Shanghai Stock Exchange Student Research

This report is published for educational purposes only by students competing in the CFA Institute Research Challenge.

If you are still shortsighted put your specs on

Our coverage of Luxottica starts with a target price of 27.1 € and an “accumulate”

recommendation. Luxottica is the world leader in the manufacturing and distribution of prescription frames and sunglasses. From 2009 onward the Group has experienced a strong growth that we expect to continue in the following years, supported by the development of Oakley, the expansion in new strategic markets and margins’

improvement. The strengthening of the USD might represent another positive factor for the Group.

Sales and margins growth. Boosted by a strong expansion in Emerging Markets we expect a strong trend in net sales with a 6.6% CAGR from 2010 to 2014. We forecast an EBIT margin improvement of 187 bps by 2014, with the wholesale segment fuelled, among other factors, by the Oakley turn-around, and retail by the further increase in the scale of operations and the Australian recovery.

Valuation method. Our coverage of Luxottica leads to a twelve-months target price of 27.1 € and an “accumulate” recommendation. We evaluate the company with a DCF analysis and compare this result with the outcome of a comparable multiples analysis.

Main risks to our analysis are strong volatility in the EURUSD exchange rate, as Luxottica is mainly an American player but an Italian producer, and challenging economic conditions, especially in Europe. An additional risk comes from the possible loss of licensed brands that could weaken its portfolio.

Alain Afflelou. We also consider a scenario in which Luxottica acquires a major European retailer. We have identified as the most likely target in the sector the major French retailer Alain Afflelou. This acquisition could increase Luxottica’s sales in the next years without having dramatic effects on the Group cost structure, given the chain’s franchise organization.

Ticker: Reuters/Bloomberg LUX.MI/LUX IM Current Price: 24.0 € Recommendation: ACCUMULATE Target Price: 27.1 €

Luxottica S.p.A.

Shareholders Structure

Shareholders

Leonardo Del Vecchio 66.98%

Giorgio Armani 4.87%

Others 1.39%

Floating 26.76%

24^th January 2012

2011 E 2012 E 2013 E 2014 E Sales 6,222 6,821 7,168 7,480

EBIT 809 913 999 1,059

Net Income 444 515 576 621 P/E 24.78x 21.39x 19.13x 17.74x EV/Sales 2.36x 2.15x 2.05x 1.96x EV/EBITDA 13.18x 11.72x 10.83x 10.24x

EPS 0.97 1.12 1.25 1.35

DPS 0.44 0.52 0.58 0.62

Forecasts Stock Data

Market Cap 11.01 bn€

52w High/Low 24.00€ / 18.73€

Performances 1m 3m 12m

Absolute 12.1% 12.1% 6.7%

Relative (FTSE MIB) 6.4% 13.4% 34.8%

Source: SSE estimates

Source: Yahoo Finance

0 1 2 3 4 5 6

50 60 70 80 90 100 110 120 130 140

millions

Volume LUX FTSE MIB

Source: Company website

24^th January 2012 CFA Institute Research Challenge

INVESTMENT SUMMARY

We initiate our coverage of Luxottica with an “accumulate” rating and a twelve-month target price of 27.1 €, with a 12.8% upside from the current stock price.

With more than 6,500 stores and 58.8 million frames produced each year in more than ten production sites, Luxottica at the present moment is already the undisputed leader in the production, distribution and selling of frames and is basically facing no threats from competitors. Still, we see plenty of room for growth and improvement and we expect the Group to be fully able to exploit these opportunities.

The following factors are the ones that we expect will drive Luxottica’s growth and are the main reasons behind our recommendation:

• Oakley turn-around: we are in the fifth year after the acquisition, and Luxottica has been able so far to perform a solid turn-around of Oakley. From the acquisition sales improved at a CAGR of 12% and EBIT at 23%, showing (once more) Luxottica’s strong ability to improve both sales and profitability of the acquired companies. However we believe that Oakley’s potential has not been fully tapped yet, also due to the extremely severe market conditions in the aftermath of the acquisition; for example Europe and Emerging Markets (EM) present major unexplored opportunities for Oakley, as well as building on the brand to attract more women customers.

• Emerging Markets: in these markets we expect an overall 2011-2014 net sales CAGR of 16% for the two divisions combined. For retail, sales will increase both through acquisitions (especially in LatAm) and organic growth (LensCrafters in China and Sunglass Hut in India). For wholesale major opportunities will come from leveraging on the strong brand portfolio and from targeted strategies (Asian fitting, etc.).

• Profitability comeback: Luxottica will focus on bringing back the margins to the peaks reached before the financial crisis, which were in 2007 of 24.95% for wholesale and 15.60% for retail. We expect it to be feasible with the former (up 249 bps by 2014) helped by Oakley and by an improving price-mix. In retail as well (up 102 bps), the main drivers will be value-added services, pushed in Luxottica’s flagship LensCrafters, further exploitation of synergies and a sound recovery in Australia.

We also expect that eventually Luxottica will step into the European retail arena, and we consider and price this eventuality in Section “Alain Afflelou”.

Risks. Currently the main risk for Luxottica is its FX exposure. The Group generates a major portion of its revenue in currencies other than its functional currency (EUR), and even if some actions to mitigate this risk are in place we reckon this risk to be extremely relevant.

The most important exchange rate is the EURUSD: a strengthening of the EUR against the USD would affect negatively both sales and profitability.

Another major risk is linked to the macroeconomic conditions, correlated to eyewear sales.

Other risks are licenses renewal and the success of Oakley’s turn-around.

Valuation. Our target price of 27.1 €, with a potential upside of 12.8%, is the outcome of a Discounted Cash Flow Analysis based on a 7.5% WACC and 2.5% long-term growth. In addition we perform a comparable multiples analysis using peer companies from two different sectors (Luxury and Optical).

BUSINESS DESCRIPTION

Founded in 1961 by Leonardo Del Vecchio, Luxottica is the global leading eyewear manufacturer and distributor, with 62.000 employees working in its vertically integrated organization, which includes a wide-reaching wholesale and retail distribution network, with chains like LensCrafters (LC), Sunglass Hut (SGH) and OPSM. One of the major points of strength of the Group is its brand portfolio, well balanced between house brands such as Ray-Ban and Oakley, and licensed brands, including Chanel, Prada and Dolce&Gabbana with Coach and Armani about to kick-in.

In 2010, net sales reached 5,798 m€ (+7.1% YoY) with an improvement in both EBIT (+13% YoY) and EBIT margin (up 83 bps), while in 2011 sales were 6,222 m€ (+7.3%

YoY).

821 939 1018 1158

0 500 1000 1500

2007 2008 2009 2010 Oakley Net Sales (m$)

107 114 152

200

0 100 200 300

2007 2008 2009 2010 Oakley EBIT (m$)

15.60%

13.85%

11.71% 11.92%

0%

4%

8%

12%

16%

2007 2008 2009 2010 Retail Operating Margin

24.95%

21.03%

18.18% 20.65%

0%

10%

20%

2007 2008 2009 2010 Wholesale Operating Margin

Figure 5. Luxottica’s retail presence Figure 4. Wholesale Operating Margin Figure 3. Retail Operating Margin

Figure 2. Oakley EBIT Figure 1. Oakley Net Sales

Distribution Platforms. The Group distribution structure is divided in:

• Retail Distribution: Luxottica’s largest segment, which in 2010 accounted for 61% of the Group’s sales, was built through several acquisitions that made Luxottica the main global player in this sector. On a geographical base, North America (83% of segment revenues in 2010) is by far the most important market, with more than 5,000 stores, followed by Australia and New Zealand (14%), with around 1,000 stores. Minor operations are in Europe (3%), especially in the UK, Africa and Middle East (1%). The Group has expanded its presence in the EM, through the acquisition of Tecnol and GMO in South America, and is strengthening the position of LC and SGH in China and India;

• Wholesale Distribution: covering more than 130 countries, main markets are Europe (47% of segment revenues in 2010) and North America (24%), but the contribution of EM (15%) is growing.

Manufacturing Units. Luxottica manufacturing system of prescription and sun frames has two main platforms: Italy and China, with six and two plants respectively. Alongside these, two facilities in US assemble most of Oakley’s eyewear products, while a smaller plant in India serves the local market and another one in Brazil (from Tecnol acquisition) will soon operate with the same purpose. Luxottica also owns in North America five lens finishing labs, which together with LC’s approximately 900 in-store labs create a wide network for lens finishing.

In this division major efficiency improvements have been deployed in the last years, like the introduction of SAP and new contract agreements (e.g. Sedico, January 2012).

Potential developments. The four main drivers behind Luxottica’s growth in the following years will be further development in EM, global expansion of SGH, growth in the US and Oakley turn-around.

INDUSTRY OVERVIEW

In this section we describe the main characteristics of the Italian eyewear industry, through data published by ANFAO (see Appendix 5). Even though these data do not account for frames produced outside of Italy, we still consider them to be adequate to describe the sector in which the Group operates.

Italian products. The Italian eyewear industry is characterized by high price and high quality products, and by the presence of brands of famous stylists. This sector is less elastic to the macroeconomic conditions in comparison to the lower segments for several reasons, the most important being the fashion content of the eyewear, which represents one of the less expensive ways for consumers to purchase a high-end item.

In 2010, the Italian eyewear production was worth 2,448 m€ (+8.7% YoY), leading the whole industry with a market share of about 27%. This percentage is even more relevant (43%) taking into account just the sun segment. The main driver supporting this growth was the solid increase in exports (+17.3% YoY), decisive for an industry that exports 80%

of the overall production. On a product basis, sunglasses’ trend was more significant (+20.4% YoY) making up 1,449 m€, while prescription frames (+11.7% YoY) stood at 707 m€. This is because the Rx segment is less elastic to economic conditions with respect to sunglasses, given its medical nature.

Major markets. Geographically, the size of this growth varies in each country:

particularly strong in EM and US, weaker in Europe. Main markets are:

• US: one of the major markets, accounting for 22% of the overall exports, which have increased by 25.1% compared to 2009, driven by the marked trend of the sun segment (+34% YoY).

• Emerging Markets: exports to LatAm increased by 31.7%, making up 5.5% of the overall exports, while the Asian market represented 16.1%, up 32.6% YoY. We expect them to continue to grow.

• Europe: it is the main market, accounting for 51.5% of the overall exports. The growth rate (+10% YoY) has been good but lower than the average and it has been driven mainly by the strong momentum of the UK (+24% YoY) and France (+16% YoY).

Nevertheless, we foresee difficult times ahead.

2.9%

82.6%

0.7%

13.8%

2010 Retail Sales by Geography

Europe North America EM ROW

47.3%

24.2%

15.0%

13.4%

2010 Wholesale Sales by Geography

Europe North America EM ROW

0 500 1000 1500 2000 2500

2006 2007 2008 2009 2010

m€

Italian Frames Exports by Geography

US EU South America Asia Figure 6. 2010 Retail Sales by Geography

Figure 7. 2010 Wholesale Sales by Geography

Figure 8. Italian Frames Exports by Geography Source: ANFAO

24 January 2012 CFA Institute Research Challenge

Figure 10. LensCrafters 5^th Avenue, NY, USA Source: SSE

Brand Portfolio Breakdown

Divisions Breakdown

Luxottica

Safilo

Marcolin

De Rigo

Marchon

Distribution channels vary on a geographical base. In the US, and in most of European countries, distribution chains already enjoy the largest market share. In Italy the independent shop is still the main customer’s choice, while in Asian countries the chaotic retail mix has not still seen a predominant retail channel. The most important factor in the choice of the point of sale, as we learned through several stores visits, is loyalty: for prescription frames this is even more significant given the influence of the optician, while for sunglasses it is mitigated by the occasional nature of the purchase and by brand loyalty. Finally, the product positioning plays a decisive role at the moment of the choice of a particular frame: 43.6%¹ of the frames sold is chosen according to its location in the shop, especially by young customers.

COMPETITIVE POSITIONING

The Group’s competitors vary according to its two reference sectors: eyewear manufacturing and wholesale distribution, and retail distribution.

Frames Producers. The most relevant drivers of the competition are the following:

• Brand Portfolio: especially for luxury products, customers look at the brand as a Rways for consumers to satisfy their need for high-end products; this is why nowadays luxury brands choose the eyewear sector to develop and establish their brand in key markets.

• Distribution Network: a global distribution network that combines brand positioning, product quality and customer service is a key factor to attract luxury brands, while in the past the main issue was royalties payments.

With its vertical integration and a strong portfolio of retail brands, Luxottica is well positioned to reach all the different segments of the market. This is what allowed the Group to win the latest “battle for the brands”, when in 2010/11 it gained the biggest part of the business under negotiation, through the agreement with Armani and Coach, and the renewal with Bvlgari. Furthermore, an additional competitive advantage of Luxottica is represented by its financial strength, which allows the Group to pay significant amounts of royalties in advance, as it did in 2006 with an advance payment of around 200 m$, to cover a 10 years agreement with Ralph Lauren. Beside this, the acquisition of Oakley in 2007 has allowed the Company to rebalance its portfolio between house and licensed brands (around 72%-38% of unit sold in 2010).

Other major eyewear producers are:

-­‐ Safilo: the second biggest player in the optical sector, with 2010 sales of 1,080 m€.

After recent changes it almost only operates through wholesale. Its main shareholder is the retailer HAL Holding. Main brands: Carrera (house brand), Dior and Gucci (licensed).

-­‐ Marcolin: eyewear producer and wholesaler listed in Milan Stock Exchange with 2010 sales of 208 m€. Main brands: Tod’s, Cavalli and Montblanc (licensed).

-­‐ De Rigo: Italian producer with a strong presence in retail (e.g. minority stake in Boots Opticians, UK). Main brands: Police, Sting (house brands).

-­‐ Marchon: American producer with strong design and production platform in Italy.

Main brands: Nike, Calvin Klein and Valentino (licensed).

Information about divisions and brand portfolio for these producers is in Figure 9.

Retailers. On a geographical base we can distinguish four major markets:

US. Here Luxottica is for the 12^th consecutive year the biggest optical retailer, with 2,891 stores as of May 2011. The Group is pushing one-hour services along with sunwear and premium lenses, carrying on a strategy launched in 2010. LC is introducing a new high- definition lens program in all its stores as well as an innovative digital measurement (AccuFit), and expanding sun Rx. The competitive positioning in the US optical retail is summarized in Figure 11. Moreover thanks to SGH, Luxottica has also a strong presence in the sunglass retail market with 1,814 stores.

Australia and New Zealand. Through several acquisitions, the Group has become the major player with over 1,000 stores. The different chains stand in complementary positions, with OPSM covering the high-end segment and Budget Eyewear the lower one.

In this market the main competitor is Specsavers that owns in the area 302 stores, generating revenues for 282 m€ in 2010.

1 Source: ANFAO Fashion

Luxury Sport

Wholesale Retail Figure 9. Producers’ competitive scenario Source: SSE estimates and companies’ data

Emerging Markets. This is where we expect a strong momentum for the Group, exploiting the growth potential, and the competitive advantage represented by its local production facilities:

-­‐ China: The expansion of LC will increase the Group’s market share, and emphasis on Asian fit and design will help to boost sales both in prescription and sun segments.

-­‐ India: The opening in 2011 of 40 SGH represents in our view just the beginning of a stronger penetration in this market.

-­‐ South America: Through the recent acquisitions, the Group is becoming one of the most important players in the area, whose potential is even greater than that of China, since it is already one of its top 10 wholesale markets.

Europe. In this area the Group operates through 161 stores, mainly in the UK. In Italy the market is very fragmented and the main distribution channel are independent shops. In the rest of Europe retail chains are more common. These are the main players:

-­‐ HAL Holdings: a leading worldwide optical retailer with various retail companies and formats totaling 4,400 stores, in 40 countries. Main operations are in Europe, through Pearle Europe, which controls 3,017 stores, and GrandVision, with 1,278 stores mostly in France. In 2010 revenues were around 2.7 bn€. It is also the major shareholder of Safilo.

-­‐ Fielmann: the major optical chain in Germany and by far market leader in the country.

Counting also Austria, Poland, Netherlands and Luxemburg the number of shops is about 650. It also has some minor production activities. In 2010 revenues were 1.2 bn€.

-­‐ Alain Afflelou: leading franchisor of over 900 optical retail stores. Major presence of franchisees in France and Spain, minor presence in Portugal, Switzerland, Benelux and North Africa. As of 31 December 2009 its stores generated revenues for 726 m€.

-­‐ Specsavers: by far the largest UK optical chain with about 700 stores and one of the main European player thanks to its 463 stores distributed around Netherland, Denmark and the Scandinavian Peninsula. In 2010 total revenues were about 1.5 bn£.

VALUATION

We derive our target price of 27.1 € using a DCF analysis and we compare it with the price obtained from a comparable multiples analysis using peers both from the Optical and the Luxury sector.

DCF. We use a WACC of 7.5% calculated under the following assumptions:

• Risk free rate: We refer to the 10-yrs German Bund. At the time of writing it quotes around 2% but in our view this value reflects the current stressed condition due to the Euro crisis. Therefore, we think more appropriate to use the average rate recorded during 2009-2010 that is 3%.

• Market Risk Premium: we decide to use 5% in line with a paper from IESE Business School².

• Beta: 1.07, regressed on the STOXX600 Europe Index using monthly data from January 2006.

• Cost of debt equal to 4.00%. This is the coupon rate of Luxottica’s 500 m€ bond issued in November 2010 and listed in Luxemburg. This value is in line with the historical YTM.

• Tax Rate: we use a marginal tax rate (IRES) of 27.5% for interest payments since the debt is issued by Luxottica Group SpA, the parent company, which is regulated by the Italian law.

• D/EV equal to 15%. Since in our base scenario we do not forecast significant changes in the financial structure or important investments, like a major acquisition, we expect the D/EV ratio to decrease from the 2010 level of 21% and in the long run to be in line with pre-Oakley levels.

• Normalized growth rate equal to 2.5%. We judge this LTG to be sustainable, mostly supported by Luxottica’s undisputed leading position.

• Forecasts of 4 years (2011-2014): we expect that outside of our time window, there will not be significant and predictable changes in the financial structure of Luxottica.

Under these assumptions, our DCF analysis leads to a fair value of 27.1 €, up from the actual price by 12.8%. This upside potential is mainly due to:

2 “Market Risk Premium used in 56 countries in 2011: a survey with 6,014 answers” - Pablo Fernandez, Javier Aguirreamalloa and Luis Corres. IESE Business School April 25, 2011 0

500 1000 1500 2000 2500 3000

Revenues (m$)

WACC Assumptions

Risk Free Rate (RFR) 3.00%

Company Risk Factor or Beta (CRF) 1.07 Market Risk Premium (MRP) 5.00%

Cost of Equity (Ke) 8.32%

Cost of Debt (gross) 4.00%

Debt Tax Rate 27.50%

Cost of Debt net (Kd) 2.90%

E/EV 85%

D/EV 15%

WACC 7.50%

Figure 11. US Optical Retail Market

Table 1. WACC Assumptions

24 January 2012 CFA Institute Research Challenge

Table 4. Multiples Snapshot Sources: Bloomberg, SSE estimates

Comparable Multiples Optical

2011 E 2012 E 2013 E 2014 E EV/Sales Avg 1.82x 1.77x 1.66x 1.58x EV/EBITDA Avg 8.47x 8.83x 8.14x 7.68x

Luxury

2011 E 2012 E 2013 E 2014 E EV/Sales Avg 3.31x 3.16x 2.84x 2.83x EV/EBITDA Avg 12.12x 11.38x 10.08x 9.77x

Luxottica

2011 E 2012 E 2013 E 2014 E EV/Sales 2.36x 2.15x 2.05x 1.96x EV/EBITDA 13.18x 11.72x 10.83x 10.24x

• Growth in EM, where we expect an important sales increase, especially in the wholesale division.

• Positive effect from the FX since we expect a USD stronger than it was in 2010 (see Section “Investment Risks”).

• Armani licence: the signature of the agreement will bring a positive effect increasing Group's net sales and enhancing its corporate image.

We also carry out a sensitivity analysis in order to gauge the robustness of our model to changes in two structural parameters, Long-Term Growth and WACC. The results are presented in Table 3.

Multiples Back Up Valuation. With this analysis we evaluate the positioning of Luxottica compared with peers operating in two sectors, Optical and Luxury. We then compare this result with our target price obtained by DCF. We consider EV/Sales and EV/EBITDA ratios.

In the Optical sector we identify as comparables Safilo, Fielmann, Essilor, Hoya and Carl Zeiss (see Appendix 6 for a description of these companies). We also consider the Luxury sector because of the high-end profile of Luxottica’s brand portfolio. In this sector we select Prada, LVMH, Burberry, Tod’s, Dior, Geox and Hermès.

As shown in Table 4, Luxottica’s EV/Sales multiples are higher than the Optical average but lower than Luxury, while EV/EBITDA values are the highest. For details see Appendix 6.

Using the average of each group, we calculate Luxottica’s prices as a Luxury and as an Optical company. Since Luxottica has a unique business mix and cannot be associated with only one group, we make a simple average of the prices previously obtained.

The price obtained, 27.07 €, is very close to our target price derived from DCF.

FINANCIAL ANALYSIS

In this section we illustrate the main assumptions behind our forecasts.

Wholesale. For the Wholesale division we expect a growth in sales with a CAGR of 6.5%

in the 2011-2014 period. The main drivers of the forecasted growth are both macroeconomic and company-specific.

At a macroeconomic level we expect sales to grow in accordance with the general economic situation: at a faster pace in North America and EM and slower in Europe.

The main internal drivers are:

• The continuing turn-around of Oakley, whose sales in the period 2006-2010 grew at a CAGR of 12%. We expect this effect to last for some more years, considering that its full potential was not exploited immediately after the acquisition given the challenging economic conditions.

• A greater contribution of Emerging Markets³³; in particular we expect EM to account for 19.3% of wholesale sales in 2014 (15% in 2010).

3Note that we are using the geographical breakdown used by the company in its official documents until the 2011 Sales press release  

0%

20%

40%

60%

80%

100%

Sales Breakdown by Division

Retail Wholesale Long-term Growth Rate 1.50% 2.00% 2.25% 2.50% 2.75%

WACC

7.00% 24.4 € 27.1 € 28.7 € 30.4 € 32.3 € 7.25% 23.3 € 25.8 € 27.2 € 28.7 € 30.5 € 7.50% 22.2 € 24.4 € 25.7 € 27.1 € 28.6 € 7.75% 21.4 € 23.5 € 24.6 € 25.9 € 27.3 € 8.00% 20.5 € 22.4 € 23.5 € 24.7 € 26.0 €

m€ 2009 2010 2011 E 2012 E 2013 E 2014 E

Net Sales 5,094 5,800 6,222 6,821 7,168 7,480

EBITDA 857 1,036 1,116 1,254 1,357 1,434

EBIT 571 714 809 913 999 1,059

Operating Taxes (160) (218) (243) (281) (311) (330)

NOPLAT 411 496 566 632 688 728

D&A 286 322 300 340 358 376

Gross OPFC 697 818 872 973 1,046 1,104

Capex (incl. Acquisitions) (200) (230) (388) (406) (332) (230)

Δ in NWC (347) (7) 18 10 25 (12)

Cash Flow to be discounted 845 581 503 577 739 793

Table 3. WACC vs. LTG Sensitivity Analysis

Table 2. Cash Flow to be discounted forecasts

Figure 12. Sales Breakdown by Division

Retail. We forecast a CAGR of 6.6% in retail sales for the 2011-2014 period. Growth attributable to the macroeconomic factor is more pronounced in this division given the small relevance of Europe (the only area where we do not expect a sound recovery for 2012).

The two main directions behind our forecasts are:

• Number of stores: we expect a relevant increase in the number of stores in EM and in particular a marked increase for LC in China. We also expect the current level of opening of SGH (about 210 per year) to be sustainable. In addition, we also account for the acquisitions in LatAm (Tecnol and GMO). For details on stores forecasts refer to Appendix 2.

• Revenues per store: our forecasts for the revenues per store are mostly motivated by macroeconomic factors. For the NAM activities we also expect the rollout of new high value-added services (e.g. AR in 1hr) in LC to be a significant traffic and revenues generator.

Profitability. Luxottica has been focusing on bringing its margins back to the historical heights registered before the financial crisis (EBIT margin in 2007 was 16.8% compared with 12.3% of 2010).

We expect a significant increase in profitability in both divisions, with wholesale (up 102 bps by 2014) still benefiting, among other factors, from the Oakley turn-around, and retail (up 249 bps by 2014) from a further increase in the scale of operations and eventually from a full recovery in Australia.

More details regarding the forecasts of the two divisions’ EBIT margin can be found in Appendix 1.

Cash Flow and Capital Structure. We expect a general increase in FCF as a result of sales and margins growth. We foresee an increase in capital expenditure from 2011 to 2013 in consideration of store openings (Appendix 2), rebranding, maintenance and the last period of SAP rollout. We also consider the recent acquisitions of GMO, Stanza and High Tech, Erroca and Tecnol.

The cash flow generated (6.43% CAGR 2010-2014) will help to repay long-term debts and sustain dividend payments, which we assume to be equal to 45% of net income in line with the average level of past years. Since in our base case we do not expect any acquisition we keep this ratio constant for the future. Furthermore, under these assumptions, long-term debt and Net Financial Position/EBITDA will decrease in accordance with Luxottica’s debt maturity profile, as we expect that part of the debts will not be refinanced. We also forecast a positive effect on FCF from Net Working Capital following SAP rollout that can lead to a decrease in inventory days of almost 20% in 3 years (detailed forecasts for financial statements can be found in Appendix 8).

ALAIN AFFLELOU

Acquisitions have always been a key expansion strategy for Luxottica, and we believe that something important could happen in the near future.

One of the factors behind our view is the current level of the Net Debt/EBITDA ratio. This ratio has been a solid predictor of the Group’s major acquisitions throughout the past years, as you can see in Figure 17. ND/EBITDA currently stands at the level reached just before the acquisition of Cole National and OPSM in 2004 and 2003 respectively, therefore it suggests that a major acquisition is feasible while a landmark acquisition (>1bn$) is unlikely.

Acquisition Rationale. Luxottica constantly looks for potential acquisition targets in two main areas: brands and retail. However at the present moment, given the positioning of brands in the sector and the turn-around of Oakley still ongoing, a major acquisition in this field is quite unlikely. On the other hand, while several Luxottica’s competitors have a strong footprint in the European optical retail, the Group has only some minor activities, it seems therefore reasonable to expect the next major deal in this area. Among the factors considered by Luxottica when selecting a target for an acquisition, the market position is fundamental. In the case of retailer for example, it is measured in terms of market share and number of stores. Other key factors are the synergies that can be exploited through the acquisition.

0%

50%

100%

Retail Sales by Geography

Europe North America Emerging ROW

0%

50%

100%

Wholesale Sales by Geography

Europe North America Emerging ROW

0 2000 4000 6000 8000

Sales (m€)

Net Sales Forecasts

0 200 400 600 800 1000 1200

EBIT (m€)

EBIT Forecasts Figure 13. Retail Sales by Geography

!!"#$%&'()*'+&,-".'/-.&0'12'3&4#%-562' '

Figure 14. Wholesale Sales by Geography

! !"#$%&'()*'+&,-".'/-.&0'12'3&4#%-562' '

Figure 15. Net Sales Forecasts

!!"#$%&'()*'+&,-".'/-.&0'12'3&4#%-562' '

Figure 16. EBIT Forecasts

!!"#$%&'()*'+&,-".'/-.&0'12'3&4#%-562' '

The next step in European retail?  

24 January 2012 CFA Institute Research Challenge

Potential target. We have identified as a likely target Alain Afflelou (AA). AA is a leading franchisor of over 900 optical retail stores in France and Spain, operating under two brands – Alain Afflelou, its core offering, and Plurielles d’Afflelou, its ‘all-inclusive’

concept. In addition to the franchised stores it operates about 40 stores in the Paris area.

AA has also its own brand portfolio, with house brands like Actuelle and L’Ideale, and exclusive licensed brands.

A perfect fit. We think that AA could be the Group’s first real step in European retail for several reasons:

• Its franchise structure would allow Luxottica to penetrate a new market without having to bear the whole burden of the stores management.

• Afflelou is the most recognized name in the optical sector in France.

• Considering that in France optical expenses are often covered by insurance, the expertise developed with EyeMed could be exploited.

• France is one of the most important markets in Europe for the wholesale division.

Moreover France, compared to the majority of European countries, has been less affected by the economic slowdown.

In addition to the previous factors we think that AA could actually be for sale. The company main shareholder is the private equity fund Bridgepoint that acquired the 60% of the stocks in 2006. The other two shareholders are another private equity fund (Apex Partners) and Alain Afflelou himself. So, given the nature of PE funds, it seems to be just a matter of when AA would be for sale. We think that in 6 years (even more for Apex Partners) a turn-around of the firm should have been performed, and therefore we expect AA to be on the market soon. Incidentally, in June 2011 AA was said to have hired Rothschild as advisor on available options⁴.

Should the ownership consider selling, given the current market conditions, we think that an IPO would be rather unlikely and therefore a private sell, with Luxottica as one of the bidder, is a more likely scenario.

Estimates. Currently AA is a private company and no detailed recent information is available. However, using data prior to its delisting (2007), we estimate AA’s sales currently to be about 210 m€ with an EBIT of 50 m€. Furthermore we expect that, given market conditions and the high profitability of AA, a reasonable price would be around at 2.6x sales (550 m€). We modelled the acquisition to be slightly leveraged (2.5:3) and the final payment to take place in two years.

Incorporating these figures in our model the target price for Luxottica would be of 28.1 €.

INVESTMENT RISKS

FX risk. As shown in Table 5 Luxottica has a composite costs and revenues structure in terms of currencies and this leads to a significant exposure to several exchange rates and most notably to EURUSD. There are two major sources of risks related to this foreign currency exposure:

• Translation risk: this risk arises when a subsidiary has a functional currency different from Euro, the functional currency of Luxottica. The Group does not manage this kind of risk.

• Transaction risk: this risk arises since manufacturing costs are in Euro and Chinese Yuan, while a significant part of revenues are in other currencies. Luxottica risk management policy states that this risk must be hedged between 50% and 100%. A strengthening of the Euro against the US dollar may negatively affect both sales, due to higher prices, and profitability, due to lower margins, for Luxottica.

Historically FX effects have been significant for Luxottica and we expect them to remain as important as in the past years. See at the end of the section for a full sensitivity analysis on the EURUSD exchange rate.

4 “Alain Afflelou Hires Rothschild To Advise On Options”, WSJ.com, 10^th June 2011 1

1,5 2 2,5 3 3,5

Net Debt/EBITDA OPSM

Cole

Oakley 3.5

3.0 2.5

2.0

1.5 1.0

2009 2010

USD EUR Other USD EUR Other

Revenues 59.5% 18.6% 21.9% 59.1% 18.3% 22.6%

Costs & OPEX 58.3% 25.3% 16.4% 57.0% 24.9% 18.1%

Figure 19. Afflelou’s presence in Europe Figure 17. Luxottica’s historical ND/EBITDA

Table 5. Costs and revenues currencies breakdown Figure 18. Alain Afflelou, Champs Elysées,

Paris, France Source: Internet

FX

Low Mild High

Macroeconomics

Low Mild High

Acquisitions approval (short-term)

Low Mild High

Acquisitions approval (long-term)

Low Mild High

Oakley integration

Low Mild High

Licences agreements (short-term)

Low Mild High

Licences agreements (long-term)

Low Mild High

Independent retailers (short-term)

Low Mild High

Independent retailers (long-term)

Low Mild High

SAP rollout

Low Mild High

Macroeconomic conditions. Eyewear sales are correlated with economic conditions with prescription business less influenced and sun more elastic.

• Economic conditions in Europe are extremely challenging with a sound recovery in 2012 still highly unlikely. For this reason Luxottica may be exposed to a relevant decrease of sales in this area that in 2010 accounted for 47% of wholesale revenues.

• Increasing penetration in Emerging Markets, both in retail and wholesale, may expose the company to the higher volatility of consumptions in this area. However at the present moment the macroeconomic outlook for this area is very positive with an expected growth in GDP of more than 6% in the next three years⁵.

• North American activities in 2010 represented 83% of retail sales; should the economic conditions deteriorate in this area sales could be strongly affected. However, at the present moment, a steady recovery is forecasted and 2011 results prelude to a solid 2012 (average GDP growth of 1.4% in the next two years)⁶.

Acquisition approvals. Luxottica has historically used acquisitions as an expansion strategy. These acquisitions are subject to approval by antitrust regulators that could halt the process; with Luxottica consolidating its leadership position some transactions may not be approved, especially in the retail sector. However, given the number of retail markets in which Luxottica is not present we believe this risk to be low in the short-term.

Oakley integration. With Oakley turn-around still ongoing, Luxottica profitability could be negatively affected should this process take longer than anticipated. However, given the positive acquisitions’ history, and in particular the outstanding turn-around of Ray-Ban, we do not expect major setbacks in this area.

Licence agreements. In 2010, in terms of units sold by the wholesale division, 27% came from licensed brands, therefore, should Luxottica lose any major licence, sales will be negatively affected.

At the present moment no licence accounts for more than 5% of total sale with Prada (4.2% in 2010) and D&G (3.5%) the two biggest contributors (we expect Armani to be the only licence above 5% in the following years). However, even if a single licence loss could not cause a major reduction in sales, this could cause a bigger image damage.

In the short-term, also considering the important gap between Luxottica and its competitors, we do not anticipate any significant risk of this kind.

For the long-term outlook, we do not think that Luxottica, after the Armani arrival, could continue expanding its portfolio without letting other brands go. On the contrary, we believe that in the long run some licensees may consider signing with smaller producers, where they could receive more attention.

Independents retail diffidence. With Luxottica gaining importance in various retail markets, independent retailers, key clients of wholesale divisions, may feel threatened and this could cause a contraction in wholesale sales with retailers preferring Luxottica’s competitors. This risk will gain momentum with Luxottica continuing expansion.

SAP rollout. In 2012 the rollout of SAP will be completed, so far the process has not presented any major problem or delays. However a small risk in the logistic and distribution is still present until the new platform is completely up and running.

FX Sensitivity Analysis. In our main scenario we use as our estimates for the EURUSD the forward curve at January 24^th, 2012; to give some more guidance on the exchange rate effects on our target price, we perform a sensitivity analysis on the EURUSD.

In detail, we determine the 70% and 90% confidence intervals for the year average EURUSD for the 2012-2014 period, using the forward value as mean and the historical volatility of the year average series as standard deviation, assuming normality. The results are shown in Figure 21.

The following table illustrate our findings:

Worst Case Forward Best Case

90% 70% 70% 90%

26.49 € 26.69 € 27.10 € 27.49 € 27.76 €

4

5 Source: IMF

5

6 Source: EUROSTAT Figure 20. Risk relevance

Source: SSE estimates

Table 6. FX sensitivity analysis results

24 January 2012 CFA Institute Research Challenge

“Worst case scenario” analysis. To further evaluate the effects that the various risks could have we run a “worst case scenario” (WCS) analysis. In particular in this scenario we account for a year average EURUSD at the highest level with 90% confidence, the loss of a major licence, a slower than forecasted recovery in Europe, a longer than expected time to reach the sales target in EM for the wholesale division and a decrease in the long- term growth rate to 2.25% (previously 2.5%).

The results of this analysis are shown in the following table. The price that would result from this scenario is of 23.93 €. We want however to stress that this price would be the outcome of a series of highly unlikely events and therefore is to be interpreted as the lower bound of our valuation.

1,10 1,30 1,50

Dec-07 Sep-08 Jun-09 Mar-10 Dec-10 Oct-11 Jul-12 Apr-13 Jan-14 Year Average EURUSD Confidence Intervals

Forward 70% Historical 90% Year Average

m€ 2010 2011 E 2012 E 2013 E 2014 E

Current WCS Current WCS Current WCS

Net Sales 5,800 6,222 6,821 6,712 7,168 6,770 7,480 6,970

EBIT 714 808 913 893 999 918 1,058 953

Net Income 402 444 514 506 576 535 620 569

Table 7. Worst case scenario analysis results

Figure 21. Year average EURUSD confidence intervals

Appendix 1: EBIT Margin Forecasts

In order to forecast the development of EBIT margins we have identified the main drivers for each division and then quantified their effect. More in detail, we have isolated periods in which each effect is the leading one and looked for a pattern; we then used that pattern to infer on future margin values.

The results are shown in the graphs on the right. Historical data go back to 2007 because in 2009 Luxottica changed its way of reporting EBIT and sales for the two divisions giving the updated value only as far as 2007. Previous data are therefore not homogeneous.

Wholesale. For the wholesale division we have identified two main drivers:

• Oakley: Luxottica in the years after the acquisition managed to increase Oakley’s profitability at a CAGR of 10% despite the extremely challenging economic conditions.

Therefore we expect that this effect will last for the next four years, with a CAGR linearly decreasing, and will vanish after 2014.

• Price-mix: we start from the fact that frames in higher segments (for example luxury frames) bring a higher margin. To measure this effect we have studied the historical trend of the revenue per frame (rpf), i.e. the wholesale revenues divided by the number of frames produced in a year.

We have observed that the YoY changes of this quantity are highly correlated with changes in the wholesale margin. Moreover we have observed that historically two factors caused changes in the rpf:

-­‐ Macroeconomic conditions: consumers position themselves in a particular segment depending on their income and, indirectly and on average, this means that rpf depends on general economic conditions. We have therefore forecasted this effect in accordance with macroeconomic forecasts.

-­‐ Brand portfolio: clearly if Luxottica moves its portfolio on average towards higher segments this will increase the rpf. For our forecasts therefore we take into account the new licences of Armani and Coach and the interruption of Ferragamo.

Retail. For the retail division we have identified four main drivers:

• Australia come back: in the last years profitability in Australia suffered due to the smaller size of stores: when sales drop (as it happened in Australia) margins decrease.

Now that some recovery in this market is starting we expect sales to pick up and profitability to follow.

• Value-added services: the new high value-added services offered in some (100) American LC have been successful and we foresee their progressive rollout to all the LC chain both in America and in China. These services yield a higher margin and we account for that in our estimates.

• Scale of operations is a major factor in retail: a bigger chain can better exploit synergies and economies of scale. To gauge this effect we used our forecasts for new stores openings (see Appendix 2).

• FX corrections: retail profitability is affected by FX changes, in particular the American activities (accounting for about 60% of division sales) have part of their costs (namely part of COGS) Euro denominated, therefore a strengthening of EUR against USD will contract margins. Note that this effect is significant on an year on year base while the cumulative effect for the interval 2010-2014 is not relevant since the exchange rates we are using in our estimates are almost the same in the first and last year of the period (1.32 in 2010 and 1.31 in 2014, more on FX in Section “Investment Risks”).

Appendix 2: Stores Forecasts

We expect the evolution in the number of stores to be led both organically, through the strengthening of the major chains of Luxottica’s retail portfolio, LC and SGH, and by acquisitions.

• SGH: the ideal target for the Company is to have 4,000 stores by 2015 but a plan has not yet been introduced by the management. However we expect the opening of about 210 stores per year to be sustainable. In developed markets in particular, the chain reinforced its presence in the department store channel through long-term strategic agreements with Macy’s in the US, Myer in Australia and Edgars in South Africa.

Under this program approximately 230 SGH stores have been opened in 2011 in US, reaching a total of 670.

18%

20%

22%

24%

26%

2007 2009 2011 2013 Wholesale Margin Wholesale Margin Forecasts

20.65%

23.14%

1.43% 0.27%

0.79%

19%

20%

21%

22%

23%

24%

Wholesale Margin Contributions

11%

13%

15%

17%

2007 2009 2011 2013 Retail Margin

Retail Margin Forecasts

11.92%

12.94%

0.39%

0.26%

0.34% 0.02%

11%

12%

13%

Retail Margin Contributions Figure 22. Wholesale margin forecasts

Figure 23. Wholesale margin contributions

Figure 24. Retail margin forecasts

Figure 25. Retail margin contributions

24 January 2012 CFA Institute Research Challenge

Following this pattern we expect the opening of about 70 stores per year, exploiting all the potential of the agreements with Macy’s and Edgars.

In EM the Group policy has always been to rebrand under SGH the sunglass retail shops acquired: this will add 70 more shops in Mexico and 65 in Israel, through the acquisitions of Stanza and Erroca. In India, the opening of 40 stores in 2011 is just a part of a franchising agreement with DLF, a leading property developer in India, which will manage the opening of over 100 stores. All of this, and the scheduled increased production capacity in India, makes us forecast that the opening of about 50 stores per year to be sustainable.

• LC: the expansion of this chain will be the engine of the Group’s strengthening in China, where it will soon initiate lens processing. We expect the Group target to open about 70 new stores per year to be doable.

• Acquisitions: the South American market will play an important role in boosting Luxottica’s sales, thanks to the 568 newly acquired stores, brought by GMO (previously owned only at 40% and therefore not consolidated in the total number of stores) and Tecnol.

Appendix 3: SWOT Analysis

Appendix 4: Acquisition History

5000 6000 7000 8000 9000

2005 2007 2009 2011 2013 Number of stores

Number of stores (forcasts)

2004 2005 2006 2007 2008 2009 2010 2011 E 2012 E 2013 E 2014 E Stores 5,371 5,360 5,566 6,251 6,255 6,217 6,350 6,872 7,597 7,807 8,017 Sunglass Hut 1,858 1,849 1,818 2,141 2,072 2,034 2,229 2,581 2,776 2,916 3,056

SH New -48 -9 -31 323 -69 -38 195 352 195 140 140

LensCrafters 888 893 977 1,116 1,136 1,197 1,155 1,205 1,275 1,345 1,415

LC New 11 5 84 139 20 61 -42 50 70 70 70

Others New 120 460 0 0

New Stores 1,989 -11 206 685 4 -38 133 522 725 210 210

Strengths Weaknesses

• Vertically integrated organization

• Strong house brand portfolio

• Global leader as high-end eyewear producer and retailer

• Large exposure to USD

Opportunities Threats

• Further expansion in China and South America

• Retail expansion in Europe

• Oakley development

• Challenging European macroeconomic situation Table 8: Store openings forecasts

Figure 26. Store openings forecasts

Figure 28. SWOT Analysis Figure 27. Sunglass Hut at Macy’s Herald Square,

NY, USA Source: Internet