Description

We recommend an event-driven long position in National Vision Holdings (“EYE”) ahead of the company’s upcoming January 23^rd, 2020 contract renewal notice date, which will take effect on August 23^rd, 2020, to operate optical stores inside of Walmart (“WMT”). We believe there is a high probability EYE’s amended master service agreement with WMT gets renewed. While the probability of WMT terminating its outsourcing relationship with EYE is non-zero, we believe – for reasons outlined below– that this is a low probability. We even believe there is a non-zero probability that WMT outsources more, if not all, of its optical business to EYE.

The short thesis, which was well articulated in a recent VIC posting by Jelly621, is simple and easy to underwrite: – WMT will not renew EYE’s master service agreement to operate 226 optical stores inside of WMT and EYE’s stock will get crushed because the EBITDA contribution from EYE’s WMT business represents greater than 100% of EYE’s free cash flow and is subsidizing growth at its America’s Best stores. Further, a non-renewal would likely force EYE to turn off the growth spigot and reduce the pace of new store openings unless they were willing to take on more debt from opening new stores. Such a lower growth trajectory would result in significant multiple compression for an expensive stock (~13x 2019 EBITDA/~3% FCF Yield) with a stretched balance sheet (~3x Net Debt/TTM EBITDA) lacking cash flow vehicle to pay down debt.

We conducted our own checks with industry participants that caused us to see the situation in a different light. Given the ~10% short interest, and our view that the shorts are playing the “WMT non-renewal” event-driven catalyst, we believe EYE shares can get squeezed higher, from current price levels near an all-time low, simply with a status quo contract renewal with WMT. Significant upside exists if WMT decides to outsource more, or all, optical stores to EYE.

1.  It's natural to ask why WMT needs EYE given the fact that WMT operates 92% of their optical stores and outsources the remaining 8% to EYE. EYE’s optical business is an insignificant piece of total WMT. We believe the adage “if it ain’t broke, don’t fix it” applies.

·     WMT’s Health & Wellness division make up only 7% of Total WMT, WMT’s owned optical stores make up only 5% of WMT’s Health & Wellness division, and less than 1% of Total WMT.

·     EYE’s optical business is, therefore, less than 1% of WMT’s Health & Wellness division, and an extremely insignificant 3 basis points of Total WMT.

·     The performance of EYE’s WMT locations exceeds WMT’s owned units on a revenue per store basis, suggesting EYE’s model works well in WMT stores and WMT captures a nice management fee stream from EYE’s revenue. According to our checks, EYE has also been executing well in terms of customer experience scores in WMT. It’s important to note that the purported “bait-and-switch" offering at EYE’s America’s Best stores – 2 glasses and a free eye exam for $69.95 – does not apply at its WMT stores.

·    WMT is beginning a bigger strategic push into consumer health and wellness. As a result, we believe newly appointed head of WMT US, John Furner, has bigger fish to fry over the next four months, given WMT’s recent overall health & wellness push, than to spend time contemplating a new course of action for EYE’s optical business.

o WMT opened its first-ever Walmart Health center in Dallas, GA on 9/13/19 delivering services including primary care, labs, X-ray and EKG, counseling, dental, optical, hearing, community health (nutritional services, fitness) and health insurance education and enrollment all in one facility.

o Commemorating the opening, SVP and President of Walmart U.S. Health and Wellness Sean Slovenski stated, “The customer is at the heart of everything we do, and that focus is reflected in the new Walmart Health center. This state-of-the-art facility will provide quality, affordable and accessible healthcare for members of the Dallas, Georgia, community so they can get the right care at the right time, right in their hometown.”

o There are plans underway to open a second health & wellness clinic in Calhoun, GA.

2.     Management regime changes at WMT likely favor the status quo

·       It is true that no WMT executives will be seated at the table this time around that had been at the signing of the 2012 master service agreement, or the 2017 amended master service agreement to negotiate this upcoming contract renewal with EYE.

·        As a result, one could argue that the relationships Reade Fahs had built with WMT business leaders have therefore been diluted.

·        Scott McCall (current SVP of General Merchandising of Health & Wellness for WMT US), with the help of Marybeth Hayes (former VP of Consumables & Health & Wellness at WMT US) signed off on the 2012 master service agreement with EYE for a five-year term. Both Scott and Marybeth are no longer in these seats at WMT.

·        Paul Beahm (former SVP of General Merchandising of Health & Wellness for WMT US) signed off on the 2017 amended master service agreement with a three-year term (as opposed to the five-year renewal contemplated in the original 2012 agreement). Paul retired from WMT in February of 2019.

·        Up until 10/10/2019, the players who would have represented WMT at the upcoming contract renewal included Greg Foran (former President & CEO of WMT US), Sean Slovenski (current SVP of Health & Wellness of WMT US), and importantly, Mony Iyer (current VP of Optical, Dental, & Hearing for WMT US).

·       Greg Foran, with whom Reade Fahs reportedly built a solid relationship, was just replaced by John Furner (former President & CEO of Sam’s Club).

3.   Mony Iyer (current VP of Optical, Dental, & Hearing for WMT’s US) is a key decision maker at the table this time around, but his job responsibilities recently changed

·        Mony was first hired as VP of WMT’s US optical business in July of 2018.

·        With WMT’s recent push into health & wellness, Mony’s responsibilities changed from solely running WMT’s optical business, to running optical, dental, hearing, and other specialty healthcare modalities (See his LinkedIn profile below).

·        As outlined earlier, optical is an insignificant piece of the health & wellness initiative. Given the management changes at the top – from Greg Foran to John Furner – in addition to more coming on to Mony’s plate, we believe optical is not a priority for WMT and insourcing of EYE’s WMT business just would not move the needle much relative to Mony’s and WMT’s other priorities.

4.  WMT’s decision to outsource dental centers and mental health clinics in its new health & wellness push is indicative of its acceptance of outsourcing partners in its consumer health businesses

·        WMT has partnered with a company named JMLS Enterprises to provide outsourced dental services across the US.

·        WMT also partnered with a company named Beacon Health Options – again, around the same time Mony Iyer began at WMT - to provide outsourced mental health services (launched in Texas in November 2018)

·        If EYE can replicate the model in its 226 WMT stores across all of WMT’s optical locations on an outsourced basis, then WMT would arguably have a much higher performing optical business.

5.   Our checks suggested that EYE sacrificed margins in the 2017 contract renewal to position the company to win more of WMT’s optical business

·        EYE has seen lower EBITDA margins during the past few years in its Legacy WMT segment and one interpretation has been that WMT intentionally set punitive contract terms with EYE.

·        The margin erosion of EYE’s WMT business is evident – from ~26% in FY 2014, to ~21% in FY 2018, and as low as ~15% in 2Q’19 – despite consistency in revenue per store.

·       We learned from a highly credible source recently removed from WMT’s optical business that Reade Fahs came to WMT at the time of the amended master service agreement in 2017 asking for a three-year term, instead of the original five year term, and believed he strategically accepted less favorable economics in the form of a lower margin structure with the intent of courting WMT for the entire vision business at contract renewal.

·        Note: the same source suggested that nothing should be read into the three-year term (as opposed to five) of the last renewal, indicating that even three years is longer than the typical WMT contract.

·        Interestingly, several months ago, several WMT employees took to the online message boards about fears of “third party outsourcing” of WMT’s optical business – the third party would naturally be none other than EYE.

6.     EYE has a more productive model than WMT’s owned stores, in terms of revenue per store, due in large part to a differentiated merchandise assortment

·        EYE has critical vendor relationships with Luxottica brands in their stores. WMT does not have access to these brands.

·        EYE is therefore able to generate higher ASP’s, while WMT-operated stores cater to the middle and low end.

·        EYE’s ability to sell higher priced, branded Luxottica helps to explain why EYE-operated stores generate ~30% greater revenue per store within WMT than WMT-operated stores that do not sell Luxottica

·        Now, one could argue that with WMT’s scale, Luxottica and WMT should find a way to enable WMT to offer at least some of Luxottica’s brands. But that is not the case today.

·       We encourage readers to call or visit EYE-operated stores within WMT, to learn firsthand the difference in merchandise mix across EYE optical stores and WMT-owned optical stores. For those who are unfamiliar, Luxottica manufacturers the following high-end brands, that you will not find in WMT-owned stores. 

·       If EYE was in control of all WMT’s optical business and able to sell Luxottica’s brands across that whole footprint, WMT would see its revenue per store increase ~$200k in-line with EYE, representing a $680mm revenue opportunity for WMT across the ~3,400 stores. And of course, WMT would participate in that incremental revenue through sales-based licensing fees from EYE.

7.     EYE provides benefits to WMT that help it operate its optical business given California regulatory requirements

·       WMT needs EYE’s wholly owned subsidiary, FirstSight, to staff its California optical centers with optometrists. Without Firstsight, WMT would not have an optical presence in California, due to regulatory changes to California law, Assembly Bill 684, which was put in place on January 1st, 2016.

·       Firstsight is a licensed health plan provider under California law that arranges for the provision of optometric services at all WMT’s in California.

·       There are 19 WMT-owned optical centers in California, in addition to 43 EYE optical centers within, for a total of 62 WMT’s in California with optical centers that are staffed by Firstsight.

·       Assembly Bill 684 ensures that the ~2mm population who receive eyecare at one of California's ~600 total optical centers have access to the ~2k optometrists in California.

·       Buried within the master service agreement, WMT has the option to acquire First Sight (see “Option Agreement”).

8.     Following the termination of WMT’s contact lens supply agreement with 1-800-Contacts in 2012, WMT awarded its entire contact lens business to EYE through its e-commerce subsidiary, Arlington Contact Lens Service, Inc. (“AC Lens”), which today acts as a critical fulfillment provider to all WMT stores.

·        AC Lens distributes contact lenses to WMT under a fee-for-service arrangement whereby AC Lens sells contact lenses and optical accessories to WMT at cost and earns a fulfillment fee per order shipped recognized as revenue in its Corporate/Other segment. AC Lens owns the contract lens distribution license that WMT does not have.

·        EYE allows WMT to be one of the lowest cost providers of contacts due to its supply relationship with AC Lens. According to WMT, “we [WMT] can offer low pricing because of our large purchasing power. We are able to negotiate the best possible pricing from contact lens manufacturers and distributors. We simply pass those savings along to our customers”

In conclusion, EYE provides WMT with many benefits – from optometrist staffing, to high-end branded merchandise, to contact lens distribution - beyond just operating ~8% of its optical stores. Coupled with the fact that optical is not a priority for WMT – and certainly will not move the needle for WMT’s health & wellness push in the short term – and the management regime changes favoring the status quo – we believe there is high probability WMT at a minimum continues with EYE as an outsourced partner.

Catalyst

·         WMT renews EYE’s master service agreement in the next four months

·         Or, WMT completely outsources their optical business to EYE in the next four months