

Gary: The eyeglasses category is about ten times the size of the contact lens category. And so, for the last number of years, we've been taking the profitability from our contact lens business and reinvesting it into the eyeglasses business. We've been spending more in growing that business and developing it, filling it out, and acquiring new customers.

Terry: In the US market, the contact lens category has been penetrated approximately 17% by the online channel, where the eyeglasses category is under 3%. So the development of the online channel is early and growing very quickly and is expected to grow to more than 10%-15% online penetration in the next few years.

Looking at last quarter's numbers, what trends stand out in terms customer behavior?

Gary: In the last quarter, for the first time, we released data that broke out the Canadian and the US glasses business for both new and then returning customers. And what we were able to show is that the model is proving itself out in Canada with rapidly growing average order values for returning customers. But even with our new customers we're seeing an increase in the average order value of that first purchase as well. So we're able to identify higher-value customers, better customers, acquire them, and see them returning more quickly. And we're seeing that same trend starting to develop in the US market which is ten times the size.

What is it that the company is doing to acquire customers?

Gary: There are a number of things that are happening. First of all, people are getting more comfortable with the online experience. We've done many, many things to make it a simple transaction for people. We've invested heavily to offer technology that allows consumers to choose and try on glasses online, we do "first pair free" promotions, and we offer a one-year return policy and low price guarantees to reduce the resistance to a purchase decision.

Second is brand awareness-we've invested heavily in brand awareness in the last year. I think people are more comfortable, more aware. They're coming to the site directly and they're willing to spend more and commit more in that transaction. We've also expanded our scope and our inventory. So we now have approximately 3,000 frames online, which we inventory. We've added to our inventory and selection of branded frames for people as well. We also started to sell progressive lenses, the multifocal lenses, which are a much higher-value product and a higher-margin product as well. And of course we've made significant, calculated investments in online and print and even in select retail locations to drive customers to us.

What would you respond to someone who asks whether glasses are something people really want to buy online? Could this be an expensive way for investors to find out that the market is limited to technology forward customers and early adopters?

Gary: That's what people used to say about contact lenses too. That's what they used to say about shoes. And what we're finding is, in fact, they are coming online and they're trying it. They're experiencing it. They're finding it's way simpler than they thought. They're loving the product that we're giving them, the speed with which they get that product, and the value and the savings that they achieve. So more and more people are getting comfortable with purchasing eyewear online. We've already served over a million eyeglasses customers in the US and over 2 million globally. So customers are coming online. They're trying it. And, more importantly, they're coming back and ordering again and again.

The company is doing north of $200 million a year in sales. That's a big number. But you're still not making money on the bottom line.

Gary: As you say, we're doing more than $200 million in sales. Approximately 75% of that is in our very profitable contact lens business while 25% of that is the eyeglasses business in which we are investing the profits from our contact lens business. The eye glasses category is under-penetrated online yet it's ten times the size of the contact lens category so we are aggressively acquiring eye glasses customers in this early stage of the business. As you've seen through the data in the last quarter, when we're acquiring customers, we're doing it through multiple channels.

Occasionally, some of the channels have what we call a first pair free offer, which is a great way to get some customer into the store in certain segments. And we've done that successfully. That's how we built our multimillion-dollar Canadian business, which is now EBITDA neutral. It's what we've done in some elements in the US to build that business. But we're also acquiring customers through a variety of other channels as well. And the average order value for those initial customers, their first-time purchase, is going up. There's a land grab out there and we want to dominate in the US the way we do in Canada. We are investing heavily in acquiring customers because it's worth our time. The customers keep coming back and keep buying more from us.

Where is the company's market position in the US and Canada right now?

Gary: We're clearly number one in Canada, both in contact lenses and eyeglasses, by quite a wide margin. We believe we're currently number one in the US in eyeglasses customers acquired online, but it's at a very early stage of market adoption. So we want to ensure that we continue to maintain and expand that position going forward.

Is breakeven within sight?

Gary: We've said that we intend to be EBITDA neutral in 2014. We invested heavily in the past year, particularly in branding in the US marketplace. That was deliberate and was a part of our strategy. We're acquiring those new customers and the average order value is going up. We're seeing those people come back sooner. And we expect that during this year, 2014, the entire company should be moving to EBITDA neutrality.

Gun to your head, someone says you have to make this business net income positive in 2014. Could you do it?

Gary: Absolutely. It's just a question of growing slower. You just have to turn down the marketing spend, perhaps acquire fewer customers. But the business gets profitable very quickly.

What we don't want to do is end up a year from now finding somebody else has overtaken us in this market. We've spent an awful lot of energy and effort and capital to get into the number-one position, particularly in this large US market and this large category of eyeglasses, and we want to make sure that we stay there and that we continue to grow that lead. And that's what we're focused on for this year.

