17 March 2017 Europe/France Equity Research Medical Supplies & Devices
Essilor International SA (ESSI.PA) Rating OUTPERFORM Price (14 Mar 17, €) 110.80 INITIATION Target price (€) 127.00 Market Cap (€ m) 24,201.9 Seeing EssilorLuxottica clearly Enterprise value (€ m) 25,583.3 Target price is for 12 months. ■ We initiate on Essilor with an Outperform rating and a TP of €127. Research Analysts Essilor and Luxottica’s share prices have trended back towards pre- Catherine Tillson announcement levels and no longer price in management’s guided merger 44 20 7888 6052 synergies of €400-600m. We think this has been driven by: a) profit taking; b) [email protected] execution risk; and c) concerns over approvals from competition authorities. Guillaume Gauvillé, CFA We understand the first point given the stock has outperformed the CAC 40 44 207 888 0321 [email protected] by c25% over the past five years, but we detail in this report why we believe the anti-trust and execution concerns are overstated. ■ The roadmap to EssilorLuxottica. We believe the market is overestimating the execution risk, and in this report we outline the seven key initiatives we think management should implement to harness the full synergies of the merger. These include i) lens insourcing, which we estimate could lead to €150m of cost synergies, and ii) centralisation of lens and frame inventory with lens labs to build the company’s competitive advantage. On anti-trust, we believe the company has some optionality in the US (the market where we believe there could be an issue) through a possible portfolio review. ■ Average EPS growth of 12% out to 2021e. We forecast €540m of EBIT synergies, driven equally by revenue and costs. This supports our >6% growth forecast for EssilorLuxottica over the next five years, along with our forecast for 330bps of contribution margin expansion by 2021. We forecast EssilorLuxottica to turn net cash in FY20e with a 40% payout ratio. We forecast a 15% TSR over the next three years. ■ Risks: We see two key risks, i) the deal does not go through because of competition issues or it is rejected by Essilor shareholders at the AGM on 11 May; or ii) the execution of the merger is poor. ■ Valuation is supportive, opening up an attractive entry point into the name. EssilorLuxottica ex synergies trades on an average historical 12- month forward consensus EV/EBIT of 17.3x. Currently the combined entity is trading at a c10% discount to this on our FY18 estimates, at 15.6x. Our target price of €127 is based on a simple average of our Credit Suisse HOLT® Linker and a pro forma DCF for EssilorLuxottica. Share price performance Financial and valuation metrics
1 3 0 Year 12/16A 12/17E 12/18E 12/19E 1 2 0 Revenue (€ m) 7,115.0 7,770.1 8,312.0 8,881.0 1 1 0 EBITDA (€ m) 1,699.1 1,815.2 1,964.0 2,105.3 1 0 0 Adjusted net income (€ m) 813.00 924.06 1,016.14 1,106.41 9 0 CS EPS (adj.) (€) 3.73 4.24 4.66 5.07 8 0 Prev. EPS (€) Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 ROIC (%) 10.6 11.6 12.3 12.8 P/E (adj.) (x) 29.7 26.2 23.8 21.8 ESSI.PA CA C 4 0 IN D EX P/E rel. (%) 194.5 182.9 184.4 184.4 The price relative chart measures performance against the EV/EBITDA (x) 15.3 14.1 12.8 11.8
CAC 40 INDEX which closed at 4974.3 on 14/03/17 Dividend (12/17E, €) 1.50 Net debt/equity (12/17E,%) 18.2 On 14/03/17 the spot exchange rate was €1/Eu 1.- Dividend yield (12/17E,%) 1.4 Net debt (12/17E, € m) 1,381.4 Eu.94/US$1 BV/share (12/17E, €) 26.9 IC (12/17E, € m) 8,962.9 Performance 1M 3M 12M Free float (%) 90.5 EV/IC (12/17E, (x) 2.9 Absolute (%) 1.2 7.0 -1.4 Source: Company data, Thomson Reuters, Credit Suisse estimates; Note: all financial tables show underlying Essilor numbers Relative (%) -0.5 3.9 -12.5 unless otherwise stated.
DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 17 March 2017
Essilor International SA (ESSI.PA) Price (14 Mar 2017): €110.8; Rating: OUTPERFORM; Target Price: €127.00; Analyst: Catherine Tillson Income statement (€ m) 12/16A 12/17E 12/18E 12/19E Company Background Revenue 7,115 7,770 8,312 8,881 Essilor produces ophthalmic lenses for prescription glasses and EBITDA 1,699 1,815 1,964 2,105 sunglasses. Additionally it sells lens manufacturing equipment as Depr. & amort. (378) (374) (400) (427) well as sunglasses and readers. EBIT 1,230 1,384 1,507 1,621 Net interest exp. (57) (51) (42) (26) Blue/Grey Sky Scenario Associates 1 1 1 1 PBT 1,164 1,332 1,465 1,596 Income taxes (285) (333) (366) (399) Profit after tax 879 999 1,099 1,197 Minorities (67) (76) (84) (91) Preferred dividends - - - - Associates & other 1 1 1 1 Net profit 813 924 1,016 1,106 Other NPAT adjustments 0 0 0 0 Reported net income 813 924 1,016 1,106 Cash flow (€ m) 12/16A 12/17E 12/18E 12/19E EBIT 1,230 1,384 1,507 1,621 Net interest (66) (51) (42) (26) Cash taxes paid (250) (333) (366) (399) Change in working capital 8 (93) (86) (100) Other cash and non-cash items 314 375 401 428 Cash flow from operations 1,236 1,281 1,414 1,525 CAPEX (294) (350) (391) (435) Free cashflow to the firm 942 932 1,023 1,090 Acquisitions (737) (125) (141) (238) Divestments 17 0 0 0 Other investment/(outflows) (3) 0 (0) 0 Cash flow from investments (1,017) (474) (531) (673) Net share issue/(repurchase) 130 0 0 0 Dividends paid (117) (369) (425) (467) Our Blue Sky Scenario (€) 137.00 Issuance (retirement) of debt 70 85 240 259 We calculate our blue sky scenario assuming the company can Cashflow from financing 82 (284) (185) (208) accelerate the merger with Luxottica and reach the top end of Changes in net cash/debt 293 438 458 384 synergy guidance. This leads to a 10% increase in profits of the EssilorLuxottica entity. We then apply the average 5 year EV/EBIT Net debt at start 2,113 1,820 1,381 924 multiple for EssilorLuxottica ex synergies. We derive a blue sky Change in net debt (293) (438) (458) (384) valuation of €137. Net debt at end 1,820 1,381 924 540 Balance sheet (€ m) 12/16A 12/17E 12/18E 12/19E Our Grey Sky Scenario (€) 90.00 Assets We base our grey sky scenario on the deal between Essilor and Total current assets 3,718 4,491 5,380 6,224 Luxottica not going through and a further deceleration in the Total assets 12,963 13,837 14,857 15,946 eyewear market especially in the US. Moreover we assume the Liabilities relationship between the company and independents is negatively Total current liabilities 3,337 3,525 3,722 3,920 impacted by the merger proposal. This leaves us forecasting a 15% Total liabilities 6,013 6,255 6,601 6,960 decline in FY18 operating profits. We apply the historic average Total equity and liabilities 12,963 13,837 14,857 15,946 EV/EBIT of 16x, thereby forecasting a grey sky scenario of €90. Per share 12/16A 12/17E 12/18E 12/19E No. of shares (wtd avg.) (mn) 218 218 218 218 Share price performance CS EPS (adj.) (€) 3.73 4.24 4.66 5.07 Dividend (€) 1.11 1.50 1.73 1.90 130 Free cash flow per share (€) 4.32 4.27 4.69 5.00 Key ratios and valuation 12/16A 12/17E 12/18E 12/19E 120 Growth/Margin (%) 110 Sales growth (%) 5.9 9.2 7.0 6.8 100 EBIT growth (%) 4.0 12.5 8.9 7.6 Net income growth (%) 7.4 13.7 10.0 8.9 90 EPS growth (%) 6.6 13.7 10.0 8.9 80 EBITDA margin (%) 23.9 23.4 23.6 23.7 EBIT margin (%) 17.3 17.8 18.1 18.3 May- 15 Sep- 15 Jan- 16 May- 16 Sep- 16 Jan- 17 Pretax profit margin (%) 16.4 17.1 17.6 18.0 Net income margin (%) 11.4 11.9 12.2 12.5 ESSI.PA CAC 40 INDEX Valuation 12/16A 12/17E 12/18E 12/19E EV/Sales (x) 3.7 3.3 3.0 2.8 The price relative chart measures performance against the CAC 40 INDEX EV/EBITDA (x) 15.3 14.1 12.8 11.8 which closed at 4974.3 on 14/03/17 EV/EBIT (x) 21.1 18.5 16.7 15.3 On 14/03/17 the spot exchange rate was €1/Eu 1.- Eu.94/US$1 Dividend yield (%) 1.00 1.35 1.56 1.72 P/E (x) 29.7 26.2 23.8 21.8 Credit ratios (%) 12/16A 12/17E 12/18E 12/19E Net debt/equity (%) 26.2 18.2 11.2 6.0 Net debt to EBITDA (x) 1.1 0.8 0.5 0.3 Interest coverage ratio (x) 21.4 26.9 36.2 63.5 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates; Note: all financial tables show underlying Essilor numbers unless otherwise stated.
Essilor International SA (ESSI.PA)2 17 March 2017
Key charts
Figure 1: Essilor is the leading lens manufacturer Figure 2: Combining with the leading frames globally manufacturer makes sense, in our view Global market share of lenses, retail value, 2015 Global market share of frames, retail value, 2015 ) %
( Chilli Beans Industrias de Optica 0.3% 1% e r a h
s Vision Service Plan Global 3%
JIN Co Ltd 0.3% t e k r
a Essilor International SA 4%
New Tian Hong Optical 0.3% m
s e
s Safilo Group SpA 14% s a
Rupp+Hubrach Optik 0.5% l g n
u Luxottica Group SpA 50% Nikon Corp 0.5% S
Fielmann 1.3%
t Rodenstock GmbH 1% e k r
Rodenstock 1.9% a m
Fielmann AG 1% ) s e % (
Carl Zeiss 6.3% m e a r r Vision Service Plan Global 2% f a
h e l s Hoya c
7.9% a
t Safilo Group SpA 6% c e p
Essilor 31.3% S Luxottica Group SpA 23%
Source: Euromonitor, Credit Suisse research Source: Euromonitor, Credit Suisse research
Figure 3: The deal would end the diversification Figure 4: And would solve some of the legacy issues story at Essilor, which has dragged on returns at each company; e.g. lack of momentum in EM Lease-adjusted ROIC, % % of Essilor group revenues from fast-growing markets
20% 23% 22% 22% 22% 18%
16% 18% 14%
12% 15% 13% 10% 12% 11% 8%
6%
4%
2%
0% FY13 FY14 FY15 FY16e FY17e FY18e FY19e
Lens & Optical instruments Sunglasses & readers Equipment Group FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse research
Figure 6: We forecast €540m of EBIT synergies by Figure 5: EssilorLuxottica has historically traded at FY21, putting EssilorLuxottica on a 10% discount 17x EV/EBIT if we take an EV weighted average on our FY18 numbers vs. history at 17x EssilorLuxottica 12mth fwd consensus EV/EBIT, EV weighted EV/EBIT multiples on our estimates for Essilor, Luxottica and average EssilorLuxottica (EV weighted)
22x 20 17.7x 18 21x 15.6x 16 13.7x 20x 14 12.4x 11.4x 19x 12 10 18x 8 17.3x 17x 17.2x 6 4 16x 2 15x Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 - FY17e FY18e FY19e FY20e FY21e
EssilorLuxottica 12mth fwd. EV/EBIT ex synergies 5 yr. avg Luxottica Essilor EssilorLuxottica
Source: Thomson Reuters, Credit Suisse estimates Source: Credit Suisse estimates
Essilor International SA (ESSI.PA)3 17 March 2017
Table of contents
Key charts 3
Initiate with an Outperform rating 5
Essilor Int. (soon to be EssilorLuxottica) 10
From medtech to consumer 13
The roadmap to EssilorLuxottica 17 1. Move Luxottica lens sourcing in-house...... 17 2. Bring frames, lenses and labs together ...... 17 3. At the same time, rationalise the lab network ...... 18 4. Consumer brands come together ...... 20 5. Leverage each other’s assets to grow brands ...... 22 6. Gain greater control over the wholesale channel...... 25 7. Use Essilor knowhow in online ...... 26
Pro forma model 28 Revenue synergies impact EBIT by €270m ...... 28 Cost synergies impact EBIT by €270m ...... 31 Essilor is not a margin story on its own...... 31 We still believe in margin accretion at Luxottica ...... 32 EssilorLuxottica EPS growth of 12% FY17-21e ...... 33
Cash generation should remain strong 35
Governance and risks 37
Valuation 38 Blue/Grey Sky Scenarios ...... 41 Financials – Essilor standalone...... 42 Financials – EssilorLuxottica pro forma ...... 45 Credit Suisse PEERs ...... 49
Essilor International SA (ESSI.PA)4 17 March 2017
Initiate with an Outperform rating We initiate on Essilor International… We rate the shares Outperform with a target price of €127, indicating c15% potential upside. Essilor is the world's leading manufacturer of lenses, accounting for c30% of the global lens market by value – a market worth €43bn in FY16 (source: Euromonitor). Lenses account for 87% of Essilor's revenue (FY16 group revenue: €7.1bn), with the remainder coming from sunglasses, readers and third-party lens manufacturing/finishing equipment. …and recommend gaining exposure to the EssilorLuxottica merger. On 16 January 2017, Essilor proposed a merger with Luxottica in a share-for-share transaction. The merger would bring together the two largest eyewear companies in the industry, with combined FY16 revenues of >€15bn. Both companies are considerably vertically integrated along their respective parts of the value chain – Essilor in lenses and Luxottica in frames. Taking a bird's eye view of their revenue exposures shows how complementary the two companies' footprints are in the eyewear market (see Figure 7).
Figure 7: Essilor and Luxottica have complementary revenue exposure Revenue exposure by product, channel and brand, as a percentage of the groupings indicated. Essilor's exposure to frames could be up to 10% of revenues if we assume the whole of the sunglass and readers division.
Frame Lens W/S Retail Online Licenses Own brands Rx Sun manufacture manufacture and sell and lens through finishing r o l i s
s 5% 95% 99% 1% 5% 25% 75% 84% 13% E a c i t t o
x 80% 20% 41% 59% 5% 30% 70% 50% 50% u L
d e y n t i i t b n
m 48% 52% 66% 34% 5% 28% 72% 65% 34% e o C
Source: Company data, Credit Suisse estimates
Both companies have significantly outperformed the market over the past five years. Luxottica’s shares are up c60% and Essilor’s up c25% relative to their respective markets over the past five years. Both stocks have had a strong run despite recent price weakness for Luxottica shares at the start of 2016. But recent share price weakness provides an attractive entry point into these names, in our view. The share prices for both of the companies are trending back towards pre-announcement levels, losing some of the 12% (Essilor) and 8% (Luxottica) gains they made on the day of the announcement. We believe this is in part driven by some profit taking given the rallies over the past five years, as well as some concerns that the deal may not go through. The latter we see as highly unlikely, given: i) the length of time the deal has been on the table (it was first publicly discussed in September 2014); ii) the fact it is largely a vertically integrated deal; and finally iii) any anti-trust issues would most likely arise in the US, where the companies have some optionality (e.g. potentially selling off standalone retail assets such as Sears Optical and Target Optical).
Essilor International SA (ESSI.PA)5 17 March 2017
Figure 8: Both companies' shares have rallied Figure 9: First year of c0% industry growth in five significantly over the past five years years Share price performance relative to the CAC 40 and FTSE MIB for Industry (retail value of spectacle frames, sunglasses and lenses) Essilor and Luxottica, respectively growth, % cc
200
190 4%
180 3% 3% 3% 170 2% 160 2% 2% 157 150 1%
140 0% 0% 0% 130 125 120 0%
110 -1%
100 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 -2%
Luxottica/FTSEMIIB Essilor/CAC40 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Thomson Reuters Source: Euromonitor, Credit Suisse research
This is not a purely defensive merger… The eyewear industry recorded almost no growth in 2016, according to Euromonitor, making it the first year without 3%+ growth since 2011. We think this may have prompted the view among market participants that this transaction is driven by the need to find new growth areas. We do not agree with this. Essilor and Luxottica reported cc growth in 2016 of 8% and 2% (on an adjusted basis), respectively. This is just below the 10-year average for Essilor of 11% and admittedly a step down for Luxottica from 7% over the past five years, but driven in part by company initiatives. Although Essilor has seen a c7% cut to earnings over the past year, we expect them to stabilise from here. Luxottica’s earnings appear to be stabilising as well (see Figure 11), suggesting this is not a purely defensive move, in our view.
Figure 10: Essilor EPS momentum to trough in Figure 11: Luxottica’s EPS momentum has FY17, in our view normalised Consensus EPS momentum 12mth fwd, Essilor Consensus EPS momentum 12mth fwd, Luxottica
5.4 2.9
4.9 2.4 4.4
1.9 3.9
3.4 1.4
2.9 0.9 2.4
1.9 0.4 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17
FY12e FY13e FY14e FY15e FY16e FY17e FY18e FY12e FY13e FY14e FY15e FY16e FY17e FY18e
Source: Thomson Reuters Source: Thomson Reuters
…and it should bring to an end the diversification strategy that has been a drag on Essilor's returns. The search for new growth areas started several years ago with Essilor moving into sunglasses and online and Luxottica into lens finishing. This diversification has been a drag on returns and capital-intensive. Pursuing the deal now should: i) preserve the synergy potential of the deal before too much investment has occurred, and ii) end the drag on returns we have seen at Essilor since FY13 (see Figure 12). The deal would also bring the management overhang to an end. Part of Luxottica’s share price pressure at the start of 2016 was driven by a number of CEOs (to be specific three, including Mr Guerra) leaving the business in rapid succession and the return of the founder, Mr Del Vecchio, in an executive role. This has highlighted succession issues.
Essilor International SA (ESSI.PA)6 17 March 2017
Signing this deal now would likely end this management overhang and although Del Vecchio plans to take an active role as Executive Chairman and CEO over the short term, in the longer term we expect management to easily pass on to Essilor’s CEO, Mr Sagnières. For the time being, we see it as a positive that both CEOs are heavily involved in the deal given the size of the combined entity and different expertise of each company. We believe EssilorLuxottica can hit the top end of the EBIT synergy guidance, at €540m. This is weighted exactly 50:50 between revenue and costs. We believe this deal removes many of the legacy concerns at both Luxottica and Essilor around i) online, ii) emerging markets and iii) brands. We believe the roadmap to these synergies is as follows: 1. Move Luxottica’s lens procurement in-house. The company spends c10% of COGS on lenses, on our estimates; we calculate that bringing this in-house could lead to savings of up to €150m. 2. Bring the frames and lens inventory together under one distribution center and build out lens lab facilities next to the centralised distribution centers. This would reduce logistics costs and operating expenses. However, we also believe it would have significant scope to support topline, which we think is less understood by the market. Combining inventory and labs would enable faster turnaround times and force wholesale partners to use the EssilorLuxottica supply chain to remain competitive. 3. Rationalise Essilor’s lens labs outside of the US, moving to a more centralised model (as with initiative #2) and close Luxottica’s labs inside the US as planned. 4. Combine the branded lens world with frame world in LensCrafters and push Essilor’s higher-end brands such as Bolon and Costa into Sunglass Hut. Additionally, use Essilor's strong relationships with the US independents and wholesale partners globally to broaden Luxottica’s distribution. 5. Leverage Luxottica’s frame manufacturing for Essilor’s higher-end sunglass brands. 6. As a combined force, with increased advertising, push further into emerging markets. Consolidate the sales force (especially in these markets) to try to remove third-party distributors and gain greater control of inventory / read through of sellout trends. Leverage Essilor’s know-how in China and Luxottica’s in Brazil. 7. Leverage Essilor’s expertise in online. Launch the ability to buy Rx and Sun Rx on rayban.com and sunglasshut.com. Launch LensCrafters omnichannel.
Figure 12: Investing in sunglasses & readers has Figure 13: Without synergies, EssilorLuxottica has been a drag on Essilor’s ROIC traded at a 17x EV/EBIT over the past 5 years Lease-adjusted ROIC, % EssilorLuxottica EV/EBIT 12mth fwd ex synergies. EV weighted avg.
20% 22x
18% 21x 16% 20x 14%
12% 19x
10% 18x 8% 17.3x 17x 6% 17.2x
4% 16x
2% 15x 0% Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 FY13 FY14 FY15 FY16e FY17e FY18e FY19e EssilorLuxottica 12mth fwd. EV/EBIT ex synergies 5 yr. avg Lens & Optical instruments Sunglasses & readers Equipment Group
Source: Company data, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimates
Essilor International SA (ESSI.PA)7 17 March 2017
We think EssilorLuxottica can grow ahead of the market and expand margins. The eyewear industry, weighted to the same product mix as EssilorLuxottica, is expected to grow at just under 5% over the next five years, according to Euromonitor. We estimate that with synergies EssilorLuxottica can grow ahead of this, at just over 6%. On an underlying basis we see Essilor as less of a margin story compared with Luxottica and forecast on a standalone basis a small recovery in contribution margins from c18.5% in FY17e to 19% by FY21e. As part of EssilorLuxottica, we see scope for much greater margin expansion, supported by margin expansion at Luxottica on an underlying basis. We therefore forecast contribution margins to tend towards 20% by FY21e. This leaves us forecasting a 15% TSR p.a. over FY17/18/19. We use a tax rate of 30%, between Essilor’s rate at c25% and Luxottica’s at >35%. We note this could be reduced if Luxottica uses the patent box or if the US corporate tax rate is lowered. However, could be higher if the US imposes import taxes, although we would note Luxottica has the capacity to move manufacturing to its US plant.
Figure 14: TSR estimates for Essilor, Luxottica and EssilorLuxottica Essilor Luxottica EssilorLuxottica FY17-19e FY17-19e FY17-19e FY17-21e Organic revenue growth 7% 5% 6% 6% Adj. contribution margin 64bps 140bps 220bps 330bps Tax rate 0.0% 0.0% 0% 0% EPS growth 11% 9% 13% 12% Dividend yield 1.5% 2.2% 2%* 2%* TSR 12% 11% 15% 14% Source: Company data, Credit Suisse estimates, *on Essilor's current share price of €108
This puts EssilorLuxottica back on an attractive multiple. Taking an EV-weighted average, EssilorLuxottica has historically traded on a 12-month forward consensus EV/EBIT of c17x. This merger and current share price weakness offers the opportunity to enter the names on a FY18 EV/EBIT of 15.6x, on our numbers, at a c10% discount to historical levels. For both stocks, valuation has always been a sticking point, with both companies typically trading at a c95% premium to the CAC40 and FTSE MIB, respectively, on 12-month forward consensus P/E. This is justified by the premium investors are willing to pay for vertical integration and strong brands. The current discount is therefore a key reason we initiate with an Outperform rating now rather than waiting for the closure of the deal. Our target price for Essilor is based on our EssilorLuxottica model. Given we believe the deal will go through, we base our target price of €127 on an average of i) our pro forma EssilorLuxottica DCF assuming a WACC of 6% and long-term growth of 3% (in line with the industry) and long-term margins of 14%, which we stress is cautious vs. history; and ii) our Credit Suisse HOLT® Linker with EssilorLuxottica estimates. In our HOLT Linker we use a 5-year explicit forecast window and a 10-year fade window before the HOLT fade framework kicks in. On our target price and FY18E earnings, the combined entity would trade on an EV/EBIT of 18x. This is higher than the historical average, but justified in our opinion given the degree of vertical integration and the higher barriers to entry the conglomerate will have. Grey Sky scenario of €90... Given there is a possibility of this deal not going through, we base our Grey Sky scenario on the underlying operating profit of Essilor as a standalone company. In this scenario, we assume i) the deal does not go through, ii) there is a considerable slowdown in the eyewear market and iii) the relationship between Essilor and the independent ECPs is negatively affected by the merger proposition. This leads to a 15% decline in FY18E operating profits to c€1,300m. Applying Essilor’s average historical 12-month forward consensus EV/EBIT multiple of c16x leads us to a Grey Sky valuation of €90.
Essilor International SA (ESSI.PA)8 17 March 2017
…and Blue Sky of €137. For our Blue Sky scenario we assume a 10% increase in base case profits for EssilorLuxottica in FY18E to €3,675m, given faster implementation of synergies and strong execution of the merger. We take the historical EV weighted average 12-month forward EV/EBIT for the combined EssilorLuxottica entity of 17x. This results in a valuation of €137. Three risks and upcoming dates. Key risks are that i) the deal does not go through because of competition issues; ii) execution of the merger is poor (although we would flag that Essilor scores in the 82nd percentile on our HOLT M&A scorecard; see our discussion of the HOLT M&A scorecard in Visions are changing, published alongside this report); and iii) the deal does not go through because it is not approved by two-thirds of Essilor shareholders at the AGM on 11 May.
Essilor International SA (ESSI.PA)9 17 March 2017
Essilor Int. (soon to be EssilorLuxottica) We initiate on Essilor International, the leading lens manufacturer globally. Essilor International is a €24bn market cap company that generated c€7.1bn of revenue in FY16. While Luxottica is the leading manufacturer and distributor of high-end branded frames, Essilor is the leading manufacturer and distributor of lenses. In FY16 Essilor's lens and optical instruments division reported sales of €6.2bn (87% of the group), accounting for 41% of the market by volume (FY15 results presentation). These lenses spread across price points from $2 to $800 (FY15 earnings call) and are branded or unbranded. The company also sells sunglasses and readers (over-the-counter basic reading glasses that do not require a prescription), which account for 10% of sales. These products fall largely within the mass space, but there is some premium exposure. Essilor also produces lens manufacturing equipment for third-party lens finishing labs.
Figure 15: Lens and optical instruments is Essilor's Figure 16: Essilor has high exposure to the US largest division market (as does Luxottica) Revenue exposure by division (product), % Revenue exposure by region, %
100% 100%
90% 90%
80% 80%
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20% 10% 10% 0% 0% FY11 FY12 FY13 FY14 FY15 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 North America Europe Asia/Oceania/Africa Latin America Lenses & optical instruments Sunglasses & readers Equipment
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
…with pro forma EssilorLuxottica modelling. On 16 January 2017, Essilor and Delfin s.r.l., the majority shareholder of Luxottica, announced plans to merge in a share-for-share transaction. The agreement stipulates that Del Vecchio (founder of Luxottica and owner of Delfin s.r.l.) will commit his 62% stake in Luxottica to Essilor, receiving 0.461 Essilor shares for each Luxottica share. The deal has yet to be fully approved. The next key date is the Essilor AGM on 11 May, when two-thirds of Essilor shareholders will need to vote in favour of the transaction for it to go through. Following this and regulatory approval, Essilor will make a mandatory public offer for the remaining outstanding Luxottica shares, and Luxottica will subsequently de-list. The deal is expected to close in 2H17. Timing a surprise but rationale is clear. Although we think the deal was understood to be a possibility for some time, the timing came as a surprise to the market. We understand the consensus view was that it would not happen with Del Vecchio still in an executive role at Luxottica or while the €1.5bn investment plan was still being executed. We believe it is highly likely this deal will go through despite the market currently pricing in synergies below management guidance of €400-600m as the share price of both companies has moved back towards pre-announcement levels. Therefore we initiate on Essilor International with both a full independent company model and a pro forma EssilorLuxottica model.
Essilor International SA (ESSI.PA) 10 Essilor International SA (ESSI.PA) Essilor International 11 Figure 17: Company timeline – key events in orange
1995 1972 1979 • Acquired 1999 1953 • ESSILOR 1992 Gentex – formed • First large leading • Started JV with • ESSEL makes through plastic lens • Launched polycarbonate Nikon (#2 lens first merger of manufacturing Crizal AR, AS lens manufacturer progressive ESSL and plant built in and smudge manufacturer in Asia behind lens SILOR the Philippines proof in the US Hoya)
1959 1975 1989 1993 1998 • ESSEL • IPO • Launched • Launched • Opened launches Transitions in Varilux production in Varilux name JV with PPG Comfort China
2010 • JV with Wanxin Optical 2001 • JV with Signet Armorlite (ww production 2003 and distribution of Kodak trademark) • Higher debt slowed • Acq. FGXI, readers 56%, sunglasses 44%. acquisitions, focus • Set up new Sun 2006 68% market share in OTC in the US on share buybacks lens department in • Acq 70% interest in Eyebiz after Saint Gobain partnership with • JV with GBX Rx in • Acq. Framesdirect.com disposes interest Oakley India • Xavier Fontanet stepped down as CEO
2002 2005 2008 • JV with Samyung • Essilor anti fatigue • Acq. Satisloh – equipment Trading Ltd in launched division South Korea and • Small buyback to offset China dilutive impact of OCEANE • Developed Vision bonds Wed in US – B2B • Introduced Essilor Azio 360 – specific to the Asian consumer
Source: Company data, Credit Suisse research 17 March 2017 Essilor International SA (ESSI.PA) Essilor International 12
Figure 18: Company timeline (cont'd) – key events in orange 2015 2013 • Acq. Vision Source and 2011 • Acq. Xiamen Yarui PERC/IVA (Dr Alliance) • JV with Shamir Optical Optical (owners of • Launched Costa in in Israel Bolon and Molsion, France and Spain • Acq. Stylemark – owns 10% of S+R division) • Acq. ECP Platform of licensed trademarks for • Acq. Suntech Optics CECOP in Spain (Dr non Rx sunglasses and (Ryders eyewear) Alliance) 2017 readers $140m revenue • Acq. Costa (1/5th S+R • Acq. Lensway.com in • Announced merger with • Launched Opti-fog division) Europe Luxottica
2012 2014 2016 • Launched Varilux S • Bought back 51% stake • Acq. Opti-Port (Dr series in Transitions from PPG Alliance) • Launched E-SPF index • Aim to reach 19.5% • Acq. My Optique Group • Launched Crizal contribution margin by (online) Prevencia 2016, before acquisition • Entering India online of Coastal.com market with • Acq. Coastal.com coolwinks.com • Acq. Photosynthesis Group in China (franchise)
Source: Company data, Credit Suisse research 17 March 2017 17 March 2017
From medtech to consumer Both companies are market leaders in their respective fields. In our initiation of coverage on Luxottica (Attractive entry point for the long-sighted, 15 June 2016) we walked through the company’s-market leading position in the frames market. Luxottica owns strong brands such as Ray-Ban – the largest spectacle frames and sunglass brand globally, with 6% and 20% market share, respectively – and licences such as Armani and Prada. Meanwhile Essilor accounts for 31% of the lens market by retail value, according to Euromonitor, with Hoya and Carl Zeiss being the next-biggest players. The company owns the brands Varilux, Transitions and Crizal. Essilor is 4x and 7x the size of its next two biggest competitors. Hoya reported sales of c€1.8bn in FY16 for its ‘Health Care related products’ division. This division encompasses the eyeglass lenses division and sits within the larger 'Life Care' category (accounting for c75% of sales in FY16). Carl Zeiss reported €1.0bn in revenues for its Vision Care/Consumer optics business in FY15. The vast majority of this, c85%, was attributed to ophthalmic lenses. This puts Essilor at c4x the size of Hoya and c7x the size of Carl Zeiss for the relevant divisions, roughly in line with the market share data from Euromonitor (see Figure 20).
