Description
Rule #1 is “Never Lose Money.” An investment in CTAC combines that principle with a well-known behavioral phenomenon: Humans in general and market participants in particular, hate uncertainty. We thus think that 1800contacts is in the perfect breeding ground of ideas: very little downside risk with uncertain, but abnormally large, upside. We’re going to evaluate the two company segments – retail and manufacturing – separately, and explain the favorable risk/reward tradeoff you get with the stock.
(Disclosure: the investment fund I manage, though small, owns shares of CTAC.)
RETAIL
CTAC has two segments. The first is retail, which is known to the public as 1-800-Contacts. Through both the phone number and the
www.1800contacts.com website, CTAC sells contact lenses directly to customers in the United States. Like any direct-sales business, selling lenses over the internet has earned CTAC enormous returns on capital. Unlike other direct-sales businesses, there is a host of regulatory issues surrounding CTAC’s retail sales.
Regulatory and Industry Background
There are four major contact lens manufacturers in the US market: J&J, Bausch & Lomb, CooperVision, and CibaVision. Ophthalmologists and optometrists sell approximately 55% of contact lenses in the US, followed by chain stores and optical retailers, with ~20% of the market; direct sellers (mail order and online) with ~13.5% of the market; and independent stores with the rest.
Contact lens sales are a cash cow for ophthalmologists and optometrists (henceforth to be known as eye care specialists, or ECSs), as they use their access to the lens-wearer to sell lenses at higher prices than other retailers and the margins are phenomenal. Thus, it’s understandable that ECSs would do everything in their power to make sure that distribution of lenses remains mostly in their hands and not in the hands of retailers like CTAC. Before 2000, the manufacturers did this job for the ECSs by restricting lens sales – they would only sell to the ECSs, and not to the 1-800-Contacts of the world. This would jack up both the margins for manufacturers, who sold to ECSs at high prices, and the profits of ECSs, who sold to patients at high prices.
In 2000 and 2001, 32 state attorneys general decided that this restrictive selling was anti-competitive and won settlements with J&J, B&L, and CibaVision that mandated that the companies would sell their lenses in a non-restrictive fashion (CooperVision was too small at the time to get any attention from the AGs). After a short period of bitterness, the big three started selling to CTAC. The settlement agreement signed by CibaVision expired this past September, with the B&L agreement expiring this month, and the J&J agreement expiring this coming April. So far, it seems like these three continue to sell to CTAC with no hindrances, and we expect this will continue.
After the settlements, ECSs had another trick they used to get patients to buy from them – simply not give them the lens prescription. The patient would have to actively ask for the prescription so he could buy it elsewhere, or he would just order it through the ECS, which is what the ECS wanted. Let’s keep in mind throughout this discussion that only with corrective lenses does the prescriber also sell the end-product, which creates obvious conflicts of interest (profit vs. patient health).
In December, 2003 Congress passed the Fairness to Contact Lens Consumer Act (FCLCA). This mandated that ECSs give patients their prescriptions before they left the office so that they could choose from where they would buy lenses. The law also forces the direct sellers to verify a customer’s prescription with his ECS, and if the ECS does not verify within eight hours of the retailer request, the prescription is deemed valid. The act went into effect in February, 2004 and has been in effect since.
Unfortunately, the FCLCA doesn’t restrict the lens manufacturers from selling certain lenses only to ECSs – that’s left to the AG settlements. But since CooperVision never signed the settlement, they figured that they could get doctors to prescribe CooperVision lenses if those lenses were not available anywhere else but at the doctor’s office. This is the scourge of “doctors-only lenses” that you will see mentioned in the CTAC 10-K about 500 times. I could tell you from my own experience that I’ve had 3 eye doctors prescribe Pro-Clear lenses for me. CooperVision doesn’t sell these lenses to anyone but doctors, so I can’t take the prescription out of the office and buy it online or at Wal-Mart. Of course, the doctor is incentivized to prescribe Pro-Clear lenses because he knows that I have no choice but to buy it from him. Basically, CooperVision figured out a way to bypass the FCLCA because they never signed the AG settlement.