Terry: I think we have a rare opportunity in the eyeglasses category, which is not well penetrated by the web, to establish coastal.com as a market leader. And, in the e-commerce world, having that leadership position, having that strong base of customers, is a tremendous benefit as the 97% of people who purchase eyeglasses the old-fashioned way look for an alternative. They will look for the market leader. And we'll be well positioned for that secular shift that is going on and will be going on for the next several years.

What specifically are you seeing in terms of customer behavior that convinces you it's so important to win new customers?

Gary: In the eyeglasses industry, people tell you that the average order cycle is about two years. We're seeing people come back more quickly than two years, and we're seeing them come back and buy multiple pairs and higher value pairs. So we're seeing very positive trends in and we think those will continue.

The big thing we're seeing is trends in the average order value for the return customers, which are really starting to climb, which is showing great confidence in the online category and online channel for people. Our NPS scores, which is a measure of customer satisfaction in the online sector, are extremely high. They're in the high 70s. We outrank anybody else in the space either online or offline. And that's not me telling you; that's our customers telling us.

So longer term, at some point when the land grab quiets down, what happens to profitability?

Gary: The real leverage in this business is the ability to dial up or down the selling and marketing component of it. That affects how fast the company grows, but it has a big impact on profitability. So, in our Canadian eyeglasses business, for example, where we're EBITDA neutral, we're still spending 44% of the top line revenue in selling and marketing, which is well above what we spend on contact lens marketing. We can dial that down. If we were to, long run, dial that down to, say, 20%, almost all of that additional 20% or 24% of expenses goes right down to the bottom line in the form of EBITDA.

However, what we've learned in this online business is that it's far better to be in the number-one position than the number-two position. And so, in those markets where we're in the number-one position, we're more profitable. Therefore in the US, which is such a large geographic space with so many customers, we're really intent on being number-one in the eyeglasses business and we are aggressively investing. But, at some point when we're comfortably in the lead, then there's an ability to turn that selling and marketing down, and that's where the profitability really starts to rise.

What are the headline numbers for how many glasses you've sold, how many customers you've catered to?

Gary: We have about 5.4 million customers globally. We've sold over 2 million pairs of eyeglasses in the last four years since we've been in this eyeglasses business. And we really only started in the US with the eyeglasses business in the last two to two and a half years. We've already sold and serviced a million unique customers.

And the lens business? How many customers do we have, or how many lenses have we sold over some period of time?

Gary: Since the company started we've sold over a billion contact lenses and served well over 3 million contact lens customers.

Terry: The nature of our business is that we're cross-selling eyeglasses to our contact lens customers, and the reverse is also happening, where we're getting new eyeglasses customers that have now also become contact lens customers. So there's some cross-pollination, which is an added benefit of the increased marketing spend.

Tell me about the opportunity you see in managed care relationships. If you do win a contract, what does that mean for the business?

Gary: There are multiple managed care providers, healthcare providers, here in the US that manage anywhere from a few hundred thousand to multiple millions of lives and virtually all of them have some form of an optical offering, which is either included in their plan or is an option for their plan. We're having discussions with them because we've heard from them that their quality of customer service and their customer experience is not at the high level that they'd like it to be. We're able with our vertical integration, with our online strategy, to provide the same or better quality product at a much lower cost to them, get it to them faster because of our logistics and our channels, and save both the consumer and the healthcare provider significant money.

Have you disclosed anything more specific in terms of the number of managed care companies that you're speaking to and when you might hear back? Or at least some commentary?

Gary: Nothing specifically that I'm able to speak publicly about at this time. But I can characterize it in that we've had many conversations with multiple players in various locations across the US--some of the very largest, some of the medium sized, and some of the smaller ones. And I would say that some of those discussions are in late innings, final innings. Some are in the early innings of the game, but there's lots of discussion and, quite frankly, I'd say a lot more interest even in the last six months. I think there's been a real ramp-up in their level of engagement and interest in pursuing this as an option.

Are any of those conversations for a national rollout, or are they more local market by local market?

Gary: Some are national. Some are state by state. And some are smaller.

History has shown that online retail category leaders like Zappos, for example, can get acquired at a high price, in this case close to $1 billion. We've read that glasses company Warby Parker, who is much smaller than Coastal, raised money at something like a $100 million valuation and we saw 1800Contacts get acquired first by private equity and more recently by WellPoint. Could Coastal get acquired?

Gary: It's certainly not something we need to do, and it's not part of our strategy. We are building the best business we can, that we hope will give the greatest return to our shareholders, and we're doing that by impressing our customers and offering them a great offering at a great price. We're just going to continue to grow that business and execute on the strategy.

But we are a public company, which means we're for sale every day in the marketplace. So, if some strategic investor or a strategic player in the optical space or the e-commerce space came to our board with an offer that--I assume they thought would have crystallized the opportunity for shareholders, that they would look at it seriously.

Have you ever received any indications of interest?

Gary: There's lots of interest in the business, right from the shareholders to consumers to people like yourself.

