2023-04-08 20:56:09 ET
Summary
- The company redefined and expanded the consumer life cycle from transaction-based interactions to long-term engagements.
- The company projected a similar cadence of revenue and store count growth in 2023. Its service revenue still grew at 70% and consisted low percentage of the total.
- The company is projected to significantly improve its profitability in 2023 due to cost savings and revenue leverage.
- The stock is likely fair valued but there are still catalysts to watch.
- Overall, we think the risk and reward are relatively balanced and rate this stock as Neutral.
Investment Thesis
Warby Parker Inc. (NYSE: WRBY ) redefined and expanded the consumer life cycle from transaction-based interactions to long-term engagements. We think the company has made a significant impact on the industry by reducing friction and adding value.
The company projected a similar cadence of revenue and store count growth in 2023. Its service revenue still grew at 70% and consisted low percentage of the total. The growth has its leg. The company is projected to significantly improve its profitability in 2023 due to cost savings and revenue leverage.
The stock is likely fair valued at the moment. The stock return is only 37% even in our sensitivity test bull case. We don't think the stock is attractive at this level.
However, we find the company's holistic vision care products and service expansion plan to be most compelling for investors. We think the plan is likely to improve its margin and trigger the market to reprice the stock.
In addition, given the eyewear industry's cycle-resistant nature, which is covered in the risks section below, we believe the downside for the stock is limited. Overall, we rate this stock as Neutral.
Company Profile
Warby Parker was founded in 2010. The company's main focus is on designing and selling affordable prescription eyeglasses and sunglasses.
As of December 31, 2022, its retail footprint included 200 retail stores, including 195 locations in the U.S. and 5 locations in Canada.
Geography Presence (Company's filing)
It generated $598 million in revenues and $27.3 million of adjusted EBITDA in 2022.
Financials and Operating Metrics (Company's presentation)
Company Fundamentals and Its Direct-to-Consumer Model
The company provides its products and service through retail stores, apps, and websites. The company aims to differentiate itself from its traditional peers by quality products at reasonable and transparent prices. Its direct-to-consumer business model and vertical integration process enable the company to learn and respond to customers' demands.
By channels, 61% of its revenues were from retail stores and 39% of its revenues were from e-commerce channels.
Revenue breakdown by channels (Company's filing)
By categories, 94% of its revenues were from products and 6% of its revenues were from services.
Revenue breakdown by categories (Company's filing)
Its integrated supply chain consists of owned optical and fulfillment laboratories as well as third-party manufacturing and laboratory partnerships. This gives the company control over product quality and fulfillment speed.
The company tracks the unit economics at the customer level, which it refers to as customer economics.
Key Takeaways from Q42022 Earnings:
Q42022 revenue (Company's presentation)
- Its total revenue increased by 10% to $146 million from $132 million.
- Active customers grew by 3.6% versus 21.5% growth in Q42021.
- Its average revenue per customer increased by 6.9% to $263 from $246 in Q42021.
- The company opened 10 new stores in Q42022 and 40 stores in 2022.
Q42022 adj. EBITDA margin (Company's presentation)
- Its adjusted gross margin decreased by 230 bps to 55.2% from 57.5% in Q42021, primarily driven by increased penetration of contacts sales and eye exam business.
- Its adjusted SG&A % decreased by 1170 bps to 55.6% from 67.3% in Q42021, due to its pullback in marketing spend, cost-saving initiatives, and revenue leverage.
- Its adjusted EBITDA margin increased 1060 bps to 5.8% from -0.9% in Q42021.
- Its inventory increased by 19% in 2022.
2023 Outlook (Company's presentation)
The Company is projected to open 40 stores in 2023.
- Its revenue will grow 8-10% to between $645 and $660 million in 2023.
- Its adjusted EBITDA margin increased significantly to 7.9% from 4.5%.
- The company expected to scale its contacts business and grow its eye exam business.
2023 Strategy (Company's presentation)
We have the following comments:
- The company projected a similar cadence of revenue and store count growth in 2023. Its contact lens revenue increased to 7.2% of its business in 2022, up from 4.3% in 2021, implying an 85% increase. Eye exam revenue increased to 2.9% of its business in 2022, up from 1.7% in 2021, implying an 89% increase. According to the company's presentation, there has been a remarkable increase of 220% in the cumulative average sales per customer for holistic vision customers in comparison to those customers who only purchased glasses. This indicates that the up-sell and cross-sell potentials are significant.
Cumulative average sales per customer (Company's presentation)
The eye exam and contact lenses business is still in the early growth stage and the company is expected to open 40 stores in 2023. These give support to the management's growth outlook.
