Value Investors Club / Eyelogic (EYE.A)

Description

Eyelogic is a tiny Canadian microcap with a trailing P/E of 10.5, a dividend of 6%, tremendous growth prospects, and several near-term catalysts that could, over the next few years, make this a multi-bagger. The market cap is very tiny (~$6M Canadian), and the stock is extremely illiquid, with insiders holding over 35% of the stock. Sorry, but as you might expect, this opportunity, for the time being, is only suitable for personal accounts. The stock is very illiquid, but less so around earnings releases, which provide the best time to build up a decent sized position. You can also try to negotiate a private transaction with management, which owns over 35% of the company, but most insider sales are usually gobbled up by other insiders. With earnings expected to come out sometime within the next week, this will hopefully be a timely post.

The situation
I’m guessing the majority of VIC members already have, or are well on their way to needing glasses or contact lenses. The process of getting a prescription has always baffled me—you make an appointment with an optometrist, who proceeds to switch a couple levers back and forth, until the correct prescription is found. Over 90% of visits to optometrists are for this simple procedure, which seems like it should have been automated a long time ago.

Eyelogic creates a system that does exactly that—the machines can be operated easily by unskilled labor, and produces a prescription as accurate as an optometrist in a fraction of the time (and, for a fraction of the price). The systems sell for about $30,000, and typically pay for themselves in only 3 months. Surprisingly, the technology has been around for a while, but adoption has been slow. Welcome to the crazy world that is the eye-care market. For additional reading on this mob-like industry, I highly recommend the previous VIC writeup of 1-800 Contacts, in addition to the below.

For those with more limited time, I suggest skipping to the “French Sale” section, which provides details on the catalysts.

The Eyecare Market
Eye-care is provided mainly by optometrists, who specialize in health of the eye. Though they are trained to treat a series of eye-ailments outside of generating prescriptions, the majority of their business is just that. Most optometrists derive nearly all their revenue from writing prescriptions for contacts and glasses and, in most cases, selling the products to the patient directly. If a system like Eyelogic’s caught on at optical stores, the Optometrist as we know it could very well be forced out of business. If Optometrists were to embrace the technology (which, for reasons of pride and fears of commoditization, they haven’t), they could substantially reduce the amount of time they spent seeing patients. Though this could technically happen, particularly if optical chains began adopting the systems en-masse, my thesis does not rely on it.

Unsurprisingly, the optometrists view Eyelogic and its system as a huge threat. In the Fall of 2006, Canadian optometrists persuaded the board of Canada to classify the Eyelogic system as a class 2 instead of class 1 device. This forced Eyelogic to suspend sales in Canada, until they received the additional certification (which was received in late February and fast tracked by the Canadian government). Luckily, in the case of Eyelogic, they have an equally powerful lobby on their side

The Optician
Opticians specialize in sales of products for the eye, mainly glasses. They have always fought the independent optometrists for business, as many optometrists sell glasses in their own office, providing a lucrative additional revenue stream. Many opticians have gone a similar route, bringing in their own optometrists strictly for the purpose of driving prescriptions and eye-care sales. Unlike the optometrist, the optician views the prescription process as a hassle. They see it as a vehicle for eye care sales, not as a revenue stream in its own right (which is why this service is usually heavily discounted in most optical stores). They would love a machine that would automate the process, and drive more people to their stores instead of to optometrists. The union of opticians in Canada has lobbied on behalf of systems like Eyelogic, and similar lobbies in other countries should be a strong ally in the battle going forward. Opticians and optical chains are currently the primary focus of Eyelogic’s sales efforts.

The Market
The eye-care and prescription market is a multi-billion dollar business. According to a 2004 labor bureau report, there are over 34,000 optometrists in the US alone. Additionally, increases in computer usage, and jobs requiring computer usage, are likely to take a toll on most people's vision, requiring increasing visits for eyeglass prescription in the future. Currently, it is estimated that about 30-40% of the population has myopia, most of whom require glasses or contact lenses. In addition to thousands of optometrists worldwide, there are also hundreds of thousands of opticians who sell eye-care products to the public. Though Eyelogic has no hard numbers on the penetration of systems such as theirs, it is estimated to be very low (<5%). Adoption has been slow, as optometrists have largely shunned the service (it would admitting that there is no skill involved in 90% of what they do, and would negate them to specialists for more serious issues).

Market adoption amongst opticians has been steady but slow. Many are afraid that if they test the system their in-house optometrists will quit, leaving them without a prescription generator if the system does not live up to its promises. The technology is still seen as a bit exotic, and many companies, though very intrigued and frankly amazed by the technology, have been waiting for others to bite before biting themselves.

Competition and Market Adoption
There are 3-4 other companies that make this equipment. Eyelogic is the leader in the Canadian market, and sells worldwide through its distribution agreements in Europe and the US. There are also 2-3 Japanese companies that make flashier, albeit less functional products then Eyelogic. Demarc, a large provider of optical equipment in the US, is the leader in the US market, though has faced similar adoption challenges as Eyelogic has faced in Canada.

Several of these companies have tried (and failed) to spend millions on high-powered marketing campaigns and low-cost machines to encourage rapid adoption, but none has worked thus far. Eyelogic has taken a measured approach to growing the market, as evidenced by their dividend. The company has doubled the size of its sales force in the last year, and would have grown revenue about 20-25% if not for the Health Canada shutdown in Septmeber.

To date, this has been a waiting game—the technology makes sense, and will be adopted at some point. It’s a question of when, not if. Thankfully, recent events have been put in motion that make this adoption likely sooner rather than later…

The French Sale:
In some respects, the temporary shutdown of sales in Canada was the best thing that could have happened to Eyelogic. In Q4, the company announced a sale of 80 systems (the largest single order in this market’s history) by a 600 (now ~750 store) optical chain. Eyelogic beat out other manufactures, validating the company’s position as the worldwide leader in this space.

Here is where things get interesting. The COO has been meeting with the large retail chains (Costo, Walmart, etc.) pitching the system for years. They are all intrigued by the technology, but no one as of yet has willing to make a dive. As with most new technologies, many companies are followers more than they are innovators. Once they see it work for someone else, they'll want it to. I believe the large French sale will help to be a strong catalyst to generate traction in large accounts, as well as be a huge selling point for Eyelogic in sales negotiations. Remember, Eyelogic beat out all the other companies to win this big order, and they'll be able to leverage that win in deals, both small and large, against competitors. If another chain wants to purchase systems, Eyelogic will be the logical frontrunner to win the business.

Catalysts:
The two most attractive short-term catalysts lie in the potential of sales to two large optical chains. One opportunity is to sell to the other ~670 stores in the French chain. The French chain is broken up into several different banners. According to management, all are interested in the systems, but infighting has slowed down progress—the banner that has the systems doesn’t want the others to get it (they essentially compete with each other), and the purchasing decision for all banners is made at the corporate, which is taking its time. The company expects to eventually sell into all these stores, but it may take some time.

In the meantime, the company is confident it can quickly sign up 130 of the remaining 670. These stores were recently acquired by the banner that bought the Eyelogic systems, and the newly acquired stores are approved by corporate to buy the systems . Eyelogic sells these systems for about $30,000 in Canada (which includes training & support), but only gets about $15,000 when they sell them through distributors (who provide the training and support). Sales from getting into the 130 newly acquired stores alone could be equal to nearly all the revenue generated in FY2006. At 75% gross margins, a lot of that revenue falls to the bottom line.

The other big opportunity is with an unspecified large chain with, in the COO’s words, “offices everywhere,” who has ordered a system for one of their stores in Canada. This is a huge win for the company, which has been waiting for a break like this for a while. The company would expect to sell slowly into this account, but again the general thesis here is that once one domino falls, the rest will fall in stride.

Longer term, the company expects to release a new product in 2008, which the company expects to have much more mainstream appeal than anything they have released to date. For now, it’s a free option.

Financials & Potential Valuation
Eyelogic reported FY06 EPS down 19% to about $.13 per share, due largely to the health Canada issue. Without this issue, the company would have earned about $.20 per share. Instead, sales for Q4 were delayed until FY07 Q1, when the company made up the majority of the sales. The company recently reported earnings of $.13 for Q1, due to the large sale to the French company, as well as the backlog of orders they had that they could not fulfill in q4. The Health Canada issue in q4 06 will inflate FY07 earnings due to the backlog filled in q1, though I expect healthy growth, even adjusting for the Health Canada issue.

With 75% gross margins, and a relatively small revenue base, it’s easy to see how a landing just one large account could have a huge impact on Eyelogic. A sale of 400 systems @ $30k per system (e.g. a company the size of the French chain in Canada) could generate net profit equivalent to the entire market cap of the company.

Revenue is lumpy, but Eyelogic’s rental program provides a degree of recurring revenue, and the new product, when it launches, is also expected to have a recurring revenue model.

This kind of thesis does not require much in the way of valuation--if the company either sells further into the French chain, or lands another large account, the stock should do very well, as illustrated by the math above.

Risks
The main risk is that someone big comes in, throws $20M+ at the market, and takes it. Though this could happen, companies have tried and failed to do this thus far. This is a complicated market to sell into, and Eyelogic knows the customer issues better than anyone. Also, it won’t take much, given the valuation and opportunity, for Eyelogic to do well, even if they don’t become the market leader.

Regulatory risks are there but also minor, in my opinion, due to the track record of the systems, the lobbying power of Opticians, and the success Eyelogic had in quickly overcoming regulatory concerns in Canada.

There is also the risk that the technology, despite delivering a strong ROI and customer satisfaction, simply does not get adopted by the majority of optical chains. Again, I think its just a matter of time, and you get a 6% dividend while you wait.

Catalyst

Sales to newly acquired stores by French banner,
Sales to other banners within French chain,
Continued market adoption of a high ROI solution,
Introduction of new product next year

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			2007	2008
Price:	2.09	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	6	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT