Business Breakdowns
· Swetha Ramachandran
[00:00:00] S1: So 2018 was the year it all happened, when Essilor merged with Luxottica. And in fact, Essilor and Luxottica themselves were heavily acquisitive companies independently prior to coming together. The story, of course, is a fascinating case study in M&A and boardroom battles. The story is one of innovation, which is primarily at the Essilor level, meeting iconization, which is at Luxottica, and its ability, for example, to take these dusty, forgotten brands like Ray-Ban and really reignite and catalyze growth for those. It's hard to remember now, but Essilor was actually, all the way back in 1959, the first manufacturer of the progressive lens, which is Varilux, which was hugely influential and was also followed by several other innovations, as well as M&A, such as Transitions, etc. Similarly, of course, Luxottica has acquired over time these iconic brands. First Ray-Ban, Oakley, and then, of course, licenses for some very coveted luxury brands such as Chanel and Prada as well. And I think what really precipitated this merger was Del Vecchio, who was the Chairman and CEO of Luxottica at the time. He was a man with a very unique vision in that he thought that integrating and controlling all aspects of the value chain in eyewear was the key to unlocking value. And of course it turns out that he was right in that this is the only company really that even today has operations across manufacturing, distribution, R&D. They have over 12,000 patents under their belt, which is again no small feat. That was a realization that prompted them. At that time, they were really only in frames and sunglasses, and the view was marrying that with lenses would be a logical next step. So this is really what brought about that merger at the time. And it clearly wasn't without its problems, as we will probably talk about later on.
· Zack Fuss
[00:00:00] S0: When you think about the combined business, one of the more interesting aspects of optical retail is the separation of the healthcare and what I'll call the fashion part of the business. And so I think when you consider the strategic motivations for a merger, but also the combined economics? Can we just talk through what it looks like in terms of where the money's being made?
· Swetha Ramachandran
[00:00:00] S1: 75% of their business today is actually from vision care. It's from corrective lenses. That is really where the bulk of the market sits. And sunglasses and frames are a much smaller 25% business overall. And the lenses business is actually much more profitable because it operates in a more concentrated market. So if we just look at the prescription lenses market, EssilorLuxottica has over 50%, almost a 55% share of this market. It tends to be much more concentrated. The other players are really Hoya and Carl Zeiss. It's almost an oligopoly. When you look at the other side of the business, which is frames and sun, that is a much more fragmented business because it's much more brand-led. And here you've got EssilorLuxottica with just over a third of the market, which is decent. It is a much smaller market. So, for example, if we look at prescription lenses, that would be basically the bulk of their sales derived from that. Frames and sunglasses are a much smaller market overall. So 75% revenue from lenses and 25% from frames and sunglasses. And here, the fragmentation is such that you don't really have a meaningful number two. Kering, which has brought back some of its brands in-house, has set up Kering Eyewear, which has roughly a 10% share of the market. Safilo, which EssilorLuxottica actually tried to buy but walked away from. I should say Luxottica, because this was pre-merger, they tried to buy it but walked away from it. That has about a 7% share of the market. But there's really not a dominant player other than EssilorLuxottica. And even here, where I would say this really differs from prescription lenses is that the other end of the market, which is a real fragmented tail, constitutes only 3% of the market for prescription lenses. But actually it makes up about 40% of the market for frames and sun.
· Zack Fuss
[00:00:00] S0: And so I think one of the popular criticisms of a business like this is that they produce a piece of plastic frames for $10, and it ends up as a $200-plus at retail product to the consumer. And I know that the truth is not exactly aligned with this infinite markup, given the gross margin profile of the business, I believe it's closer to 60%. How do the unit economics of what they sell work? What part of the business is more commoditized versus differentiated? Prescription versus luxury? How do you think about the different components and strategies?
· Swetha Ramachandran
[00:00:00] S1: So I guess when we think about pricing power, what I really like to look at is gross margins. Stable, as well as high, gross margins tend to indicate that a company has sustainably durable gross margins over time. And here it doesn't strike me that eyewear is a segment that is particularly strong in pricing power. So why do I say that? On the one hand, gross margins are higher than, let's say, the sporting goods footwear category. If you look at Nike and Adidas, which are incredibly strong brands but still have gross margins only in the 50s percentage-wise, that gives you an indication that it's not just about strong brands. There's also a lot going on in terms of scale and distribution that drives gross margins as well. On the other hand, EssilorLuxottica's gross margins, at about 63-64%, they've remained very consistent over the last five years since the merger. Management itself is not guiding to a material uplift in gross margin because they expect that these benefits from price mix will be offset by some growth at some of their insurance businesses, etc., where there's not as high pricing power. So, I would say this business's pricing power is nowhere near as high as in luxury brands, where it can exceed 80% in some cases, but it's also not as low as footwear. That suggests to me that pricing power is moderate, but that you should expect some price elasticity given the market fragmentation and greater substitutability. It's not the case that you are basically being gouged, if you will, because you have to buy a pair of Ray-Bans. There are perfectly respectable and serviceable substitutes out there in the market because of how fragmented it is, because of how relatively low the barriers to entry are. Although, of course, EssilorLuxottica would say that scale gives them an enormous benefit in terms of procuring efficiencies.
· Zack Fuss
[00:00:00] S0: Speaking to that scale: obviously a high-profile merger completed in 2018. It feels like yesterday, but we're coming up on almost seven years. Take us through the trials and tribulations of combining the business and some of the complementary M&A they've done since.