For now, the latest regulatory chapter has been written. CTAC lobbied hard to get Congress to pass a law prohibiting the FCLCA “loophole” – doctors-only lenses – and codifying the AG settlements. In September, Congress basically closed the issue saying that new regulation would create more problems than it would solve. It’s unlikely, though, that the issue is gone. 39 AGs recently wrote to Congress supporting legislation that would ban doctors-only lenses. Also, in April, Utah passed a state bill outlawing doctors-only lenses, and it’s possible that other states will follow.
These doctors-only lenses, according to CTAC management estimates, account for only 3% of the total market, but they have significant effects on CTAC results: they focus management attention on legal issues instead of the core business, decrease operating margins drastically as CTAC spends non-deductible cash on fighting the legal battle, and force inefficiency onto the company supply chain.
Furthermore, CooperVision in general hasn’t been very nice to CTAC when it comes to distributing its products, and CTAC has stated recently that about 20% of its orders have to be filled from indirect sources – i.e. the manufacturer won’t sell it to them. Management estimates that about 50% of inventory is dedicated to these 20% of orders. Many times, they can’t even fill the orders, meaning they lose customers along the way, dampening the growth rate of the business.
That ends the discussion of the status quo. Let’s look at the valuation of the retail business and address some of the risks.
Valuation
|
|
2003 |
2004 |
2005 |
|
Retail Sales (000’s): |
181,331 |
204,406 |
219,559 |
|
Gross Margin: |
37.60% |
40.21% |
39.37% |
|
Operating Margin: |
2.04% |
5.67% |
7.01% |
|
D&A Rate: |
2.46% |
2.18% |
2.27% |
|
Capex Rate: |
0.69% |
1.40% |
2.66% |
|
EBITDA Margin: |
4.50% |
7.85% |
9.28% |
|
Legal Expense Rate: |
3.53% |
2.74% |
2.14% |
We estimate a normalized EBIT margin of ~9%. 2003-2004 EBIT margins are understated due to a mix of lower gross margins, higher legal expenses, and expenses for upgrading IT, which is especially important for a website, and only got operating leverage as sales increased. Looking at the 2005 EBITDA margins of 9.3%, we subtract 1-1.5% for maintenance capex, but add ~1% as we expect legal expenses to come down significantly as a percentage of sales once the whole regulatory mess is cleaned up (it might take a year or two). At 9% normalized EBIT margins on 2006 expected sales of $220M, we get normalized EBIT of ~$20M.
Our model for intrinsic value uses the following assumptions (for a more detailed description of our model, you could see our Tyco writeup earlier this year; basically, it is a simplified DCF model where we use as few inputs as possible – normalized EBIT, ROIC, growth rate, and a WACC):
- ROIC: From the data in the 10-K, we know that the retail segment has $32.5M of tangible assets, for a pre-tax return on tangible assets of over 60%. This probably understates incremental ROIC, as CTAC has increased its revenues in both of the last two years with decreases in tangible assets each year. We use 50% pre-tax ROICs in our model.
- WACC: we use a simple 10% cost of equity and 7% pre-tax cost of debt. With CTAC’s capital structure (debt is ~12% of EV), we estimate the WACC at ~9.5%.
- Growth rate: given the anemic growth in 2005 and so far in 2006, this is a tough one. The recent slow growth has been a product of two things:
- The havoc caused by CooperVision restricting CTAC sales. This manifests itself in cancelled orders and customers not returning because CTAC doesn’t carry the lens they want.
- The lack of advertising in the last year. Anyone who knows consumer businesses knows how much advertising powers a small company with $200M in annual sales. CTAC has abandoned advertising for FY 2006 (this will artificially inflate EBIT margins) in order to concentrate on legal challenges to the doctors’ cartel. At some point in the near future, they will start advertising again and growth will pick up.
In our model, we assume that point (a) is a permanent feature of the landscape and that point (b) is temporary. We therefore assume a long term growth rate of ~4%. There’s very little question in my mind that this is absurdly conservative, but we use it nonetheless. Anything extra is free (we’ll get to all the free options later).
