Description

Despite more than doubling since the January trading update, in my opinion, Inspecs remains a one of the more compelling recovery opportunities in the U.K. smaller company universe. This is a proper market leading vertically integrated eyewear business with good brands (own and white label), a passionate management team with skin in the game, and a long runway for organic and inorganic growth. At c8x ‘23 EV/ EBITDA there is still room for the multiple to double if management execute flawlessly from here. Through cost reductions and self-help margin recovery with a bit of organic growth, earnings over the medium term can grow 50-60%. Optionality exists in 1) smart eyewear and, 2) own store retail, with the latter more interesting and immediately quantifiable. I expect the shares to reach 200p in 2023 as the recovery plays through and with earnings momentum ahead of consensus. There is scope for 3-400p on a medium-term view with the current business model and strategy. The optionality would deliver further upside.

Inspecs is a British, vertically integrated eyewear and lens designer, manufacturer and distributor. It was founded in 1988 by the same management team that are still in the business today and own c20% of the equity. The business IPOd in 2020 a month before Covid into which management sold around 25% of their holding, so remaining well aligned with new shareholders. However both Robin Totterman (now exec chair) and Chris Kay (cfo) have rebought shares since - Robin subscribed £1m into the Eschenbach transaction and Robin and Chris bought c£600k in the market after the October 22 trading update.

Inspecs supply a mix of own brand and OEM/ white label for optical chains such as Specsavers, Fielmann in Germany/ Europe and National Vision in the US. They also cover most price points with the legacy Inspecs business operating at the value end ($9 per frame average) and Eschenbach at premium ($30 per frame average). As a result, Inspecs earns 50% gross margins and Eschenbach earns 70%. While Eschenbach earns lower normal EBITDA margins (normalised 9% vs 20%) the underperformance in 2022 now provides a catalyst to look at costs more closely in Germany and management think that the Eschenbach business can and should earn c14% margins going forwards.

 Own manufacturing is predominately across sites in England, Italy, China and Vietnam, with production expansion likely to the added soon to Portugal on the back of chain customer requests to de-risk China supply. There are also other meaningful operations in the US (Tura – US independents business) and England (Norville – lens business).

 Eyewear is relatively defensive, albeit (as proven by Germany) consumers will defer purchases if extremely stressed. But eyesight continues to deteriorate and glasses get damaged and require replacement over time so purchases can only be deferred so long. Because Inspecs cover the all parts of the market, there is a reasonable argument that they should be agnostic to trading up and down.

 Inspecs is a unique asset in the UK smaller company space and comparable only realty to EssilorLuxotica in the sense that they combine frame and lens manufacture and production. EL are differentiated through their retail expansion but, as I will discuss, this is the next strategic step for Inspecs and would drive a step change in margins. With Richard Peck, ex-David Clulow and Luxottica, now at the wheel, I think they are well positioned to deliver this part of the strategy once the share price has recovered >200p.

SUBS OVERVIEW

Inspecs is the parent of several subsidiaries which combine together to create the vertically integrated, brand owning group.

Inspecs Eyewear was the original, Bath-based outfit and now a design studio and brand management centre for own and licensed brands.

Killine was acquired in 2017 for an EV of $44 million and is the primary designer, manufacturer and distributor of unbranded and private label eyewear. Killine manufactures through China and Vietnam primarily, but can also draw on Algha – an ultra-premium British manufacturing outfit of handmade rolled gold eyewear. The heritage here is fascinating in itself.

https://killine.com/wp-content/uploads/2019/02/Inspecs-Killine-Group-2019-presentation.pdf

Norville was acquired in 2020 and is a specialist lens manufacturer based in England. Inspecs paid £2.4m and this was essentially an asset purchase with £4.9m of net book value including £1.2m of freehold property. The strategic rationale is similar to Luxottica and Essilor’s merger, to bring frames and glazing into one outfit and internalise the margin. While Norville generated £12m of revenue and was break-even, companies house shows gross margins of >60%.

Eschenbach was acquired in 2020 for 95mEUR. Eschenbach generated $170m of revenue and $12m of EBITDA. The business is based in Germany and designs and distributes own branded and licenced eyewear through Europe and also into the US through its subsidiary Tura. Strategically, Eschenbach broadened the group into the independents market.

Bode and Ego were acquired in 2021 and add several own and licensed brands to the group. Ego is Stockholm based and BoDe is German with existing distribution links to Eschenbach.

MARKET

Eyewear is a mid-single digit grower. Higher end (branded) eyewear grows faster than this and is supported by a growing, ageing and more prosperous middle class. Prescription eyewear is classed as a medical device and there are myriad issues tied to poor and deteriorating vision and awareness of these is increasing, thus supporting further growth.

Traditionally most eyewear is purchased in store through independents and chains where consumers can combine an eye test with a prescription purchase. While there is some shift to online, the propensity to shop in-store remains, since glasses frequently require adjusting to individual faces and consumers prefer the option to deal with a person if there are any problems. Consumers also prefer to try on various frames first and only then are these made up with prescriptions. Glasses purchased with a prescription are typically non-refundable so purchasing online is tricker. However, Inspecs is channel agnostic and can ultimately supply frames and lenses into stores and online.

Inspecs supplies both chains and independents. While chains are very dominant in the UK with Specsavers and Vision Express having c80% share. In most other markets, independents thrive and hence the desire to own Eschenbach which sells into this channel. Independents in the US are 40%, and 60% globally. For Inspecs, gross margins are very different, but operating margins are similar – independents generate a c70% gross margin but carry lots of salespeople in operating costs. Conversely, chains have lower gross margins but also far fewer salespeople. Chains are also far less working capital intensive and optically, these are much better businesses in my opinion (hence probably why the business managed to IPO on such a high multiple), however the growth opportunity is also lower and Inspecs needs to cover the whole market.

EssilorLuxottica is the largest and most vertically integrated in the market following the merger with Essilor which took them into the lens market. They have licensed brands and own brands and sell through almost 10k stores and 100k opticians, globally. At nearing 200m frames annually they are c20x the size of Inspecs. The acquisition of Grand Vision adds a further 7k stores. In 2022, EL generated 24.5bnEUR revenue, 64% gross margin, 23% EBITDA margin and 17% operating profit margin. This premium margin profile is driven by the depth of their vertical integration. Inspecs will aim to become a mini-EL in time.

Machron is no2 with 19m frames (c2x Inspecs) and largely US facing with Calvin Klein, Nike and DKNY. Machron is owned by VSP Vision, a non-profit eye health company, and manufactures from Italy combined with other 3rd parties. They are twice the size of Inspecs by frame volume.

Safilo is no3, previously no2 before losing Gucci to Kering. Safilo have all sorts of problems. It’s likely that they continue losing licensed brands. They have also lost sales into Grand Vision. In 2022, Safilo generated revenues of c1bnEUR at 9% EBITDA margin. Revenue hasn’t grown in the last decade+ and EBITDA margins have declined from c16%

Kering is the next largest at around 500m revenue and is mostly high end and wholly owned brands.

While EL dominates the market, I think that there remains a gap for lower volume brands looking for an end-to-end license partner, which will benefit Inspecs. Killine caters to large and small chains, with the latter as small as 30 stores able to use Killine’s team to design, manufacture and distribute their own labelled eyewear to sell in store at enhanced margins.

Inspecs, unlike others, are not tied to Italian and western-only manufacturing and can offer more cost advantage through China and Vietnam, and soon Portugal too. Inspecs is the only manufacturer for private label outside of China and one of only two that produce own brands and private label combined. In contrast, EssilorLuxottica only manufactures and distributes own brand. While own brands are key to higher margins, at it’s current scale, Inspecs’ wider proposition is more attractive to chains and independents as a one stop shop supplier and distributor. This is especially important as chains are continuing to consolidate supply. Anecdotally, Specsavers have moved from 36 to 12 and now to 9 suppliers. Chains install their own quality control and supply auditors on site, so those suppliers which can offer wider design and manufacturing options and locations should benefit in the consolidation.

Overall, Inspecs is a top10 global player and will get nearer to top5 in time. They have a unique proposition as a one stop shop for global manufacturing and distribution of private label and own brands, plus lens manufacturing, but there remains more to play for with an expansion into retail over the medium term.

2022: WHAT HAPPENED

2022 was disastrous with the shares declining from 400p to 40p. Crucially, I don't think any of the issues are repeating, and all have been or are fixable through 2023:

1.     Post acquisition of Eschenbach, management were required to restate accounts on the back of poor bookkeeping in Turo in the US. Realistically, this probably is a case of management dropping the ball regardless of the narrative presented that COVID prevented visits to the site. However, the correct processes have now been put in place and the US business is much better understood. I found management very open to admitting fault here.

2.     Norville was allowed to lose too much money and will have generated over a $5m EBITDA loss in 2022. This was certainly a management oversight and they admit this. They have taken action to right size the cost base here with c$1.5m of annualised cost savings mostly from headcount (30 heads). The business will now break even at c$7m of revenues and the expectation is that it will return to profitability in q423 and a positive total contribution from FY24. I think it could do better than this.

3.     The October update highlighted weak consumer confidence in Germany - lowest ever recorded, a combination of gas/ energy prices and escalation in Ukraine. German consumers are traditionally risk averse and don't buy on credit so even essential eyewear becomes delayed. This has since reversed as highlighted in the January trading update and through peer reporting. OptiMunich in Jan was very strong for Inspecs.

4.     FX, depreciation versus USD through 2022 drove c$3m of headwinds. This is reversing now with USD weakness since beginning of 2023, but will be masked now by the Group moving to GBP.

These issues combined drove an expected breach of banking covenants, which were subsequently waived by HSBC in Q222.

VALUE CREATION

This is a recovery play initially so what matters is management rebuilding trust in the guidance, reducing leverage, and otherwise restoring confidence in the strategic direction of the business, before resuming growth.

2023 consensus (one analyst) is $25 of EBITDA so a bridge form this year's earnings is an appropriate place to start. It’s worth noting that adj 2022 EBITDA of $19.2m, was ahead of the year-end guidance given in January of $17.9m, on $249m of revenue.

1. Norville moving to break-even: as discussed, Norville the lens facility generated a $5m loss in the year due to relocating the facility which resulted in delays and quality issues and ultimately lead to customers leaving. The issues have been fixed and customers are returning. Cost savings have also been implemented and the site breaks even at $7m revenue. My expectation is for a $1m loss this year and growth in 2024

=$19.2m + $4m = $23.2m

2. Cost savings: management have outlined other cost saving measures across the group other than Norville, and fully annualise in 2023. $400k comes from changing Eschenbach company cars from Mercedes to Skoda. $200k from subletting Eschenbach office space, and a further c$400k from other headcount reductions. There may be more upside from further cost focus elsewhere in the group.

= $23.2m + $1m = $24.2m, vs $25.5m guidance

3. Margins: freight costs are reducing quickly and will begin to impact from Q2 onwards. Other material supply chain benefits also to begin coming through as China market is over capacity and reopen for business. FX is also reversing from the $3m negative impact from last year, albeit switch to £ will temper this. Overall, I expect a $2m benefit from improving gross margins and other operating margin tailwinds including more mix from own label/ brand

= $24.2m + $2m = $26.2m

4. Growth: I expect a better revenue outcome this year vs the $261m consensus. Anecdotally, we know that OptiMunich was “very, very strong”. There are significant new launches coming in Q2 with Titanflex Ladies which is an own brand and where the male equivalent is the bestselling frame in Germany, ahead of any Luxottica frames. SuperDry will be distributed through Tura in the US – roughly 12 SKUs in 600 stores. And Ego will put Barbour (own brand) into c1800 Specsavers stores in H2. Assuming 1SKU sold per week per store, fully annualised this could be 1m additional frames. Other strongly growing brands are Liberty which was in-housed through the Ego acquisition and has good international potential. O’Neil and Radley are also performing well and should benefit from wider distribution. There is potential upside in Norville from new customers. And Sunglasses are also still trading behind pre-Covid and should benefit from more travel this summer.

= 2022 they sold 10.7m frames with a very weak Q3/4. Assuming 5% natural growth/ recovery + 250k additional frames from the catalysts outlined above for 11.5m = $267m revs, on our new gross margins and cost base = c$28m EBITDA

Other anecdotal points of support for a strong 2023 come from mgmt. commentary where “Q123 is ahead of Q122”, which itself was an exceptionally strong period coming out of lock down. The going concern statement on page 60 of the annual report also points to “current trading…ahead of budget and there has been no erosion of margin”. My understanding is also that an overhauled bonus/ ltip structure will be set well ahead of consensus, inline with the internal budget.

