Description

Last year, I wrote up 1-800-CONTACTS essentially as a litigation play based on what I thought was a likely chance of victory in its fight against Johnson and Johnson. The company won that battle and the stock soared to the high 20s. The company achieved most of the gross margin improvements that were promised. However, rather than take those savings to the bottom line, the company has reinvested them into the business and into lobbying for a nationwide prescription release bill. Last week, those investments paid off as President Bush signed the release bill into law. Despite what I view as an enormous catalyst for value creation, the stock is mired at its lows for the year despite the enormous run up in both the internet and retail sectors. I am writing this idea up again with an eye towards the implications of the company’s investment in SGA and the bill that just passed. The proper way to think about CTAC is to compare it to other disruptive companies in an entrenched industry. Like Southwest Airlines in the early days, CTAC is fighting a lonely battle against entrenched competitors who use regulations to impede its progress.

- Optometrists control about 75% of the contact lens market. They are the only doctors I am aware of that are allowed to serve as a retailer and derive a significant portion of their income from these sales. They have been up in arms as CTAC and other alternative providers take their livelihoods away, consequently they often refuse to release prescriptions to CTAC and others – against their patients’ wishes. It is important to note that this position of selling what one's prescribes is unique and highly conflicted. The current distribution system for replacement lenses is built from this model. This model needs to change and will. The prescription cannot and should not be used as a weapon to blunt competition in the lens replacement market. Regardless if CTAC is the company to help drive this change, it is 100% to clear to me that the system as it stands now is flawed. 1-800's growth is a function of how poorly the current system serves consumers. The best analogy to the CTAC situation today is to Southwest’s situation in the early days when AMR tried to use regulation to keep them out of Love field. AMR failed and is on the verge of insolvency today and Southwest is the most profitable airline in the world. Travelers have benefited greatly from Southwest's prosperity, so too shall the lens consumers as 1-800 continues its growth.

- Since CTAC settled its litigation with JNJ in 2002, which refused to sell to them lenses for years, CTAC has markedly improved is gross margins. This settlement has contributed to an over 800 basis point pickup in gross margin in the past twelve months. The company believes that it can get another 500 basis points of gross margin just by getting the same terms as other retailers currently receive or $9.7mm on a run rate basis and $5.8mm net of taxes at a 40% rate. The higher margins would result in a net income increase of $0.44 per share.

- The company has plowed the improved gross margin into lobbying/litigation (more on that below) and SGA to grow revenue. So there has been no impact of the improved margin on the bottom line. Quarter over quarter, CTAC increased SGA, and RD expenses by $7.9mm and incurred an additional $1.6mm in legal, which wouldn’t be needed after a prescription release bill was passed. These expenses total $37.8mm on a run rate basis. At a 40% tax rate, almost $22.7mm of that would fall to the bottom line or $1.73 per share. Because CTAC is following JNJ's verification procedures, it is losing sales to online merchants who don't bother to verify prescriptions. On the most recent earnings call, CTAC said sales would have been $55.0mm had they sold to every customer who came through the transom for the quarter - $6.6mm higher than was reported or $26.4mm annualized. Had they received a 44% gross margin on those sales (their current 39% plus the 5% they say they will get), CTAC would have generated an additional $11.6mm for the year almost of all of which would fall to the bottom line for $7.0mm of net income or $0.53 cents per share. Thus if the company were able to recapture these sales (which should be possible with the prescription release bill), get the 500bp of gross margin improvement on their existing sales, and were eliminate its litigation/lobbying costs (not needed now that the bill is law) and scale back SGA to last year's levels, it would be earning something like $2.50 on a run rate basis (-.20 +.44+1.73+.53 = 2.50) and the stock is trading at a 8p/e.

- But the reason I am long this stock is not for pro forma accounting, it is for the huge potential growth that should come from the prescription release bill. This bill finally creates a uniform legal standard by which customers will be able to force their doctors to release their prescriptions to alternative providers - opening up the 75% of the market that the ODs currently control. CTAC currently has a mid to high single digit market share. As the leading alternative lens provider in the country, it is not impossible to imagine sales doubling or tripling in the not to distant future. If you take the $55.0mm in potential sales this quarter and triple it you get $165.0mm or $660.0mm in sales annually. At a 44% gross margin that is $290.4mm of potential pretax margin. If advertising expense ramps to $60.0mm and SGA caps out at around 11% of sales or $72.6mm, you will have pretax income of $157.8mm and net income of $94.7mm or $7.23 per share. A 15x multiple would yield a $108.39 stock.

- I have been long this stock from the single digits. It is numbers like the ones mentioned above that keeps me buying the stock at these levels. This company should be earning at least $2.00 a share even without the bill. A 20 P/E gets you $40.00 or a 100% return from here. Netflix, which I think has a worse internet based business model, trades at 92x 2004 earnings. That multiple would yield a $184 stock price on $2.00 of earnings - not that I think any company should trade at that multiple but apparently the market disagrees with me.

- In summary, I believe CTAC is cheap on many levels and has the chance to dominate a huge market now that the legal roadblocks have been overturned.

Catalyst

Market share gains from ODs due to prescription release bill and cost savings from ending litigation should drive a large pickup in eps. Multiple expansion to internet and specialty retail multiples would be nice but not necessary to drive value creation.