Figure 19: Luxottica has a market-share-leading position in the Rx and sun frames market Figure 20: Essilor dominates the lens market Market share, %, 2015, fixed 2016 FX, retail value Market share, %, 2015, fixed 2016 FX, retail value ) %
( Chilli Beans 1% Industrias de Optica 0.3% e r a h
s Vision Service Plan Global 3%
t JIN Co Ltd 0.3% e k r
a Essilor International SA 4%
m New Tian Hong Optical 0.3%
s e
s Safilo Group SpA 14% s a
l Rupp+Hubrach Optik 0.5% g n
u Luxottica Group SpA 50% S Nikon Corp 0.5%
Fielmann 1.3%
t Rodenstock GmbH 1% e k r
a Rodenstock 1.9% m
Fielmann AG 1% ) s e % (
m Carl Zeiss 6.3% e a r r Vision Service Plan Global 2% f a
h e l s c Hoya
a 7.9%
t Safilo Group SpA 6% c e p
S Luxottica Group SpA 23% Essilor 31.3%
Source: Euromonitor, Credit Suisse research Source: Euromonitor, Credit Suisse research
Essilor has outgrown the lens market, supported by acquisitions. Essilor manufactures lenses in 32 plants across the world. On a volume basis, c75% are stock lenses or basic myopic lenses. The remaining lenses are semi-finished and sent either to one of the company’s 490 lens labs and seven export labs or to a third-party lab. The company’s lens division has grown ahead of the market over the past decade (see Figure 21) but only when we look at constant currency growth; i.e. including bolt-on acquisitions. From FY10 to FY15 on an organic basis (or LFL basis, as the company defines it) the lens division has grown on average just below the market at c3.9% vs c4.5%. We therefore believe the acquisitions of lens labs have helped to drive the company’s 41% share of the prescription lens market on a volume basis (Figure 22). Acquisition of lens labs builds up barriers to entry. These acquisitions have been largely focused in the US, with the company acquiring c160 labs over the past two decades. We believe they have helped drive market share gains and built up barriers to entry because: 1) they improve Essilor’s competitive advantage as they widen its distribution network, building up barriers to entry by providing a better service to the retailers and ECPs
Essilor International SA (ESSI.PA) 13 17 March 2017
2) by buying lens labs it ensures further penetration of Essilor’s patented value- added products in retailers. We therefore see clear advantages to acquiring lens labs both from a distribution standpoint and to ensure Essilor’s innovation in lenses can be transferred to the end consumer. Such acquisitions also support Essilor’s growth.
Figure 22: Acquisitions have helped drive the Figure 21: Essilor has relied on acquisitions to grow company’s 41% volume share of the global ahead of the market and take share ophthalmic lens market Lens division cc growth, LFL growth vs. lens market cc growth, % Global market share of lenses, volume terms, Essilor data, %
14% 41% 12% 39% 37% 36% 10% 31% 8% 28% 26% 26% 6% 25% 25% 23% 4%
2%
0%
(2%)
(4%) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Regionally adjusted World Lenses cc growth Lenses LFL growth FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Source: Company data, Euromonitor, Credit Suisse research Source: Company data, Credit Suisse research
Lab acquisitions have opened the company up to the largest profit pool in the value chain. Another reason we see exposure to lens labs as favourable is because this is where a significant portion of the value is added and the largest profits lie along the lens value chain, in our opinion. At this point the lens puck is edged, coated and personalised, with each layer carrying a considerable markup to the consumer and limited cost to the lab. Essilor reports that selling a finished lens through Essilor’s own lab is 2x as profitable as selling a semi-finished lens to an independent lab.
Figure 24: …has led to continued innovation year- Figure 23: Strong R&D investment… on-year R&D spend in €m, lhs vs. spend as % of sales, rhs Number of new products launched, lhs vs number of patent sets, rhs
250 5.0% 350 1600
4.5% 300 1400 200 4.0% 1200 3.5% 250 1000 150 3.0% 200 2.5% 800 150 100 2.0% 600 1.5% 100 400 50 1.0% 50 200 0.5%
- 0.0% 0 0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY09 FY10 FY11 FY12 FY13 FY14 FY15 R&D spend, lhs, €m % sales, rhs new products launched, lhs # sets of patents, rhs
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
Innovation has also helped grow market share and limited pricing pressure. We understand the lens category faces significant pricing pressure, which has left lens ASP roughly flat from 2005 to 2015, according to Euromonitor. Innovation helps to counter this pricing pressure and builds up barriers to entry as the industry reports a 10-20% uplift in price for each new layer of technology or improvements to existing technology (see Figure 25 for an example using Essilor's Crizal brand). The company claims to account for c75% of total R&D spending in the optical industry (source: Essilor FY14 results ppt), spending
Essilor International SA (ESSI.PA) 14 17 March 2017
on average c3% of sales per annum (see Figure 23). Note this hardly compares to the average spend by pharmaceutical companies on R&D, which averages around 15% of sales. More recently, the company has increased investments in advertising. The lens industry is at a later stage on the innovation S-curve, with lens manufacturers increasingly bringing out next-generation products rather than completely new lines of innovation (see Figure 29). Although manufacturers such as Essilor have moved towards unchartered territory with preventative solutions, the lens industry is still searching for the next groundbreaking development, enhancing the pricing pressure. Therefore we see manufacturers, especially Essilor, increasing their investments in advertising in order to create more established lens brands (see Figure 26). B2C advertising spend now sits at c3% of sales, combined with B2B marketing of around 5% of sales. This compares with European staples at around 12-15% of sales.
Figure 25: Pricing and volume power from value- Figure 26: Essilor is consistently investing more in added innovation for the Crizal brand marketing and advertising its lens brands Base 100 in 2005, AR = anti-reflective Consumer marketing budget on prescription lens brands, €m. Note the company also carries out B2B marketing, which is c5% of sales
Crizal 250 200 Crizal Prevencia UV
200 Crizal Forte 150 150
Crizal 2
100 100
50
50 2005 2006 2007 2008 2009 2010 2011 2012 2013 0 Worldwide Crizal Volumes Price premium vs. non AR lens 95-'00 01-03 03-11 12-13 14-15 2016
Source: Company data, Credit Suisse research Source: Company data (Essilor US Field Trip), Credit Suisse research
We therefore expect Essilor to shift its focus from medtech to consumer. We believe this will enable the company to compensate for any loss in barriers to entry and pricing power from declining innovation. We note sunglasses and frames, a considerably more branded purchase, have seen positive pricing pressure over the past decade, according to Euromonitor. Therefore we are reassured that this transition from innovation to branding can protect revenues. We see the lens division becoming more of a consumer-branded purchase than medical moving forward.
Essilor International SA (ESSI.PA) 15 17 March 2017
Figure 27: Innovation combined with advertising Figure 28: Impact of TAYE awareness campaigns on and marketing can drive revenue eye exam growth Y/Y growth in brand building for Transitions TAYE campaigns went nationwide in 2010/2011 in the US
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0% 2007 2008 2009 2010 2011 2012 2013 2014 2015
Eye exam growth Population growth
Source: 2014 Essilor Investor Day Source: Essilor US Field Trip, Credit Suisse research
Quantitative proof that advertising spend can boost lens sales. The strategy of investing in advertising lens brands has already led to some tangible impacts on the top line. The company aims for at least a 1:1 return on marketing investment. Figure 27 and Figure 28 show how appropriate use of marketing and advertising can increase consumer engagement. Figure 28 looks at the impact of the ‘think about your eyes’ (TAYE) campaigns that were launched in 2010/2011 to increase eye exams in the US.
Figure 29: Varliux brand has seen new editions each year for the past decade Timeline of major product launches
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Varilux (progressive lens) Varilux® Varilux® Varilux Road Varilux Varilux Varilux Ipseo Varilux India Varilux Varilux Varilux Varilux S Varilux E Panamic Ellipse Pilot Physio Physio f-360° New Edition 360° Comfort Physio 2.0 Physio 3.0
Vailux Varilux Varilux Varilux Varilux Varilux Comfort New Liberty Computer Ellipse 360° Physio 2.0 Comfort 3.0 Edition
Varilux® Varilux Varilux Kan Ipseo Comfort 360°
Varilux® OpenView Crizal Crizal Alizé Crizal Avancé (coatings) Crizal® with Clear with Crizal Crizal Crizal Sun Crizal Forte Crizal UV Alizé Guard (Crizal Scotchgard Sapphire Prevencia A2) Protector
Crizal Alizé + Crizal Easy
Nikon Nikon Presio Nikon Presio Nikon W W Seeproud Transitions Transitions Transitions Transitions (photchromic) Transitions Transitions Generation Graphite Graphite Gen V Signature VI Green Green Transitions Xtractive Definity Definity Definity 3
Optifog Optifog
Xperio (polarised Xperio Xperio lens) Xperio Gradient Colors Polar
Source: Company data, Credit Suisse research
Essilor International SA (ESSI.PA) 16 17 March 2017
The roadmap to EssilorLuxottica Understanding where revenue and cost synergies lie. To understand the potential of both the current Essilor and future EssilorLuxottica, we lay out a roadmap of how we think the merger may be executed. Additionally, we add to this what synergies we would expect to come from the strategies on the revenue and cost lines. Management has guided towards a €200-300m p.a. EBIT impact from revenue synergies, a €150-200m p.a. EBIT impact from supply chain optimisation and a €70-100m p.a. EBIT impact from G&A and purchasing cost reduction. Our pro forma model is built up from our estimates around synergies and our underlying assumptions for Essilor and Luxottica individually. These are detailed later in this section. 1. Move Luxottica lens sourcing in-house We think one of the company's first initiatives after the merger could be to move Luxottica’s lens procurement in-house. Luxottica buys stock lenses and semi-finished lenses for both its sunglasses and prescription frames. We understand Essilor currently supplies Luxottica with 30% of its lens consumption. We estimate that c10% of Luxottica’s COGS is spent on lenses; i.e. €250m as of FY15. We estimate this by assuming of the 93 million frames produced per year, 60% are sold through the retail channel and therefore contain lenses at a price of roughly €4. Of the remaining 40% sold through the wholesale channel, 60% are sunglasses and sold with lenses costing roughly €2. We believe this may be a slight underestimation given prescription lenses at wholesale prices can vary considerably, but we would rather err on the side of conservatism. Additionally, as a sense check we know 20% of group revenues come from lenses. This would put revenues at c€2bn and imply a 7x markup on the lens from cost to retail value, but we would rather be more conservative and risk an upside surprise. Insourcing could save €150m, or 2% of COGs. The cost of €250m of lenses to the manufacturers (assuming Essilor’s 60% gross margin) is c€100m. By insourcing the lens consumption and assuming an interparty transaction at cost prices, we would expect to see cost savings of c€150m from this measure alone. From a modeling perspective, we do not assume these savings hit the P&L in full in the first year (i.e. FY18). This is because we assume Luxottica will still have some procurement contracts in place with a guaranteed timeframe. Additionally, we assume Essilor will have to make some investments into expanding its manufacturing capabilities. Therefore this flows through our model over the three years with a gradual ramp-up. 2. Bring frames, lenses and labs together Supply chain optimisation will come through the streamlining of Rx production. We think another priority would be to bring together the inventory of frames and lenses with lens labs. We believe the market is underestimating the synergy potential of such a move on both the top line and the cost line. We had the opportunity to see how this would work in the US on the Essilor Investor Field Trip, where we saw the logistics around the FrameDream. This is an initiative for the US independents but follows the same principles of moving frame and lens inventory to the same location. In brief, FrameDream offers independents the ability to store frame inventory at Essilor’s DCs and hand over the admin associated with ordering frames and edging and mounting the lenses. Essilor currently has 250 ECPs signed up for this programme with plans to have >1,000 signed up by YE17. Logistics cost savings and rationalisation of distribution centers. Having the frame and lens inventory together in one place removes an important step in the Rx process of sending the customer's frame from the retail store to the prescription lab. This step adds logistics costs and delays to orders, with the lens and frame not running through the supply chain concurrently. In addition to reducing logistics costs, there would be rental cost savings by centralising the warehouses. Luxottica currently has three main hubs and
Essilor International SA (ESSI.PA) 17 17 March 2017
15 smaller peripheral hubs while Essilor has 16 hubs with a broadly similar spread across regions. Therefore consolidation should lead to some rental cost savings.
Figure 30: Luxottica costs by nature and reporting Figure 31: Essilor costs by reporting line in € millions, unless otherwise stated in € millions, unless otherwise stated
Luxottica 2015 As % of sales Essilor 2015 As % of sales Employee benefits expense 2,619 30% COGs 2,704 40% Consumption 1,448 16% Production costs 428 5% R&D 214 3% Logistics costs 186 2% Selling and distribution costs 1,678 25% D&A 477 5% Other operating expenses 857 13% Operating lease expense 684 8% Operating costs 2,749 41% Advertising media and promotion expense 342 4% Trade marketing 185 2% Total 5,453 81% Royalties 169 2% Share-based compensation expense 50 1% Personel costs 2,045 30% Other 873 10% Total 7,460 84%
COGs 2,835 32% Selling 2,779 31% Royalties 169 2% Advertising 590 7% G&A 1,087 12% Operating costs 4,625 52% Total 7,460 84%
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
We estimate €30m of cost savings from this initiative. Luxottica breaks out costs by type, providing us with some granularity on distribution and logistics costs. We estimate the company could reduce Luxottica’s logistics costs by 5% and operating lease expense by low-single digits, generating €30m of selling and distribution cost savings. This would speed up servicing and encourage wholesalers to use EssilorLuxottica labs. Not only will this initiative bring cost synergies, it will also improve the service EssilorLuxottica can offer through its brick and mortar and online stores. The company will be able to easily undercut standard delivery times of 7-10 working days for prescription eyewear. We believe this will encourage ECPs and wholesale partners to also use EssilorLuxottica’s labs and supply chain in order to stay competitive and offer customers a similar turnaround. Additionally, we think wholesale partners may be more inclined to sign up as it will provide inventory and cash flow benefits as less stock will be needed to be held in store. Moreover, for those independents that may have had limited inventory in store, by removing the step of sending the frame to the lab, it allows the store to keep the potentially high turnover product in its display cabinets, thereby reducing the likelihood of missing sales. Therefore we believe this initiative should help drive topline growth and increase the company's exposure to lab services. This topline synergy will leverage costs EssilorLuxottica already has. We would expect this initiative to help support Essilor’s Lens and Optical instruments growth globally. Assuming this adds around 0.5% to Essilor’s LFL (Essilor’s definition of organic growth) for the division from 2018 to 2021, this would add c€120m to revenues. Given the company already has the infrastructure and therefore will be able to leverage the costs, we assume this revenue synergy is costed at a 50% margin, which in itself may be a bit conservative given Essilor’s gross margin sits at c60%. This leads to a c€60m EBIT impact at the peak in FY21e. 3. At the same time, rationalise the lab network We do not think Essilor is likely to shut down its US lab network, but instead should look at Luxottica’s. Essilor’s largest lab network by country is the US, with c125 labs. Luxottica also has a large lab presence there owing to the bolt-on labs associated with its
Essilor International SA (ESSI.PA) 18 17 March 2017
c900 LensCrafters stores. The company has noted potential cost synergies to be gained through streamlining the lab network. We think this is certainly possible for Essilor outside the US, where together EssilorLuxottica can move to a more centralised model, and should be a priority in tandem with the centralisation of inventory (initiative #2). But in the US, we believe management should continue to focus on removing only Luxottica’s lab presence rather than rationalising both Essilor and Luxottica’s and moving to a purely centralised model. The US market is relationship-driven and we think EssilorLuxottica will look to maintain this. Pre-merger, Essilor lacks labs in only a handful of states (e.g. Mississippi and Alabama – see Figure 32) and the company has stated that it ‘need[s] 10 labs to serve the same number of clients as c150 for example’. However, Essilor has historically struggled to consolidate its lab network in the US for two reasons. i) These labs tend to be family businesses and see Essilor as a strong business partner. If Essilor looked to use a strategy of buy and close down, its reputation would be affected and labs would be less willing to partner with it. As family businesses, they tend to more hesitant to work with larger corporates anyway, so managing their reputation and this relationship is important if Essilor wants to continue to acquire in the future. ii) The ECPs that use the labs also tend to be relationship-driven, holding longstanding partnerships with specific labs. We believe it is important for Essilor to maintain its strong relationship with the industry, especially during the next couple of years as it merges with Luxottica. This relationship is something Luxottica arguably lacks as it is seen as more of a competitor than purely a supplier given its retail presence.
Figure 33: Opportunity for further bolt-on Figure 32: There is little white space left for acquisitions in labs is probably highest in Europe, expansion in the US the company could consolidate in APAC/MEA # prescription lens labs lab/GDP, 1/$b. *IMF definition of Europe and central Asia
1 CT:4 1 1 MA: 2 1 7 GDP, $t # labs #labs/GDP 1 RI:3 1 1 3 1 US 17.947 125 6.96 1 4 NY:5 2 3 2 2 1 Europe* 19.986 40 2.00 3 3 5 12 2 1 4 2 2 2 4 APAC/MEA 28.634 241 8.42 6 4 3 3 Latam 5.148 41 7.96 1 2 2 2 North America 19.503 168 8.61 7 1
3
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse estimates, GDP data from databank.worldbank.org
Closing down Luxottica’s LensCrafters labs would lead to smaller, more profitable stores. Luxottica was already taking steps to centralise its lens lab locations. It has built up three main centralised labs and had stated it was hoping to gradually close down the 900 labs it had linked to the LensCrafters stores in the US. Again, we believe this is the best strategy as it will reduce the average store size by 40-50%, driving a low-single-digit reduction in operating lease expense, on our estimates. Additionally, the stores should see lower staffing costs and improved sell out as staff can focus more on serving customers than finishing the lenses in the back office.
