Attractive Valuation Or Is Luxottica's Business Model At Risk?

| About: Luxottica Group (LUX)

Summary

Luxottica has been dominating the eyewear market for decades.

The company has many sustainable competitive advantages.

High gross margins indicate strong brand power and stable demand.

Increased competition and management uncertainty are a cause of concern.

The stock has fallen 33% YTD but still trades at relatively high valuation multiples.

Luxottica (NYSE:LUX) is the largest eyewear company in the world with a market capitalization of ca. €20B. The company primarily designs, manufactures and distributes mid to high-end eyewear products. It also directly sells those to the end customer through online sales and a strong retail net work.

Sustainable Competitive Advantages:

* Vertical Integration - Luxottica achieved its quasi-monopoly power over the years through excellent integration of acquisitions and execution of its vertically integrated business model. The company is involved in all parts of the value chain. It creates and designs the products after which these get manufactured in their production facilities and distributed through its logistics network in over 150 countries. About 20 years ago, the company also entered the retail space and now has a network of over 7,200 stores worldwide that accounts for ca. 60% of its revenue. Its retailing experience is also vertically integrated as in some stores the customer can purchase his glasses after having had an eye exam in-store. To complete its vertical integration, Luxottica also owns the second largest vision benefits company in the U.S. (EyeMed). The only space in which Luxottica is not a dominant player is the production of lenses. In this space Essilor (OTCPK:ESLOY), Hoya (OTCPK:HOCPY) and Zeiss (OTC:CZMWF) are the key players.

* Non-cyclical industry - Luxottica's revenues are primarily derived from the sales of prescription glasses and sunglasses. Except in underdeveloped countries, almost every single person has a pair of sunglasses. Other than giving you protection from the sun, sunglasses are also largely considered a fashion accessory. Given that this is very likely to stay in place, it is a very sustainable product and solid business to be in. Prescription glasses are also very sustainable products as vision correction is a necessity. With approximately 2.5 billion people in the world who need glasses or eye improvement measures, it is very likely the most common flaw of the human body. With people spending less time outdoors and staring at screens more than ever before, it is unlikely that this will improve. On top of an aging and growing population, about 1 billion people do not have access to the eyewear they need. Consequently, this market has plenty of room for growth especially in emerging markets. Alternatives such as contact lenses and surgery are taking away some market share but the market for glasses is expected to remain strong. This is because most people who wear contact lenses also own a pair of glasses and surgery remains an expensive alternative with risks involved.

* Brand Power - The name Luxottica will not sound familiar to many people. However, the large varieties of brands they own or have licensing agreements with are among the most well known brands worldwide. Among others, Luxottica owns Ray-Ban, Oakley and Persol. At the same time it has licensing agreements to design, manufacture and distribute eyewear for brands such as Prada, Chanel, Bvlgari, Burberry, Versace, Armani, Dolce & Gabbana, Michael Kors (NYSE:KORS), Ralph Lauren (NYSE:RL) and many more. Given that so many fashion companies are nowadays active in this industry, it can be said that Luxottica can be partially credited with making glasses 'cool' again.

* Pricing Power - Glasses are the first thing people put on in the morning and the last thing they take off at night. They thus form part of the 'look' of a person who needs to wear them constantly. Given that people who need subscription glasses wear them so often, most people are willing to pay a premium for a fashionable premium brand. Similarly, sunglasses are fashionable and are even called 'face jewellery' by some people. Given that sunglasses form an integral part of peoples' appearance, especially in sunny countries, most are also willing to pay a premium for such an accessory. On top of these fundamentals, Luxottica owns the largest optical chains that include Sunglass Hut, LensCrafters, Pearle Vision, OPSM and glasses.com, among others. Furthermore, they have retail licensed brands that include Sears Optical and Target optical and host relationships that include Macy's. This retail footprint coupled with the strong brands in its portfolio gives Luxottica very strong pricing power and as such can be considered a 'price maker'. The retailers need Luxottica's brands in their stores if they want to offer a large variety of prestigious brands. This is evidenced by the high prices and by their recently implemented minimum advertised price policy in the U.S. & Canada. At the same time other brands want access to Luxottica's retailing business. If LensCrafters and/or Sunglass Hut decide to drop a certain brand, sales of that brand will experience large headwinds, as was the case with Oakley before Luxottica acquired the company.

Competition:

Luxottica is the clear market leader in the mid to high-end eyewear industry. Its closest competitor Safilo (OTCPK:SAFLY) has license agreements in place with brands such as Gucci, Hugo Boss and Givenchy among others. However, sales in the wholesale division of Safilo are 3x less compared to Luxottica and Safilo's retail presence is as good as non-existent with less than €100m in sales. Safilo had negative EPS in 2015 and in general its financial and operating ratios are nowhere near as consistent and healthy as Luxottica. This is reflected in its market capitalization of ca. €0.6b.

A growing and more threatening competitor is Warby Parker, which was founded in 2010 with the specific purpose to take away market share from Luxottica. Warby Parker is primarily an online retailer that offers designer prescription glasses and sunglasses. They have an excellent and easy to use online platform. Their online business model is simple; you can choose 5 different frames that you can try for 5 days. They send those to you and after 5 days you send them back with the prepaid return label they provide. Upon making the online purchase, they will send you a new pair. The glasses offered are much cheaper and the concept seems to be working, as they are growing rapidly and attracted investments from American Express (NYSE:AXP) and Mickey Drexler among others. Clearly, it is too early to call them a significant competitor as they do not have any licenses with famous brands and have a retail presence of only 37 stores.

Given that Luxottica's products are considered to be upper scale and expensive, it faces additional competition from the lower priced category from companies such as Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST). Luxottica derives about 60% of its revenue in North America and only approximately 18% in Europe. In Europe, revenue is driven by the wholesale business as retail revenue accounts for less than 20% of total European revenues. In Europe, there is more retail competition with Fielmann (OTC:FLMNY) and Grandvision. Retailers Grandvision and Fielmann sell Luxottica brands in their stores and it is the combination of wholesale and retail that gives Luxottica its dominant position.

An almost identical concept to Warby Parker exists in Europe with Ace & Tate. Ace & Tate is also growing rapidly and started out in Amsterdam. It now has a presence in several cities in the Netherlands, Belgium and Germany. Through its online business model it is able to grow very rapidly and reach many customers. Luxottica's vertically integrated business model is unique and is likely to remain the dominant player in the industry for the foreseeable future. However, even though it might take many years, the biggest threat is not from other high street retailers but rather the rapidly growing online businesses providing quality designer glasses at a fraction of the price. Those businesses are also vertically integrated as the design and manufacturing process also happens in-house. In case one of the luxury brands enters into a license agreement with either Warby Parker or Ace & Tate, Luxottica's dominant position will be in danger.

Management

Today Mr. Del Vecchio has voting rights over 60% of the issued shares through a company named Delfin S.à.r.l. Generally, it's positive to see management with a significant stake in the company. The problem in this case is that Mr. Del Vecchio is 81 years old and holds the majority, which gives him complete control. For example, several years ago there were merger talks with lenses manufacturer Essilor, which is of similar size to Luxottica. Luxottica decided to end the talks and it is believed that the dilution of Del Vecchio's stake in such a deal was a key reason that talks did not continue. Unlike Berkshire Hathaway (NYSE:BRK.B), which has been thinking of a succession plan for many years, Luxottica's Del Vecchio just recently returned as an executive to the company after an absence of about 10 years. He has indicated that he returned for succession planning purposes and intends to leave its executive role in a few years but this brings uncertainty. After 3 CEO's have departed within 15 months, Management seems more stable with Massimo Viane and Del Vecchio himself in charge now for almost 2 years. However, it is unknown how the company Delfin will be split should Mr. Del Vecchio pass away. Disputes among family members are not uncommon, especially given the fact that he has children from three different marriages.

Operations

Luxottica has been enjoying continuous excellent gross margins above 65%, indicating strong brands and pricing power. In this respect, Luxottica belongs in the same category of companies such as Alphabet, Microsoft, Coca-Cola and LVMH. EBITDA & Net Income margins are not as impressive but are still considered to be very healthy.

Margins

2011

2012

2013

2014

2015

Adj EBITDA

18,30%

19,05%

19,57%

20,30%

21,30%

Adj Operating Income

13,20%

14,00%

14,56%

15,30%

16,01%

Adj Net Income

7,30%

7,90%

8,44%

8,93%

9,48%

Click to enlarge

Source: Annual Reports 2011-2015, Atid Capital in-house

Management has been rather successful at growing operating income and net income at double the rate of revenue growth. However, this target has been revised downwards twice this year. First it was expected to slow to 1.5x the growth in sales in 2016 and after the H1 2016 results it has been revised downwards to grow at the same pace as growth in sales. The reason therefore is the weak macro environment and increase in growth capex but the latter should eventually lead to faster growth rates again for operating income and net income margins.

As Kenra Investors mentions in its article, we also have some short-term growth concerns. We would need to wait and assess the upcoming sales figures in order to conclude whether this slower growth is temporary or not. Nevertheless, we are optimistic about the company's growth prospects ad its solid expansion plans in the long term.

The ROE has increased consistently from 13% to almost 17% over the last 5 years, implying that management delivered an excellent job. Generally, we look for a ROE of at least 15% and as such Luxottica passes this test.

Leverage

Luxottica also does not have any risk in terms of leverage. It has been deleveraging very rapidly over the past 5 years and now has a Net Debt / EBITDA ratio of 0.54 and a Debt/Equity ratio of 0.35. Earnings before Interest & Taxes can also cover interest expenses almost 13x. The very low debt levels are a prudent strategy but also slow the rate of growth. Nonetheless, this gives the company plenty of opportunities to increase its leverage. Consequently, they are able to make large acquisitions and/or invest in its business to grow organically.

2011

2012

2013

2014

2015

Total Debt / Equity

0,81

0,61

0,50

0,50

0,35

Net Debt / EBITDA

1,80

1,25

1,03

0,66

0,54

EBIT/Interest Exp

6,7

7,0

10,3

10,6

12,9

Click to enlarge

Source: Annual Reports 2011-2015, Bloomberg

Valuations

Two quick valuation metrics that give an indication of the valuation of a company are the EV/Revenue ratio and the EV/EBITDA ratio. As a rule of thumb, companies trading below an EV/Revenue ratio of 2 and/or an EV/EBITDA ratio of 10 are considered relatively cheap and demand further analysis. The current EV/Revenue ratio for Luxottica stands at 2.3 and its EV/EBITDA ratio is slightly below 11. These are fairly low ratios for companies with the likes of Luxottica but also not cheap. However, the current EV/Revenue ratio and EV/EBITDA ratio are at their lowest levels for many years, which are signs of undervaluation.

EPS

The table below shows a consistent compounded annual growth rate of 15% for EPS and dividends, which is well above the 12% we generally require. In addition, it can be seen that we are now able to buy the stock at multiple levels seen in 2012.

2011

2012

2013

2014

2015

2011-2015 CAGR / Current data**

Adj EPS

0.98

1.19

1.30

1.44

1.78

15%

Div per share

0.49

0.58

0.65

0.72*

0.89

15%

Avg sh price

21.5

27.5

38.3

40.6

59.3

41.0**

Adj EPS multiple

21.9

23.1

29.5

28.2

33.3

23.0**

Click to enlarge

* Excl special dividend
* Data as of 13/10/2016

Source: Yahoo Finance, Annual Reports 2011-2015, Atid Capital in-house

FCF

Earnings multiples are of uttermost importance when assessing the entry point of a stock. However, we believe that free cash flow is the key measure that must be looked at. Luxottica mentioned that their capex includes both growth capex and maintenance capex. The ratio in recent years has become roughly 50/50. Consequently, we add growth capex to net income to calculate free cash flow. We added 10 percentage points to maintenance capex as the distinction between growth and maintenance is sometimes difficult to make. For example refurbishing a retail store could be considered growth as it should increase sales but at the same time it could be maintenance, as an outdated store would suffer from declining sales. So in case of 50/50 growth vs maintenance capex, we used 40% growth and 60% maintenance capex. These calculations lead to the following table:

2011

2012

2013

2014

2015

2011-2015 CAGR / Current data*

FCF (€ m)

600.38

851.40

746.90

957.03

973.60

15%

Avg share price

21.5

27.5

38.3

40.6

59.3

41.0*

FCFm/sh.

1.30

1.83

1.58

2.01

2.03

2.03*

Multiple

16.5

15.0

24.2

20.2

29.2

20.2*

Click to enlarge

* Using latest share price and 2015 data

Source: Annual Reports 2011-2015, Atid Capital in-house

On this basis, Luxottica generated almost €1B in Free cash Flow in 2015. Given its current market capitalization of €20B, that leads to a FCF multiple close to 20. This metric makes the current valuation more attractive in comparison to the higher PE multiple.

Conclusion

Using last year's EPS of 1.68 and the current share price of 41 indeed gives a PE multiple of 24.4. On an EPS adjusted basis this gives us a multiple of 23.0. However when looking at Free Cash Flow the multiple is more attractive, close to 20.

In terms of valuation and entry point, our conclusion is in line with the article previously mentioned by Kenra Investors. Given the current weaker growth figures, increasing competition from the online business models and management uncertainty, we would be looking to enter at an earnings multiple around 20 as Luxottica remains a fantastic business. Should these concerns not have been there we would even consider entering at an earnings multiple around 25. In addition, a FCF multiple below 20 for a company with the likes of Luxottica is also attractive. Consequently, if we assume the same profitability levels as in 2015, a further 10-15% decline in the share price would certainly make us initiate a position (share price between €35-37).

We also agree with Kenra Investors that with the S&P trading at a PE multiple in excess of 25, the market in general is at risk of significant declines. Therefore we are happy to wait for further multiple contractions.

Luxottica is a company we would like to have in our portfolio for the long run given its sustainable competitive advantages. It is an excellent stock for diversification purposes as it has a unique business model. The stock has already fallen 33% year-to-date. We are eagerly awaiting a further decline of 10-15% to initiate a position.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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