Using the above assumptions, we get a fair EV/EBIT of ~11. At the risk of repeating myself too often, 11x EBIT for a stable cashflow business (customers need to get new lenses all the time), with >60% pre-tax ROICs, is really cheap. 11x EV to our normalized EBIT estimate of ~$20M gets us to $220M for the business. That’s $14/share after accounting for the debt.
Risks
No discussion of valuation would be complete without acknowledgement of what the valuation does not include, both on the upside and the downside. We’ll address the downside first. In our view, there are two major risks to the retail business:
- Further doctors-only penetration: as the settlement agreements with J&J, B&L, and CibaVision expire, there is the risk that these three companies will look at the success that CooperVision has had with Pro-Clear and create their own “doctors-only” lenses. This would wreak further havoc on the CTAC supply chain, as CTAC would strain to find ways to carry the inventory and would have to go through several middlemen, like it has to with Pro-Clear presently. The larger negative effect on CTAC, though, would be a larger segment of the market not available for it to sell.
How would this affect valuation? Assuming that the aforementioned three companies do introduce their own doctors-only lenses, and that they each gain the same market share that CooperVision’s doctors-only lenses have (3%), this would mean 9% market share for the new doctors-only lenses. Take that away from CTAC’s present unfettered access to 80% of the market, and you can shave off 12% of our normalized EBIT number. Using that number, with the same assumptions as before, that would still bring us to a fair EV of ~$195M, or $12/share after accounting for debt.
We’d like to chime in with our opinion as to what the odds are of the three manufacturers doing something like this: it’s extremely unlikely. Given the recent support of the 39 state AGs for a national codification of their previous settlement, and given the “Spitzerization” of the AG role (i.e. the propensity of AGs to get free publicity by fighting “for the public interest”), we think the AGs would go after the manufacturers if they ever tried a stunt like this. And if it does happen, and the manufacturers get sued, CooperVision won’t be left alone this time around.
- Manufacturer hardball tactics: another possibility now that the AG settlements are expiring is that the three manufacturers decide to play hardball with CTAC the way CooperVision does. That means not only restricting CTAC from selling doctors-only lenses, but restricting CTAC from selling any of their lenses. Honestly, this would mean all bets are off with our investment thesis – margins would contract, sales would contract, etc.
Thankfully, we really don’t expect this to be within the realm of manufacturer options for two reasons:
- 1-800-Contacts now represents 7% market share of lenses sold in the US. In a mature and competitive market, we think the major manufacturers would be loath to give up any market share to competitors. Further, ECS share of lens sales has been reduced from 75% to 55% over the last 3 years. We don’t think that the big manufacturers would risk the wrath of the Wal-Marts and Targets of the world in order to influence consumers to go through ECSs.
- The legal environment would definitely be hostile in this case. If you think the AGs would get busy if the three manufacturers introduced doctors-only lenses, imagine what would happen if they tried to restrict their entire product lines.
Free Options
Here’s what you’re getting for free with CTAC’s retail division:
- What if the doctor-referral network works out? CTAC is working on building a network of doctors that would work as follows: John Doe goes to the 1-800-contacts website because he needs lenses. He knows his prescription is expired, but the website says you can “call this number” and they will arrange an appointment for John with a doctor at a convenient time and place. When that doctor sees John and prescribes him lenses, he will work through www.1800contacts.com. The whole concept is to make a sufficient number of doctors revolt against the cartel. Will this work? CTAC already has over a thousand doctors in the network and I don’t have to explain the power of the network effect to this audience. This would have the power to totally change the long run economics of the business, but you’re getting it for free. This brings us to…
- Long run change in the industry: from Econ101, we all know that most cartels, in the long run, are broken up by free market forces, whether that’s competition or price or cheating within the cartel. It looks like CTAC is doing whatever it can to induce that cheating by building the aforementioned doctor network. If the cartel were broken, CTAC management expects sustainable growth to be in the 8-10% range, while margins would be higher (as CTAC didn’t have to go through several middlemen to get 20% of its inventory) and cashflows would increase due to a less intensive inventory requirement. This is what bedrock referred to in his previous write-up of CTAC when he compared it to Southwest –the long run erosion of the cartel’s power.
- More legal action: This could come in a number of ways. CTAC could convince state legislatures to do the codification that Congress didn’t do. They already succeeded in Utah, and they’re trying in other states. Another possibility is that with a change in Congressional leadership, Congress would take up the issue again in the name of protecting the consumer. Yet another possibility is that the AGs get back on the case, as they have shown an interest in doing, and scare the entire industry into breaking the doctors’ cartel and selling through all distribution channels on a competitive basis.
So you’re looking at an unlikely downside scenario where the retail division by itself is worth $12/share, and an upside scenario where it’s worth well over $20 share, with what we consider to be a median valuation at $14/share. And we’ve only looked at half the company!
MANUFACTURING
CTAC’s manufacturing division is called ClearLab. If you want more info, you can read the 10-K, but briefly, ClearLab develops, manufactures, and distributes contact lenses. This includes manufacturing private label contact lenses for retailers along with developing innovations in the field on lenses. The business was put together through a series of acquisitions several years ago and has manufacturing operations in Singapore and England. As you might expect, ClearLab really can’t sell any of their lenses into the largest lens market in the world – the US – because it would be competing with its suppliers in the retail side of the company.
Part of the disappointment investors have had with CTAC shares has been the performance of this division, which was supposed to break even by the end of FY 2005. Unfortunately, it’s still been hemorrhaging money recently and has been beset mainly by capacity utilization issues as it a) ramps up its contract manufacturing business and b) introduces a revolutionary innovation in lens design and packaging.
Intellectual Property
If you’re wondering what a puny player like ClearLab with annual sales of $20M (and a lot of losses) can do to revolutionarily innovate against the largest players in an industry with global sales well over $10B, then look at ClearLab’s licensing deal with Menicon, the largest lens manufacturer in Japan (the third largest contact-lens market in the world, with 25% of the global market).
In June, CTAC hosted a large presentation about the breakthrough subject of the deal. For details about the product, you can sit through the presentation here:
http://www.aquasoft.com/. Briefly, ClearLab has developed a patented method of manufacturing and packaging lenses – branded with the name Aquasoft – in an incredibly convenient manner for lens-wearers, with the side benefit of also being healthier for one’s eyes.
For the exact terms of the deal, I would advise the reader to look at pages 28-29 in the 10-K that CTAC filed in March of this year. In short, Menicon licensed the IP, including lens material, manufacturing technology, and related knowledge from ClearLab. In return, ClearLab received a $10M upfront payment with another $8M in payments over the next two to four years hinging on regulatory and production milestones achieved by Menicon. Once Menicon actually launches the product, it must pay CTAC a minimum of $5M annually beginning the earlier of the second year after product launch or 2012. Based on discussions with CTAC management, if the product is successful in the Japanese market, the annual royalty payments would almost certainly exceed the minimum.
The Search for “Strategic Alternatives”
At this point , CTAC has only 25% of the market covered with its Aquasoft lens through the licensing deal with Menicon. Given that a) CTAC can’t develop the IP on its own to sell into the US because of the conflict with the retail suppliers and that b) setting up the manufacturing facilities in order to develop the IP in the rest of the world will require a lot of capital, CTAC announced in its Q2 earnings release that it exploring strategic alternatives for the ClearLab division.
The uncertainty here is significant as nobody really knows what the value of ClearLab is. At the present stock price, this entire segment is basically a free option at this point, as the valuation of the stock is a pretty good deal even if we were just paying for the retail operation. But it’s worth looking at the potential value of ClearLab in a sale to a strategic or financial buyer.
Valuation
It’s not worth looking at ClearLab’s financials as a starting point for a valuation as the segment is a startup, with a sporadic cost structure. There are a couple of ways we can look at the valuation of this segment:
- The investment in ClearLab thus far: management has estimated that up to this point, the total investment in ClearLab has been ~$100M. Management also firmly believes that the division is worth more than it has invested in it. If we just take management’s word (and I agree that this should often be labeled as dangerous to one’s portfolio), then the division is worth an extra $7/share.