Private equity or strategic players? Or both?

Gary: We talk to lots of people, and lots of people talk to us. But, like I said, we have our head down, we are focusing on growing the business and giving our customers a great experience and building a really successful company that we hope will have great returns for the shareholders.

What are investors missing about the stock right now that, relative to so many transactions that we can look at, shares seem priced very cheaply?

Gary: We believe there's a great opportunity for investors here. We know that the 1-800-Contacts sale to Wellpoint was approximately 2 to 2.4 times revenue. We trade at about 1 times revenue. So we think there's an opportunity there for investors, and that's why we're talking to you and others. Often times, it's the transaction that crystallizes the opportunity going forward for people. So those transactions sort of speak for themselves.

I think, as people understand better the value proposition that we give to our customers, when they understand the value of the contact lens business and how strong that is, how profitable that is, and how stable and predictable that business is, and then, when they understand the value of the eyeglasses potential and the size of that category for us, they get a much better sense of what the company can be worth.

If I told you that I think just the lens business justifies the market cap and the glasses business is basically available for free, would you tell me I'm nuts?

Gary: No. I would say that that's a pretty good valuation when you compare what's out there and you look at the profitability of the contact lens business and value it anywhere near any of these other comparables. That's enough-- that pays for the business itself. And the eyeglasses business, which could be a much, much larger category for us is there as an option for people.

In your meeting with investors, are there one or two things that come to mind as things people often do not get or misunderstand about the company?

Gary: In many cases, people don't understand the inherent safety--the fallback position for their investment that's inherent in the contact lens business. It's very profitable. It's very stable. It's very predictable. It's proven itself out for years. And it continues to grow handsomely. I think people focus on the eyeglasses business because that's new and interesting and obviously has great growth potential but there's always this downside protection they have because, if you ever were to shut off the eyeglasses business, the cash just comes welling up through the floorboards from the contact lens business. When conservative investors understand that, they get far more comfortable with getting excited about the eyeglasses opportunity, knowing that there's some real strong protection for them with a solid, profitable core to this business.

The year is almost over. As you look out to 2014, what are your key goals for the new year?

Gary: We're want to continue to grow the business. We want to continue to extend our lead in the US space for eyeglasses. We want to move towards EBITDA neutrality so that the business stands alone and can continue to grow on its own. And I think you'll see us want to grow some of these partnership opportunities that we're engaged in discussions about now and put some of those on the ledger.

Warren Buffett is famous for investing in businesses with moats around them. What do you view as your competitive advantages?

Gary: I think we have a number of barriers around our business. One of the key ones is our vertical integration. We have developed three state-of-the-art, highly automated optical laboratories--one in Canada, one in Washington state here in the United States, and one in Europe, in Stockholm.

We serve our customers by controlling the quality and controlling the manufacturing process. We're able to ensure that we get a great product to the customer, a great customer experience that others find very difficult to compete with. Most of the other people who start to play in the online optical space are virtual businesses with online marketing. They don't actually hold any inventory, delivery is slow, and the quality is something that they can't control directly. And there are also huge costs embedded in that model as they deal with suppliers and service providers. So we're more efficient and we're more effective. We get better product, better quality to our customers, and are able to blow them away with the offering. And I think that's a huge component of it.

We've also spent, literally, tens of millions of dollars in the last numbers of years understanding our customers, perfecting the website, making sure that the purchasing as people come through the store works well for them. I like to say we've made a thousand mistakes and fixed them all. Somebody starting today has got a thousand mistakes to make and figure out how to fix them. And, by then, we'll already be well ahead of them.

So I think there's a big moat around this business.

Almost out of time. For a shareholder who buys a bunch of stock and is willing to close their eyes and open them five years from now, what do you think they see when they open their eyes?

Gary: I think they see a global market-dominant optical store online that has strong support from managed care around the world and a highly successful, highly profitable business with a dominant lead in the marketplace.

Thank you very much, gentlemen.

Disclosure: I am long COA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no plans to trade in the stock in the next 72 hours. This article and the interview herein may contain historical information and forward-looking statements within the meaning of applicable securities laws with respect to the business, financial conditions, and operational results of the interviewed company (the "Company"). Such statements reflect the current beliefs, views, assumptions, and expectations of the Company with respect to future events and are subject to uncertainties and risks. Many factors could cause the actual results, performance, or achievements of the Company to be materially different from those expressed or implied by such forward-looking statements. Some of these factors may include changes in the markets in which the Company operates and in the general business environment and economic conditions, the loss or gain of customers, unpredictable sales cycles, competitive pressures, market acceptance of new products, inability to meet efficiency and cost reduction objectives, changes in business strategy, and various other factors, both referenced and not referenced in this article. In addition, various risks and uncertainties, including but not limited to those described in reports filed by the Company with the Securities and Exchange Commission or other regulatory organizations, as applicable, may affect the Company's operational results. No obligation is assumed to update any forward-looking statements.