Essilor International SA (ESSI.PA) 19 17 March 2017
With Essilor’s lab network, disruption and loss of sales should be minimised. The only risk to this strategy was the loss of consumers and disruption it would bring to the stores over the transition period. LensCrafters is c50% of the company’s North American retail sales, which in turn is c48% of Group revenue in FY16, according to our estimates. Therefore disruption here, as we saw in 3Q16, can have a significant impact on Group results. Also, the company claims c50% of LensCrafters’ transactions still use the 1-hour coating service, which relies on these instore labs. However, with Essilor’s lab network, LensCrafters still should be able to offer a quick turnaround service and limit the disruption. 4. Consumer brands come together Essilor is turning into a consumer lens company. As we mentioned in the company introduction, ‘From medtech to consumer’ on page 13, Essilor has gradually moved towards investing more in its lens brands. This has come with an increasing desire for greater B2C contact over the past 5-6 years, with interest accelerating since 2014, when the company acquired Coastal.com. Management commentary has warmed up to the prospect of retail, and the purchase of Doctor Alliance Groups and franchisers suggested growing frustration with being a pure play wholesaler. This made sense as with investments in brands the company also needs to have greater visibility on sell-out trends and an understanding of how consumers view the brands. This desire for B2C contact is therefore fulfilled with Luxottica’s wide retail store network. Combining the strength of both these branded products will help EssilorLuxottica grow faster than the market. Our next initiative would be to launch Essilor lens brands in LensCrafters and Luxottica’s other optical stores. We understand Luxottica did not actively promote the Essilor lens brands in stores and online, as: i) it looked to promote its own branded lenses; and ii) will have wanted to limit the pricing power it passed to Essilor, which supplied c30% of its lenses. As a combined product with the strong ‘medical’ roots from Essilor and luxury from Luxottica, we can see, with good advertising, why EssilorLuxottica expects to see revenue synergies going forward. We see this both in terms of driving shorter replacement cycles and trading up of vision correction users, and engaging new consumers driving greater industry penetration. For just LensCrafters this leads to a c€50m EBIT impact from increased revenues. We believe this could support LensCrafters LFL, especially in the US, where sometimes it has seemed that Luxottica has been on the back foot of innovation. Increasing LensCrafters LFL by up to 1% over FY18/19/20/21 adds up to €100m at peak to the revenue line, again at a 50% margin this is an EBIT impact of €50m at peak. We would note this estimate may be low as we would expect some benefit for Luxottica’s other optical retailers such as Target/Sears and David Clulow and again the margin associated with this revenue synergy is perhaps overly conservative. This will be helpful in EM, which remain under penetrated. According to Essilor, fast- growing markets represent a €30bn market opportunity (based on sell out value for eyewear, Essilor FY16 results), just under half that of developed markets and out of €96bn globally. While the company sees 2-3% baseline growth in developed markets, it expects >10% for these fast-growing markets. For both companies the emerging market story has not quite played out – especially in China, which is the second-largest eyewear market globally, at €10bn (Essilor FY16 results presentation). China accounts for 6% of Essilor sales and only 3% of Luxottica sales. Essilor’s share of revenues from fast-growing markets has plateaued since FY13 and we understand Luxottica has always struggled to find the right strategy in the region. Therefore, as for developed markets, we would expect the combined entity to increase advertising spend in emerging markets, promoting the whole value proposition with Essilor’s medical routes and Luxottica’s branded knowhow. As such, we think EssilorLuxottica may start to make headway in the region.
Essilor International SA (ESSI.PA) 20 17 March 2017
Figure 34: Essilor has reported strong double-digit Figure 35: Essilor's percentage of sales from fast- growth in key countries over the past six years growing markets has plateaued at c22-23% Ex currency growth (largely LFL data) % Group revenue generated from fast growing markets
FY10 FY11 FY12 FY13 FY14 FY15 23% 22% 22% 22% Fast growing markets 22% 26% 27% 20% 21% 14% 18% China 29% 66% 47% 16% 50% DD 15% India 13% 24% 29% 43% 17% 20% >20% 12% 11% Latam 23% 25% 23% 21% 17% 17%
FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
And Luxottica could learn from Essilor’s pricing practices. We believe Essilor has managed to make ‘relatively’ faster headway in emerging markets vs. peers because it has covered a broader range of price points and therefore a wider consumer market. The company has focused on the mid-tier as well as low tier by offering different brands or unbranded alternatives in markets that generally have lower consumer engagement. We know Luxottica has tried to replicate this with the Vogue brand, pulling down price points to engage consumers. However we believe more could be done with this brand in order to cover more of the pricing architecture and promote consumer engagement in the category. This in turn should encourage faster improvement in premium product engagement and therefore scope for trading up sooner rather than later.
Figure 36: Essilor covers all cities in China… Figure 37: … and all price points in EM Essilor brand strategy in China as of FY12 Essilor brand strategy in India as of FY10
Source: China Field Trip November 2012 Source: Essilor Investor Day Dec 10, 2010
EssilorLuxottica should benefit from the catch up in value growth in China. According to Essilor, the volume business in China is as large as the US but the value of the market is still much smaller. We believe that by covering each part of the pricing architecture, from high to low, EssilorLuxottica is in a prime position to capture any trade up of lenses. This, plus the impact of combined advertising, leads us to believe that EssilorLuxottica can achieve higher growth in emerging markets. If we increase Luxottica wholesale RoW sales by 1-2% and Essilor’s Lens division sales for APAC and LatAm by 1%, we see scope for €150m revenue synergies at peak, €75m on the EBIT line.
Essilor International SA (ESSI.PA) 21 17 March 2017
Figure 39: But value growth remains lacking; upside Figure 38: China volumes have been strong potential for premium products is high in millions of lenses, 2012 Premium products as a % of market volume, 2012
500
450 50% 400
350
300
250
200
150 15% 11% 11% 100
50 1% 2% 0 2011 2013e 2015e 2017e 2019e Photchromic Progressive Lenses High Index Renewals New wearers Trade-in Taiwan Mainland China
Source: Essilor China Field Trip – November 2012 Source: Essilor China Field Trip – November 2012 5. Leverage each other’s assets to grow brands Essilor has been moving into mid- to low-tier sunglasses... In 2010 Essilor acquired FGX International, a US-based distributor of sunglasses and reading glasses. This was the company's first step into the plano sunglass segment, with revenues at the time of c$259m (FY09). Note Essilor was already active in plano sun lens manufacturing (through BNL) as well as prescription sun lens manufacturing (through their labs). This was followed by the acquisition of Stylemark in 2011, which included licences for fashion brands such as Nine West and Reebok and in 2013 of Xiamen Yarui Optical Company in China, which designs, manufactures and markets sunglasses under a number of brands including Bolon and Molsion.
Figure 40: Essilor’s sun exposure is focused in the Figure 41: Luxury sunglasses are outgrowing the US and skewed towards lower price points wider sun segment given strong pricing power Sales break down of sun revenue, % Euromonitor estimates of sunglasses vs. luxury sunglasses growth
10%
8%
6%
4%
2%
0%
-2%
-4%
-6% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017e 2018e 2019e
Luxury Sunglasses Sunglasses
Source: Essilor US Field Trip 2016 Source: Euromonitor
… which was driven by the need to find more growth. Essilor believes sun should grow at 5-7% vs. prescription at 3-4% p.a. Therefore, the investments into sunglasses shift the company towards a higher-growth category. The split of revenue is focused on the lower-end sunglasses (see Figure 40), which are growing below luxury sunglasses, according to Euromonitor (see Figure 41). Sun sales accounted for c10% of group revenue in FY15 and fall in both the sunglasses and readers division (with sun accounting for c60% of the division) but also in the lenses and optical instruments division, which captures the sales of pure sun lenses or pure sun Rx lenses (6% of lenses business as of FY13).
Essilor International SA (ESSI.PA) 22 17 March 2017
However, it lacks a competitive advantage. Although the company has some frame manufacturing capabilities (c50% of Bolon frames sold), we believe it lacks the size and vertical integration required to compete directly with pure play frame manufacturers. Additionally, as sunglasses/frames are more a branded product, controlling distribution is even more crucial and Essilor lacks a strong retail presence. Moreover, Essilor does not have any globally recognised brands. The company’s two main brands in the higher end space where branding is more important, in our opinion, – Bolon and Costa – have been reporting promising trends in their key regions but are not distributed globally. Essilor can use Luxottica to develop frame know-how… We think an important initiative would be to transfer Essilor’s key brands and higher-end frames such as Costa, Bolon and Molsion to Luxottica’s manufacturing facilities (moving Costa to the US and the Bolon family to China, given their respective roots). This would avoid any cannibilisation of the ‘made in Italy’ brands. Transferring these higher-end brands to Luxottica’s manufacturing plants would lead to cost savings given scale benefits and purchasing cost reduction. Additionally, we believe it could help boost capacity utilisation at the Oakley plant in the US, which we know has sometimes lagged the group. However, we doubt any of the FGX readers or lower-end frames would be made in-house given it would most likely be cheaper to remain with the current manufacturing partners. …and manufacturing capacity in Latam in particular... Latam accounts for 6% of both Essilor and Luxottica’s revenues, with the majority of this coming from Brazil. Over the past couple of quarters, Luxottica has continued to report good trends in Brazil, with 2016 still reporting sales growth despite the unfavorable economic situation. We believe this is because the company owns its own manufacturing capacity there and benefits from the strong sun culture. We believe Essilor’s sun segment will benefit from both the market knowledge, retailer relationships Luxottica has there, manufacturing capacity and Luxottica’s recent acquisition of Oticas Carol (franchisor). …as well as expand globally more easily. We think Essilor’s Costa and Bolon family could also be pushed into Sunglass Hut or LensCrafters. We believe these two brands are the most appropriate, given the lower price point of the rest of the portfolio. Essilor’s brand portfolio is 25% exposed to license brands largely through the FGX acquisition (Ironman license), Stylemark acquisition (Reebok, Dockers, Hello Kitty and Disney licenses) and Fabris Lane (Karen Millen and French Connection). Additionally the other two own brands, Foster Grant and Ossé, do not fit the product segmentation in Sunglass Hut. This will benefit Bolon and Costa in particular given both lack global coverage, with Bolon heavily exposed to Asia and in particular China, while Costa is more exposed to the US.
Figure 43: Although at a very different stage of the Figure 42: Bolon has grown significantly in China brand lifecycle, Bolon has shown promising growth but hindered more recently by the ARTEMIS launch given it is largely sold in Asia Bolon growth commentary in China. Online c20% of sales 2016 cc growth, % growth, global sunglass brands, retail value
Bolon Growth comments 35% 1Q14 >20% 30% 1H14 dd 25% 3Q14 >20% 20% FY14 >20% 15%
1Q15 high growth 10%
3Q15 high sd 5% FY15 dd. LFL 0% 1Q16 -33% due to ARTEMIS, online up 70% 2Q16 -ve high sd -5% -10% 3Q16 slightly positive 2007 2008 2009 2010 2011 2012 2013 2014 2015
Bolon Ray-Ban
Source: Company data, Credit Suisse research Source: Euromonitor
Essilor International SA (ESSI.PA) 23 17 March 2017
Sunglasses will benefit the most as Rx for Bolon and Costa remains small. We believe expanding through own retail that is established will also be more beneficial for the brands as the stores will have a greater awareness of product segmentation at each location. Increasing the growth of Essilor’s sunglass division by <1.5% would boost revenues by €100m (note there will be some price/mix effect here as the company will be selling at full price rather than wholesale price). We do not adjust the Sunglass Hut LFL as we do not want to double count and prudently assume putting Costa and Bolon in stores will not increase the sell through but instead replace other brands. Additionally we look only at sunglass sales at this stage given Rx remains very small for both brands as it has only just been launched. This leads to a €50m EBIT impact at peak, on our estimates. The only internal competition we see is between Bolon and Ray-Ban in Asia. Bolon has seen steady pricing growth over the past couple of years with RSP increasing from 450 RMB to 550 RMB between 2013 and 2016, a CAGR of 7%. Using the transactional website for China, we find prices range from 598 RMB to 1,580 RMB with an average price of 822 RMB, or $115 (using a 1/0.14 rate). Although we see this pricing dynamic as a clear positive, it does mean the brand is steadily encroaching on Ray-Ban’s price point. Although these brands are clearly at very different stages of their life cycles (Ray-Ban's retail sales are 14x Bolon's, according to Euromonitor), the brand has demonstrated significant growth over the past 10 years. That is bearing in mind it is largely focused in Asia, which historically has been a soft region for sunglass sales. We see the potential for internal competition between these brands in Asia, although Ray-Ban can clearly learn from how Bolon has grown and managed to engage consumers in the region.
Figure 44: Costa average price is greater than Ray- Figure 45: Essilor has stayed clear of luxury fashion Ban according to our pricing analysis and performance, which now makes sense Pricing analysis from US websites, $
340
279
209 176 149 115
Ray-Ban Costa Min Max Avg
Source: Company data, Credit Suisse research Source: Essilor presentation, FY16 results call
Costa is also a strong US brand... Acquired in 2014, Costa is another promising brand within Essilor’s portfolio. The company in dollar volumes has grown tenfold between 2003 and 2014, with an average CAGR of 20%. However, the key issue for this brand is its overexposure to the US and in particular the Southeast US, where it generates 70% of its sales. ... with similar pricing to Ray-Ban/Oakley. We carry out a pricing analysis of the 240 different models of sunglasses on the Ray-Ban US website against the 82 different models on the Costa US website. The average price point for Costa is $209, with a range of $149 to $279. For Ray-Ban we find a minimum price of $115, maximum of $340 and an average of $176, below Costa’s average (see Figure 44). But given the roots of the brand in water sports, the internal competition is not as big. Costa is heavily skewed to sports, with c60% portfolio exposure. Management wants to rebalance it towards optical, dtc web and e-comm/ sun specialty, with management targeting the optical and web channels to grow nearly 3x in the next five years, according
Essilor International SA (ESSI.PA) 24 17 March 2017
to management. Even though management wants to turn Costa into more of a lifestyle brand, we believe its roots will remain in the fishing/coastal world, and maintaining this focus will limit the competition with Oakley (land sports) and Ray-Ban (more fashion-oriented). Essilor can help Luxottica with the independents in the US. Luxottica has traditionally struggled with independent retailers in countries where it has a strong retail presence; i.e. in the US. This is despite the fact that independents in most markets still account for >50% of revenues. This is because they have seen Luxottica as competition rather than a wholesale partner, given a Luxottica store may be located only several shops down the road. We believe EssilorLuxottica will be able to push more of Luxottica’s products into independents given the relationships Essilor has, especially in the US with the buying groups that cover c30% of the independents market, on our estimates. Increasing Luxottica’s wholesale North America by 0.5% p.a. adds c€20m each year to the revenue line. Using Luxottica’s gross margin, this leads to a c€15m impact on the EBIT line, on our estimates. But the dynamics with the independents need to be watched carefully. Our channel checks would suggest some independents resent being so exposed to one supplier and are worried that the merger could leave EssilorLuxottica as a competitor rather than a partner. The company will need to negotiate this carefully to avoid losing valued wholesale partners.
Figure 46: From the very basic lens… Figure 47: …to the most advanced sun lens FY14 results presentation FY14 results presentation
Source: Essilor FY14 results presentation Source: Essilor FY14 results presentation
And transfer of knowledge from Rx lenses to sun opens up new opportunities. Rx lenses have been Essilor's focus for innovation over the past decade. Therefore, EssilorLuxottica can benefit from the transfer of knowledge it has built up around Rx to sun lenses as well as sun Rx lenses. This includes technology such as e-spf and anti-reflective properties. We would also expect some benefits from the work Oakley and Ray-Ban have carried out in lenses, with the PRISM and Chromance lenses, for example. Given this technology has already been developed and should require only minor tweaks, this should come at a high profit margin. An outperformance of Rx Sun will drive positive mix for EssilorLuxottica, in our opinion. We do not currently explicitly include this in our numbers. 6. Gain greater control over the wholesale channel Combined expertise in the wholesale channel. Essilor is 99% wholesale while Luxottica is c40% wholesale. We would expect EssilorLuxottica to combine sales rep resources. Sales representatives are responsible for: i) meeting with wholesale partners to place orders and sell product; and ii) checking that the product is being correctly displayed and sold. We believe both companies can further develop their distribution… The eyewear industry remains highly fragmented, with independents often the majority share of the market in different countries, therefore products tend to be distributed via third-party distributors. This is especially true in emerging markets. However, this can mean over- distribution and a lack of control around where the product ends up. Both companies
Essilor International SA (ESSI.PA) 25 17 March 2017
looked to gain greater control in 2016, with Essilor implementing ARTEMIS for its largest sunglass brand in the region – Bolon – and Luxottica starting to remove third-party distributors in China. The ARTEMIS programme is a new inventory management system that tracks the level of inventories at the wholesale level as well as at the retail level thereby monitoring sell-through more effectively, improving Essilor’s visibility on market trends. This is similar to the STARS and SMILE programmes Luxottica and Safilo have in place for their wholesale channels. By working together to create a unified sales force. As a combined entity, we see scope for EssilorLuxottica to develop a sales force that can cross-sell products and cover a wider network, allowing the company to move completely away from third-party distributors. Additionally, with greater weight in the market, we believe the company will find it easier to do this without losing retailer partners, something Luxottica has mentioned as a problem when it tried to remove third-party distributors in China. Luxottica should also benefit from Essilor’s recent partnership with Photosynthesis group, a HK-based company that owns franchise retail banners such as MJS. Given employee costs are the largest cost for both companies, we forecast only a small reduction. As part of consolidating an EssilorLuxottica sales force, we would also expect some reductions in corporate roles. Given headcount is 30% of both Essilor and Luxottica’s cost base we forecast only a marginal reduction of 1% (or €50m). This flows through our G&A line in FY20-21E. 7. Use Essilor knowhow in online EssilorLuxottica will take market share in the online channel with omnichannel initiatives. In Key theme #2 of our sector note, Visions are changing, we outline our view of online. We believe the channel will become more important with time, and will help grow topline. However, it will also reduce industry profit pools given the costs associated with free returns, refunds, etc. and break down barriers to entry. We believe EssilorLuxottica will outperform the industry in this area for several reasons. 1. Overall Essilor has been very active in the online space – faster to move and, we believe, more realistic about the threat it poses. As a simple anecdote, Essilor has a head of online strategy, Bernhard Nuesser, while GrandVision does not. Therefore we believe EssilorLuxottica will remain committed to this channel going forward. One of the biggest risks we have seen for many companies in disruptable industries is when the threat of online is not taken seriously. 2. Essilor already owns best-in-class pure online retailers across the globe. As omnichannel developments have lagged the pure online players, we believe these will outperform over the short term as omnichannel attempts to catch up. We also believe Essilor has a greater knowledge base in online than most industry peers as it gained a lot of experience during the turnaround of Coastal.com, especially with regards to the negative implications of promotions. 3. Essilor also covers independents with Myonlineoptical. In 2009 the company launched myonlineoptical.com, which (as of the 2014 Investor day) covered 1,500 ECPs. This provides ECPs with an online platform solution for a monthly fee of $99- $129. This platform can be used to create the independents own website (with a customisable homepage), offers technical support, gives consumers access to centralised customer service and help with order management. For an additional monthly fee, ECPs can have access to virtual eyewear try-on software as well as other benefits. 4. Luxottica’s omni-channel effort is progressing with Sunglass Hut but lags with LensCrafters. EssilorLuxottica has the potential to benefit from omni-channel if it can be developed properly. In the long run, we believe omni-channel will outperform pure
Essilor International SA (ESSI.PA) 26 17 March 2017
online and therefore as a combined company EssilorLuxottica can benefit from this trend in the longer term. We therefore believe with the dynamics in the short term and the longer term, EssilorLuxottica is positioned to outperform in this channel. Additionally, given its size and manufacturing capabilities, the drag on profits from this channel should be relatively lower and if EssilorLuxottica integrates the back end of these websites we would expect some further margin benefits. Given limited disclosure, we see scope for €100m extra revenues from the outperformance of online. We expect the online channel for the industry to be 10% of sales by 2025e, as we detailed in our online section. This implies an average growth rate of 10% p.a. for the channel. Taking 2017 as the starting point with 5% of group pro forma sales online, we grow online sales by 12%, ahead of our expectations for market growth, out to FY21. If we compare this to the value if online grew in line with the market, we get a €100m uplift to the top line. However, unlike the other revenue synergies we have calculated, we believe – given Essilor’s target of 10-12% contribution margin for this channel – it is appropriate to cost the revenues at a lower margin %, leading to a c€20m EBIT impact, on our estimates. With retail, online and doctor alliance groups in the US, wholesale could become redundant. There is the potential that with all the touch points of the new EssilorLuxottica, at the end of the value chain, the company could look to pull back on wholesale in the US. Although we would not see this as a priority, we would see it as a net positive given the promotional environment in the US. We note this is also something other brands such as those in the luxury goods sector have done over the past decade. The idea would be to still supply independents included in Essilor’s Doctor Alliance Groups, but reduce the exposure to online third parties and independents not within Essilor’s remit. This would reduce the likelihood of aggressive price wars online and in stores as EssilorLuxottica would ultimately control almost all distribution and pricing for its products. We note this has already been partly done for Ray-Ban using the MAP policy. We see this as very much a US theme, as this is where the company has the greatest penetration of distribution channels.
Figure 48: Essilor has websites across the Americas, Asia and Europe Key website banners
Source: US Field Trip 2016
Launch transactional sunglasshut.com and rayban.com. As we have mentioned, Luxottica’s omnichannel is lagging for LensCrafters but we also see potential upside for rayban.com and sunglasshut.com. We think a key initiative would be to launch the ability to buy Rx and Rx sun online for these websites as soon as possible, leveraging Essilor’s supply chain. The company already offers this on websites such as framesdirect.com and eyebuydirect.com, so clearly it has the expertise and infrastructure in place. We believe this would help support our view that as EssilorLuxottica, the company can grow its online sales ahead of the market.
Essilor International SA (ESSI.PA) 27 17 March 2017
Pro forma model Revenue synergies impact EBIT by €270m Our EssilorLuxottica revenue forecast is driven by the underlying models for the two companies. In the merger model we simply aggregate the individual company models given the level of detail we have. We then add an estimate of the revenue synergies to the top line to calculate the overall group revenue. Taking Euromonitor industry forecasts and weighting them based on Essilor and Luxottica exposures to i) lenses, ii) sunglasses, iii) luxury sunglasses and iv) luxury frames suggests EssilorLuxottica should grow organic revenues at 5% over the next five years to remain in line with the market. Essilor’s constant currency growth includes scope growth – this has added on average 6% growth to group topline p.a. over FY06-FY15. In the independent Essilor model, we reduce scope growth (i.e. growth driven by bolt-on acquisitions) to 2% going forward given the merger may limit further bolt-on deals in the short to medium term.
Figure 49: Both companies separately are growing ahead of the market, on our estimates Constant currency growth, including scope for Essilor and EssilorLuxottica.
16%
14%
12%
10%
8%
6%
4%
2%
0% 2010 2011 2012 2013 2014 2015 2016 2017e 2018e 2019e 2020e 2021e Product weighted industry growth EssilorLuxottica (pre synergies) Essilor (incl scope) Luxottica EssilorLuxottica (incl synergies)
Source: Company data, Euromonitor, Credit Suisse estimates
We estimate a peak EBIT contribution from synergies of c€270m, at the top end of management guidance. We forecast a ramp-up of revenue synergies to c€590m. This translates to €270m on the EBIT line.
Figure 50: Breakdown of revenue synergies and how they impact the P&L Revenue synergies, €m Comments FY18e FY19e FY20e FY21e Lens+frames inventory together Add 0.5% growth to lens division LFL 30 60 90 120 Combining branded Add 1% to LensCrafters LFL 25 50 75 100 White space expansion of brands Add up to 1.5% to sunglass division 25 50 75 100 Luxottica in independents Add up to 0.5% to North America wholesale division 20 20 20 20 EM growth Add 1-2% to Luxottica w/s Row and 1% to Essilor APAC/LATAM 25 75 125 150 Online out performance Grow at 12% p.a. instead of 10%. 40 60 80 100 Total 165 315 465 590 COGs impact (75) (148) (221) (282) Gross profit 90 167 244 308 Operating expense impact (16) (24) (32) (40) Total on EBIT line 74 143 212 268 Source: Credit Suisse estimates
Essilor International SA (ESSI.PA) 28 17 March 2017
This is supported by a Luxottica organic revenue CAGR of 5% to 2017-2021. Our merger model is built up from the combined individual company models of Luxottica and Essilor. Therefore, to understand the group growth we detail our assumptions for Luxottica and Essilor which are then combined with our absolute synergy number. We make few changes to our underlying growth assumptions for Luxottica (see Increase target price given merger synergies, published in conjunction with this report). We have lowered our organic growth expectation for FY17 marginally given new management guidance of low to mid-single digit constant currency growth for FY17. Additionally, we have lowered the space contribution as the company starts to consolidate its retail presence in North America, which is offset by some expansion outside the US. We also reduce our LFL assumption in the outer years for the sake of conservatism. The model drivers are detailed below.
Figure 51: Luxottica top line drivers Growth %, non-adjusted FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Group LFL 5.5% 5.8% 3.4% 4.0% 3.9% 0.6% 2.8% 4.0% 3.9% Space contribution 3.4% 0.0% 1.2% 0.3% (1.5%) 6.2% 1.6% 0.6% 0.2% Retail organic growth 9.1% 5.8% 4.7% 4.3% 2.3% 6.8% 4.4% 4.6% 4.1% North America 16.0% 14.9% 6.2% 10.3% 6.3% (3%) 2.3% 5.0% 6.0% Europe 6.6% 4.1% 8.0% 1.2% 5.1% 2.8% 4.0% 5.0% 5.0% Row 13.5% 14.6% 15.8% 12.6% 9.7% (2%) 4.2% 9.0% 10.0% Wholesale organic growth 11.2% 10.0% 12.0% 8.6% 6.9% (0.4%) 3.6% 6.3% 6.9% Group organic growth 9.9% 7.5% 7.5% 6.1% 4.3% 3.9% 4.1% 5.3% 5.2% Source: Company data, Credit Suisse estimates
Essilor’s old target of 6% group LFL by 2018 suggested a focus on organic growth. Over the past 10 years, Essilor has grown at an average LFL (organic growth) of c4% at the group level (see Figure 52). As we have mentioned, group overall growth has been supported by acquisitions, which have contributed >50% of topline growth. However medium-term targets set by the company at FY14 results suggested the company felt that by orienting itself more towards sunglasses, emerging markets and online, it could generate improvements in underlying growth performance. The market had been very focussed on the company’s ability to reach the 6% LFL goal prior to the merger announcement. Clearly it is now less concerned about this target but it is still important to bear in mind that achieving 6% in FY18 did not appear to be in consensus numbers before the deal.
Figure 53: Essilor has shifted its business to increase Figure 52: New LFL target sits above 10-yr average its exposure to higher-growth categories Group LFL growth profile over the past decade Essilor’s expectations of industry growth for each area
9%
8% 14%
7% 10-12% 6%
5%
4% 6-7% 6-7% 3%
2% 3-4% 1%
0% FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
LFL Avg. LFL FY18 target Fast growing markets Rx Sunwear Online Total Industry growth
Source: Company data, Credit Suisse research Source: FY15 results presentation
We forecast an acceleration in LFL supported by online... In our underlying Essilor model we forecast peak growth of 5.4% by FY18e. On an underlying basis we forecast a slight recovery in North America Lens LFL, as suggested by the OBB survey (see Visions
Essilor International SA (ESSI.PA) 29 17 March 2017
are changing published alongside this report), but some moderation in Europe, which recorded strong growth through FY16. The company does not break out online sales and growth consistently, so it is difficult to incorporate growth expectations explicitly into our numbers, but we boost our Lens division LFL slightly over the forecast years to account for the benefits of strong online growth. … and the sunglasses and readers division. Additionally, we expect an improvement in the sunglasses and readers division LFL as the division laps the weakness in 1H16 caused by the implementation of ARTEMIS. Overall we forecast c6% growth for the division over the next five years, which is at the lower end of company expectations as we take into consideration that its sun exposure is more towards the lower price point products, which are growing more slowly than the higher end, according to Euromonitor. Therefore at the group level, for FY17 we forecast 4.5% LFL group growth vs. management guidance of 3-5%.
Figure 54: We forecast a peak LFL for FY18 Detailed underlying Essilor growth assumptions (note scope varies for each division) € m unless otherwise stated FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Lenses & Optical Instruments 3,562 3,796 4,445 4,505 4,970 5,840 6,218 6,780 7,254 7,762 % reported growth 13% 7% 17% 1% 10% 18% 7% 9% 7% 7% % LFL 2% 5% 5% 2% 4% 5% 4% 4% 5% 5% Sunglasses & Readers 187 209 344 355 503 673 685 774 837 897 % reported growth NA 12% 65% 3% 42% 34% 2% 13% 8% 7% % LFL NA 1% 6% 3% (1%) 7% 1% 7% 6% 5% Equipment 143 185 199 205 197 202 212 216 220 222 % reported growth 38% 20% 8% 3% (4%) 3% 5% 2% 2% 1% % LFL 21% 18% 1% 7% (2%) (8%) 5% 1% 3% 2% Total 3,892 4,190 4,989 5,065 5,670 6,716 7,115 7,770 8,312 8,881 % reported growth 19% 8% 19% 2% 12% 18% 6% 9% 7% 7% % LFL 3% 5% 5% 2% 4% 5% 3.6% 4.5% 5.4% 4.5% Source: Company data, Credit Suisse estimates
Figure 55: Lens & Optical Instruments division growth assumptions for Essilor ex synergies Detailed underlying Essilor growth assumptions for the Lens & Optical instruments division by region € m unless otherwise stated FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e North America 1,516 1,519 1,736 1,770 2,038 2,587 2,707 2,917 3,065 3,219 % reported growth 12% 1% 16% (0%) 15% 27% 5% 8% 5% 5% % LFL 1% 4% 4% 1% 5% 4% 2% 3% 5% 4% Europe 1,402 1,471 1,559 1,572 1,653 1,777 1,905 2,016 2,138 2,268 % reported growth 5% 5% 6% 0% 5% 8% 7% 6% 6% 6% % LFL 0% 2% 3% 1% 0% 4% 3% 4% 4% 3% Asia/Pacific/Middle East/Africa 450 556 829 812 898 1,071 1,138 1,265 1,394 1,521 % reported growth 31% 24% 50% 5% 11% 19% 6% 11% 10% 9% % LFL 8% 13% 12% 4% 8% 6% 8% 8% 8% 7% Latin America 194 250 322 351 381 405 468 584 658 753 % reported growth 45% 29% 19% 9% 9% 6% 16% 25% 13% 14% % LFL 17% 10% 13% 10% 11% 8% 8% 6% 7% 7% Source: Company data, Credit Suisse estimates Adding in the revenue synergies gives an organic growth CAGR of 6% to FY21e. Combining our estimates for Luxottica and Essilor and incorporating our synergy profile leaves us forecasting revenue to grow to just over €22.5bn by FY21e, a CAGR of 6%. We ramp up our synergies steadily from FY18e over the four-year period. This leaves EssilorLuxottica growing c70bps on average over FY18-21e, ahead of the standalone companies.
Essilor International SA (ESSI.PA) 30 17 March 2017
Cost synergies impact EBIT by €270m We initially thought this was a cost-driven deal. Our initial thoughts around this deal were that the underlying synergies would be driven far more by the cost line rather than the revenue line. However, management expects synergies to be split 50:50 between revenues and costs. Given costs are far more controllable than revenues, we believe this range of synergies is of lower risk. We also believe these synergies will fall through faster than the revenue synergies. We forecast peak cost synergies of €270m in 2021. Bringing together our assumptions from the road map and assigning them by P&L line item, we can see how the cost synergies impact the margins. We use the same modeling for our pro forma costs as revenues, adding together the line items from the individual models and then applying a synergy number on top. This puts our total synergies, revenue-driven and cost-driven, towards the top end of management guidance, at €540m on the EBIT line.
Figure 56: Estimated cost synergies and impact on the P&L Cost synergies, €m Comments FY18e FY19e FY20e FY21e Lens insourcing Usual cost for Luxottica ~ 10% of COGs, buy at cost so assuming margin of 60% 60 120 150 150 Logistics & DCs Reduce Luxottica's logistic costs by 5% and reduce operating lease expense by low single digit, 5 20 30 30 Labs and network streamlining Reduce operating lease expense by low single digit, saving c20m 5 10 20 20 Combining manufacturing Reduce Essilor cogs by <1% 10 15 20 G&A savings Reduce employee costs of group by 1% 25 50 Total 70 160 240 270
COGS 60 130 165 170 Selling and distribution costs 10 30 50 50 Other operating expenses 25 50 Source: Credit Suisse estimates
We note manufacturing will be kept largely separate. Our forecast for the largest reduction of COGS comes through the insourcing of lens procurement. We forecast only a small reduction to Essilor’s COGS from insourcing for frame manufacturing for the high- end brands. This is because we do not expect manufacturing plants to be integrated. Both components of eyewear require very different manufacturing processes, therefore we would not expect any synergies from combining the manufacturing footprint. Essilor is not a margin story on its own This is supported by fairly stable margins at Essilor… Essilor has never been a margin story, in our view, maintaining steady margins over the past decade as we understand the company had the ability to flex variable costs and drive core leverage to offset acquisition dilution. For the COGS line, we understand c20% is raw material cost, c10% is amortisation, while 40% is labour (although the company can vary this slightly by hiring interim workers to manage overflows). Internal logistics costs and general costs/support account for the remainder. This leaves us estimating c40% variable costs to 60% fixed costs. The core business margin (i.e. excluding the impact of acquisitions) has in fact increased by 45bps p.a. on average over the past nine years. In FY14/15 the company saw an acceleration of this leverage to 60/70bps, driven by the synergies realised through the Transitions Optical integration.
Essilor International SA (ESSI.PA) 31 17 March 2017
Figure 57: Steady margin story over the past Figure 58: Essilor has levered its core business decade. Company guiding towards 18.5% in FY17 costs each year, negated by acquisitions Essilor CS adj. contribution margin, % sales Margin accretion/dilution on core business and from acquisitions, bps. FY17-FY19 CS estimated net margin expansion
20% 70 60 60 18.8% 18.8% 18.9% 19% 18.6% 18.6% 18.5% 50 50 40 18.1% 18.1% 18.1% 18.1% 17.9% 17.9% 17.9% 17.9% 30 30 27 18% 20 20 8 17% 0
16% -2 -10 -20 15% -30 -40 -40 14% -50 -50 -50 -60 13% -70 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e
12% Operating leverage on core businesses Dilution from acquistions FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
We see scope for some gross margin improvements. On the gross margin side, we forecast on average c30 bps of margin improvement per year on average out to FY21, with a small decline in FY16/17e. Management commented that the c90bps decline in FY16 was driven by three factors: i) lower sales of Transitions to third parties, equivalent to a revenue loss of €220m (these are higher-margin products); ii) growth of online, a lower-margin business at this stage; and iii) lower lens sales in North America. We expect online to continue to drag on performance in FY17 but to be partly negated by the company’s initiatives around Transitions. Therefore we forecast 30bps of gross margin contraction in FY17. Our underlying COGS assumption sits between 4% and 6%, depending on organic growth, just below the historical growth of 10%. We believe lower growth is appropriate as the company looks to realise some efficiencies between different assets and move to a more centralised model, leveraging the fixed manufacturing costs. However, advertising costs are now adding extra margin pressure. FY16 was the first time the company has had to cut margin guidance – from ≥18.8% to 18.5%. Although the cut was marginal and in fact Essilor reported an 18.6% margin at results, we believe this could be a sign that management is less willing to flex variable spending. In fact, with the focus on branded lenses, we believe it means management will continue to invest in advertising etc. even if lower organic growth creates some deleveraging. Advertising B2C currently sits at c3% of sales, combined with 5% of sales associated with B2B advertising. We know advertising does cause a considerable drag as in FY14 and FY15 there was a c60bps dilutive impact from the incremental marketing spend the company had committed. Therefore we expect this to continue even with the merger as both companies need to continue to invest in their brands. Limited drop-through to contribution margins… Given the dynamics around advertising spend, we forecast limited drop-through to the bottom line and estimate contribution margins to increase slightly to 19%. We keep R&D at 3% of sales and grow selling and distribution costs at around 6-8% underlying, as we believe the company will continue to invest in advertising. Other operating expenses remain c12% of sales. We believe further margin accretion is also hampered by the outperformance of online, with management targeting a considerably lower contribution margin of 10-12% for the channel by FY18. We still believe in margin accretion at Luxottica …but some accretion at Luxottica. We continue to forecast margin expansion for Luxottica after FY17. We adjust our forecasts following FY16 full year results and new company guidance of low to mid-single digit constant currency growth with 0.8-1.0x
Essilor International SA (ESSI.PA) 32 17 March 2017
operating income growth as a multiple of sales growth for FY17 (please see our report on Luxottica, Increase target price given merger synergies). This results in a c2% cut to earnings forecasts in FY17. However, we still forecast moderate operating profit expansion to just over 17% by 2021, driven by the company’s continued efforts to streamline production, improve efficiency and rationalise its logistics platform.
Figure 59: FY14 and FY15 benefited from the integration of Transitions, innovation and faster Figure 60: We expect some margin contraction in growth FY17 as the company prioritises investments Essilor gross margin progression, % of sales Luxottica operating margin progression, % of sales
61% 17.0% 16.6% 16.5% 16.1% 60% 16.0% 16.0% 15.8% 59% 15.3% 15.5% 15.2% 58% 15.0% 14.6% 57% 14.5% 14.2% 14.0% 56% 13.5% 13.2% 55% 13.0%
54% 12.5%
53% 12.0% FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e FY11 FY12 FY13 FY14 FY15 FY16e FY17e FY18e FY19e
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates EssilorLuxottica EPS growth of 12% FY17-21e EPS growth of 12% over the next five years. Incorporating our revenue and cost synergy assumptions, we forecast 12% EPS growth for the combined entity over 2017-21 and therefore accretion of c16%. We expect some margin deceleration in FY17 relative to standalone Essilor's FY16 margin because we assume the companies come together but no synergies are reported. We then assume margins reaccelerate above Essilor’s historical peak of 18.6% by FY20/21. We use the weighted average tax rate of 30%. We note that additional positive upside for EPS could come from any reduction in Luxottica's tax rate through the potential patent box or a reduction in the US corporate tax rate.
Figure 61: EssilorLuxottica gross margins are Figure 62: EssilorLuxottica operating margin should helped by the merger recover higher than previous Gross margin, % of sales Operating margin, % of sales
64.4% 64.0% 63.6% 20.0% 62.9% 19.6% 62.4%
18.8% 18.9% 18.6%
59.7% 17.7% 58.8%
16.7%
FY15 FY16 FY17e FY18e FY19e FY20e FY21e FY15 FY16 FY17e FY18e FY19e FY20e FY21e
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 33 17 March 2017
Figure 63: Estimated EPS growth for Essilor, Luxottica and the combined Essilor Luxottica. EPS accretion FY15 FY16e FY17e FY18e FY19e FY20e FY21e 5 yr CAGR Essilor 17% 7% 14% 10% 9% 7% 7% 9% Luxottica 23% 4% 4% 13% 9% 8% 8% 8% EssilorLuxottica 8% 15% 16% 12% 10% 12% EPS accretion 0% 3% 7% 4% 2% Total: 16% Source: Company data, Credit Suisse estimates
This leads to a 15% TSR over the next three years. Bringing this together, we see scope for EssilorLuxottica to grow ahead of the market at c5%. Additionally, we believe the company will be able to expand margins further and faster as a combined entity. Assuming EssilorLuxottica adopts a 40% payout ratio, between Luxottica’s 50% and Essilor’s c30%, this leaves us forecasting a TSR of c15% over the next three years.
Figure 64: TSR estimates for Essilor, Luxottica and EssilorLuxottica Essilor Luxottica EssilorLuxottica FY17-19e FY17-19e FY17-19e FY17-21e Organic revenue growth 7% 5% 6% 6% Adj. contribution margin 34bps 140bps 220bps 330bps Tax rate 0.0% 0.0% 0% 0% EPS growth 11% 9% 13% 12% Dividend yield 1.5% 2.2% 2%* 2%* TSR 12% 11% 15% 14% Source: Company data, Credit Suisse estimates, *on Essilor's current share price of €110.8 (as of 14 March 2017)
Essilor International SA (ESSI.PA) 34 17 March 2017
Cash generation should remain strong Essilor generated >€700m FCFE over the past five years. Both Essilor and Luxottica are highly cash generative. Looking at FCFE, Luxottica has generated around €600m p.a on average from FY11-FY16, while Essilor has generated slightly more, at c€700m p.a. over the past five years. However, over the same period Essilor has spent on average c€765m p.a. on acquisitions. In fact, historically 43% of Essilor’s cash spend has been on acquisitions, while c20% has been on dividends and c30% on capex.
Figure 65: Essilor's cash has been largely used to Figure 66: Slightly more money is tied up in fund acquisitions Essilor's inventory vs. Luxottica's Uses of cash over the past decade, % of total Net cash conversion cycle, days
100% 84 80 90%
80% 66 63 70% 61 56 55 54 60% 51 53 52 47 46 50% 43 44 38 37 40% 34
30% 22 23 20% 15 15 10%
0% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 10 yr avg 5 yr avg FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 Acquisitions Dividends Capex Essilor Luxottica
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
Essilor has a lean net cash conversion cycle. Essilor has been reducing its inventory days from the peak of 153 days in FY14. We believe this peak was driven by a buildup of inventory following higher-than-expected growth the prior two years as one of the company’s biggest competitors, Hoya, suffered a flood in its main manufacturing plant. This was compounded by the loss of a number of contracts in Europe in FY13. The company has seen an increasing level of finished and semi-finished products in FY15 but we think this may be a function of new business lines and not a cause for concern.
Figure 67: Proportion of inventories from finished Figure 68: On a non-lease adjusted basis and semi-finished goods has increased in FY15 EssilorLuxottica turns net cash neutral in FY19e Inventory break down by category, % Net debt to EBITDA (non-lease adjusted), (x)
100% 50% 2.0x
80% 40% 1.5x
60% 30%
1.0x 40% 20% 0.6x
20% 10% 0.5x 0.3x 0.1x 0% 0% 0.0x FY09 FY10 FY11 FY12 FY13 FY14 FY15
-20% -10% (0.2x) (0.5x) Raw materials and other supplies Goods for resale Finished and semi-finished products FY10 FY11 FY12 FY13 FY14 FY15 FY16e FY17e FY18e FY19e FY20e Write down of inventories % growth Essilor Luxottica EssilorLuxottica
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 35 17 March 2017
Modelling the EssilorLuxottica cash flow and balance sheet. i) For capex, we simply sum our independent assumptions for Luxottica and Essilor. We do not assume any reduction in capex spend because of merger synergies and therefore simply sum the underlying models. Overall capex reduces slightly as we assume Luxottica’s spend as a percentage of sales decreases from peak of >7% in FY16-FY18e (driven by the three-year investment plan). This is partly negated by a minor increase in capex for Essilor as a percentage of sales from FY17e. We use the same approach for our depreciation and amortisation assumptions, simply summing the forecasts in our underlying Essilor and Luxottica models. ii) Working capital is kept roughly flat for Essilor’s underlying model on FY16e, at around c40 days, while Luxottica increases marginally to 34 days as historically the company has sat much higher. For the EssilorLuxottica model we forecast this independently rather than aggregating the underlying model. We assume the company would have greater inventory management as a combined entity given a number of proposed initiatives, such as potentially combining DCs and lens labs, etc. We therefore forecast the net cash conversion cycle to reduce from 42 days to 32 days between FY16 and FY21e. iii) Similar to Essilor’s independent model, we forecast cash outflows due to acquisitions in EssilorLuxottica. This is because we include in our model a scope forecast for bolt-on acquisitions. To forecast this, we take an net cash consideration paid / sales of 1.3x, the same as the average multiple paid over the past decade. This leads to us forecasting c€1bn of spend on acquisitions over the next five years. This compares to €3.5bn over the past five years. iv) Historically Luxottica has adopted a c50% payout ratio and Essilor a 30% ratio. We therefore model this going forward for our individual company models but for the EssilorLuxottica model we take a simple average and forecast a 40% payout ratio. v) Our net debt is built up in 2017 by the combination of underlying companies, with the net finance costs also an aggregate in 2017. From 2018 forwards we model the pro forma independently for net debt and finance costs. We assume some reduction in the cost of gross debt going forward and some reduction in gross debt to equity as the company continues to pay off debt. vi) On the balance sheet, we add €18.4bn to goodwill, based on closing price pre acquisition. On the cash flow statement (which then flows through our consolidated reserves on the balance sheet) we incorporate a capital increase, given at the time of modeling the companies’ share prices did not reflect the exchange ratio of 0.461. This will change as the share price fluctuates until the deal is closed.
Essilor International SA (ESSI.PA) 36 17 March 2017
Governance and risks We think investor confidence in Essilor's management is high. The current CEO, Mr Hubert Sagnières, has been with the company since 1989 and took over the position of Chairman and CEO in January 2012. Having spent time on the road with the company and investors during the US Field Trip in September 2016, we think investor confidence in Essilor's management is high. For Luxottica, corporate governance has been a concern since Mr Andrea Guerra left in late 2014. Having seen a number of CEOs leave over the past two years with little explanation, investor concern was understandable and was likely one driver of the significant share price decline in early 2016. However, we think it has become clear to investors that Del Vecchio being back in an executive position is not necessarily a negative. The founder has put in place some forward-thinking strategies and initiatives that have caused short-term pain but are arguably positive for the longer-term strength of the business and brands. The deal removes the management overhang for Luxottica, in our view. It is hard to add any real colour on who will be leading the merger over the medium term. So far we know the following: i) Del Vecchio will have the title of CEO and Executive Chairman of EssilorLuxottica ii) Mr Sagnières will have the title of Executive Vice-Chairman and Deputy CEO. iii) Both have equal decision-making power and both will remain Chairmen of the individual entities. iv) For a strategy to be implemented or a decision made, both have to agree – neither of them has an overriding vote. v) Post transaction, the Delfin fund (owned by del Vecchio) will own 31-38% of the shares of the new entity and the voting rights will be capped at 31%. Given we believe this transaction was partly driven by Mr Del Vecchio's search for a successor, we expect him to step down after around two years, as this would be consistent with his original plans announced in March 2016 to step down after 2-3 years in an executive role. Either way, we think having both managers in place over the short term is necessary for both companies to see an acceleration in growth over 2017/2018 after a weak 2016 and to ensure the merger goes smoothly given each company's size and expertise. Clearly this deal carries execution risk... Both companies plan to be run as separate entities over the short term, with integration up and running by 2H18, we believe. Some may worry that Luxottica’s investment plans could fall by the wayside over 2017, but with Del Vecchio in charge, we see this as highly unlikely. We believe management will remain proactive, as exemplified by the recent M&A deals; i.e. closing the Salmoiraghi call option (November 2016) and the acquisition of Oticas Carol in Brazil (January 2017). … and some market participants are worried about anti-trust issues. As mentioned previously, we do not believe anti-trust issues will stop the deal from going through, especially given it is a vertically integrated deal. We think the companies may be required to divest some interests in North America, given they are overexposed there and control a large portion of the market, but we think this could involve standalone assets such as Sears Optical or Target Optical. These may be less valuable assets, given they drive a lower proportion of retail sales and are in less central locations compared with Luxottica’s flagship banners such as LensCrafters and Sunglass Hut. Luxottica runs 581 Sears Optical stores and 476 Target Optical stores in North America. Given the deal has clearly been on the table for some time, having been first publicly discussed in September 2014, and perhaps pushed through earlier than expected because of two companies’ investment plans, we see the risk of significant anti-trust issues as low.
Essilor International SA (ESSI.PA) 37 17 March 2017
Valuation Concerns over the deal have opened up an attractive buying opportunity, in our view. Taking an EV-weighted average, EssilorLuxottica has historically traded on a 12- month forward consensus EV/EBIT of c17x ex synergies. This merger and current share price weakness offers the opportunity to enter the names on a FY18 EV/EBIT of 15.6x, on our estimates, at a c10% discount to historical levels. Note this historical multiple does not include synergies. The company could justify a higher multiple given its vertical integration. For both stocks, we think valuation has always been a sticking point, with Essilor and Luxottica typically trading at a c95% premium to the CAC40 and FTSE MIB, respectively, on 12- month forward consensus P/E. This is justified by the premium investors are willing to pay for vertical integration and strong brands. As a combined entity, this is likely to be more of a factor, perhaps justifying an even higher multiple. Moreover, looking at larger conglomerates such as Inditex, which currently trades on an EV/EBIT of 18x CY18E on Credit Suisse estimates, vs the sector at 14x, we understand a larger company with greater diversification should trade on a higher multiple vs. the sector. The current discount is therefore a key reason we initiate with an Outperform now rather than waiting for the deal to close. At our target price of €127 and FY18 EBIT forecasts, the stock trades on an EV/EBIT of just under 18x. Although this is higher than the historical average, we believe it is justified given the barriers to entry and likely competitive advantage of the combined EssilorLuxottica.
Figure 69: EssilorLuxottica has historically traded at Figure 70: As synergies start to flow in in FY18e, a c17x EV/EBIT ex synergies EssilorLuxottica looks increasingly attractive EssilorLuxottica 12mth fwd consensus EV/EBIT, EV weighted average EV/EBIT multiples on our estimates for Essilor, Luxottica and EssilorLuxottica
22x 20 17.7x 18 21x 15.6x 16 13.7x 20x 14 12.4x 11.4x 19x 12 10 18x 8 17.3x 17x 17.2x 6 4 16x 2 15x Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 - FY17e FY18e FY19e FY20e FY21e
EssilorLuxottica 12mth fwd. EV/EBIT ex synergies 5 yr. avg Luxottica Essilor EssilorLuxottica
Source: Thomson Reuters, Credit Suisse research, pricing as of close on 14 March 2017 Source: Company data, Credit Suisse estimates, pricing as of close on 14 March 2017
Our Outperform rating and target price methodology. We derive our valuation for Essilor from our pro forma EssilorLuxottica model. Note the numbers that appear in Essilor-only financial tables are our underlying Essilor International assumptions without the Luxottica merger. Our target price is an average of our EssilorLuxottica DCF (€127) and our EssilorLuxottica Credit Suisse HOLT® Linker (€127). For our DCF we assume a c14% EBIT margin, 3% terminal growth rate and WACC of 6%. We use Essilor’s unlevered beta of 0.8 for the WACC calculation. This compares to Luxottica’s unlevered beta of 0.9. Full DCF details are given in Figures 71 and 72. We believe 3% terminal growth rate assumption is appropriate given this is our underlying industry growth forecast. Additionally, a margin of 13.5% appears reasonable to us; since 2004 the company has achieved margins of around 16-17% and we prefer to remain cautious.
Essilor International SA (ESSI.PA) 38 17 March 2017
Figure 71: Our detailed DCF model using EssilorLuxottica pro forma DCF model based on our pro forma forecasts. Note: FY16 shows only Essilor numbers. FY16e FY17e FY18e FY19e FY20e FY21e FY22e FY23e FY24e FY25e FY26e Net sales 7,115 17,550 18,719 20,019 21,335 22,693 24,023 25,259 26,378 27,358 28,179 Growth 6% 147% 7% 7% 7% 6% 6% 5% 4% 4% 3% Clean EBIT 1,230 2,868 3,254 3,719 4,116 4,478 4,441 4,355 4,219 4,034 3,804 Margin 17.3% 16.3% 17.4% 18.6% 19.3% 19.7% 18.5% 17.2% 16.0% 14.7% 13.5% Depreciation & Amortization 378 912 987 1,067 1,151 1,242 1,257 1,278 1,287 1,284 1,268 As a % of capex 128% 87% 87% 89% 93% 97% 94% 96% 97% 99% 100% Change in working capital 8 (195) (143) (160) (157) (202) (240) (253) (264) (274) (282) As a % of sales -0.1% 1.1% 0.8% 0.8% 0.7% 0.9% 1.0% 1.0% 1.0% 1.0% 1.0% Cash Tax (250) (825) (948) (1,096) (1,227) (1,346) (1,335) (1,309) (1,268) (1,213) (1,143) Cash tax rate (as a % of EBIT) 20% 29% 29% 29% 30% 30% 30% 30% 30% 30% 30% Capex (294) (1,050) (1,129) (1,194) (1,237) (1,284) (1,331) (1,333) (1,324) (1,302) (1,268) As a % of sales 4.1% 6.0% 6.0% 6.0% 5.8% 5.7% 5.5% 5.3% 5.0% 4.8% 4.5% FCFF 1,073 1,710 2,021 2,337 2,647 2,890 2,793 2,738 2,651 2,531 2,379 y-o-y change 17% 59% 18% 16% 13% 9% 5% -2% -3% -5% -6% Source: Company data, Credit Suisse estimates
Figure 72: Our DCF derives an equity value of €127/share WACC FY17e Gross debt 4,734 Market cap. 48,325 Pre-tax cost of debt 3%
Levered beta 0.8 Risk-free rate 3% Market risk premium 5% Cost of equity 7% WACC 6% Terminal growth rate 3%
Fair value FY17e Total EV 58,411 FY1E net debt (2,214) Market value of minorities (564) Pensions (509) Fair value of equity 55,124 Equity value per share (12-month) 127 Source: Company data, Credit Suisse estimates
We also use a HOLT Linker with a 15-year forecast period. To recap, a HOLT Linker uses the HOLT valuation framework and our forecasts to value the company. We use a 15-year forecast period, including our five-year explicit forecasts, before applying the fade algorithm as both Essilor and Luxottica are classified as 'super e-CAPs'. eCAP stands for 'empirical competitive advantage period'. This designation is awarded to firms that demonstrate persistently above-average CFROI® levels as measured by four properties; i) CFROI ≥8% for 4/5 years, ii) CFROI trend ≥ -10% over five years, iii) CFROI volatility ≤30% over five years and iv) five-year real asset growth ≤30%. Within the extra five years of forecasts we reduce our growth and margins gradually, but admittedly at a slower rate than the normal fade model. Additionally, given the company is extremely cash generative, we limit the amount of cash that builds up on the balance sheet as we assume it will continue to be used for acquisitions or returned to shareholders. If instead we allow this cash to build up on the balance sheet, the HOLT valuation is heavily penalised as the cash weighs on the forecast CFROI levels. We detail our valuation metrics in Figure 73.
Essilor International SA (ESSI.PA) 39 17 March 2017
Figure 73: Warranted price of €127 with our HOLT Lens Linker HOLT Lens Linker
ESSILOR - LUXOTTICA PRO- FORMA (ESSI) Current Price: EUR 110.80 Warranted Price: EUR 127 Valuation date: 14-Mar-17
Sales Growth (parallel % point change to forecasts) Dec 14A Dec 15A Dec 16E Dec 17E Dec 18E
EUR -2.0% -1.0% 0.0% 1.0% 2.0% Sales Growth, % 11.9 174.3 4.2 8.3 6.7
e
g EBITDA Mgn, % 22.2 22.7 22.0 21.5 22.7
n -2.0% -30% -17% -3% 13% 32% a
h Asset Turns, x 0.85 0.9 0.9 0.9 0.9 c
t n i
o -1.0% -22% -9% 6% 23% 43% p
) CFROI®, % 14.8 18.3 17.5 16.9 17.8 s % t
l s e a l l
c Disc Rate, % 4.1 3.4 3.3 3.3 3.3 a e 0.0% -15% -1% 14% 33% 53% r r a o f
p Asset Grth, % 9.7 148.0 5.3 5.9 4.8
(
o t n i g
r 1.0% -8% 6% 23% 42% 64% a
M Value/Cost, x 5.2 5.0 4.5 4.3 4.1
A
D Economic PE, x 35.2 27.5 25.7 25.1 22.7 T
I 2.0% -1% 14% 32% 52% 75% B
E Leverage, % 14.0 15.0 15.6 16.3 17.0 a t
a More than More than Sales Growth (%) D 10% Within 10% 20 10% upside o downside 18 i r 16 a
n 14 e
c CFROI & Discount Rate (in %) 12 S 10
t 8 s 25 y
l 6
a 4 n 20
A 2
e 0
s 15 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 s i u S
10
t EBITDA Margin i 30 d
e 5 r 25 C
- 20 0
2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 T Historical CFROI Historical Transaction CFROI 15 L Forecast CFROI Forecast CFROI
O CFROI Discount Rate 10 H 5 Asset Growth (in %) 0 20 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029
15 Asset Turns (x) 1.0 10 0.9 0.8 5 0.7 0.6 0 0.5 0.4 -5 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 0.3 0.2 Historical Asset Growth Rate Forecast Growth 0.1 Forecast Growth RAGR Normalised Growth Rate 0.0 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029
Source: Credit Suisse HOLT®. CFROI and HOLTare trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries. For display purposes, these charts have been capped as follows. Asset Growth and Sales growth are capped at 20%.
Source: Company data, Credit Suisse estimates, HOLT®
Essilor International SA (ESSI.PA) 40 17 March 2017
Blue/Grey Sky Scenarios We calculate a Grey Sky valuation of €90... Given there is a possibility of this deal not going through, we base our Grey Sky scenario on the underlying operating profit of Essilor, as a standalone company. In this scenario we assume i) the deal does not go through, ii) there is a considerable slowdown in the eyewear market and iii) the relationship between Essilor and the independent ECPs is negatively affected by the merger proposition. This leads to a 15% decline in FY18 operating profits to c€1,300m. Applying Essilor’s average historical 12-month forward consensus EV/EBIT multiple of c16x leads us to Grey Sky valuation of €90. …and Blue Sky of €137. For our Blue Sky scenario we assume a 10% increase in base case profits for EssilorLuxottica in FY18 to €3,675m, given faster implementation of synergies and strong execution of the merger. We take the historical EV weighted average 12-month forward EV/EBIT for the combined EssilorLuxottica entity of 17x. This results in a valuation of €137.
Essilor International SA (ESSI.PA) 41 17 March 2017
Financials – Essilor standalone
Figure 74: Balance sheet and cash flow summary €m unless otherwise stated FY11 FY12 FY13 FY14 FY15 FY16e FY17e FY18e FY19e Non-current assets 3,730 4,081 4,546 7,627 8,699 9,245 9,345 9,477 9,722 Inventories 753 830 869 1,002 1,099 1,190 1,300 1,377 1,456 Receivables 1,122 1,148 1,192 1,327 1,456 1,512 1,651 1,766 1,887 Cash and Cash equivalents 390 661 786 626 466 786 1,310 2,007 2,651 Current assets 2,429 2,826 3,031 3,162 3,272 3,718 4,491 5,380 6,224 Assets held for sale ------Total assets 6,158 6,907 7,577 10,789 11,971 12,963 13,837 14,857 15,946
Equity to parent 3,325 3,657 3,756 4,915 5,707 6,543 7,098 7,689 8,328 Minorities 133 257 285 345 385 407 483 567 658 Borrowings (long term and short term) 916 916 1,174 2,447 2,579 2,606 2,691 2,931 3,190 Trade payables 62 76 63 58 87 94 94 94 94 Other Liabilities 1,590 1,745 2,014 2,679 2,828 2,906 2,986 3,009 3,017 Liabilities 2,700 2,994 3,536 5,529 5,879 6,013 6,255 6,601 6,960 Total Equity and liabilities 6,158 6,907 7,577 10,789 11,971 12,963 13,837 14,857 15,946
Cash flow FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Operating cash flow 668 840 843 1,032 1,194 1,236 1,281 1,414 1,525 Net purchase of PP&E (205) (241) (297) (232) (327) (294) (350) (391) (435) Net acquisitions (364) (158) (330) (1,836) (765) (737) (125) (141) (238) Others (17) (17) 6 (7) (21) 14 - - - Investing cash flows (586) (416) (621) (2,075) (1,113) (1,017) (474) (531) (673) Financing cash flows (59) (252) (38) 1,039 (252) 82 (284) (185) (208) Effect of exchange rates 5 (4) (15) (147) 4 33 - - - Net increase (decrease in cash) 23 171 184 (4) (171) 301 524 697 643
Net debt (cash) 525 255 388 1,821 2,113 1,820 1,381 924 540 Net debt to Contributions from operations (x) 0.7 0.3 0.4 1.7 1.7 1.4 1.0 0.6 0.3 Net debt to EBITDA (adj.) (x) 0.6 0.2 0.3 1.2 1.3 1.1 0.8 0.5 0.3
DPS 0.85 0.89 0.94 1.02 1.11 1.50 1.73 1.90 2.07 Payout ratio 35% 32% 33% 25% 31% 40% 40% 40% 40% Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 42 17 March 2017
Figure 75: Full P&L €m unless otherwise stated FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Revenue 4,190 4,989 5,065 5,670 6,716 7,115 7,770 8,312 8,881 cc. organic growth, % 5.0% 5.2% 2.1% 3.7% 4.6% 3.6% 4.5% 5.4% 4.5%
COGS (1,868) (2,205) (2,227) (2,355) (2,704) (2,934) (3,227) (3,418) (3,615) Gross profit 2,321 2,784 2,838 3,315 4,012 4,181 4,543 4,894 5,266 Gross margin, % 55.4% 55.8% 56.0% 58.5% 59.7% 58.8% 58.5% 58.9% 59.3%
Research and development costs (151) (162) (164) (188) (214) (214) (233) (249) (266) % sales 4% 3% 3% 3% 3% 3% 3% 3% 3% Selling and distribution costs (960) (1,140) (1,145) (1,367) (1,678) (1,750) (1,930) (2,076) (2,242) % sales 23% 23% 23% 24% 25% 25% 25% 25% 25% Other operating expenses (462) (588) (612) (717) (857) (896) (939) (1,004) (1,080) % sales 11% 12% 12% 13% 13% 13% 12% 12% 12% Total operating expense (1,573) (1,890) (1,921) (2,272) (2,749) (2,860) (3,101) (3,330) (3,588) % growth 8% 20% 2% 18% 21% 4% 8% 7% 8% % sales 38% 38% 38% 40% 41% 40% 40% 40% 40% Contribution from operations 748 893 917 1,043 1,263 1,321 1,441 1,564 1,678 % sales 17.9% 17.9% 18.1% 18.4% 18.8% 18.6% 18.5% 18.8% 18.9% % growth 6% 19% 3% 14% 21% 5% 9% 9% 7% Adj. Contribution from operations 748 893 917 1,056 1,263 1,321 1,441 1,564 1,678 % sales 17.9% 17.9% 18.1% 18.6% 18.8% 18.6% 18.5% 18.8% 18.9%
Strategic acquisition costs (8) (2) (11) ------Other income and expenses from operations, net (9) (18) (8) (104) (9) 6 7 7 7 Compensation costs on share based payments (23) (28) (32) (39) (49) (64) (64) (64) (64) Gains and losses on disposals of assets, net (2) 16 (1) 544 - - - - - Net restructuring costs (23) (25) (22) (104) (22) (33) - - - Impairment losses - (5) - (118) - - - - - Reported operating profit 683 831 843 1,222 1,183 1,230 1,384 1,507 1,621 % sales 16.3% 16.7% 16.6% 21.6% 17.6% 17.3% 17.8% 18.1% 18.3% Adj. operating profit 683 836 843 989 1,183 1,230 1,384 1,507 1,621 % sales 16.3% 16.8% 16.6% 17.4% 17.6% 17.3% 17.8% 18.1% 18.3%
CS adjusted EBITDA 929 1,124 1,164 1,507 1,643 1,699 1,815 1,964 2,105 CS adjusted EBITDA margin 22.2% 22.5% 23.0% 26.6% 24.5% 23.9% 23.4% 23.6% 23.7%
Total Financial results (13) (18) (20) (46) (63) (66) (51) (42) (26) Reported profit before tax 670 813 823 1,176 1,120 1,164 1,332 1,465 1,596 CS Adj. profit before tax 670 818 823 945 1,120 1,164 1,332 1,465 1,596
Income tax expense (179) (207) (199) (193) (308) (285) (333) (366) (399) Tax rate 26.8% 25.5% 24.2% 16.4% 27.5% 24.5% 25.0% 25.0% 25.0% Reported net profit of consolidated companies 490 606 624 983 812 879 999 1,099 1,197 Adj. net profit of consolidated companies 490 611 624 699 812 879 999 1,099 1,197 Share of profits of associates 28 24 22 3 1 1 1 1 1
CS adjusted net profit 518 635 646 702 813 880 1,000 1,100 1,198 Attributable to minority interests 13 46 53 60 56 67 76 84 91 Attributable to Group equity holders 506 589 593 642 757 813 924 1,016 1,106 Note: We use a USD/EUR rate of 1.06 for FY17/18e Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 43 17 March 2017
Figure 76: Per share data table € unless otherwise stated FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Weighted average number of shares ('000s) 207.25 208.26 210.16 210.51 212.23 213.82 213.82 213.82 213.82 % growth (1%) 0% 1% 0% 1% 1% 0% 0% 0% Diluted weighted avg. number of shares ('000s) 209.68 211.02 213.06 214.82 216.58 218.11 218.11 218.11 218.11 % growth (1%) 1% 1% 1% 1% 1% 0% 0% 0%
Basic Reported EPS 2.44 2.80 2.82 4.11 3.57 3.79 4.32 4.75 5.17 % growth 11% 15% 1% 46% (13%) 6% 14% 10% 9% Diluted Reported EPS 2.41 2.77 2.78 4.32 3.50 3.73 4.24 4.66 5.07 % growth 11% 15% 0% 55% (19%) 7% 14% 10% 9%
Basic CS Adj EPS 2.44 2.83 2.82 3.05 3.57 3.79 4.32 4.75 5.17 % growth 1% 16% 0% 8% 17% 6% 14% 10% 9% Diluted CS Adj. EPS 2.41 2.79 2.78 2.99 3.50 3.73 4.24 4.66 5.07 % growth 2% 16% 0% 7% 17% 7% 14% 10% 9% Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 44 17 March 2017
Financials – EssilorLuxottica pro forma
Figure 77: EssilorLuxottica full P&L €m unless otherwise stated FY15 FY16 FY17e FY18e FY19e Synergies 165 315 Revenue 6,716 7,115 17,550 18,719 20,019 Reported growth incl synergies 18% 6% 147% 6.7% 6.9% Organic growth (Luxo + Essilor, ex synergies) 5% 4% 4.9% 6.0% 5.9% Organic growth incl synergies 4.9% 6.6% 6.9%
Synergies - 60 130 COGS (2,704) (2,934) (6,604) (6,872) (7,139) Cost of revenue synergies - (75) (148) Gross profit 4,012 4,181 10,946 11,771 12,731 Gross margin, % 59.7% 58.8% 62.4% 62.9% 63.6%
Research and development costs (214) (214) (233) (249) (266) % sales 3.2% 3.0% 1.3% 1.3% 1.3% Synergies - 10 30 Selling and distribution costs (1,678) (1,750) (5,863) (6,155) (6,513) % sales 25.0% 24.6% 33.4% 32.9% 32.5% Synergies - - - Other operating expenses (857) (896) (1,925) (2,040) (2,167) % sales 12.8% 12.6% 11.0% 10.9% 10.8% Cost of revenue synergies - (16) (24) Total operating expense (2,749) (2,860) (8,021) (8,461) (8,970) % growth 21% 4% 180% 5% 6% % sales 40.9% 40.2% 45.7% 45.2% 44.8% Contribution from operations 1,263 1,321 2,925 3,311 3,776 % growth 21% 5% 121% 13% 14% % sales 18.8% 18.6% 16.7% 17.7% 18.9%
Adj. operating profit 1,183 1,230 2,868 3,254 3,719 % sales 17.6% 17.3% 16.3% 17.4% 18.6%
CS Adj. EBITDA 1,643 1,699 3,780 4,241 4,786 % sales 24.5% 23.9% 21.5% 22.7% 23.9%
Total Financial results (63) (66) (118) (94) (68) Reported profit before tax 1,120 1,164 2,749 3,160 3,651 CS Adj. profit before tax 1,120 1,164 2,749 3,160 3,651
Income tax expense (308) (285) (825) (948) (1,095) Tax rate 27.5% 24.5% 30.0% 30.0% 30.0% Reported net profit of consolidated companies 812 879 1,925 2,212 2,556 Share of profits of associates 1 1 1 1 1
Reported net profit 813 880 1,926 2,213 2,557 Attributable to minority interests 56 67 151 173 200 Attributable to Group equity holders 757 813 1,775 2,040 2,357 % growth (19%) 7% 118% 15% 16% Note: 2015 and 2016 numbers are Essilor standalone Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 45 17 March 2017
Figure 78: Per share data table € unless otherwise stated FY11 FY12 FY13 FY14 FY15 FY16 FY17e FY18e FY19e Weighted average number of shares ('000s) 207.25 208.26 210.16 210.51 212.23 213.82 434.74 434.74 434.74 % growth (1%) 0% 1% 0% 1% 1% 103% 0% 0% Diluted weighted avg. number of shares ('000s) 209.68 211.02 213.06 214.82 216.58 218.11 439.40 439.40 439.40 % growth (1%) 1% 1% 1% 1% 1% 101% 0% 0%
Basic Reported EPS 2.44 2.80 2.82 4.11 3.57 3.81 4.08 4.69 5.42 % growth 11% 15% 1% 46% (13%) 6% 7% 15% 16% Diluted Reported EPS 2.41 2.77 2.78 4.32 3.50 3.73 4.04 4.64 5.36 % growth 11% 15% 0% 55% (19%) 7% 8% 15% 16%
Basic CS Adj EPS 2.44 2.83 2.82 3.05 3.57 3.80 4.08 4.69 5.42 % growth 1% 16% 0% 8% 17% 7% 7% 15% 16% Diluted CS Adj. EPS 2.41 2.79 2.78 2.99 3.50 3.73 4.04 4.64 5.36 % growth 2% 16% 0% 7% 17% 7% 8% 15% 16% Note: 2011-2016 numbers are Essilor standalone Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 46 17 March 2017
Figure 79: EssilorLuxottica balance sheet Balance sheet FY15 FY16e FY17e FY18e FY19e Goodwill 5,295 9,566 27,967 27,967 27,967 Other intangible assets 1,826 3,394 3,654 3,944 4,294 Property, plant and equipment 1,200 2,940 2,942 2,935 2,949 Investments in associates 5 25 25 25 25 Non-current financial assets 139 113 113 113 113 Deferred tax assets 169 305 305 305 305 Long-term receivables 24 34 34 34 34 Other non-current assets 41 140 140 140 140 Non-current assets 8,699 16,517 35,181 35,463 35,828 Inventories 1,099 2,083 2,258 2,317 2,372 Prepayments to suppliers 32 103 103 103 103 Short-term receivables 1,456 2,444 2,680 2,858 3,054 Tax receivables 60 105 105 105 105 Other receivables 34 93 93 93 93 Derivative financial instruments recognized in assets 64 126 126 126 126 Prepaid expenses 61 138 138 138 138 Marketable securities - - - - - Cash and cash equivalents 466 1,653 2,520 3,579 3,497 Current assets 3,272 6,746 8,023 9,319 9,489 Total assets 11,971 23,263 43,204 44,782 45,317
Share capital 39 68 68 68 68 Issue premiums 400 561 561 561 561 Consolidated reserves 4,504 10,222 29,600 30,457 31,558 Own shares (286) (434) (434) (434) (434) Oceane conversion option - - - - - Hedging and revaluation reserves (131) (176) (176) (176) (176) Translation differences 424 417 417 417 417 Net profit attributable to group equity holders 757 1,664 1,775 2,040 2,357 Equity attributable to parent company owners 5,707 12,321 31,812 32,933 34,351 Equity attributable to non-controlling interests 385 413 564 737 937 Total consolidated equity 6,092 12,734 32,375 33,670 35,288
Provisions for pensions 295 509 509 509 509 Long-term borrowings 1,905 3,300 3,352 3,486 2,654 Deferred tax liabilities 422 658 658 658 658 Other non-current liabilities 404 509 509 509 509 Non-current liabilities 3,026 4,976 5,028 5,162 4,330 Provisions 369 484 484 484 484 Short-term borrowings 674 1,350 1,382 1,438 1,095 Customer prepayments 31 36 36 36 36 Short-term payables 1,357 2,420 2,635 2,729 2,820 Tax payables 87 111 111 111 111 Other current liabilities 316 1,116 1,116 1,116 1,116 Derivative financial instruments recognized in liabilities 9 24 24 24 24 Deferred income 10 12 12 12 12 Current liabilities 2,853 5,553 5,800 5,950 5,698 Total equity and liabilities 11,971 23,263 43,204 44,782 45,317 Note: 2015 and 2016 numbers are Essilor standalone Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 47 17 March 2017
Figure 80: EssilorLuxottica cash flow statement Cash flow statement FY15 FY16e FY17e FY18e FY19e Consolidated net profit 813 879 1,925 2,212 2,556 Share of profits of associates, net of dividends received (1) 1 1 1 1 Depreciation, amortization and other non-cash items 380 378 912 987 1,067 Profit before amortization and depreciation and associates 1,192 1,258 2,838 3,200 3,624 Provision charges (reversals) (8) (49) - - - Gains and losses on asset disposals, net (1) (8) - - - Cash flow after tax and finance costs, net 1,183 1,201 2,838 3,200 3,624 Finance costs, net 54 58 118 94 68 Tax expenses (including deferred taxes) 308 285 825 948 1,095 Cash flow before tax and finance costs, net 1,545 1,544 3,781 4,242 4,787 Taxes paid (265) (250) (825) (948) (1,095) Interest (paid) and received, net (35) (66) (118) (94) (68) Change in working capital requirement (51) 8 (195) (143) (160) Net cash from operating activities 1,194 1,236 2,643 3,057 3,463
Purchases of property, plant and equipment and intangible assets (327) (294) (1,050) (1,129) (1,194) Acquisitions of subsidiaries, net of cash acquired (765) (737) (125) (141) (238) Purchases of non-consolidated securities (15) (1) - - - Change in other non-financial assets (13) (2) - - - Impact of changes in the scope of consolidation - - - - - Proceeds from the sale of other financial assets, property, plant and 7 17 - - - equipment and intangible assets Proceeds from the sale of subsidiaries, net of cash sold - - - - - Net cash used in investing activities (1,113) (1,017) (1,174) (1,270) (1,432)
Capital increase 46 161 124 - - (Purchases) sales of treasury stock, net - (31) - - - Dividends paid to Essilor shareholders (216) (79) (762) (799) (816) Dividends paid to minority shareholders of consolidated subsidiaries (35) (38) (48) (120) (122) Bond issues 300 - - - - Increase / (decrease) in borrowings other than finance lease liabilities (345) 70 84 189 (1,175) Purchases of marketable securities - - - - - Repayment of finance lease liabilities (2) (1) - - - Other movements - - - - - Net cash used in financing activities (252) 82 (601) (729) (2,113)
Net increase (decrease) in cash and cash equivalents (171) 301 867 1,058 (82) Net cash and cash equivalents at BoP 598 431 765 1,633 2,691 IAS 39 adjustments to opening cash and cash equivalents - - - - - Impact of change of consolidation method applied to the joint ventures - - - - - Effect of changes in exchange rates 4 33 - - - Net cash and cash equivalents at EoP 431 765 1,633 2,691 2,609 Note: 2015 and 2016 numbers are Essilor standalone Source: Company data, Credit Suisse estimates
Essilor International SA (ESSI.PA) 48 17 March 2017
Credit Suisse PEERs PEERs is a global database that captures unique information about companies within the Credit Suisse coverage universe based on their relationships with other companies – their customers, suppliers and competitors. The database is built from our research analysts’ insight regarding these relationships. Credit Suisse covers over 3,000 companies globally. These companies form the core of the PEERs database, but it also includes relationships on stocks that are not under coverage. For more information, see our November 2016 PEERs report: A chain reaction: Supply chain strategies
Figure 81: Essilor PEERs map
Source: Credit Suisse PEERs
Essilor International SA (ESSI.PA) 49 17 March 2017
Companies Mentioned (Price as of 14-Mar-2017) Essilor International SA (ESSI.PA, €110.8, OUTPERFORM, TP €127.0) Fielmann (FIEG.DE, €71.66) GrandVision N.V (GVNV.AS, €22.98) HOYA (7741.T, ¥5,424) Inditex (ITX.MC, €31.39) Luxottica Group (LUX.MI, €50.1) Safilo Group Spa (SFLG.MI, €6.58)
Disclosure Appendix Analyst Certification Catherine Tillson and Guillaume Gauvillé, CFA, each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
3-Year Price and Rating History for Inditex (ITX.MC)
ITX.MC Closing Price Target Price Target Price Closing Price ITX.MC Date (€) (€) Rating 35 20-Mar-14 21.42 18.60 U 13-Mar-15 28.16 20.00 30 16-Sep-15 30.29 23.00 17-Mar-16 29.79 25.00 25 19-Sep-16 32.39 26.20 22-Sep-16 33.37 27.20 20 06-Mar-17 30.60 25.00 15 * Asterisk signifies initiation or assumption of coverage. 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017
U N D ERPERFO RM
3-Year Price and Rating History for Luxottica Group (LUX.MI)
LUX.MI Closing Price Target Price Target Price Closing Price LUX.MI Date (€) (€) Rating 55 15-Jun-16 44.82 52.00 O * 07-Oct-16 40.85 50.00 50 * Asterisk signifies initiation or assumption of coverage.
45
40 01- Jul- 2016 01- Sep- 2016 01- Nov- 2016 01- Jan- 2017 01- Mar- 2017
O U T PERFO RM
The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts’ stock rating are defined as follows: Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark* over the next 12 months. Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July 2011.
Essilor International SA (ESSI.PA) 50 17 March 2017
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Target Price and Rating Valuation Methodology and Risks: (12 months) for Essilor International SA (ESSI.PA)
Method: Our target price of €127 is based on a simple average of our HOLT Linker and a DCF (WACC of 6%, long-term growth of 3%) based on our pro forma EssilorLuxottica model. We rate the shares Outperform as we believe the stock looks attractive on most metrics and has a stronger competitive positioning than its peers as the eyewear industry faces increasing disruption from online. Risk: Key risks to our Outperform rating and €127 target price include: The merger with Luxottica falls through. Further deceleration and weakness in the US optical market. Increased competition from other lens manufacturers. Bad weather affecting the sun season. Resistance from independent opticians in the US to take on Essilor-branded products. Acquisitions of overpriced or poor-quality assets.
Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures/view/selectArchive for the definitions of abbreviations typically used in the target price method and risk sections. See the Companies Mentioned section for full company names The subject company (ESSI.PA, LUX.MI, SFLG.MI) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (SFLG.MI) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (SFLG.MI) within the past 12 months Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (ESSI.PA, LUX.MI, SFLG.MI) within the next 3 months.
Essilor International SA (ESSI.PA) 51 17 March 2017
For date and time of production, dissemination and history of recommendation for the subject company(ies) featured in this report, disseminated within the past 12 months, please refer to the link: https://rave.credit-suisse.com/disclosures/view/report?i=285018&v=y9tmaih8idswilbo3sazcsxc . Important Regional Disclosures Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report. The analyst(s) involved in the preparation of this report may participate in events hosted by the subject company, including site visits. Credit Suisse does not accept or permit analysts to accept payment or reimbursement for travel expenses associated with these events. Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit https://www.credit- suisse.com/sites/disclaimers-ib/en/canada-research-policy.html. The following disclosed European company/ies have estimates that comply with IFRS: (ITX.MC). Credit Suisse has sent extracts of this research report to the subject company (ESSI.PA) prior to publication for the purpose of verifying factual accuracy. Based on information provided by the subject company, factual changes have been made as a result. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. This research report is authored by: Credit Suisse International ...... Catherine Tillson ; Guillaume Gauvillé, CFA To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the FINRA 2241 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Credit Suisse International ...... 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Essilor International SA (ESSI.PA) 52 17 March 2017
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Essilor International SA (ESSI.PA) 53