Description

1-800 Contacts (CTAC)

1-800 CONTACTS is the Salt Lake City based provider of contact lens replacements. The company sells all the major brands of contact lenses through its toll free number and internet web site. The company carries over 30,000 SKUs and ships over 90% of its orders within one business day of receipt to its estimated 2 million customers.

CTAC changed the way contact lenses were sold in the United States. Traditionally lenses were bought directly from eye care practitioners (ECPs) who are in the unique position among medical care providers of being able to write and sell prescriptions to favored brands (i.e. perhaps the manufacturer that gave them the most margin as opposed to the best lenses for the customer). Since wearing replacement lenses requires constant reordering, the online channel is the perfect selling medium for this product and CTAC is the leading online provider with about 5.5% market share. The company has built huge brand awareness by investing about $100mm in advertising (50% broadcast) over the past four years. It has an extensive database on all its customers which is an invaluable marketing tool.

Approximately 70% of all lenses are still bought from eye care practitioners and this statistic is where the opportunity for the investment lies. CTAC has been fighting a long running battle with the ECPs and JNJ, whose Acuvue brand accounts for 40% of the company’s sales. JNJ currently refuses to sell directly to CTAC and the company must buy on the grey market from distributors and ECPs. To be price competitive with ECPs, Wal-Mart, and Lens Express, which have a direct selling relationship with JNJ; CTAC must sell Acuvue lenses at breakeven margins. The reason JNJ refuses to ship to CTAC is that the customer retention rate for ECPs is an order of magnitude higher when they prescribe lenses that cannot be bought from alternative channels, and JNJ wants to be seen as on the doctors’ side. So great is the hatred for CTAC among ECPs that many refuse to release prescriptions to the company even at the request of their customers. The company has been fighting various legal battles with JNJ and state optometry boards for the right to get doctors to release customer’s prescriptions. The company just won a major legal battle against JNJ in Acuvue’s hometown of Jacksonville, Florida and there is now in the Senate, “Contact Lens Prescription Release Act of 2002,” which would require ECPs to release prescriptions to customers and agents (i.e. CTAC). This law would supercede the crazy quilt of state laws that restrict patient prescription rights and make it harder for CTAC to operate.

CTAC is also fighting JNJ by trying to steer its customer base to other leading brands such as CIBA or Bausch and Lomb. This quarter, the company completed the acquisition of IGEL, which is a contract lens manufacturer for CIBA. The acquisition cost the company $10mm in cash, 700,000 shares of restricted stock and some deeply out of the money warrants. The cash portion was financed by the company’s existing lender, Zion’s bank, and can be paid down by reducing JNJ inventory to a more normal level (the company had been carrying about $10mm of excess inventory due to earlier supply constraints that have been alleviated through price increases).



Valuation

The company’s profitability has been hurt by the ongoing battle with JNJ. EBITDA has fallen from around $18mm in 2001 to a run rate of about $9.2mm right now. If the company were to stop fighting JNJ today, run rate EBITDA would be about 13.76 once the legal bills stopped flowing. CTAC estimates that it could generate at least $20mm in incremental cash flow if it could buy directly from JNJ.

In the meantime, the company has successfully experimented switching customers from JNJ to other brands by referring them to ECPs that will release prescriptions to CTAC. It was this study that drove the IGEL purchase. IGEL currently breaks even, but CTAC hopes to drive volume through its customer base to its own private label product. That scale should help drive the bottom line. Ocular Sciences makes about 25% EBITDA margins. If CTAC could convert 10% of its roughly $170mm in sales to its own brand at a comparable margin than an additional $4.25mm could flow to the bottom line.

It is worth valuing CTAC under four different scenarios: no settlement of JNJ and no incremental profits from IGEL, no settlement/Senate bill with JNJ and $4.25mm in EBITDA from IGEL, settlement/Senate bill and $4.25mm in EBITDA from IGEL. Finally, we will look at a dream scenario where the company gains share from the 70% that the ECPs hold to grow to about 11% of the market. In this last scenario, margins are held constant and the market does not grow beyond its current size even though neither is likely. So much cash flow is generated in the last two scenarios that I show the company as debt free though in reality they would be earning interest income. Since there is very little capital spending in this business, I view the 15x earnings and 8x EBITDA multiples as very attainable. I have not accounted for IGEL warrant dilution nor have I accounted for any buybacks of stock even though the company continues to buy stock back (2.7mm shares out of 3.0mm authorized). It is worth noting that insiders continue to buy stock as well.

Run Rate IGEL JNJ/IGEL 11% Share
Sales 168.93 185.82 185.82 371.64
EBITDA 9.2 13.45 38.01 76.01
DA 1.7 2.48 2.48 4.96
EBIT 7.5 10.97 35.5 71.05
Interest (.770) (.770) NM NM
EBT 6.7 10.2 35.5 71.05
Taxes (2.7) (4.08) (14.21) (28.42)
NI 4.0 6.12 21.29 42.63
EPS $0.33 $0.507 $1.76 $3.53
LTM CapX 0.7 0.7 0.7 0.7
Debt 19.0 19.0 NM NM

Valuations:
PE @
10 $3.33 $5.07 $17.60 $35.30
15 $4.95 $7.60 $26.40 $52.95
20 $6.60 $10.14 $35.20 $70.60

EBITDA @
6 $2.99 $5.11 $18.87 $37.74
8 $4.51 $7.33 $25.17 $50.33
10 $6.04 $9.56 $31.46 $62.91

EBIT@
9 $4.01 $6.60 $26.44 $52.93
12 $5.88 $10.90 $35.26 $70.57
15 $7.74 $12.04 $44.08 $88.22

If nothing changes on the JNJ front, the company is overvalued and should probably be a mid single digit stock. However, if IGEL works or if the company stops the legal tab and continues to sell JNJ on the black market (the legal bills and IGEL working are about the same improvement to the EBITDA line), the company is probably close to fairly valued at current levels though significant upside would remain for share gains at the expense of the ECPs. If Congress where to pass the current Senate bill and JNJ were forced to sell to CTAC, the upside is tremendous. The stock is a $25-35 stock. The dream scenario probably won’t occur but it is nice to think about a 5-7x your money.

Risks

If nothing changes in the company’s outlook and sales to JNJ customers continue to erode, the stock could be cut in half or worse. It is worth noting that Bausch and Lomb sales were up 8% and CIBA sales were up 18% the previous quarter which all came out of JNJ’s hide since overall sales were slightly down as the company cut back on advertising to fund a build of JNJ grey market inventory. Thus, there is a play here for the other manufacturers to use CTAC to steal share. This company is heavily shorted and as best I can tell the short story is, it is not good to piss off your largest supplier and that JNJ or the ECPs will eventually through the courts or other actions drive CTAC out of business. While this is possible, the company is still profitable despite this battle, has enormous name recognition and brand equity, and a CEO, Jonathan Coon, who is fanatically committed to delivering lenses better, faster, and cheaper. With the IGEL acquisition, he is out to make a sea change in the industry. His fanaticism and the fact that the company is extraordinarily pro-consumer is why CTAC will win.

Catalyst

A Passage of the Senate bill; A legal settlement with JNJ (they may not want to lose share forever); State by state court victories; The IGEL acquisition driving sales and margins higher.