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.  

Conversations with ABC formers suggest that the Signature Offer is a bait and switch scam designed to get folks in the door for significant upselling. The exact words one former used: 

“(After first laughing) Of course it is (a bait and switch scheme to get customers in the door so they can be upsold). The Signature Offer is an absolute joke. If it was taken seriously, no sales rep would ever get paid and ABC would go bankrupt.”  ABC Former

To the former’s latter point (ABC going bankrupt if the Signature Offer was actually something that got meaningfully and consistently redeemed as marketed), the Signature Offer was first introduced in 1997, 22 years ago at the same $69.95 price point. If the Signature Offer was even a remotely meaningful contributor to ABC’s business, it would be mathematically impossible for them to hold price flat 22 years without becoming considerably less profitable given a cost structure that is susceptible to the most basic of inflationary cost pressures (Optometrist salaries, sales rep salaries, health insurance, basic eyewear raw materials, etc.). EYE calls out its business model’s unsurprising sensitivity to basic cost inflationary pressures in its filings and even recent Sellside hosted investor meetings (where it flagged optometrist inflation in particular). In fact, EYE’s current brick and mortar retail margins outside of WMT  (per its disclosed segment profitability financials) are in-line with recent historical norms and even above those disclosed in the EYE / ABC Fairness Opinion 15 years ago.

“Inflation. Our financial results can be expected to be directly impacted by substantial increases in product costs due to materials cost increases or general inflation which could lead to greater profitability pressure as costs may not be able to be passed on to consumers.” EYE IPO Prospectus

“We are a low-cost provider and our business model relies on the low cost of inputs. Factors such as wage rate increases, inflation, cost increases, increases in raw material prices and energy prices could have a material adverse effect on our business, financial condition and results of operations. Increases in compensation and other expenses for vision care professionals, as well as our other associates, may adversely affect our profitability. Wage and hour regulations can exacerbate this risk. Additional tariffs or other future cost increases, such as increases in the cost of merchandise, shipping rates, raw material prices, freight costs and store occupancy costs, may also reduce our profitability. These cost increases may be the result of inflationary pressures which could further reduce our sales or profitability. Increases in other operating costs, including changes in energy prices and lease and utility costs, may increase our cost of products sold or selling, general and administrative expenses. Our low price model and competitive pressures in the optical retail industry may inhibit our ability to reflect these increased costs in the prices of our products, in which case such increased costs could have a material adverse effect on our business, financial condition and results of operations.” EYE 2018 10K

Below is a basic example of this dynamic in its most extreme form (for illustrative purposes) assuming 100% of ABC’s revenues are derived from customers redeeming the Signature Offer. The latter of course isn’t true because ABC derives revenues from other sources. EYE has privately thrown out a ~20% number (portion of customers that utilize the Signature Offer), but even if one were to take this at directional face value (or even half of that) and assume a probably overly generous 2% annual cost inflation, there’s plausible scenarios where overall ABC margins should be half of what they were historically.

So, it appears the only real relevance of the Signature Offer is to manipulate a significant number of customers to come in the door as the Company itself has alluded to.

“For the past 20 years, America’s Best has led with a signature offer of an eye exam and two pairs of eyeglasses for $69.95. We believe there is no better value in the marketplace and that this affordability and convenience has driven ongoing traffic growth and high customer loyalty along with increased market share.” EYE IPO Prospectus

Once in the store, however, customers get completely taken advantage of with aggressive bait and switch sales tactics. ABC has also earned an impressive D- rating from the Better Business Bureau and no, it's not because people broadly hate buying glasses / getting their eyes checked. For perspective, Warby Parker has an A+ rating and Walmart Vision Centers have an aggregate A- rating. Customer complaints like the below are a dime a dozen.

Should the FTC get involved and force ABC to meaningfully change / or get rid of the Signature Offer, organic growth would plummet and EYE has already run afoul of the FTC before.

 https://www.mediapost.com/publications/article/307930/contact-lens-seller-agrees-to-7-million-settlemen.html

“Some of our promotions, such as our America’s Best offer of a “free” eye exam, are subject to compliance with laws and regulations governing use of this term. The Federal Trade Commission (“FTC”) has authority under Section 5 of the Federal Trade Commission Act (the “FTC Act”) to investigate and prosecute practices that are “unfair trade practices,” “deceptive trade practices,” or “unfair methods of competition.” EYE 10K

With or without FTC involvement, ABC organic growth is poised to continue its slowdown to levels well short of levels management has led the Street to believe -  Even without FTC involvement, ABC’s bait and switch scheme is inherently unsustainable given the inability to capture recurring revenue post the scam, word of mouth spreading (particularly in today’s digital age), and natural attrition of aggressive sales reps. To the latter point, one ABC former emphasized the notably high attrition among ABC sales reps, noting that it's pretty much impossible for them to consistently meet the lofty sales / bonus targets EYE sets out for them once they’ve already churned thru thru all the low-hanging fruit in a given area (i.e when they can prey on unassuming consumers with the Signature Offer prior to word getting out) and EYE’s reluctance to add personnel. So, productive reps get burned out and move on to greener pastures, ultimately leaving a given ABC store with a much smaller addressable market run by less effective employees. These idiosyncratic growth pressures are further exacerbated by what is a fundamentally commodity offering in what’s become an increasingly mature, saturated, and competitive marketplace. For perspective, according to VisionMonday, the top 50 optical retail players in the U.S. operated an estimated ~14,700 stores in 2018 and represented 40% of the market, implying tens of thousands of brick and mortar optical retail locations already nationwide with intensifying competition from disruptive and differentiated e-commerce players like Warby Parker and Zenni on top of that (every ABC former we spoke with emphasized Warby Parker in particular as a clear and noticeable headwind to recent sales). Inorganic store adds are thus done into either existing and already highly penetrated markets (such as California) inherently more competitive and less profitable than at any point in the Company’s history (not to mention where their brand value is already steadily eroding given the bait and switch scheme) or into new and less attractive geographies with less favorable demographics, inferior structural cost profiles, and diminished economies of scale. It is likely not a coincidence that 40% of ABC stores reside in CA, TX, FL, and IL, which rank as the 1st, 2nd, 3rd, and 6th most populous states in the U.S., respectively. Either way, these relatively less effective stores further perpetuate a sustained organic growth slowdown as they are rolled into the organic / SSS calc after a year. Bigger picture, the total market for vision care products and services sold at optical retail locations has CAGR’d at 2%-3% historically (as EYE readily admits in its Investor Presentation) and there is little to prevent organic growth trends at ABC to moderate down to at or below these levels (vs. the sustainable 5%+ management has led the Street to believe), particularly considering that ABC organic growth trends have already plummeted to 4.5% from the ~12% reported at its Q417 IPO and three of the four retail chains it operates outside of ABC are already comping well below the industry growth rate (WMT - flattish, Fred Meyer - down 7.5%, Military - down 2.2%). Nevertheless, the Street continues to believe that this dramatic slowdown can stabilize, sustain, and inflect….for the next decade!

Appropriately valuing EYE’s WMT business separately from the remaining business suggests 30%-50% additional downside to shares - Lazily capitalizing EYE’s WMT business at whatever valuation one deems appropriate for its non-WMT business (~70% of EYE’s non-WMT revenues and an even greater portion of non-WMT EBITDA is derived from ABC and the remaining ancillary service lines are much lower multiple businesses than ABC) is extremely misguided given the transformationally inferior growth, superior profitability, and much higher risk profile of the WMT business. Valuing EYE’s WMT business is actually quite straightforward. The bear case is simply that WMT cuts EYE for good at the upcoming contract renewal and WMT’s value is simply the remaining FCF it will generate up until expiration in August 2020. The bull case would be that (1) For whatever reason, WMT throws EYE a proverbial bone and lets EYE keep operating the 227 stores (2) WMT also doesn’t impose any incrementally more punitive terms as it did with the 2017 renewal and (3) EYE is able to offset the inherent profitability headwinds from cost inflationary pressures against a flat go-forward top-line (even though they’ve never been able to do this before). In this bull scenario, the value of WMT effectively just becomes at best the perpetuity value of its current FCF at whatever discount rate one deems appropriate (I generously use 10% even though the risk of an eventual WMT loss will remain high even if they are extended for a few more years). 

