National Vision Holdings (EYE) - Bristlemoon Shorts, Edition #1
National Vision Holdings (EYE) - Bristlemoon Shorts, Edition #1
EYE and the upcoming Walmart contract loss
In this post we are providing a look-in at the Bristlemoon short book. We plan on this to be an ongoing series where we present a brief overview of a short idea. Some words of caution before reading further. Shorting is a difficult way to make money and if you’re an individual investor then shorting stocks is an ill-advised way to try to generate investment returns (we will in the future write a piece on the perils of shorting). None of the following is investment advice and we reserve the right to change our view.
Bristlemoon readers can also access some of the resources we used to research EYE via the links below:
Tegus – Bristlemoon readers can enjoy a free trial of the Tegus expert call library via this link
Koyfin – Bristlemoon readers can get 20% off a Koyfin subscription via this link
National Vision Holdings (NASDAQ: EYE)
Summary metrics
Price: $21.00 (8 January 2024)
Market cap (diluted): $1.6 bn
ADV: ~$21m
Short interest: 9.5%
Days to cover: 7 days
P/E fwd: 35x
What the business does
National Vision Holdings (NASDAQ: EYE) is one of the largest optical retailers in the U.S., providing eye exams, eyeglasses and contact lenses to mostly lower income consumers. Many of EYE’s customers rely on tax refunds to pay for eyewear and eye care, making the period after U.S. tax refunds in March the seasonally largest revenue period for the company.
About one-third of EYE’s customers are insured, with the remaining two-thirds uninsured. The corollary of this is that the majority of EYE’s customer base must reach into their own pockets to fund their eyecare purchases. According to the company at the UBS Global Consumer and Retail Conference in 2023, “We're less developed in the insurance category than most other chains because our budget-conscious consumer isn't insured. They don't have a job that gives them business insurance.”
EYE’s owned brands include America’s Best and Eyeglass World, as well as Vista Optical located in select Fred Meyer Stores.
Source: Company filings
Source: Company filings
The company prides itself on being able to offer two pairs of eyeglasses for $79 with the eye exam included. 82% of EYE’s revenue, and 94% of its gross profit, is from products. Some portion of this spend is non-discretionary (i.e., contact lenses or replacing broken glasses which typically follows a 1.5-2 year replacement cycle). This non-discretionary component of EYE’s business is reflected in the fact that existing customers represented 65% of EYE’s total customers in 2022.
Short thesis
Lower income consumers getting squeezed
EYE’s lower income consumers are getting squeezed worse than any other socioeconomic group from the inflation-driven cost of living crisis. The company acknowledged this at a recent UBS conference: “the brunt of the inflation is borne by our customers, and so they are very strapped.” Student loan payments resumed in October 2023 and inflation, while moderating, is still exacerbating the financial difficulties faced by lower income Americans.
The risk for EYE, particularly given two-thirds of their customer base is uninsured, is that eyewear purchase cycles elongate as these consumers look to stretch the dollars they have by delaying purchases of eyewear. Furthermore, to the extent that the unemployment rate increases from its low level at present, part of the managed care customer base (i.e., insured customers who represent one-third of EYE’s customer base) could lose their jobs, lose their optical insurance coverage (which is typically tied to their employment), and this could further slow demand for EYE’s products and services. The company’s comps are expected to decelerate, with management mentioning on the 3Q23 call: “we do expect some deceleration in the implied Q4 comp”. Prior year comps will also get progressively more difficult over the next four quarters.
Walmart contract termination
Perhaps the most interesting angle of the EYE short thesis is the fact that on July 26, 2023, National Vision Holdings announced that its Walmart partnership had been unexpectedly terminated and will formally end in February 2024. In connection with the non-renewal of the Walmart contract, AC Lens, one of National Vision’s subsidiaries notified Walmart that it is not renewing its agreement for wholesale and e-commerce contact lenses distribution, and that the AC Lens agreement will terminate on June 30, 2024.
At the Goldman Sachs Global Retailing Conference in September 2023, Reade Fahs, CEO of EYE, commented on the Walmart contract termination (in a somewhat contradictory way): “it was an unexpected thing, but it was not something that we haven’t been prepared for”. National Vision has had a partnership with Walmart for 33 years, supplying and operating Vision Centers in select Walmart stores, in addition to providing contact lens distribution and related services to Walmart. Walmart had said back in 2002 – a time when they comprised 95% of National Vision’s sales and profits – that they were going to end the partnership. So, while the relationship did persist for another two decades, it was an overhang the management team was clearly aware of.
This partnership termination immediately reminded us of Dean Foods (formerly NYSE: DF), a now bankrupt company which saw a cascading of issues when Walmart cancelled its milk processing contract and decided to insource those volumes. The parallels with EYE are clear: one of the company’s largest earnings contributors is now set to disappear in 2024 and will instead become a competitor. EYE is transitioning the operations of the 229 Vision Centers to Walmart, with one of the largest, well-capitalized companies in the world suddenly becoming a competitor. So how meaningful is this earnings impact likely to be? The company provided some details that allow us to piece together what these agreements contributed to revenues and earnings:
Source: Company filings
From the above, we can gauge that the Walmart agreements accounted for 17% of EYE’s revenues and 25% of their pre-tax earnings in FY22. That is an enormous chunk of earnings to be losing. On the 3Q23 earnings call, the CFO disclosed that the Walmart agreements are expected to account for $355 million of EYE’s FY23 revenue, which is guided to be $2.12 billion at the midpoint (i.e., 16.7% of revenues). In addition, the remaining non-Walmart portion of the company’s AC Lens operations, which generates approximately $45 million in sales and is “immaterial from an earnings perspective” is also being wound down.
The company guided to revenue related to the Walmart Vision Center operations and AC Lens operations in FY24 ranging between $140-$150 million and with a roughly similar margin profile to FY23, implying a $5.3 million to $5.6 million pre-tax profit range (at a 3.8% margin). This compares to $400 million in revenue and approximately $15 million in pre-tax earnings expected to be generated in FY23 by the Walmart store operations and the AC Lens operations.
In other words, around $250 million in revenue and almost $10 million in pre-tax earnings is disappearing for EYE in FY24 (that equates to c.12% of the revenues and c.15% of the pre-tax earnings that were generated in FY23). And there is the fact that FY25 will have an even greater financial impact as it’s the first full year excluding the Walmart contribution (recall that there are still some Walmart revenues being generated in FY24). This will create an earnings hole that will be difficult to fill.
Furthermore, it is likely that there is de minimis maintenance capex attributable to the Walmart Vision Center stores (these stores are physically located within Walmart stores), meaning that there could be an outsized negative impact on EYE’s FCF as earnings fall away without a commensurate reduction in capex levels. For example, a 15% reduction in LTM pre-tax earnings would cause a 54% decline in FCF without an associated decline in capex.
Optometrist shortage and labor inflation
EYE is facing weakening demand at a time when an acute shortage of optometrists is fueling inflation in the company’s cost base. A study by the Baylor College of Medicine found that in 2019, more than 25% of U.S. counties did not have a single practicing eye care provider (and this was noticeably before the pandemic)[1]. Many optometrists retired during COVID and there is an insufficient new supply of optometrists to ensure National Vision’s stores are adequately staffed. Management acknowledged this on the 3Q23 call:
“So we don't expect that the supply environment will change as it relates to doctors anytime soon…as far as base wages go, we had previously seen wages expand in the low single-digit range historically, and now that's closer to the mid-single-digit range, and we do expect that going forward at this time.”
Attracting optometrists to National Vision’s stores is even more difficult as they lack the margin structure to pay optometrists significantly more to compete with other eyecare chains, and the nature of the work at National Vision’s brands is high volume and less satisfying for practitioners. An Executive Vice President at MyEyeDr, a competitor to National Vision Holdings, made the following comments on a Tegus call (Bristlemoon readers can enjoy a free trial of the Tegus expert call library via this link):
“When you're working on an America's Best or an Eyeglass World, then typically your reach is a little bit more narrow. You're just doing a lot of the same types of exams, trying to get as many of them as you can. That's a harder value proposition”. [in terms of attracting and retaining optometrists]
EYE identifies in its store base what it refers to as dark stores and dim stores. Dark stores have no optometrist coverage, rendering these stores 80% less productive as it’s more difficult to purchase eyewear when there’s no optometrist to provide a prescription. These dark stores were at their highest level in 2Q22 at a mid-single digit percentage of the company’s store fleet, but this number has since halved. Dim stores are stores that have only part-time coverage by optometrists and the company has not disclosed what portion of the store fleet these stores comprise.
We can run some rough math on this. In FY22 EYE had an average store count of 1,316 stores, implying revenue per average store of around $1.3 million. If we assume 5% of the store base was dark in FY22 and 80% less productive, then we can deduce that 95% of the store base was averaging $1.35 million in revenue per store and 5% of the store base was doing $270,000 in revenue per store (i.e., 80% less productive).
The halving of the percentage of dark stores would have provided a comp uplift in FY23, given that a store regaining adequate staffing could garner a 2.5x to 4x sales productivity uplift. Note that a store no longer being dark also means that it could be classified as dim as opposed to reverting to a fully staffed (and fully productive store). A dim store is 50% less productive than a fully staffed store due to understaffing (compared to a dark store that has no optometrist and is 80-90% less productive).
If we assume that the 2.5 percentage point reduction in dark stores is split 50:50 between those stores becoming dim and fully productive, then there’s an approximately $10,000 per store sales productivity uplift which equates to an incremental $13 million comp store uplift. If instead we assume that all 2.5 percentage points of those dark stores become fully productive (a 4x uplift) then that’s an approximately $23,000 per store sales uplift, generating $30 million of incremental comparable store dollars.
From these calculations, we can (very roughly) estimate that 70-150 bps of comp store benefit could have emanated from these dark stores regaining staffing. EYE is guiding to ~2% comparable store sales growth for FY23, meaning that a significant portion of that comp growth is likely being driven by the dark store uplift, a finite source of comp growth that is unlikely to be repeatable in future periods (we believe there will be a low-single digit percentage of the store base that remains dark due to the optometrist shortage).
For a low-single digit net margin business, an inflating cost base puts EYE in a precarious position: they can raise prices and erode the value proposition for an already stretched low-income consumer and risk market share losses, or they can absorb this labor cost impact and take the margin hit. EYE is choosing to raise non-headline prices. We have seen this elsewhere in the industry with online players such as Zenni and Warby Parker. Warby has not increased the price of their $95 frames, but their product range has increasingly skewed towards the $150 to $200 price band.
EYE has been increasing prices and on the 3Q23 earnings call the CEO commented that: “we have some programs that we're going to be putting in place at the very end of this year that…we think, are going to play a nice role in improving our margins next year”. This is certainly a risk, but one that we believe has been more than priced into the store at current levels.
Leverage to come back into focus this year
EYE has a trailing 12-month net debt to adjusted EBITDA of 1.9x. The key word in that sentence is trailing. Recall that a chunk of the company’s earnings is falling away next year as the Walmart contract terminates. If the company is unable to plug this earnings hole, then this will put upward pressure on this leverage ratio at a time when the company’s May 2025 convertible notes will become current, and attention will shift to settling those obligations in what remains a less accommodating credit environment that what has persisted in recent years.
Risks to the short
Remote exam rollout
EYE has been rolling out capabilities to perform remote eye exams at its stores. Patients come into a store and the optometrist can perform the eye exam from an external location (although notably different states have different licensing rules so cross-state exams are not always possible). This provides greater flexibility for optometrists (helping attract and retain personnel) but can also direct idle optometrist capacity towards higher demand stores, thus improving store productivity levels.
Most of the company’s initiatives have been directed at the company’s America’s Best brand, which has seen comparable store sales growth accelerate (+5.7% in 3Q23 vs. 1.8% and 1.7% in 2Q23 and 1Q23, respectively), although part of this is from easy compares. This is a risk to the short if America’s Best comps continue to improve, and if the same playbook can successfully be applied to the company’s Eyeglass World business. However, we would also note that: 1) it is expensive to roll out this remote exam equipment in stores; and 2) they are rolling out these capabilities to the remainder of the store relatively slowly due to regulatory hurdles. CEO Reade Fahs made the following remarks on the 3Q23 earnings call:
“As of the end of Q3, more than half of our America's Best locations have been enabled with remote exam capabilities and electronic health care records reflecting the progress we've made through the initial heavy implementation phase over the past 2 years. We remain on track to roll remote capabilities out to at least 200 stores this year. And as we look ahead, given the work done to date as well as the evolving state regulatory landscape, we expect the pace of our implementation of remote to slow in 2024.”
At the Goldman Sachs Retailing Conference in September 2023, CEO Reade Fahs commented that: “we expect to get through the heavy implementation cycle of our remote rollout in mid to late ‘24”. What this means is that EYE will still be investing in the remote rollout throughout FY24, creating a margin headwind over the next few quarters.
Trade down activity
Given EYE’s value-positioning in the eyecare market, there is the risk to a short that relatively higher income consumers trade down into EYE’s value segment. From the 3Q23 earnings call:
“So trade down continues, and we're seeing a greater percent of our customers coming from over $100,000 households and managed care is part of that, but some relates to non-managed care as well.”
EYE has been increasing its market share recently, so this needs to be monitored.
Source: Morgan Stanley Research
Store rollout potential
Retailers with store rollout stories can be dangerous shorts, as longs are likely to latch on to the long-term growth story and look-through any short-term weakness. However, the store unit economics for EYE are okay but not remarkable: the majority of the company’s owned stores have achieved profitability during the second year of operation and have paid back invested capital in three to five years. EYE CFO Melissa Rasmussen framed the store rollout opportunity at the Goldman Sachs Retail Conference last year:
“So with the expansion, we have a considerable white space for America's Best and Eyeglass World. 2,150 stores is what we were last analyzing as we did our last white space analysis, and we currently have 1,380 stores as of July 1. So we continue to expect that we'll expand and have similar economics to the store base that we've previously opened with that America's Best and Eyeglass World”.
There is, however, a fly in the ointment. You need optometrists to achieve new store model targets. A Former District Manager at National Vision in the Virginia market on a Tegus call commented that National Vision was in fact opening new stores without a doctor, which would carry materially degraded unit economics (Bristlemoon readers can enjoy a free trial of the Tegus expert call library via this link):
“And other thing that they seem to be doing, which makes zero sense is their opening new stores, so they're opening them without a doctor. And in the past, we would never do that. It just doesn't make any sense. If I didn't have a doctor, I'm not opening the doors.”
We see many subpar retailers mention unrealistic long term store rollout targets that provide hope for longs. We are skeptical about the company’s ability to reach its long-term store target without a marked degradation of store unit economics. This view is based on the ongoing optometrist shortage and the difficulty in staffing new stores.
What is the market missing? / Catalyst(s)
For all its problems, EYE’s valuation would lead onlookers to believe the financial future of the company is bright. EYE trades on 35x FY24E consensus adjusted EPS and 28x FY25E numbers. We would note also note these consensus numbers are likely too high given the Walmart contract termination, persistent labor inflation, and demand weakness from EYE’s low-income consumers.
The sell-side is modeling $62 million and $63 million of adjusted operating income in FY23E and FY24E. In FY24, there is around $10 million operating income falling away due to the Walmart contract loss. This implies that EYE’s core business (ex-Walmart) will grow operating income by $11 million year-over-year in order to hit the FY24E numbers. This equates to roughly 21% year-over-year growth for the core business (i.e., an incremental $11 million of operating income on the $52 million of core operating income, ex-Walmart).
The company has announced that beginning in 2024, it will be implementing an incremental expense reduction program targeting annualized savings in the range of $10 million to $12 million. These cost outs are focused on streamlining corporate overhead (such as optimizing non-customer facing labor costs) as well as reducing travel expenses and third-party spend. This, along with the non-headline price increases, has been guided by EYE management to more than offset the profitability gap created by the termination of the Walmart partnership. While the price increases and cost outs will help, and may be capable of fully offsetting the Walmart profitability gap, the stock is still richly priced. Thought of another way, the company has to execute well to unlock these benefits and then even still, the earnings that would be generated in this scenario are being ascribed a high multiple by the market.
We acknowledge that we could wrong on this short. The macroenvironment could markedly improve as inflation moderates. The company’s pricing and cost-out self-help levers could provide a material earnings benefit. This is particularly so given that 94% of gross profits come from selling products (as opposed to optometry services). EYE’s remote exam capabilities could alleviate optometrist labor cost pressures which further boosts the product side of the business as more prescriptions are written. These are genuine risks. However, on the balance of probabilities we believe that the current price more than bakes in the benefit of these factors. The company will give FY24 guidance on the 4Q23 call which we believe will serve as a downside catalyst as the Walmart contract termination sinks in and starts to impact the company’s financial results.
Disclaimer / Disclosures
The information contained in this article is not investment advice and is intended only for wholesale investors. All posts by Bristlemoon Capital are for informational purposes only. This article has been prepared without taking into account your particular circumstances, nor your investment objectives and needs. This article does not constitute personal investment advice and you should not rely on it as such. This document does not contain all of the information that may be required to evaluate an investment in any of the securities featured in the document. We recommend that you obtain independent financial advice before you make investment decisions.
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George Hadjia is associated with Bristlemoon Capital Pty Ltd. Bristlemoon Capital may invest in securities featured in this newsletter from time to time.
[1] https://blogs.bcm.edu/2023/07/21/eyeve-heard-enough-todays-physician-shortage/#:~:text=More%20than%2025%25%20of%20U.S.,these%20providers%20was%20an%20ophthalmologist.