Christopher Rossbach presented his in-depth investment thesis on Essilor (Paris: EI) at European Investing Summit 2017.
Essilor is the leading global prescription lens producer with a vertically integrated supply chain and 41% market share (more than 3x that of the next competitor). The company owns advanced lens technology backed by €200+ million per annum R&D spend. Essilor has significant growth opportunities in Europe, the U.S. and Asia from socio-economics (growing population, ageing, higher incomes) and technological innovation (varifocals, coatings). The pending merger with Luxottica creates a global leader cross the value chain (lens, frame and sunglasses, retail, online) and synergies of €420-600 million. Essilor and Luxottica are highly complementary businesses due to minimal overlap in ophthalmic lenses (Essilor) and sunglasses/frames (Luxottica). The combined company possesses strong competitive advantage, participates in good and growing markets, has strong management, and solid balance sheet, setting the stage for long-term compounding. Essilor shares recently traded at a pre-synergy 2017E P/E of 26x and a post-synergy 2020E P/E of 18x, based on conservative assumptions on synergies.
The following transcript has been edited for space and clarity.
We are a private investment office. We manage money for the Stern family and other families’ trusts and charities on a long-term view. Our investment horizon is ten to twenty-five years and those are the kinds of investments we look for. We have positions the Stern family has held for forty years or longer. We do not look for companies we think will generate short-term returns. We look for businesses that have the potential to generate significant returns over time.
The basic approach we have is to look for quality and value. Quality is the gating condition. We define quality as a strong competitive position in a good and growing market, a company with a long management track record aligned with shareholders, and a balance sheet that is solid enough that the company can prevail regardless of the economic environment.
We want to be in a position to own companies for the long term and not to be forced to sell. We are not forced to sell because of the nature of our investors and, likewise, we don’t want to be forced to sell by virtue of issues at a company, whether that is disruption, which we worry about a lot, or balance sheet issues that can lead to capital increases.
In value investing parlance, we are more Phil Fisher than Ben Graham-style investors. We look for long-term compounding and criteria aligned with those Phil Fisher laid out in his book, Common Stocks and Uncommon Profits, which I highly recommend.
We have a global approach but we invest a lot in Europe. At a past installment of this conference, we talked about MTU Aero Engines, the German manufacturer of aircraft parts and servicing provider. The stock was off to a slow start so I had to give an update after the first year. Since then, it has returned over 100% in share price terms.
In the past, I also talked about Henkel, the German consumer products and industrial adhesives company. The stock generated a 52% return in the year after that presentation.
I have talked about Dignity, the UK funeral service provider. It is up only 3%, so it has not performed well so far. It has been impacted by the uncertainties in the UK. We are still confident about it.
Finally, we talked about Sika, one of our long-term holdings. It’s the Swiss leader in additives for the construction industry and in waterproof membranes, with a strong original equipment business but even stronger product prospects in the refurbishment of buildings. The stock is up 59% since last year and has significant prospects. I talked about our involvement in the company because we believe in constructive engagement rather than confrontation with management. However, at Sika we have to stand up for our interests in the face of an attempt by the founding family to sell their shares to Saint-Gobain, the French construction company, without extending the same offer to other shareholders. We’ve been working alongside other large shareholders, especially the Bill and Melinda Gates Foundation Trust (Cascade), to stand up for our interests. It is something we do when necessary, and the returns so far justify what we’re doing. The offer came at a share price of around CHF 3,000 and recently headed toward CHF 8,000, quite a return for one of the best companies in the world.
In-Depth Investment Thesis on Essilor
This year’s idea is a global leader in its business, in the middle of a merger with another global leader, which will create a globally dominant company in its industry. It has had good share price performance over time but has recently suffered from near-term issues that may have been caused by merger-related dislocation. Investors do not seem focused on the combined company — markets often look for deals to complete before adjusting for them.
In this situation, we have all the things we look for in investing. We have the quality of an outstanding business, we have value-creation prospects due to an ability to compound over the long term, and also the fact it is at almost a 20% discount to where it traded recently in anticipation of the benefits of this merger.
The company is Essilor, the number-one global prescription lens producer. It has market share of 41%, more than three times the nearest competitor. It has a vertically integrated supply chain and a strong distribution moat, with 350,000+ optical retailers for whom the company is a critical supplier alongside the providers of frames.
They are the leader in advanced lens technology, spending more than €200 million on research and development. No competitor can afford to spend as much. They have significant growth opportunities in Europe, the U.S., Asia, and the rest of the world — due to socioeconomic factors, growing and aging populations with a greater need for vision correction, and growing incomes. People can increasingly afford to buy glasses and lenses that allow them to see better, and to afford R&D-driven technical innovation.
Essilor is in a pending merger with Luxottica, the global leader in eyeglass frames and sunglasses. Luxottica has consolidated over the years many of the great global sunglass brands. They have extensive franchising of brands for whom they are the sunglass partner. Luxottica’s own distribution channel ranks among the leading global retailers of sunglasses. The combination both strengthens the business and solve a succession issue at Luxottica. Significant merger synergies will help generate value. They also mean the combined company is more attractive from a valuation perspective than suggested by recent headline multiples.
The eye care market is growing 6-7% a year. The eye correction market and the eye protection market are under-penetrated, with 55% and 80% still untapped, respectively. Most of us are used to eye correction, particularly as we grow older and spend more time in front of computer screens. Eye protection — the protection from UV light outdoors and from harmful light from computer screens — is a market we are only starting to understand. Blue light from computer screens has significant impact on our eyesight as we age. We all will need to consider it in terms of the glasses we wear in front of computer screens.
The under-development is particularly acute in the U.S., where advanced lens technology such as Essilor’s has not penetrated as much as simpler and cheaper solutions. People are learning about the benefits and opticians are starting to understand how to educate customers in terms of protecting and preserving their eyesight. Untapped potential in China exists across the board, both in areas in which GDP per capita is at European and U.S. levels, as well as in the vast areas and populations that are still catching up.
The top three players hold 63% market share in prescription lenses, and the remaining market is highly fragmented. The eye protection market is also highly fragmented. Essilor has scale advantages, and there continues to be significant potential to grow and create value through consolidation.
The merger with Luxottica creates an opportunity to invest in an emerging global leader that over the next 5-25 years should become on par with other global leaders in their industries. We may be at the beginning of a company we will compare to a Louis Vuitton or a Nestle in terms of their relative scale, their competitive advantage, and the value they can create over time.
The global optical market was €96 billion in 2015, consisting of the markets for contact lenses, eyeglasses, reading glasses, sunglasses, and frames. It is the total addressable market for Essilor and Luxottica. If you assume that 100% of vision needs are covered, the market potential would increase to €300 billion. Whether we get to 100% of coverage and whether economic growth creates a time lag in getting there are clearly issues. However, this highlights the market potential for these companies.
The U.S. is the biggest market in value terms but it is not yet widely penetrated by the more advanced solutions of Essilor. You won’t recognize Essilor brands unless you are an optician or have bought a pair of glasses recently and are highly aware of the lenses. The penetration of those lenses is not at the level of Europe, so the world’s biggest market is still an emerging market for Essilor’s lenses.
China is the second-largest market, with estimated size of €10 billion and growing. It is an important market for branded sunglasses and eyeglass frames but also for Essilor. They have a combination of local and global brands across functionalities and price points. China has significant potential as a driver of growth.
There are 7.2 billion people worldwide, 63% of whom need vision correction and 100% need vision protection, whether from the sun’s UV light — with drivers like climate change, cancer, and the impact of light on our eyes as we grow older — or from blue light from computers.
Of the 63% of the global population that needs vision correction, 1.9 billion is corrected and 2.5 billion remains uncorrected (both shortsightedness and farsightedness). As we age, we need reading glasses, an almost universal requirement. The first step is to buy cheap glasses available anywhere, but as our eyesight changes a need develops for prescription reading glasses and varifocals. Of the uncorrected number, 1.6 billion people are in Asia, 550 million in Africa, and 170 million in Latin America, reflecting the global industry growth ahead. Also, the corrected number is a number that includes people who are using the most basic of lenses and would benefit from having more sophisticated lenses.
On the vision protection side, 1.4 billion people are equipped with sunglasses. It’s a moving definition in terms of the types of sunglasses and lenses. The market growth is significant, but 5.8 billion people are unequipped. There is a large market for Essilor from a functionality perspective in sunglasses and blue light protection and also from a simple consumer perspective — people like to have sunglasses and might be attracted to Luxottica’s brands.
Essilor’s supply chain moat is significant. They have 32 plants globally, from which they send lenses and contact lenses to sixteen distribution centers, from which the products go to 350,000+ eye care professionals. It is a tremendous moat because eye care professionals depend on the reliability and quality of suppliers. It is unappealing to switch from a provider that meets criteria around the range of products, the ease of doing business, the training, understanding the functionality, the selling process to convince customers of the benefits, and the ability to deliver the glasses on time and at a quality customers expect.
Similar reasoning applies to the e-tailing trend. Eyeglasses are being sold online, and that retail disruption has tremendous impact on eye care professionals, whether they are part of the large chains that are consolidating and have economies of scale, or whether they are individual retailers. Essilor is effectively disruption-proof in that regard because e-tailers have to source lenses for their glasses. They are operating through more consolidated prescription labs and are the natural customers for Essilor, which has the scale to supply them in a cost-effective manner and, therefore, be part of the scale advantage of e-tailers as compared to retailer opticians. We are agnostic whether the growth takes place through opticians, i.e., the traditional channel, or whether it happens through e-commerce.
Many people are familiar with the products, owing to their last optician visit. However, eyeglasses are not just eyeglasses. Numerous layers of actual lenses and coatings are involved in a sophisticated lens. On the front, it’s not just a piece of plastic or glass; there is tint, factors for smudge, water repellents, UV resistance, and scratch resistance. On the back, there is not just scratch resistance but also efficiency in terms of avoiding light, dust, coatings for smudge and water. Many ingredients go into sophisticated lenses.
In terms of the e-mirror UV range, there is increasing sophistication and opportunity for differentiation as a result of these lenses. It significantly helps the competitive position of a company like Essilor. If we look at the price bridge between these lenses, on a monofocal, a simple eyeglass you might use if you’re near-sighted, the price goes from about €100 to €250-275 for a comprehensive upgrade, taking you from scratch resistance to thinner lenses, polarization, and anti-blue light. If you think of the importance of your eyesight, these are things one needs to consider.
If you look at progressive lenses, which you need when you move from being near-sighted to having difficulties reading, you start with €300 and move through the same steps of scratch resistance, thinner lenses, polarization, and anti-blue light to a total cost of over €530. These are important attributes, and not unlike a car, the upgrades come at significant incremental margins to the producer and form a basis for the attractiveness of the business.
Those are the two key investment criteria for Essilor — market growth and the company’s product-driven differentiation moat.
The Luxottica and Essilor businesses are incredibly complementary. Essilor is the leader in ophthalmic lenses, which Luxottica doesn’t produce. Luxottica is the leader in sunglasses and frames, which Essilor doesn’t produce. Luxottica also has significant retail and online distribution presence, whereas Essilor is a wholesale distributor and has only a limited online presence. It’s a natural fit for these two companies to come together. Their combined competitive advantage and the financial benefits of the combination are significant.
In terms of brand recognition, Luxottica either owns or has the franchises for many of the most recognizable and desirable eyeglasses and sunglasses. Sunglasses have become so expensive in part because Luxottica and Safilo have consolidated the market, similar to what LVMH and recently Kering have done in luxury goods.
Luxottica decided to boost quality, limit the distribution, cut the discounts and sales offered to wholesalers, and to increase prices. They have become more scientific about customers’ price elasticity. It turns out that price (in-)elasticity on sunglass purchases is such that people are prepared to spend a lot of money on a product that is easy to wear, recognizable, and says something about the person wearing it. There is a fashion element. Also, sunglasses get lost and broken and have to be replaced.
It’s a great market, and the combined Essilor/Luxottica covers the whole range of lenses, sunglasses, and frames as well as distribution. Luxottica, through SunGlass Hut, Pearle Vision, and LensCrafters, operates direct retailers in various markets to capture the margin. Through brands like Ray-Ban and Oakley, Luxottica has a significant omnichannel presence. Ray-Ban, in particular, has limited distribution and increased prices, which has dramatically changed the production and margins of that brand.
The two companies are quite similar in size, profitability, leverage, and market cap, so the two organizations are complementary but also compatible. Essilor has €6.7 billion in sales compared to Luxottica’s €9 billion for combined sales of €15+ billion; EBITDA of €1.6 billion and €1.9 billion, respectively, for a combined €3.5 billion. Essilor has slightly higher margins — 25%, compared to Luxottica’s respectable 21% — as you might expect for a wholesaler that adds value through R&D.
Importantly, because it is a merger, the leverage of the company continues to be conservative. While we are advocates of efficient balance sheets, we are far away from saying that companies should lever up in the short term in order to buy back shares or to pay special dividends as opposed to reinvesting for the long term.
As an aside, the recent “activism” at Nestle amounts to saying, “continue doing what you’re doing, just a little more and a little faster”. The idea of curtailing long-term growth by allocating capital for shorter-term returns makes no sense. It’s good to see that family-controlled Luxottica and well-run French company Essilor have both resisted that and are investing in their businesses.
Essilor’s share price has done well since 2012, going from €70 per share to a high of €124-125 and recently coming back down toward €70 per share. The run-up has been entirely due to earnings growth, comprised of organic growth, creative acquisitions, and some currency translation impact. The price-to-earnings ratio has remained remarkably constant, averaging ~25x and ranging from 18-30x.
As Phil Fisher rather than Ben Graham-style investors, we are concerned with long-term compounding. We are in agreement with the Buffett quote, “It’s better to buy a great company at a good price than a good company at a great price.” The five-year share price performance of Essilor bears that out. The respectable compounded annual return has been achieved at a fairly constant P/E ratio.
To benefit from that return, one has to say, first, we accept that a quality company like this trades at a premium multiple; second, ranges of 10-20% around that multiple are part of what happens in markets — they might be potential reasons to buy because it’s always good to buy at a bargain price, but they are not reasons to sell and go off looking for something else. If we expect to make 8-10% or more annually over the long term, a 10% discount to the multiple amounts to just one year of compounding. Trying to optimize the entry point is a short term-oriented, pointless exercise.
Essilor stock has flat-lined over the last two years, which has to do with the business, currencies and, most recently, some uncertainty around the deal. The one-year share price performance highlights the opportunity we have. The price has ranged from €95-120 per share and was recently around €105. The company has had outstanding results in aggregate but has recently suffered some dislocation because of merger-related uncertainty among independent retailers. Essilor downgraded its growth estimate from a range of 3-5% to 3%, which has caused a share price reaction.
The stock price run-up was in part because of the merger and anticipation of the benefits. The fact that people have gotten a bit discouraged is a positive aspect. The regulatory review of the merger has taken longer than expected due to the strong competitive positions of the two companies. It seems that some investors and sell-side analysts are waiting for certainty that the deal will close. This dislocation of market share, which they can win back, against a backdrop of growth, is exactly the type of opportunity we look for when investing in companies.
Why now? Because of this opportunity, the expected completion of the merger at the end of 2017 pending the regulatory review, and the valuation. The numbers, based on conservative assumptions around the benefits of the combination, suggest 15% accretion by 2020. On a pre-synergy basis, the combined company trades at a 2017 P/E of 26x. Post-synergy, the 2020 P/E goes down to 18x, an attractive valuation in absolute terms for a company that can grow in both nominal and real terms, i.e., a company that has the pricing power to offset inflation.
We view management’s €600 million synergies estimate as conservative. We estimate earnings growth of 8-9% over the next five years or, including growth synergies, 12-15%. It suggest that buying such a globally leading company at recent the market quotation may be a real opportunity.
The following are excerpts of the Q&A session with Chris Rossbach:
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About the instructor:
Chris Rossbach is Managing Partner of the London-based family office, J. Stern & Co. Established to provide investments for the Stern family, it is devoted to long-term investments for families with a multi-generational approach. J. Stern & Co. builds on the Stern family’s 200 year old banking tradition with a conservative approach and institutional-level analysis and resources. It manages bespoke concentrated global equities portfolios following a strict value approach, based on its own proprietary analysis, with a long-term investment horizon. Prior to co-founding J. Stern & Co., Chris had senior investment roles at Merian Capital, Magnetar Capital, Lansdowne Partners and Perry Capital. Chris holds a BA from Yale University and a MBA from Harvard Business School.
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