- The company expected its gross margins to continue to face pressure due to increased optometrist hiring costs from new stores opening. However, its restructuring efforts in Aug 2022 started to play out. As a result, even though the company keeps opening new stores and the gross margin is under pressure, its adj. EBITDA margin will increase by 340 bps.
- The company will continue to cut marketing spending this year, especially in its e-commerce channel. Our observation is that the company is gradually moving away from its original online-centric business model and pivoting towards a more service-driven approach similar to traditional brick-and-mortar stores. This gives investors short-term visibility of where the company is going but also puts a ceiling on its long-term potential, in our opinion. If we compared it with the largest player, EssilorLuxottica S.A. (OTC: ESLOY), Warby Parker generated slightly higher revenue on per-store bases, but at much lower margins. It is because (1) Warby Parkers has a low store density, (2) Warby Parkers focuses on large layout stores, which draw in more consumer traffic on per store basis, and (3) EssilorLuxottica S.A. "ESLOY" has a scale advantage. ESLOY generated 24.4 billion euros in revenues in 2022 and had 17,000 stores worldwide. We think Warby Parker has a long way to go. While it now incurs high costs, its strategy of using user experiences to set its offerings apart from those of its traditional competitors has some upside potential.
Financial comparison (LEL Investment)
Industry
According to The Vison Council, a non-profit trade association that represents the manufacturers and suppliers of the optical industry, the U.S. eyewear market was approximately $76 billion, and the U.S. prescription eyeglasses and sunglasses market were approximately $36 billion. Independent optical retailers made up approximately 40% of all optical retail sales in 2022, while optical retail chains made up the vast majority of the remainder.
In the company's 10-k, the company considered the market it serves to be huge, stable, and undergoing change.
Most people need vision correction: The Vision Council reported that 82% of adults in the United States were using some form of vision correction as of the third quarter of 2022, equating to approximately 275 million people. In addition, the number of Americans ages 65 and older will nearly double over the next 40 years, reaching 80 million in 2040, according to the U.S. Census Bureau. It is estimated that at least 93% of people aged 65 and older wear corrective lenses, as older adults require more vision correction.
•Consistent replenishment cycle: On average, glasses wearers replace their glasses every two years, according to the Vision Council. Additionally, an estimated 43 million people in the United States wear contact lenses that are typically disposable, replaced on a daily, weekly, or monthly basis, driving frequent repurchases. Over 80% of contact wearers purchase contact lenses at least once per year.
•Increasing screen time usage: With the rising usage of smartphones, tablets, computers, and other devices, three out of four adults report experiencing digital eye strain at some point during the day, contributing significantly to increased vision correction needs and a steady influx of new customers within the eyewear market.
•Acceleration of e-commerce penetration: While e-commerce penetration is at an all-time high in the U.S. and abroad, it is largely nascent in the eyewear industry, representing approximately 15% of eyewear product sales in 2022.
•Increasing prominence of telehealth: The Vision Council reported that over 50% of people receiving an eye exam would be interested in having a virtual or telehealth eye exam. DTC telehealth is expected to grow by nearly 50% by 2028, or a CAGR of 5.6%, reflecting an evolution of consumer preferences from in-person to remote medical care.
Also, the company believes it can create value for the industry through the shopping experience, transparent pricing, and personalization.
•Underinvested Shopping Experience. The legacy customer journey largely entails going in person to an optical retailer, browsing frames stored behind locked cases, and feeling overwhelmed by the assortment. Customers rely heavily on a dominant physical footprint with little to no digital counterparts.
•Confusing, Unstandardized, and Opaque Pricing. Beyond the selection of frames, the purchase decision involves complex, multi-step decision-making with an emphasis on upselling lens alternatives and coating options. We believe there is also little connection between pricing and quality.
•Unappealing Value Proposition. Glasses have historically only been offered at a premium price point, leaving millions of customers without access to stylish, affordable eyewear. There is often a significant markup at 10 to 20x from manufacture to sale, as products are often burdened by various licensing, wholesale, and retail fees that support the legacy supply chain. Upon checkout, customers often find their vision insurance (if they have it) only covers a portion of their purchase.
•Limited Ongoing Customer Engagement. The eyewear industry has been built to maximize individual transactions versus optimizing the customer journey. In addition, a concentrated number of companies license the vast majority of premium eyewear brands sold and often wholesale their products through retailers, so they lack a direct connection to their end customers.
We think the company's initial success online was built upon the trust of the customers in transparent pricing. The industry was highly segmented and thus retail store locations used to play important factors in customers' shopping decisions. The company redefined and expanded the consumer life cycle from transaction-based interactions to long-term engagements. We think the company has made a significant impact on the industry by reducing friction and adding value.
Growth plan
We think the company's service growth plan most appeals to investors. The company planned to expand its holistic vision care service includes:
- Glasses. The company, on average, released over 20 eyewear collections each year.
- Contact Lenses. According to the company, the contact lens market is estimated at $17.9 billion and contributed only 7% to the company's net revenue in 2022.
- Eye Exams and Vision Care. According to the company, the eye exams and vision care market is estimated at $15.3 billion and contributed only 3% to the company's net revenue in 2022.
- Vision Insurance. According to the company, vision insurance comprises over 50% of purchases made in the vision care market and contributed only 4% to the company's net revenue in 2022.
We have the following comments:
- The company has gained a strong following among consumers, who appreciate its design capability. The company's success in products is largely attributed to its data and consumer-driven design approach. We think this core strength can continue to support its growth.
- Only 7 insurance providers are now accepted by the company as in-network providers. Investors should keep a close eye on the company's new collaboration with insurance providers going forward as we believe this area has the potential to dramatically increase consumer traffic for the business.
Valuation
Multiple Valuation
Valuation metrics suggest the stock is not cheap compared to its sector median. It is likely the market still priced it as a growth stock.
Multiple Valuation Metrics (Seeking Alpha)
DCF valuation
The company estimated there were over 48,000 optical retail stores in the U.S. as of the end of 2022. The eyewear market is fragmented. The leading player such as ESLOY only had less than 10% market share on a store count basis. The company with a market share of less than 0.5% ought to have room to expand.
We make the following assumptions based on the company's financials and current market conditions:
- 1% penetration with an average sales per store at $3 million
- 20% WACC
- 3% terminal growth rate
- 7.5% free cash flow margin
- Net debt -208 million (Q4 2022)
- Outstanding shares 115 million (Q4 2022)
Applying the DCF method, we can arrive at an equity value of $977 million ($8.4 per share), which implies a 23% decline from the current stock price.
With the sensitivity test below, we can see that the stock is undervalued only if its free cash flow margin increases above 10%. The company is expected to improve its EBITDA margin to 8% in 2023 but not enough to convince the market to push it higher.
Even if the free cash margin meets the bull scenario of 15%, the stock return is still only 37%.
As a result, we don't think the upside potential is very attractive.
Sensitivity Test (LEL Investment)
Catalysts
A stock's potential upside in our DCF valuation could be caused by an unexpected jump in its free cash flow margin or a decline in WACC.
In our opinion, margin improvements through the below metrics can act as catalysts for the stock: (1) the company's continued AUV growth; (2) the increase in service penetration rate; (3) innovation on new products like insurance, (4) increase in average revenue per customer.
According to the company's growth strategy, we believe that broadening the company's service offerings could temporarily reduce gross margins but also leverage SG&A expense through higher consumer traffic. Its new store expansion plan will cause its AUV growth and SG&A expense % under pressure. However, we think if the company can continue to increase its average revenue per customer metric, the stock might be supported by long-term investors.
In addition, we believe the following factors are triggers for the drop in WACC: (1) the Fed's lowering of interest rates, and (2) recession to lower the yield curve.
Given the eyewear industry's cycle-resistant nature, which is covered in the risks section below, we believe an economic downturn may not necessarily be negative for the stock. If the WACC falls below 15%, our DCF model suggests that the stock is undervalued. We believe that the macro slowdown may also act as a catalyst for the stock.
Risks
Macro slowdown
The company believes that the eyewear industry is relatively resistant to economic cycles and fluctuations.
The nature of our business, which involves the sale of products and services that are a medical necessity for many consumers, provides some insulation from swings in consumer sentiment and general economic conditions.
We found that ESLOY, as the leader in the industry, decreased by 2% in revenue, and 22% in operating income in 2008. This gives support for its argument.
However, investors should keep in mind that ESLOY is the leader in the industry and has a diversified portfolio and footprint. Warby Parker currently still operated at a loss of $100 million in 2022 and only had $200 million cash on hand.
Summary
The company operated in a relatively stable and cycle-resistant industry. This provides support to the downturn. The company has a clear consumer experience differentiation value proposition to compete with its traditional peers. The industry was also highly segmented and thus we think the competition risks are limited at the moment. However, our DCF model and multiple analysis suggest not very attractive stock returns. We think the risk and reward are relatively balanced.
For further details see:
Warby Parker Progresses At A Consistent Pace