NATIONAL VISION HLDGS INC EYE S
October 02, 2019 - 12:55pm EST by
jelly621
2019 2020
Price: 25.00 EPS 0.67 0.78
Shares Out. (in M): 81 P/E 37.3 32.1
Market Cap (in $M): 2,036 P/FCF 87.1 80.0
Net Debt (in $M): 505 EBIT 83 94
TEV ($): 2,541 TEV/EBIT 31 27
Borrow Cost: General Collateral

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Description

SUMMARY THESIS

There appears to be considerable risk that optical retailer National Vision is about to lose (or see its business materially reduced by) its largest customer that just so happens to be Wal-Mart (WMT). WMT represents more than 100%+ of the Company’s total levered FCF (3x+ Net Debt / EBITDA) and 40% of maintenance unlevered FCF, a reality that appears entirely misunderstood. A detailed review of the nearly 30 year long relationship between EYE and WMT as well as conversations with WMT formers suggest that WMT could terminate the relationship imminently (given the 7 month notification period required ahead of the current agreement’s expiration on 8/23/2020) in a scenario not entirely dissimilar to WMT did to Murphy USA in 2016 when it ended its two-decade long relationship. Should WMT renew / extend the current agreement (as it relates to the 226 Vision Centers EYE operates for WMT), recent precedent suggests it could be done at significantly more punitive terms considering the last contract renewal (not coincidentally just prior to EYE’s 2017 IPO) featured revised terms that have subsequently driven a ~35% cut to EYE’s WMT EBITDA, a reality also that appears entirely misunderstood. Arguably even more interesting than what WMT does or doesn’t end up doing is the Street’s material and unsustainable misunderstanding of how to value EYE. Despite its significant contribution to EYE’s overall profitability, WMT represents less than 10% of overall EYE revenues and management (not surprisingly) will never proactively volunteer any insightful information about the stores it operates for WMT. This in turn has led the Street to treat WMT as a throwaway service line where WMT is implicitly valued at whatever lofty EBITDA multiple / FCF yield deemed appropriate for the rest of the business. This creates a dangerous dynamic for longs given the markedly inferior top-and bottom line growth opportunity and significantly heightened risk profile of WMT business, altogether equating to a business worthy of a much lower valuation than EYE’s non-WMT business, which is precisely how WMT was valued by sophisticated stakeholders long before EYE’s Q417 IPO. As WMT increasingly enters the discussion ahead of the looming renewal, so does the likelihood of EYE finally becoming valued like it should (basic SOTP consisting of WMT and non-WMT), which will crystallize the asymmetric downside opportunity to shares from current levels. Outside of Wal-Mart, EYE’s future growth is entirely dependent on its America’s Best (“ABC”) discount eyewear chain facing mounting growth headwinds from the unsustainable nature of its “egregious” (per an ABC former) bait and switch strategy and rising competition (Warby Parker, e-commerce), both of which have been consistently and increasingly pressuring growth trends since EYE’s IPO. It appears more likely than not that these growth pressures will intensify (rather than abate) and drive organic growth expectations down to the low single digits at best (vs. the mid-single digits management would like bulls to believe). As it relates to the short, there are multiple credible datapoints suggesting that EYE’s current lofty overall valuation (~15x+ 2019E EBITDA, ~1.5% Unlevered FCF Yield when the majority of EYE’s FCF is being generated by a business worthy of a sub 5x EBITDA multiple and FCF yield well into the double digits) and leverage (3x+ Net Debt / EBITDA with abysmal go-forward FCF conversion prospects) lacks any rational relative or absolute valuation support, limiting share price upside potential from current levels. On the other hand, in a scenario where EYE loses WMT (or the Street correctly begins to value EYE’s WMT with an appropriately higher risk profile into the August 2020 expiration) and organic growth expectations for the remaining business continue to moderate, the stock could get cut in half.

