Every now and then you unearth a stock that just seems too cheap, regardless of what is going on in the rest of the universe. Seeing as it is World Series time, it seems appropriate to post on the stock market’s equivalent of the hanging curve ball. Disagree if you must, but my nominee in this regard is Vancouver-based Coastal Contacts Inc.
Coastal Contacts is
Figure 1: Hanging Curve Ball, Meet Mr. October
Coastal is still enjoying the earlier stages of a penetration curve. Where traditionally contact lenses were dispensed by opticians, the market is shifting towards online distribution. The key driver, not surprisingly, is significantly lower prices. Online suppliers charge about half of traditional clinic-level costs. Benefits packages that cover only part of the cost of a traditionally filled contact lens prescription go much further online. And for the increasing number without benefits, the choice is clearer still. Consequently, Coastal Contacts continues to post mid-teens annual sales growth – not too shabby in the best of times, but almost unheard of in 2009. And there is much more market share to be gained from dispensing opticians, who still hold more than 85% of the $5 billion global contact lens business.
Coastal is more than just a Canadian operation, earning more than 80% of its revenues abroad. Coastal is the market leader in
One of the interesting things about the contact lens business is the inability of the contact lens manufacturers themselves to get into distribution. Their hands are tied, in my view, by their relationship with the opticians. If the manufacturers were to compete directly with the opticians, they would risk losing share in 85% of the market that the eye doctors control. That is the sort of short-term pain that is difficult to stand for the manufacturers. It is easier for Ciba Vision or Bausch & Lomb to step back and sell to both distribution channels and let the market decide this battle.
Figure 2: Share Price Development
Coastal Contacts possesses a strong balance sheet, boasting $14 million in net cash at July 31. This strong financial position allowed management to repurchase 18% of outstanding shares during the market mayhem of its last fiscal year. The healthy balance sheet also supports investments required to build market share that less well-financed competitors must eschew.
Coastal is not your father’s internet retailer – it generates a healthy amount of cash from operations. I estimate that Coastal will generate at least $135 million in revenue this year and produce over $5 million of free cash flow. Growth companies rarely throw off fat cash flow streams, but by my estimate Coastal’s free cash flow yield is approaching 10%.
There are no businesses without risk and Coastal Contacts is no exception. Aggressive
Assuming Coastal can grow its free cash flow by 10% per year over the next five years, a discounted cash flow value of close to $2.00 per share appears reasonable. Undervalued on a stand-alone basis, additional potential exists for Coastal to be acquired by one of several potential strategic buyers. Industry leader 1-800 Contacts should be able to generate significant synergies through acquisition. Likewise, Hamburg-based Fielmann AG, a powerhouse in European discount eyewear, could no doubt make an accretive acquisition at prices above two dollars. Chinese players lacking Western distribution (e.g. Shanghai-based Horien Contact Lens Co.) may also be suitors for a strong, geographically diversified vendor.
Traditional retailers like Costco and Wal-Mart may also be looking for entry points. Interestingly, Wal-Mart has struck up a joint venture with 1-800 Contacts. Surely Tesco or Aldi would entertain a play of this nature as well.
Management does own a sizeable chunk of stock, about 27%. There is also a shareholders’ rights plan. But given there are also three million options outstanding at a $1.00 average strike price, I think a serious bid of $2.50 would get pretty serious consideration to say the least. There is just too much upside to be had in the short run.
Coastal Contacts is a good business. It is arguably undervalued, growing strongly in a recession, without a controlling shareholder and surrounded by potential deep-pocketed acquirers. I may be no Reggie Jackson, but this pitch looks worth a swing to me.