EYE - National Vision Holdings: Good Progress But I Prefer To Wait For More Evidence

2023-12-19 03:43:40 ET

Summary

• EYE's 3Q23 results beat expectations with a 6.6% increase in net revenue and improved gross margin.
• Optometrist retention rates are improving, which is crucial for stabilizing costs and increasing appointment availability.
• I think it is better to wait for the financials to show solid proof of normalizing growth rates and improved margins before investing.

Summary

Readers may find my previous coverage via this link . My previous rating was a hold due to National Vision Holdings ( EYE ) poor 2Q23 results, which showed no signs of improvement with regards to the optometrist capacity issue. I was also uncertain about EYE's long-term growth profile as the relationship with Walmart ( WMT ) terminates. I am revising my buy rating for EYE as I await the business to show a definite improvement in its results. Specifically, I want to see more evidence of growth normalizing and margin improvements.

Financials/Valuation

EYE's recent results came in better than expected. 3Q23 net revenue increased 6.6% y/y to $532.4 million, beating the street expectation of $526.2 million. Of the 6.6%, 4.3% was driven by comparable store sales growth, which was supported by an increase in both transactions and tickets. Gross margin also performed better than expected, albeit still in decline. Gross margin decreased 71 bps to 52.7% as the continuous headwind from higher optometrist-related costs was offset by higher exam revenue and a decrease in product costs. Consequently, management defined EBITDA as decreasing 11.9% y/y to $39.1 million, with margins decreasing by 155 bps y/y to 7.4%.

Another reason for my hold rating is that the market appears to be already pricing in the recovery in growth and margin for EYE (i.e., looking past the WMT termination). The stock has rebounded from its low of $13.71 to $19.76, a whopping 44% increase. 1-year forward earnings multiple has also increased to 35x. I believe using a 2-year forward earnings multiple makes more sense here as EYE is in a recovery mode; hence, 1-year forward growth is going to be distorted by a small base. Using consensus estimates in my model, where:

1. EYE is expected to see a 7% decline in FY24 (mostly due to the WMT exit) and a recovery in FY25 (3%, which I think is fair as EYE sees a tough 1H24 comp even though organic growth should improve).
2. Margin improved due to cost savings initiatives, price increases, and the exit of low-margin WMT businesses.

We can see that FY24 is going to experience almost 100% growth because FY23 was extremely weak. However, this 100% growth only leads to $45 million in earnings, which is still below FY22 levels (and by a large amount when compared to FY21). Hence, I feel that using a more normalized multiple that removes y/y lumpiness is a better approach: a 2-year forward earnings multiple. EYE currently trades at 25x 2-year forward earnings, and using this valuation, my target price is $19, implying a 5% downside. Certainly, EYE's 2-year forward valuation could increase as it is now trading at the lower end of its trading range, but I am using a more conservative assumption until EYE shows a definite improvement in its results.

Comments

First and foremost, based on management comments, it seems like the optometrists issue is gradually turning for the better. Recall that in 2019 (pre-covid), the optometrist retention rate was close to 90% (I take this as the normalized rate), but fell closer to 80% in 2021. A lot of work and effort has been put into salvaging this situation, including more flexibility in hours and employment terms for optometrists. It was encouraging to hear management say that retention rates have continued to improve for the second straight year, and there is a record high of new graduates (optometrists) joining EYE's system. Giving new readers some background as to why this metric is very important: normalizing retention should help stabilize optometrist costs and improve appointment availability. You can think of appointment availability as capacity; the more capacity, the more room to capture demand. In addition, optometrists are important for EYE when it comes to opening new stores. Comparing this to a normal clinic setup, you can open a new clinic with receptionists and general pharmacists, but having a doctor is the most important thing. You would also need replacements and backup doctors to ensure the clinic (or store for EYE) keeps running. As such, having a deep pool of optometrists is very important.