KEY ELEMENTS OF THE SHORT THESIS

The Street materially underappreciates the financial and valuation significance of EYE’s Wal-Mart business, which represents less than 10% of EYE’s overall revenues but more than 100% of free cash flow - EYE does not proactively volunteer WMT’s profitability trends in its standard 8-K earnings releases or earnings calls (nor does the Sellside ever ask). Coupled with the fact that WMT represents less than 10% of overall revenues, the Street is quick to completely gloss over WMT as a throwaway service line and implicitly value WMT economics at whatever lofty EBITDA multiple / FCF yield it happens to be ascribing to the rest of the business. This of course wouldn't be a big deal if:

(1) WMT’s overall revenue contribution was a directional proxy for its overall contribution to profitability / FCF and ,

(2) Relative to the other 90% of EYE’s revenue base, the WMT business had similar near-term  / future growth prospects and a comparable associated risk profile (i.e. WACC). 

Unfotunately for EYE, saying the exact opposite is true would still be a considerable understatement. With respect to item (1), while not immediately given / discussed with earnings, EYE provides detailed segment financials (a line-item called “Legacy” represents 100% of the operations related to the stores it operates for WMT and nothing else) in their subsequent 10-Ks / 10-Qs down to EBITDA (FCF can then be easily derived from there because there is negligible CapEx associated with the WMT stores and the little that is there is actually going down). The below should be fairly self explanatory, but note WMT’s staggering contribution to EYE’s overall FCF (as it alludes to below in its risk factors), well north of 100% despite representing less than 10% of revenues (note the “NM’s in the yellow shaded rows are because EYE FCF was negative outside of WMT in those periods).

We derive significant revenues and operating cash flows from our relationships with our legacy and host partners through our operations of 227 Vision Centers in Walmart stores, 29 Vista Optical locations within Fred Meyer stores and 54 Vista Optical locations on military bases.” EYE 10-K



Even on a more generous levered (EYE’s onerous debt burden isn’t going anywhere soon) and unlevered maintenance FCF basis that excludes all New Store CapEx (which also isn’t going anywhere anytime soon as EYE has committed to keep plowing money into less efficient stores for years to come), WMT has represented 40%-70% of EYE’s total FCF over the last three years.


WIth respect to item (2) and whether such a sizeable WMT profitability stream should be ascribed a risk profile (discount rate) on par with EYE’s non-WMT business, the short answer is “No, not even close”. Signifcantly more on this below.

A detailed review of EYE’s nearly 30 year long relationship with WMT suggests a significant degree of risk should be associated with the upcoming expiration of the current agreement - When the relationship was initially formed in 1990, WMT needed a third party partner to operate its optical locations given they were a relative new entrant into the optical space and looking for operational guidance. By 1997, EYE operated 328 stores inside of WMT (~55% of the 600 total WMT Vision Centers at the time), eventually peaking at 435 in 2001. But as one might expect from the largest retailer of all time, WMT eventually figured things out and materially began to de-emphasize its relationship with EYE. EYE currently operates 227 stores inside of WMT, just 6% of the now thousands Wal-Mart Vision Centers nationwide (vs. its historic peak of 50%-60%). Cut another way, even though WMT has expanded its total number of Vision Centers by ~400% over the last 20 years, EYE has seen the stores WMT lets it operate cut in half relative to its 2001 peak. Most recently and most notably as it relates to the current 227 stores EYE operates for WMT, the agreement was last up for renewal in 2017. WMT renewed the agreement for another three years, but at significantly worse terms as evidenced by the dramatic 30%-35% decline in EBITDA derived from WMT since 2016. 


Despite no proactive transparency in addressing the declines in WMT EBITDA in any of its post IPO earnings calls (nor has the Sellside ever asked), EYE noted the below in its recent 10-K suggesting WMT agreed to renew only after reducing EYE’s management fee, which has then been further exacerbated by profitability headwinds from basic cost inflation against a perpetually flattish top-line, a dynamic that will persist and put a lid on EYE’s ability to show meaningful Company wide margin improvement even if WMT renews at the current terms.


“Costs of services and plans as a percentage of net sales of services and plans in the legacy segment increased from 33.3% for fiscal year 2017 to 40.1% for fiscal year 2018. The increase was primarily driven by increased optometrist costs and lower management fees.“  EYE 10-K

“In addition, under our current management & services agreement, we earn fees based on a percentage of the revenues from the Vision Centers we manage. The agreement also allows Walmart to collect penalties from us if the Vision Centers do not generate a requisite amount of revenues, which penalties equal a percentage of the shortfall. We may not be able to maintain the performance levels required and, as a result, may be forced to pay penalties to Walmart or default under this agreement at a point in time when our fees from the arrangement will already be lower than anticipated. Further, a breach by us of the terms and conditions of this agreement could cause us to lose all management fees derived under this agreement, which could adversely affect our financial position and results of operations.” EYE 10-K

Even with the considerable decline in WMT margins since 2016, the margins EYE derives from its WMT business are running close to double its margins outside of Wal-Mart and triple WMT’s own corporate average, suggesting substantial runway for any subsequent renewal(s) to feature incrementally punitive financial terms.

Finally, the original Management & Services Agreement (MSA) between WMT & EYE (Exhibit 10.31) effective 5/1/12 to 5/31/17  was supposed to be automatically renew for an additional 5-year term ending in 2022, but it appears WMT used the 2017 renewal as an opportunity to reduce the extension to guarantee just a 3-year term ending in 2020. This begs the obvious question, If WMT was so happy with EYE, why didn’t they renew for the originally planned 5 years versus 3? 


Original 2017 MSA

This Agreement begins on the Effective Date and continues until May 31, 2017, unless sooner terminated or extended in accordance with the terms of this Agreement. This Agreement will automatically renew for one additional five-year term unless one Party gives the other Party written notice of non-renewal no later than November 1, 2016. Exhibit 10.31

Updated 2017 Agreement

The Term is hereby extended for three (3) years, until August 23, 2020 (the “Extension Date”). EXHIBIT 10.32


Conversations with Wal-Mart formers suggest that it’s always been a question of “when” not “if” WMT will sever ties with EYE and that EYE has become entirely irrelevant to WMT’s future growth strategy
- According to WMT formers, WMT’s logic in forming the relationship with EYE ~30 years ago was simply that WMT was entering a new vertical and looking for a little bit of help to accelerate its institutional knowledge of optical retailing. So, WMT and EYE entered into a bunch of staggered multi-year leases where EYE would do a bunch of the start-up work, but WMT’s overarching intent was always to ultimately reassume complete control of EYE operated stores. Fast forward 30 years, the facts show this is exactly what has been happening as WMT has since added thousands of Vision Centers while simultaneously cutting the absolute number of stores it lets EYE operate by 50%. One former characterized the WMT Vision Centers that remain under EYE’s control as being “left for dead” in large part because EYE itself knows that “the writing is on the wall” in terms of the inevitable end of its relationship with WMT. Because of this, the former noted that EYE completely stopped making the necessary investments in the WMT stores it operates, which in turn has translated to disillusioned employees and anemic sales. Note the consistently flattish reported revenue growth at the EYE operated WMT Vision Centers significantly trails WMT’s ~3% SSS corporate average and EYE’s purported Company wide organic growth trends outside of WMT). With respect to the disillusioned employees, the former noted that WMT routinely poaches any steller EYE employees for its own Vision Centers, who are happy to jump ship given the apathetic work environment pervasive at EYE operated Vision Centers, lack of appropriate incentives, and WMT’s willingness to do things like transfer years of services for salary / benefits (i.e. if an employee has worked at an EYE operated Vision Center for five years and moves over to WMT, the employee would be given five years of tenure at WMT). Moving forward, WMT’s goal is to marry its vision services with the rest of its health offerings in an endeavor it has been increasingly publicly vocal of as of late.

 

9/4/19 Steve Bratspies, Walmart EVP and CMO - “But I think when you think about health and wellness for us. First, you start with, we have a pretty big business already with pharmacy, optical, our OTC business. It's roughly 10% to 11% of our total business. So it's a meaningful business to start with that we've built over the years and continue to grow. But the way you should think about it is, think about a supercenter and you think about our approach as we try to meet lots of different needs for lots of different customers and have one‐stop shopping. We're trying to think through that same model how that can apply to health and wellness and to health care.”  