The simple average of the above bear / bull scenarios suggests fair value for EYE’s WMT business should be $110 million, equating to ~4x EBITDA. This methodology maps precisely to how EYE was valued in its 2005 take-private by Berkshire when WMT was the virtual entirety of EYE’s business and had a similarly uncertain future. One could certainly make the argument that 4x EBITDA for EYE’s WMT business is still too aggressive considering it represents a 36% premium to the 2005 takeout valuation even though the market EV / EBITDA multiple is up a modest ~10% since the transaction date and WMT EBITDA will actually be ~10% lower this year than it was in 2005 (yet another datapoint speaking to the non-existent growth opportunity at WMT). Link to the full 2005 Fairness Opinion below for those interested. 

https://www.sec.gov/Archives/edgar/data/868263/000095013505004240/b56055d9sc14d9.htm

“TM Capital used discount rates of 15.0%, 17.5% and 20.0% and terminal value multiples of 3.5x, 4.0x and 4.5x, reflecting the risks inherent in the Company’s Vision Center II growth strategy and the limited economic life of its Wal-Mart business.” EYE July 2005 Fairness Opinion

This exercise (valuing WMT separately in a basic SOTP) then helps crystallize the embedded valuation premium being ascribed to EYE’s non-WMT business. Stripping out WMT financials and reducing EYE’s current consolidated Enterprise Value (using projected YE 2019 net debt as 2H19 will be significantly FCF negative due to seasonality and the timing of a working capital tailwind that boosted 1H19 FCF) by the fair value of the WMT business as calculated above suggests EYE’s non-WMT business is being valued at a massive premium to publicly traded peers (Grandvision before its recent takeout and Fielmann) despite unequivocally deserving a discount. There are a number of reasons a discount is warranted, including:

• EYE’s inferior scale (non-WMT brick and mortar revenue base is a fraction of peers)
  
• EYE’s inferior profitability (EYE margins are half of peers) and FCF conversion.
  
• EYE’s inferior business mix (15%+ of EYE’s non-WMT business is highly unfprofitable given the commodity nature of services like contact lens distribution)
  
• EYE’s significantly higher leverage (350% higher than the peer average)
  
• The higher degree of risk associated with EYE’s go-forward growth trajectory (in no small part attributable to the inherently unsustainable nature of ABC’s bait and switch scheme discussed at length above)

   

Even if one were to entirely ignore all of these reasons for a warranted valuation discount and ascribe EYE Fielmann’s (the richest valued name in the space) current multiple / maintenance uFCF yield arbitrarily rolled forward to 2020 Street forecasts that are far from derisked, there’s a credible argument to be made that EYE shares still have 30%+ downside potential even giving credit for a bull case WMT valuation.  Anecdotally, it’s also worth noting that across the entire optical ecosystem (contact lens manufacturers, etc), EYE appears to be the only Company that adds-back SBC, which inflated 2018 reported Adjusted EBITDA by ~14%. 

Perhaps most telling is that even if one were to value EYE’s non-WMT business at the NTM EBITDA multiple recently paid for GrandVision by industry behemoth EssilorLuxottica - a multiple paid by a strategic for a better business - EYE shares are still arguably worth 10%-20% less than current levels with even more downside if using GrandVision’s takeout FCF multiple.

As for the Street, thoughtful attempts to value EYE have been entirely non existent since EYE re-emerged as a public company a few years ago. It’s a quirky smallish cap name that they have no familiarity with given the recent IPO and lack of even one U.S. public comp (and just one globally post the recent GrandVision takeout). Sellside price targets are thus reverse engineered to to equate to a certain level of upside by slapping on an arbitrary multiple (with no credible justification) and/or DCFs using jerry-rigged WACCs and nonsensical unlevered FCF estimates. For instance, Morgan Stanley uses just a 6.5% WACC on its total Company unlevered FCF forecasts even though WMT will continue to be the dominant driver of those forecasts as the modest cash flows from the non-WMT business are negated by the planned New Store CapEx required to keep building  less productive stores. For perspective, from 2016 to 2018 total Company normalized unlevered FCF was around $67mm vs. the $75mm generated by WMT (i.e. non-WMT unlevered FCF inclusive of New Store CapEx was negative). If EYE were to come out tomorrow and say that they were never going to build a new store ever again, then WMT (assuming of course they can hold onto it). would still represent ~40% of EYE’s total unlevered maintenance FCF. At the same discount rate that was used to value WMT economics in 2005 (and as walked thru above it appears that the risk profile associated with WMT is as high as its ever been), a 6.5% WACC on consolidated cash flows would imply a negative WACC for the non-WMT business! Arbitrarily using a 10% WACC for the WMT business (which would implicitly value WMT EBITDA at 7.6x EBITDA vs. the 3x EBITDA WMT was acquired for in 2005 when WMT EBITDA was 10% higher), would still imply just a 4% WACC for non-WMT maintenance FCF, just 1-2% above what one could earn in cash with about one trillionth the risk.  

“TM Capital used discount rates of 15.0%, 17.5% and 20.0% and terminal value multiples of 3.5x, 4.0x and 4.5x, reflecting the risks inherent in the Company’s Vision Center II growth strategy and the limited economic life of its Wal-Mart business.” EYE July 2005 Fairness Opinion

https://www.sec.gov/Archives/edgar/data/868263/000095013505004240/b56055d9sc14d9.htm

Similarly, Berenberg uses just a 7% WACC on best case top-line growth forecasts reflecting continued growth CapEx.along with a non-sensical go-forward profitability ramp (see below) that implies EYE will somehow take uFCF margins to ~6% vs. its historical 5 year average of just 2% and the 0.7% achieved most recently in 2018 (which benefited from tax reform). This would only be a few hundred bps below what Fielmann and GrandVision have been able to achieve even though they have EBITDA margins running 10% higher than EYE’s non-WMT business.

Done thoughtfully and correctly, however, a DCF of EYE’s non-WMT stores (America’s Best, EyeGlass World, Fred Meyer, and Military), which represent the entirety of its go-forward non-WMT profitability, is helpful in illustrating the downside optionality in today’s share price. See below.

PRIMARY RISKS / MITIGANTS

Takeout - Recognizing that EYE has been acquired twice before, an eventual takeout certainly is a risk worth contemplating. If a takeout were to ever happen down the line, it’s challenging to come up with scenarios in which it would be done at a price above current levels (or at least not meaningfully above) or at a time where one wouldn’t have already had ample opportunity to profitably move beyond the short. There are a number of reasons for this, which in no particular order include:

• While EYE has been acquired twice before, the Company was ascribed valuations well south of current levels at 3x EBITDA in 2005 (America’s Best was also acquired around the same time at sub 4x EBITDA) and ~10x EBITDA 2014 (vs. 15x currently). It’s also worth noting that when KKR paid 10x EBITDA for EYE in 2014, not only was WMT visibility and profitability far superior to current levels, but the overall was business was organically comping at levels 100% higher than current.
  
  
• When KKR decided to begin its exit in Q417 (when both WMT and non-WMT had superior operating / growth profiles vs. current), one would think that they ran a dual-track Sellside / IPO process. To the extent they did, then clearly there wasn’t any acquisition interest or if there was, it was at levels south of where they priced the IPO, which was done at valuations below current. To the extent they did not run a dual-track process for whatever reason, it is ultimately moot since KKR went on a fire-sale soon after the IPO and has already liquidated 100% of its holdings in EYE in less than two years with its most recent sale just a few months ago. KKR isn’t stupid and if they thought an expensive takeout was in the cards anytime soon, my guess is they would still be holders of the stock in at least some nominal fashion.
  
  
• With respect to potential strategic acquirers (and the type of superior potential premium that can come from a strategic over sponsor acquisition), really the only one of consequence is EssilorLuxottica. EssilorLuxottica is now completely out of the picture given the recent GrandVision announcement. Besides the fact that EssilorLuxottica will be in digestion mode for the foreseeable future, as mentioned above the GrandVision takeout was done at a valuation that one could argue implies material downside for EYE from current levels.
  
  
• Recent insider sales from EYE’s management team.

Catalyst

• Upcoming WMT renewal catalyzes greater awareness around the financial realities of the relationship
• Upcoming WMT renewal catalyzes greater awareness around how to properly value EYE (WMT and Non-WMT should be valued separately)
• Continued moderation of ABC sales trends, which will be accelerated upon any FTC involvement