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%.
Danger and
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.
The value proposition definitely makes it a good business.
Having said that, what are the barriers to entry? They don't have a brand name per se, only marketing. Someone could come in tomorrow and open a web site with a 800 number. You don't need that many distribution centers for the business plan to work. I do agree, however, that it would be easier to acquire them than start from scratch.
What discount rate do you use for a micro-cap such as Coastal?
Very good idea overall, thank you for posting it.
Posted by: ValueGuy | October 21, 2009 at 11:42 AM
Hi VG,
Thanks for the question. With respect to barriers to entry on CC, I actually believe they are quite strong. First time online contact lens buyers may shop based on web search, but this business has a very high re-order rate, which means that a big customer list is a really stong competitive asset.
A second barrier to entry relates to certain industry specific scale economies. The first is purchasing power vis-a-vis the large suppliers like Ciba Vision. Leaders in this business will buy at lower costs than start-ups. Moreover numerous fixed costs relate to specific countries. If you need to pay Google for search priority, that is a fixed cost that tracks to a country. If you need to have a legal department to stickhandle through the regulatory roadblocks that optician colleges will try to establish, that is a fixed cost. So you can see how a market leader in online contacts retail can have a significant profitability advantage over new entrants. Successful leaders in this situation typically re-invest a portion of their excess profits in price reductions that further accentuate their relative advantage.
As for discount rate, I wouldn't differentiate between Coastal and a large cap. If you ask me, Bank of Nova Scotia ought to be tagged with a 25% discount rate and Coastal with only 10% because the relative risks are far more significant in the former than the latter.
GC
Posted by: Geoff Castle | October 21, 2009 at 06:54 PM
Thanks for the idea. The investment case is so simple to understand. Unless a large player like Walmart/Tesco wants to engage in some kind of predatory pricing to destroy their competitors (which is likely more costly than buying COA outright), I think COA has staying power. Btw, COA also has a call option to the huge and fat-margin eyeglasses market.
I have followed your blog since its inception and see that you have written about a few small-cap gems. As a retail investor, I face difficulties in finding good canadian stock investment opportunities because there seems to be no easy-to-access market data / stock screeners tailored to the canadian market. I wonder if you could write about your searching process in a future article?
Posted by: gokou3 | October 22, 2009 at 12:00 AM
Thanks for the idea. Can you elaborate on your $5m FCF estimate? It's not that obvious from the financials and I'm being lazy.
Posted by: Wood | October 23, 2009 at 06:45 AM
Hi Wood,
Sometimes in the past I have posted my modelling. I might do that this weekend. In the meantime however, I am forecasting 2009 FY sales of C$136. million and EBITDA of $8.0 million. From the $8.0 million EBITDA, I subtract zero interest, cash taxes estimated at $1.2 million, expansion in net working capital estimated at $0.0 million, and capital expenditures of $1.0 million for a Free Cash Flow run-rate of $5.8 million.
I might as well also elaborate here on the "free cash flow yield is approaching 10%." At $1.25 share price, the market capitalization of Coastal is $72.3 million. From that total, I net out the $14.0 million cash balance that Coastal reported on July 31, to give me an Enterprise Value of $58.4 million. If you divide the unlevered Free Cash Flow into the Enterprise Value you get a FCF yield of 9.9%, which in my books is "approaching" 10%.
Note that Coastal's free cash flow yield is much higher than the free cash yields on a wide variety of "income trusts" from the past five years that actually paid out a distribution much higher than that by borrowing cash to fund distibutions. NOT That I am encouraging management to pay the cash out. These days building a war chest is a pretty sound strategy.
Posted by: Geoff Castle | October 23, 2009 at 01:19 PM
Thanks Geoff. Why are you assuming no new working capital? Seems like they would need a fair bit of inventory etc to grow like that. Seems to be the case for Coastal so far and not many product sellers can manage otherwise.
Posted by: Wood | October 23, 2009 at 03:23 PM
If you look at the past two fiscal years, net non-cash working capital is not significant, fluctuating in a range of -2 million to + 2 million. Essentially the $20 million of inventory, receivables and prepaids is offset by payables of similar magnitude.
Posted by: Geoff Castle | October 23, 2009 at 04:42 PM
Hi, Thanks for the idea.
Posted by: invierta proyectos | February 08, 2010 at 02:39 PM
Great Idea! http://www.contactlenses-without-prescription.com/
Posted by: Contact Lenses without Prescription | April 19, 2011 at 10:01 AM