- Let’s do a really conservative analysis of the division based on potential royalty revenues if ClearLab were licensing its IP to manufacturers across the entire world market for lenses instead of just 25% of the world market in Japan. (CTAC can’t really license the IP to a manufacturer in the US, as it would risk alienating the entities that supply its retail segment.) This would come out to ~$74M in upfront revenue and a $20M minimum annual revenue stream. At 3-5x royalty sales (which is grossly conservative given that this would basically all flow to the bottom line) and a 50% haircut on the upfront revenue (assuming only 50% fell to the bottom line), you get a value for ClearLab of $95-130M, which fits with management’s estimate of “more than what was invested so far.”
Risks and Free Options
The main risk to our above valuation is that the IP is either worthless or worth a lot less than we think it is. To be totally honest, we are not experts in this field. We’re relying on both our conversations with management and, much more importantly, the Menicon licensing deal, as corroborators of the fact that the IP is indeed valuable and protect-able.
The above valuation of the royalty stream carries with it a nice margin of safety:
· We assume that the actual manufacturing operations not related to Aquasoft (the private label and other manufacturing operations) break even and are worthless. If these operations could get the operating leverage necessary to operate profitably (a clear possibility for a strategic buyer), these operations would be worth something.
· We don’t assume upside to the annual $5M in revenues that Menicon is guaranteeing. If, as management has stated, the royalty payments stand a good chance of being higher than the minimum, our valuation would rise accordingly.
· The value of NOLs: ClearLab has lost plenty of money in the past and will not have to pay taxes until it recoups its investment. For the Singapore operations this is not a big deal given that ClearLab’s tax rate in the country will be zero for the next five years as a result of certain Singapore tax benefits. But in the UK, there are NOLs that we are not even figuring into our valuation that would certainly have value to an acquirer.
COMBINED VALUATION
Based on a sum-of-the-parts valuation, we think putting a $320M EV on the entire business ($220M for retail, and $100M for ClearLab) is conservative, and gives you a total value of $21/share after accounting for debt. Furthermore, your downside is incredibly well-protected: the balance sheet is in good shape, and the IP assets of ClearLab mean that you’re getting the retail division for really cheap.
The problem is that the sum of the parts is worth more than the whole. The retail business is a severe hindrance to the expansion of the ClearLab business, and we suspect that the manufacturing losses and R&D development are a drain on management resources that could be used for the retail division. Thankfully, management knows this and is exploring all options to separate the two businesses so that the maximum value could be extracted for shareholders. As an added bonus, CTAC wouldn’t be subject to very much taxation from a sale of ClearLab given the amount invested in it thus far.
Risks
The main risk to our thesis, aside from the segment-level risks, is that no transaction takes place and management is unable to exploit the value of the company’s assets. We think that risk is outweighed by the fact that the management team and other insiders own 31% of the company (CEO Jonathan Coon owns 21.5% of shares outstanding) and are thus incentivized to create as much value as possible for all shareholders.
We also think this board would be interested in the fact that the shareholder base is quite stable – aside from the 31% of the company owned by insiders, four value shops own another 40% of the shares. These investors are unlikely to bail out at the first sign of trouble, and validate our claim that there’s a lot of value in these shares that the market is missing (the largest of these holders, Frank LaGrange Johnson, just joined the board of directors last week).
As the retail side of the business continues cracking the cartel, and the manufacturing side of the business is sold or gains traction in some other way (capital injection, etc.), the market will realize the shares are worth a lot more than the conservative $21 we assign them.
Catalyst
1. The “exploration of strategic options” comes to fruition and the earnings power of the retail segment is unmasked.
2. Any type of regulatory breakthrough causes a liberalization of the market, a jump in CTAC’s retail earnings, and a brightening of future prospects.
3. The doctor-referral network starts gaining traction, the powerful network effect takes hold, and this causes operating leverage kicks in significantly.