Support for a stronger 2023 from peers reporting so far:

·   EssilorLuxottica: lfl store sales growing hsd. Total revenues +c10%. All regions accelerating vs Q422. S/price +10% ytd

·   Safilo: US soft and some lingering issues from H2. Europe quite strong. Issues are specific to Safilo rather than market. S/price -10% ytd

2024 and medium term

Beyond 2023, I expect an organic rebuilding of margin as the Escenbach business recovers and Norville returns to profitable growth. In normal times, this should be a c12-14% margin Group which is broadly supported by the fact that 1) Inspecs pre-Eschenbach was a $60m revenue, $13m EBITDA business; and, 2) Eschenbach was $170m revenue, $12m EBITDA = 11% blended, but now with lower operating costs across the businesses. Add in recent acquisitions of Ego and Bode which bring in house higher margin own brands, plus operating leverage from the 50% gross margins, and a bit of growth, then I think that these margin expectations are not unrealistic. On a c$280m revenue business = $34-39m. This is in line with the pre-Q32022 guidance of 12% EBITDA margins growing to 14% by 2024 on $278m of revenue.

Revenue growth should be supported by various factors. The investment in Vietnam and Portugal expansion will add to total capacity – Vietnam expansion, which will break ground in Q3 this year, will add 5m frames of capacity in the region. A Portuguese site will increase this further. Both sites are backed by demand from chain customers looking for Chinese alternatives for supply and near shored supply chains. Moreover, Inspecs should be able to increase penetration through existing outlets. For example, Machron sells 19m frames through 86k points of sale, versus Inspecs at only 10.7m through 75k. A similar penetration rate through the existing 75k outlets, backed by a capacity expansion, would guide to $380m of revenue potential.

Upside optionality

There are two opportunities for Inspecs to generate much more material upside. The first is through its skunk works/ smart eyewear programme where they have an agreement with Bosch to develop smart industrial/ commercial eyewear. This is blue sky and there are others like Luxottica also investing in this area. Skunk works has begun generating revenues through an Amazon lens agreement.

https://www.essilorluxottica.com/highlights2022/smart-eyewear

The second and more quantifiable is through an own store retail expansion, as EssilorLuxottica have done. I would expect that this would create a pathway towards EL economics of 60+% gross margin, 20+% EBITDA margins and 15+% operating margins (behind EL since Inspecs would probably put licensed brands through own stores). This is probably a 2024 or 2025 strategic goal given the current share price as would require new equity to acquire a chain of stores.

VALUATION

There are 107m fully diluted shares @ 120p = £128m mkt cap + $57m of bank and IFRS 16 leases = £170m EV

EBITDA basis:

’23 consensus $25.4m = 8.3x

’23 my estimate $28m = 7.5x

24/ 25 $34-39m = 5.4-6.2x

Looking at comps and Inspecs historics, 15x is a reasonable EBITDA multiple, as per FactSet.

Even with interest rates taking the shine off growth multiples, there is still plenty of upside from 120p through only a modest re-rating to say 10-12x + some earnings growth to $34m = 220-273p

FCF basis:

Equity free cash flow basis is less compelling but provides reasonable downside support at a punitive 10% FCF yield with a good argument for yield compression when the recovery plays through and the business returns to growth.

While the business is not optically capital light, stripping out intangibles and looking at returns on operating capital does look more favourable and these should improve as the business scales.

One must also get comfortable with the level of adjustments here but a lot are certainly non-repeating and non-cash going forwards. I expect that there will be a focus and incentives tied to cleaner numbers and after interest and tax numbers in the future.

Catalyst

Short term

> confidence through 2023 on EBITDA guidance and potential beat, can drive re-rating to c10x

> confidence on 2024 numbers and a return to growth plus a stabilised cost structure and balance sheet 

> leverage coming down as indicated to 1.5x (mgmt. guiding to this at Sept 23)

> broker/ joint broker and shareholder refresh

Medium and long term

> margin synergy plans coming through in Eschenbach

> optionality through smart eyewear and/ or retail

> organic growth through ongoing capacity investment and increasing penetration through existing channels