Description

Luxottica Group (LUX), headquartered in Milan, Italy, is the global leader in premium-priced fashion, luxury, and sports eyewear.  The Company manufacturers, distributes and retails premium sun and prescription glasses (mainly plastic and metal frames) through a global wholesale and retail network covering over 130 countries.  Fueled by years of easy credit, rising home values, soaring investment and retirement portfolios, low unemployment and high consumer confidence, Luxottica, like so many luxury goods companies, was a major beneficiary of the growth in discretionary consumer spending.  Revenues have risen by over 80% over the past six years, reaching an all-time high of €5.2B in 2008.  For all the obvious reasons (lack of credit availability, declining asset values, mounting unemployment, etc, etc), today's consumer is far more value conscious, and is migrating from high cost luxury brands to lower cost generic substitutes.  Despite the headwinds facing the Company and the luxury goods industry in general, Luxottica trades at 13x our estimate of 2009 EBITDA and 30x our estimate of 2009 EPS, rich on an absolute basis and almost double the Company's peer group average.  Moreover, the Company's highly leveraged balance sheet could force them to renegotiate specific covenants within their credit facilities that appear likely to be violated in the upcoming year, and will likely hinder their ability to continue growing through acquisitions.  Considering that the Company sells a highly discretionary consumer item at price points ranging from $100 - $500/pair, we find it hard to justify Luxottica's current valuation in the marketplace. 

Company Overview: 

The Company's Retail segment (60% of consolidated revenues) operates 6,250 stores in North America, Asia-Pacific, China, South Africa and Europe.  Luxottica, through a series of acquisitions over the last 15 years, is now the largest optical retailer in the world, and operates such recognizable retail chains as LensCrafters (acquired in 1995), Sunglass Hut (2001), Pearle Vision (2004) and Oakley (2007).  North America has averaged 85% of total retail sales over the past four years, with the remaining 15% generated primarily in the Asia-Pacific region.  Due to the fragmented nature of the European retail industry, the Company does not have any retail locations in Continental Europe, and very few in the U.K.  Approximately 10% of their stores are franchised, and substantially all of their locations are leased.  The average price for a pair of premium sunglasses sold through Luxottica operated retail concepts is $250, while mid-priced glasses retail between $100-$150/pair.

The Company's Wholesale segment (40% of consolidated revenues) manufactures sunglass and prescription glass frames at 11 production facilities worldwide.  Today, sunglass frames amount to 60% of unit sales, while prescription frames account for the remaining 40%.  Manufactured frames are sold as either house brands (57% units sold) or designer lines (43%).  Between the two, Luxottica manufacturers almost every major high-end sunglass brand in the world.  The Company's designer lines are produced under license agreements with typical terms of between three and ten years.  In exchange for the ability to manufacture and retail designer line frames, the Company is required to pay a royalty that ranges from 5-14% of sales, in addition to mandatory marketing costs, with most agreements requiring a guaranteed minimum royalty payment regardless of sales volume.  The following table includes some of the Company's major House and Designer Brands:

After experiencing several years of strong growth within their Retail and Wholesale segments, signs of weakness are becoming ever more evident within the Company's customer base.  Luxottica's retail same store sales (SSS) have declined quite rapidly since 2006, and actually entered negative territory in 2008. Most notably, SSS during the 4^th quarter of 2008 fell precipitously across all of the Company's major retail concepts, as 4Q08 SSS fell -11.5% at LensCrafters & Pearle Vision and -12.9% at the Sunglass Hut, while licensed brand SSS declined -9.7% during the quarter. 

Based on commentary from both management and their competitors, we believe that the double digit declines in same store sales during 4Q08 have carried into the first few months of 2009.  The consulting arm of Bain & Co. recently estimated that global luxury goods sales would decline by 10% in 2009, with sales dropping as much as 20% in the first half of the year before stabilizing in 2H09.  The report also predicts that U.S. luxury goods sales will decline by 15% in 2009, as the struggling U.S. consumer continues to gravitate toward lower-priced substitutes.  Luxottica has historically been reluctant to reduce prices on their luxury eyewear given the impact it could have on their licensed brand designer relationships and the perceived quality or prestige of higher end labels.  However, recent dialogue from management indicates that the Company is becoming amenable to price reductions and promotions. As competition from Walmart, Costco, and other broad-line retailers continues to intensify in the eyewear market, we believe Luxottica will be forced to lower existing prices or introduce more affordable lines in order to maintain market share.  As was the case in prior downturns in the early 90's and early 00's, we believe the typical eyewear replacement cycle of 2.3 years will extend by at least six to nine months as consumers attempt to limit discretionary expenditures.  Additionally, the Company has minimum sales guarantees within their licensing agreements for designer lines, which are typically based on a percentage of the previous year's sales, usually 80%.  If sales of designer brands drop below these levels, the Company will be required to pay a penalty or "catch-up" payment to the designer, further impacting the division's profitability. 

Since wholesale orders are typically placed quarters in advance of expected delivery by retailers, wholesale & manufacturing revenue trends lag retail results, indicating that more trouble lies ahead within the division.  Similar to trends seen in the retail segment, wholesale growth slowed considerably in 2008, in particular during the 4^th quarter, as overall demand contracted significantly.  While pro forma sales within the division increased +1.3% at constant exchange rates for the full year ended 12/31/08, wholesale revenues were down -8.3% during the fourth quarter, causing pro forma operating margins to drop from 20.3% in 4Q07 to 17.2% in 4Q08.  Italian eyewear export trends provide additional evidence of the difficult operating environment Luxottica's wholesale division is facing.  As shown in the following table, Italian eyewear exports declined 5.6% in 2008 vs. 2007.  Most notably, Luxottica's largest geographic end market, North America, which accounted for 59% of consolidated sales during 2008, witnessed eyewear export declines of 20.3% year over year:

Luxottica's insatiable appetite for acquisitions over the last decade has resulted in a highly-leveraged balance sheet that will likely impede their ability to grow and may force the Company to renegotiate restrictive covenants within their credit agreements.  While management was lauded for their growth by acquisition strategy over the past several years, in hindsight they appear to have overpaid for recent acquisitions which were largely debt financed, i.e. their $2.1B acquisition of Oakley in November 2007 at 14.3x EBITDA.  Luxottica maintains several credit agreements with various financial institutions, all of which expire by 2013.  The most restrictive covenant within their various credit agreements is a maximum leverage ratio (Funded Debt/EBITDA) of 3.5x.  While the Company was in compliance with all of their financial covenants at 12/31/08 (2.9x at year end), if our models are anywhere near accurate, Luxottica will likely trip their leverage covenant in 2009, forcing the Company to negotiate with lenders and potentially restructure their credit facilities.  Most of the Company's credit agreements contain cross-default provisions, enabling any creditor to declare any financial indebtedness due and payable prior to its stated maturity as a result of an event of default.  The most likely shorter term impact if the Company were to trip the covenant in 2009 would be an increase in their effective borrowing costs and/or additional restrictions on the Company's distribution of cash flow.  Longer term, depending on the magnitude of the decline in their operating performance and the willingness of their lenders to renegotiate credit terms, Luxottica could potentially face bankruptcy risk.  As a precautionary measure, Luxottica announced their intent to terminate dividend payments to shareholders in 2009.  Furthermore, we believe Luxottica's highly-leveraged balance sheet will hinder their ability to grow through acquisitions for the foreseeable future, forcing the Company to focus on organic growth, which we expect to decline at a double digit rate in 2009.

Based on our estimates, the market is currently valuing Luxottica at 13x '09 EBITDA and 30x '09 EPS, multiples that appear incredibly rich for any business in today's market, not to mention a luxury eyewear Company expected to see double digit sales declines and significant margin contraction.  In our base cash scenario, we expect Luxottica's consolidated revenues to decline -10% at constant foreign exchange rates during 2009, roughly in line with management's expectations.  Using management's budgeted foreign exchange rate expectations for 2009 vs. the Euro (reporting currency), as well as the Company's sales and operating cost breakdown by currency, we are able to model out the Company's 2009 expected operating results.  Our model assumes that 50% of the Company's operating costs are fixed, as disclosed by the Company.  The following table shows our expectation of the Company's earnings power at different sales levels:

Using our base case estimate for revenues to be down -10% at constant foreign exchange rates, we estimate that Luxottica will generate approximately €732 million of EBITDA and €0.47/share in EPS during 2009, which is well below current consensus estimates of €900M and €0.66/share of EBITDA and EPS, respectively.  We believe that sell-side estimates are still overly ambitious and fail to fully incorporate the degree of operating leverage inherent in Luxottica's business and the associated margin dilution that will occur when sales decline.  To give you a better idea of how expensive we believe Luxottica is at today's prices, the following table lists other European luxury goods manufacturers and their valuations using 2009 consensus estimates. 

As mentioned numerous times throughout the Company's annual report, "Demand for our products, particularly our higher-end designer lines, is largely dependent on the discretionary spending power of the consumers in the markets in which we operate."   As consumer purchasing power continues to weaken considerably in this economic environment, discretionary purchasing patterns are shifting from higher end luxury goods (such as those produced and retailed by Luxottica) to lower cost generic substitutes. Given Luxottica's significant exposure to this trend, its leveraged balance sheet, and rich valuation, we believe a short position in the Company's equity presents a compelling risk-reward profile.

Risks:

• Global consumer discretionary spending, in particular that of the U.S. consumer, proves more resilient and stronger than our expectations
• Company's ability to reduce operating costs and achieve operational synergies from Oakley acquisition are greater our expectations
• Company's ability to gain market share within the wholesale division which could dampen the impact of organic declines in revenue.
• More favorable FX tailwinds than management's budget
• Relatively low float and significant holder concentration

Catalyst