The Imitation Game: Quality Investing Case Studies

The Imitation Game: Quality Investing Case Studies
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Part 2 focused on applying the framework laid out in Part 1 to an example, FPA’s International Value Fund, and showed how the process of screening through Funds’ holdings functioned in order for investors to find a handful of investment ideas to add to their watch list.

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In Part 3 of this series, I’ll analyze two sets of ideas from FPA’s International Value 3Q17 Commentary: EssilorLuxottica and Ryanair.

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Luxottica and Essilor are two fascinating businesses. They satisfy my criteria of high-quality and event-driven names in terms of the recent anti-trust scrutiny around their pending merger (the European Commission has until March 8, 2018 to decide).

When the deal was announced, I remember being highly skeptical of it merger succeeding. It seemed to me that two large oligopolistic business merged would add up to a monopoly in the eyewear and lenses markets.

But what has occured to me recently is that the investment theses around both these companies, don’t rely entirely in one single factor, like the deal going through. In fact, both companies happen to be compounders with durable competitive advantages:

Luxottica Group S.p.A: Luxottica is the world’s largest eyewear manufacturer and distributor, based in Italy, with a strong brand portfolio consisting of 7 proprietary brands including Ray-Ban and Oakley, and over 20 licensed designer brands that include D&G, Bulgari, Chanel, etc.

The brand power behind Luxottica’s products reinforces its pricing power. To sustain a firm’s competitive advantage, brands must not only eliminate search costs to customers (costs incurred by buyers when trying to decide on what to buy), but also deliver value in some form or another. Luxottica does that – customers are prepared to spend money on products that are of high quality, recognizable and that create status and fashion-statements. And to top it off, sunglasses, like cell-phones and cameras, break or get lost or become outdated. Ultimately, they need to be replaced after some time, which makes for another ingredient for pricing power.

Luxottica isn’t just a collection of brands, though. Luxottica to me seems like an antifragile platform that not only thrives more than competitors during good times, but also benefits from distress in the markets by being able to be opportunistic and grow its market share. What allows the company to do that is the forward model that it has built over the years to integrate its entire supply chain. Luxottica operations cover product design and manufacturing, to the logistics, to both retail and wholesale distribution of frames and sunglasses. By owning retail stores like Sunglasses Hut and others, Luxottica can distribute their products through their network of over 7,300 stores, in more than 130 countries, and at a faster pace than competitors.


Quantitative evidence of this economic moat can be seen both in how Luxottica’s total operating expenses have decreased from 51.93% in 2012 to 50.49% in 2016 (and to 47.45% in 1H17), as well as in the Company’s net margin growth, which has risen from 7.54% in 2012 to 9.36% in 2016 (and to 11.45% in 1H17).

Now imagining the effect of Luxottica’s pricing power and cost advantages in a market where only 19% of the world’s population wear sunglasses, showing how much Luxottica can still grow, it’s not far-fetched to expect such margins to just improve.

Now moving on to Essilor…


Essilor International S.A.: Essilor is a company that produces ophthalmic lenses along with ophthalmic optical equipment, and holds the largest market share, of 41%, in the visual health market of around €96Bn. The firm houses 13 brands and employs a vertically integrated model, extremely similar to Luxottica’s (explained above); with 33 plants around the world, Essilor produced around 540 million lenses in 2016, which reach over 350,000 eye care professionals.

There are two important effects of this integrated model. One, it creates significant cost advantages, which explain how Essilor can profitability operate with an R&D budget of around 75% of total industry’s R&D spending. And second, this model also creates high switching costs due to the nature of the industry of eye care, which relies on quality and accountability of suppliers. It’s always better to stick to suppliers that ensure quality, deliver always on time, provide a range of products, understand functionality, and that are easy to deal with in their expertise and integrity.

These two advantages are strengthened by the business’ large portfolio of intellectual property (IP), of over 8,000 patents. This data point is paramount for an investment thesis on Essilor, given the uncertainty of deal completion with Luxottica, as well as all the disruption going on in every sector nowadays, with Warby Parker and other startups entering the space. These patents serve as another layer of protection for a company that depends on its product and cost advantages to keep growing and taking market share, as Essilor does.


The picture above displays Essilor’s  operational success over the years. In my opinion, from the research done so far, Essilor has a high probability of sustaining this performance. This is evident becuase of the growth potential in the eye care market, where according to data from Worldbank and Essilor’s 2016 estimates, 4.6 billion people need vision correction but only around 2 billion are corrected. Therefore, the potential for growth is abundant.



As regards management, both companies are led by exceptional owner-operators. The quality of both managers’ efforts over the years is evident by the historical returns on capital produces by both Luxottica and Essilor as shown below:


What is most interesting, however, is how insiders are positioning themselves amid all this legal uncertainty. Both CEOs, Leonardo Del Vecchio (founder of Luxottica) and Hubert Sagnières (CEO of Essilor), remain large holders of their company’s stock. And Del Vecchio will remain the largest shareholder of the new company with around 31-38% (although voting rights will capped at 31%). Anyway, shareholders’ interests seem to be highly aligned with managements’.


Merger Advantages

So, both Essilor and Luxottica are high quality companies:

Brand recognition…check. Relatively inelastic, high-quality products…check. Supply-based cost advantages…check. Both companies benefit from a growing market, an overall aging global population, growing incomes worldwide, and eye care becoming more and more important. Check, check, and check.

It seems that since the only elements that each company lacks, the other compliments it, as shown by the diagram bellow:


Well, it’s clear that Luxottica and Essilor complement each other’s operations beautifully; Luxottica will be supplied by Essilor which will optimize its entire supply chain, as well as streamlining its online presence, while Essilor will be able to leverage Luxottica’s unparalleled retail channels. This level of bargaining power helps both firms leverage better terms in licensing deals with brands and in acquisitions of new brands, etc. And more, in today’s world of constant disruption, this influence over customers’ choices and experiences is an asset that appreciates in value.

However, this begs the question of how much of this potential is already discounted in the companies’ prices? Arguably, all of the above information is well known, so where lies the edge here?

This is where the event-driven criterion comes into play, and why I stress it for investment selection. The complexity around the anti-trust assessment process generates misunderstanding and confusion, and thus, volatility in price. This allows investors to purchase Essilor’s or Luxottica’s (or EssilorLuxottica’s, later on) stock at a lower price than what the market discounts for the potential of the merged entity. By exploiting the recent and expected legal issues, investors can purchase the companies’ compounding potential at a discount. This interests me.

However, there are debates around the merger, especially in regards to the pricing pressures it might impose on customers, competitors, and distributors/suppliers. In late September of this year, “The European Commission has opened an in-depth investigation to assess the proposed merger between Essilor and Luxottica under the EU Merger Regulation. The Commission has concerns that the merger may reduce competition for ophthalmic lenses, and will further investigate effects on eyewear.”

Nonetheless, the deal is vertical, not horizontal. Horizontal mergers, on the other hand, are usually the issue for the Commission, where firms that are selling similar products in the same market, merger and therefore end up decreasing competition in their market. This isn’t the case for EssilorLuxottica. Luxottica and Essilor operate in different stages of the production process, so both companies are flexibile on their distributors; there are no contracts for exclusivity or any similar limitation, so distributors are free to sell to other providers. Therefore, there’s a win-win result from this merger. It’s true, EssilorLuxottica would hold around a 15% market share as a combined entity, but within a market with various other smaller and local competitors, making it an overall fragmented market, where customers still have flexibility of choice.

To me, so far, the benefits outweigh the costs. The synergies created from this merger would be remarkable. These efficiencies would come in the form of (1) increased quality of products, (2) increased variety, and (3) faster speed, both in terms of production and delivery.

Regulators must compare the benefits and costs in regards to a [possible] but not [probable] great increase in prices, versus the three efficient outcomes mentioned above. This is a bet an investor has to make if he or she is looking to invest in either company, or the combined entity. Although I think there’s a high chance of the deal going through – at least with the information I’ve gathered until the publication of this post – I’m far from an expert on competition law, and know that especially in cases of regulatory scrutiny, anything can happen.

Anyway, my point is that this might not matter. What’s good about all this attention is that these top tier companies have been brought into vogue: two quality businesses, which whether combined or not, might very well be fantastic compounding investments over time. So, if the merger doesn’t go through, a fall in price would follow suit, which could create great buying opportunity for the opportunistic investor seeking stable and growing compounders.



The hesitation for me now seems to be about price. At the moment, both companies trade at high EV/EBITDA multiples: around 13x for Luxottica and 15x for Essilor (according to Factset Research data).

The same is true for the combined entity, which according to my EV/EBITDA analysis, EssilorLuxottica would trade at around 15.1x on a pre-synergy basis.

I do understand that they are both high-quality companies and deserving of a premium multiple. However, relative to their growth prospects, and the combination of capital preservation and compounding benefits that purchasing their stocks offers investors, both companies look attractive. But I’m not entirely comfortable paying such a high price for now. I’d rather wait for a larger margin of safety. For now I remain patient, skeptical and studious.



Ryanair Holdings plc


Now what about Ryanair?

What was it that caught my attention? Well, FPA has been an investor in Ryanair for a few years already, as well as other famous funds. Given the risks with airlines, I’ve never been inclined to look at Ryaniar or its peers. However, Ryanair isn’t a typical airline, and thanks to funds’ letters and commentaries like FPA’s that bring such companies to light, the recent negative news around the company may be good for value hunters.

So, what recently affected Ryanair’s prices were labour law issues and shortage of pilots. FPA’s recent commentary puts it best: “Investors’ concerns stemmed from a European Court of Justice ruling that the “habitual place of work” used to determine where cabin crews can sue their employer isn’t limited to the nationality of the airline and its aircrafts, or to the concept of “home base”. In typical fashion, the market incorrectly interpreted the ruling as a challenge to Ryanair’s use of Irish law in labor contracts (that comply with European law anyway), and a potential threat to its cost advantage. At the same time, the company had to cancel flights due to a temporary shortage of pilots. The shortage appears to have been the result of a scheduling mistake by management, although a regulatory change involving the timing of pilots’ annual leave also played a role. The combination of these events, which generated a lot of bad press, negatively impacted sentiment, and put downward pressure on Ryanair’s stock price.”

This is an opportunity to invest cheaply in high-quality assets and people. Given the company’s history of market share gain, the Brexit uncertainty might be a good opportunity for the predator to hunt some preys.

But onto profiling the business. Ryanair, based in Ireland, is Europe’s leading low-cost airline. The company enjoys a structural cost advantage in a highly inefficient industry, managed by passionate and relentless people, which makes it almost impossible for other airlines to compete with or replicate. This moat helps it deliver fantastic results and grow consistently and exponentially over the years, in the face of fears of fare deflation and excess capacity in the airline market. The company has a history of opportunism in terms of taking market share from competitors during downturns by leveraging its cost advantage, as well as its intelligent capital allocation. This is proven by Ryanair’s excellent historical performance: ROCE of 20%, ROE of 30%, and ROA of 11%. The Company has also proved to be highly profitable, with operating margins at 20%. O’Leary and his team have certainly been taking good care of their baby.


But where exactly do this growth and these returns come from? Well, the sources of the company’s advantages are the following:

  • The firm’s cost discipline is unparalleled. Ryanair’s unit and overhead costs are around half of its main competitor, Easyjet, and far lower than other competitors. Ryanair also spends less in marketing than any of its competitors (the only one that competes is Wizz Air Holdings plc). This allows Ryanair charge low fares and still fly planes profitably to small airports, which in turn leads to dominance in those regions and by result, lower landing fees, which feeds the firm’s growth. For example, this year, Ryanair’s profit after tax increased by 6% to €1.316bn; as average fares fell 13% to €41, and unit costs were cut 11% (ex-fuel fell 5%). Of course, low-price alone doesn’t create a lasting advantage, but when combined with operational efficiency and opportunism, as we can see from O’Leary’s management style – through, for example, the leverage Ryanair uses from its profitability to gain more favorable acquisition financing terms and the pressure it puts on competitors to cut costs – the recipe seems one of durable success.


  • This cost discipline matches with the operational and capital allocation efficiency of management. The company has a history of buying a uniform fleet of planes when demand is low, therefore buying cheaply. This buying in bulk strategy has an additional advantage of receiving “rebates from manufacturers and facilities staffing an in-housing maintenance crew, which is vastly cheaper than alternatives.” Further, investors must look at Ryanair’s capital allocation. Management has had a great history of creating shareholder value through capital allocation, as last year, over €1Bn was returned to shareholders through share buybacks: “management has acted as capable stewards of capital, opportunistically retiring 15% of the company’s share count over the last 5 years at attractive prices – with nearly 30% of that reduction taking place during the Brexit vote…all while maintaining a pristine balance sheet, which carries less than €600mn in net debt against €2bn in LTM EBITDA.” This proactiveness highly resembles 3G Capital’s imposed culture on AB Inbev, Burger King, Heinz, etc. Needless to say, it’s a recipe for success.
  • And finally there’s the company’s culture…ah, the culture! The business is built around a focus on cost cutting, intense work ethic and incentive alignment. Ryanair’s employees work for longer, receive incentive-based pay, and the company doesn’t suffer from the same union scrutiny as competitors. Oh, and incentives are all in place with O’Leary and the rest of the board owning about 5% of the entire company – everything seems be in place here.

With this clear competitive advantage, the Company seems primed to capitalize on the growing market trend displayed below:





So why haven’t I invested in Ryanair yet after praising it so much? Well, consistent success in investing seems to be highly driven by both quality and price. The former has been dealt with, but the latter remains to be seen. Ryanair currently trades at 13.3x trailing P/E, 11.5x EV/EBITDA, and 15x adjusted FCF. In terms of forward looking multiples, Ryanair trades at 12.5x earnings, according to Thompson Reuters data. My next step is to analyse normalized earnings and decide whether Ryanair truly looks cheap based on my own valuation assumptions.



FPA International Value Fund, 3Q17 Commentary




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