 

https://corporate.walmart.com/newsroom/2019/09/13/in-dallas-georgia-walmart-unveils-enhanced-store-experience-and-first-ever-walmart-health-center

 

By partnering with local providers, the new Walmart Health center will deliver 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, conveniently located outside the store with a separate entrance for customers. The clinic will provide low, transparent pricing for key health services for local families, regardless of insurance status.”

In a recent 9/26/19 Jefferies note (ironically trying to defend EYE) describing a site visit to one of these new “one-stop shops”, the optical portion was specifically called out as appearing uniquely  INSOURCED.  

“Feedback from our Wal-Mart coverage team’s Sept visit to the new store+clinic prototype in suburban Atlanta indicated the optical portion was largely as is currently - integrated & insourced. Jefferies, 9/26/2019

EIther way, this clear strategic shift from WMT certainly marginalizes the need to retain ties / pay anything but significantly reduced fees to EYE, an ancillary third party operator of an irrelevant number of standalone Vision Centers, particularly when also considering:

(1) WMT has already been materially slashing its business with EYE over the years to the point where WMT itself is already seamlessly operating the other 90%-95% of its Vision Centers, 

and, 

(2) WMT had no problem imposing incrementally more punitive terms the last time the contract was up for renewal.

 

Thoughtful public questioning the rapidly deteriorating WMT financials, upcoming contract expiration and worrisome historical precedent has been non-existent since EYE’s 2017 IPO  - Across the seven earnings calls EYE has held since its IPO, EYE’s public posturing around the 227 stores it operates for WMT has been pretty much exactly what one would expect it to be. The hodgepodge of Sellside Analysts assigned to cover EYE just because of the IPO appear to care little about this smallish cap orphan stock with no peer universe or synergy with anything else they cover. As a result, there have never been any probing questions around the rapidly deteriorating WMT financials, upcoming contract expiration and worrisome historical precedent. The infrequent Sellside questions that do exist are incredibly benign, which EYE management is easily able to punt with short, cliche, and entirely non-committal responses like the below.

Patrick R. Moore (Senior VP & CFO)
“We focus every day on our relationship with them. We've been saying for well over a decade that we want to be a great partner to them and we've been their partner for 27 years. But in terms of their future decisions, you've got to ask them that.”  Q318 EPS Call

In the absence of any Sellside probing, these types of responses aren’t particularly surprising. After all, it’s not as if EYE management was ever going to proactively volunteer something along the lines of the below, particularly not as KKR was rushing hand over fist to sell every single share of its stock (impressively, they have already been able to get 100% out with the IPO not even two years old).


“Hi everybody! Ignore our earnings 8-K release and instead check out the segment financials we disclose in our Ks and Qs. See how our business with WMT represents more than 100% of our FCF and is currently clipping down 20% YoY in large part because we keep missing the performance targets WMT gave us when we re-upped the contract in 2017? Oh, and one more thing, did I mention that this contract is up for renewal in less than a year but with a required notification date just 4 months from now?

 

Outside of Wal-Mart, EYE’s value will largely depend on the performance of its America’s Best (“ABC”) discount eyewear chain whose growth depends on a blatant and inherently unsustainable bait and switch scheme - ABC currently represents 70%+ of EYE’s non-WMT business and an even greater portion of non-WMT EBITDA. ABC was acquired by EYE in July 2005 for ~4x EBITDA in parallel with Berkshire’s acquisition of EYE. EYE also operates a smaller optical chain called EyeGlass World, but with EYE having added 115 new stores since IPO with 108 (~94%) being ABC, it’s pretty clear that they are pinning future growth aspirations on ABC. This isn’t all that surprising considering that ABC SSS averaged 9.5% from 2014 thru 2018, materially higher than any of its other businesses even though ABC is at 6-7x the scale. So what’s been ABC’s secret recipe? The Company’s longstanding “Signature Offer” for two-pairs of eyeglasses plus an eye exam for $69.95.