So while we're not -- while we don't quantify specific capacity levels, I think if we're saying retention has improved for the second year in a row, that our recruitment is going to deliver a second record year and record new grads who tend to start in July and August, and then Patrick just went through the remote successes, those do add up to improved capacity. Source: 3Q23 earnings

As we previously shared, our optometrist retention rate is in the 80% to 90% range. While there are some variability within that range from 2019 through 2021 mainly due to increased retirements and other pandemic-related factors, our retention rate improved in 2022 compared with 2021. Source: 1Q23 earnings

With the optometrist situation starting to turn for the better, I am now slightly more comfortable focusing on the growth outlook of the business, which seems positive if the optometrist situation continues to improve. While management guidance for FY23 suggests comparable store sales growth (2%) implies a deceleration in the next quarter, I don't think this is the right way to view EYE's business as EYE faced an easy comp in 3Q22 (down 8.1%). The better way is to look at EYE on a 3-year stack basis, as it normalizes the optometrist impact since 2021 and also any y/y lumpiness. From a 3-year stack basis, management FY23 guidance implies a positive sequential acceleration, which I take as an initial indication that sales comp growth is starting to normalize back to mid-single digits (EYE's historical growth average).

EYE's growth recovery has been aided by the macro situation as well. The company has benefited from the trade-down movement, which appears to be accelerating as more customers with household incomes over $100,000 are being noted by management. Aside from macro tailwinds, I also expect EYE's internal initiatives to yield positive results, which should improve growth. Specifically, by year's end, management intends to impose a number of non-headline price hikes. While we do not know the magnitude of the price increase as it is not disclosed, I think a good benchmark would be at least more than the prevailing inflation rate, which is around 3%. The reason I say so is because management expects the pricing increases to contribute to margin improvement in FY24. Assuming the cost base increases in line with inflation, for the margin to expand, pricing should be higher than the inflation rate. If we assume the 3+% pricing growth sees a 50% pass-through rate (remember this is not an immediate increase on the headline), this should yield a 1.5% growth contribution. Along with the macro tailwinds and store openings, organic top-line growth (excluding Walmart) should sustain mid-single-digit growth easily.

The price increase strategy not only helps with topline growth; it should also help to cushion the impact of the termination of the partnership with WMT. Price increases combined with an expected $10 to $12 million in annualized savings from the expense reduction initiative should offset the profit headwind from exiting the WMT and AC Lens businesses, which collectively contributed $15 million in EBIT.

Combined, the Walmart store operations in the AC Lens operations are expected to generate approximately $400 million in revenue and earnings before income tax of approximately $15 million. Source: 3Q23 earnings

Overall, I think progress with the optometrist situation has been made for sure. While higher optometrist-related costs are likely to remain a margin headwind given the continued mid-single-digit wage pressure, EYE should see margin recover once the retention rate normalizes, the pricing initiative takes effect, and the expense reduction initiative yields results. That said, I think a better time to invest is when all of these have shown their impact on the financials. Remember that the partnership with WMT is going to end in June 2024, so FY24 financials are going to be hard to dissect (e.g., WMT revenue makes it hard to analyze the impact of price increases). I think a better time to invest is after 2Q24 when we have a clear view of top-line and margin improvement.

Risk & conclusion

EYE is aiming to increase prices in an environment where consumers are tight on their budget. An excessive price increase could hurt sales as it negates the trade-down trend that EYE is benefiting from today. Expense reduction initiatives may not yield as much savings as expected, which, combined with the exit of WMT, could drive near-term profits lower than expected.

Overall, my rating for EYE remains hold rated. Progress in resolving optometrist capacity issues is encouraging, with improved retention rates and an influx of new graduates. However, I would like to take more time to observe how effective EYE's pricing strategy and cost-cutting initiatives are. For me to revise my rating, I want to see concrete evidence of sustained growth normalization and margin improvements.

The risks involve potential sales impact from aggressive price increases in a budget-constrained consumer environment and uncertainties regarding the expected expense reductions and WMT's exit implications on short-term profits.

For further details see: