The merger between Luxottica (NYSE:LUX) (OTCPK:LUXGF) and Essilor (OTCPK:ESLOF) (OTCPK:ESLOY) will create by far the biggest eyewear company in the world. While cost synergies could be significant and the company's moat would widen thanks to the higher vertical integration, I think the current valuation is still not attractive. With the Fed tightening, an overvalued market and still some doubts on the company's growth prospects in the medium term, I think EssilorLuxottica is not a stock to buy at the moment.
An unexpected deal (for me)
Luxottica and Essilor have agreed a $50 billion merger that will create a global eyewear giant with revenue of roughly $16 billion in a $90 billion industry.
Shares of Luxottica and Essilor jumped 8% and 12%, respectively, suggesting great optimism around the effects of this deal. We can easily understand why. The deal will merge two leaders in the eyewear industry, creating a huge, vertically integrated giant that will manage all the stages from the production of lens to retail sales.
Investors who are familiar with these stocks know that the level of vertical integration of Luxottica is not replicable by competitors and constitutes a strong competitive advantage. The moat that Luxottica was able to build during the years can protect the company from every competitor in the market today.
Luxottica's wide moat is based on a combination of brand power and vertical integration. Regarding brands, the company owns Ray-Ban, the most famous eyewear brand in the world, and several other known brands such as Oakley, Persol, Alain Mikli and several others. It is also the largest licensee of brands in the eyewear industry, through agreements with Bulgari, Giorgio Armani, Chanel, Prada (OTCPK:PRDSY) (OTCPK:PRDSF), Michael Kors (NYSE: KORS), Burberry (OTCPK:BURBY) (OTCPK:BBRYF), Coach (NYSE: COH), Dolce & Gabbana, Versace, Tory Burch and many more. As I said, Luxottica manages all the stages that go from production to retail sale, and it's a dominant player in all those stages, with the exception of the production of lenses.
This was true until last Monday. After the merger with Essilor, the new company will be the dominant player in every stage and segment of the market.
I was almost shocked by this deal. I really thought that other smaller players would try to merge in order to compete with Luxottica. My idea was that players like Safilo Group (OTCPK:SAFLF, OTCPK:SAFLY) and Grandvision could join forces in order to create a vertically integrated player that could compete more effectively with Luxottica. Instead, the most vertically integrated company decided to become even more vertically integrated and chose to join forces with the global leader in the production of lenses to reach this goal.
Every time two big players announce a merger or an acquisition, many investors are concerned that competition authorities could block the deal. According to antitrust laws in the western world, agreements between two or more independent market operators which restrict competition are forbidden. Moreover, Antitrust laws usually prohibit companies that have a dominant position in a market to abuse that position, for example by charging unfair prices, by limiting production, or by refusing to innovate to the prejudice of consumers. It's not easy to understand whether there are good reasons to block this deal or not.
First, Luxottica and Essilor operate in different stages of the "production cycle". The complementary nature of the two companies permits significant cost synergies, a more efficient productive process and cancels the possibility of detrimental competition between the two companies in the future, if one of them decided to expand in the counterpart's segments. Honestly, I don't see anything that could be put in place by the new group and that could hurt customers.
Nonetheless, the merger will significantly improve the group's position against Essilor's competitors, such as Carl Zeiss AG (OTCPK:CZMWF, OTCPK:CZMWY) and Hoya Corporation (OTCPK:HOCPF, OTCPK:HOCPY), and will be an issue for Luxottica's competitors. The point is, Luxottica's rivals use lenses produced by Essilor, which means that, after the deal, their main supplier will be also their main competitor. At the same time, the two companies are sure the merger will not be blocked because t he global giant will have only 15 per cent of the world market. This is actually a very little number compared to other deals that have passed antitrust scrutiny, such as the merger between AB Inbev and SABmiller, which together control 30% of the beer market in the world. Moreover, the development of e-commerce channels has changed the competitive landscape and permitted the entrance of other players that are constantly gaining market share (e.g. Warby Parker), and the merger will not reverse this trend easily.
Considering the market share of the new company and the complementary nature of the two businesses, I think the probability of an intervention by antitrust authorities is very low. Anyway, we should monitor the situation and try to understand the authority's approach to this deal.
I have never written about Essilor, but in several occasions I said that Luxottica was a good stock for long-term capital appreciation, thanks to its wide moat and the possibility to exploit favorable industry trends.
In the past few months I have been a bit skeptical about the company's valuation in comparison to its growth prospects in the medium term and, while some of these concerns remains, we can be sure that the deal with Essilor will improve results. Significant cost synergies will boost profits and, if the group's prediction is right, operating income will rise by up to €600 million in the medium term, which means by 23.7%. If we assume a proportional increase in net income, the group is currently trading at 26 times forward earnings.
According to management, the group could be better positioned to exploit growth opportunities in Asia and Latin America. As I said in my previous article on Luxottica, growth in those regions is the only factor that can justify the current valuation. But performance in the emerging markets remains to be seen.
There is no doubt that after the deal EssilorLuxottica will be stronger than Luxottica or Essilor alone, and with an even wider moat. Nonetheless, my doubts on the current valuation remain.
Paying 26 times forward earnings only for the moat is too much. There are too many risks involved. Cost synergies could be less than expected and the environment in the fashion industry could remain unfavorable for a while, due to a strong dollar. Moreover, the market is trading at the highest multiples of the last century, if we exclude the .com bubble, and the Fed intends to raise interest rates several times this year. I am not concerned about the group's prospects, but I think that with the Fed tightening and the stock trading at these multiples, the present value effect of higher interest rates could limit the upside and may even trigger a correction. I am bullish on the new company and I am very positive on the effects of the merger on the business, but I don't think the new stock is a good buy at the moment. I think that for both Essilor and Luxottica, the most reasonable rating remains a HOLD, since I don't see a favorable risk reward at these levels, but I don't see a high risk of significant downside either.
On the other hand, I think other deals in the industry could follow in the short-medium term. I have been following the industry for a while and I think a deal between other companies (e.g. Safilo Group and Grandvision) is plausible, especially now that the two market leaders have joined forces.
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Disclosure: I am/we are long KORS.
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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