Description

Essilor is a historically great business with advantages in scale/IP/technology that is becoming a more commoditized contract manufacturing business.  We expect earnings to disappoint as recent price concessions to a consolidating customer base should get worse not better.  We’ve heard pretty consistent feedback from customers and competitors, but these risks aren’t yet part of the discussion on the street and are not priced into the stock.  We believe the multiple may de-rate significantly from ~29x it trades at today (all time multiple high), and the stock price could fall 50% to 15x a lower earnings number reflecting pressure on profit and ROIC going forward. 

Business Description and Background 

Essilor is the world’s largest designer and manufacturer of corrective lenses for eyeglasses, with approximately 40% world wide share. The company is involved all portions of the value chain from the design, manufacture, and distribution of lenses. Their customers are either the labs selling to optical retailers, or in a case where Essilor owns the lab themselves, they would have a direct relationship with retail. The company has three segments – lenses, equipment and readers (reading glasses) with lenses accounting for 90% of revenue and substantially all the profit. Based on our math and work in the field, we believe progressive lenses and coatings account for around 75% of the company’s overall profit. The company has always been a favorite of French investors given its historic steady 3.-5% organic growth, exposure to demographic trends like an aging population and global growth, along with a well regarded management team and has thus generally traded at a significant premium to the market.

Thesis

This has historically been a pretty good business with an oligopolistic market structure, especially with respect to progressive lenses. That is changing dramatically due to the fragmentation of intellectual property around lens designs and increasing competition among varying actors in the value chain creating broad deflation in the eyeglass market. Essilor’s products are becoming less differentiated as progressive lenses become much easier and cheaper to produce. Furthermore, retailers realize that Essilor has no brand awareness among consumers, so anyone with scale is creating their own private label brand using lenses that cost €10 or less vs. the average of about €35 that Essilor historically receives. Essilor is actually acting as a contract manufacturer for companies like WMT and COST who are selling lenses under their own brands, but this is happening at ASP’s that are a fraction of what Essilor would make selling to an Eye Care Professional (ECP) where they can make around €100 for a high end progressive lens. Importantly, these lenses are sold at gross margins in the 90% plus range and the cost to produce them is nearly identical to those on the lower end. We calculate that a 15% decrease in the average price of progressive lenses would reduce gross profit by almost 30%. Field research tells us that several chains in Europe are moving to private label aggressively and Essilor can be swapped out very easily with no impact on sales. This was demonstrated last year as the company lost a large contract in northern Europe with the chain Grand Vision after an aggressive tender in which prices were reduced 15% year to year.

Essilor is also being pressured by other members of the optical value chain. One example is the insurer VSP who is building out their own lab network and mandating that doctors send orders from VSP patients to those labs. Furthermore, VSP is creating their own private label designs and incentivizing doctors to steer patients towards them. This, in combination with pressure on reimbursements to doctors is making VSP a real issue for Essilor. It is evident that these circumstances are pressuring the company. They have recently announced a 5x increase in marketing spend in an effort to drive consumers to ask for their brands, and they are acquiring companies outside their typical core competency (sunglasses, online retail) in order to broaden their addressable market.

 We will likely see these issues manifest themselves in a reduction of Essilor’s lofty multiple as investors start to recognize the risk to future profit and earnings.  

Catalyst

Contract losses and reprices rolling in over time pressuring profitability and outlook.