Why Luxottica Group and Essilor International Pair So Well Together

By Motley Fool Staff Markets Fool.com

The cast of Industry Focus: Consumer Goodszeroes in on the upcoming merger of Luxottica Group (NYSE: LUX) and Essilor (NASDAQOTH: ESLOY)in one of the biggest M&A deals of 2017 year-to-date. Tune in as the team covers the many ways in which these two European industry leaders complement each other, from their product lines to their balance sheets.

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A full transcript follows the video.

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This podcast was recorded on Jan. 24, 2017.

Vincent Shen: These two companies are going to come together, I think their new headquarters is going to be based in Paris. What else do you think our listeners need to know about the deal?

Asit Sharma: The first thing our listeners need to know about this deal is, is it a complementary deal? Or are these companies just overlapping each other? Many times, when two giants merge, Wall Street loves it initially, there's a pop in both stocks. And that certainly was the case here. I think Essilor popped about 13% the day this deal was announced, which was last Monday, and Luxottica shares popped about 8%. That's the initial excitement that manifests itself when two really big companies announce that they're going to merge operations. But longer-term, this can work to the disadvantage of both companies. If you merge up and start to dominate an industry so much, the statistics which pertain to growth, you inform those statistics. Growing faster than the industry becomes difficult when you are the industry.

What's different about this deal is that these are two very complementary products. Essilor as a lensmaker sees itself very much as a health vision company. Oddly enough, Luxottica, although we know them for brands like Oakley and Ray-Ban, they also see themselves as a health vision company. When you think about sunglasses, they provide protection against UV light, and also a new phenomenon that's blue light, the light from all our devices, especially at light, which tends to deteriorate our eyesight and overall health quality. So, these companies see themselves as merging up as a giant health vision company. And I think that's important because they will be able to, together, co-market products. They also have some synergies in their supply chains. So, that's the first thing you want to answer when you look at a merger like this -- is this just pooling a lot of assets together that won't grow faster than the industry in the long-run? Or does this have the potential for gains down the road? This deal certainly does.

Shen: I think what you described in terms of what might be considered the mission statement for these two companies, health vision companies, is really important. Long-term, I think the combined entity, which is going to be named EssilorLuxottica, it's a very strong position to benefit from some global tailwinds around healthcare for your vision, which includes, there's an aging population, there's growing needs for eyewear and health of your vision in emerging markets. And, I think both companies have been touting this number, basically an estimate that 2.5 billion people worldwide still grapple with vision problems of some kind, and their products, be it the lenses or the sunglasses or whatever it is, can come together and help address this issue, certainly a huge market.

Overall, for this combined entity, it will generate half of its revenue in the U.S., with Europe accounting for about one quarter and Africa, Asia, and the Middle East making up the remainder. Definitely a lot of opportunities, I think, for the company, not only in its more entrenched markets like the U.S. but in emerging markets as well.

Sharma: That's true. And what's really interesting in terms of how that market looks on paper, Luxottica has great brand presence in the U.S. and Europe as a maker of frames. So, if you take the demographics you were talking about, Vince, as people age in developed countries, they also have that disposable income to buy high-end frames, vanity frames, really. Essilor is very well-placed in emerging markets where there's a growing need for people to have corrected lenses and corrected vision. In places like the Middle East and Africa and Asia, that's really a limitless market for this combined company, which is something that I'm very excited about when you look at them together.

Some of the other things about this deal that are attractive from a financial standpoint are just the synergies involved. Since they don't have a lot of overlap, the companies can really dig into each others' strengths. I think they're shooting for a combined 400 to 600 million of cost savings annually. That translates to about $430 to $640 million per year on an annual run rate of about $16 billion. It's quite a savings just in the near-term. Another thing from a financial standpoint, which I really love, is that the combined EBITDA of this company -- that is earnings before interest, taxes, depreciation and amortization -- is going to be about $3.7 billion on that run rate that I was just speaking on. You may wonder, is this EBITDA supported by a lot of debt?

Oftentimes, the reason big companies merge is they're very leveraged on their balance sheet, and when you combine, you have the ability to refinance. But neither one of these companies is that leveraged. In fact, their combined pro forma balance sheet is going to show a net debt to EBITDA ratio of under one time. What that means is, if you take the relationship between debt on the books and earnings in one year, they're about equal. And that's a great position to be in. So, another reason to really be interested in this combined company.

I do have one complaint, though. I don't like this name. EssilorLuxottica. You know? That is really hard to pronounce. But, I'll return to that. Let's talk about some risks we might see in the deal. Do you want me to jump in with once, Vince, or do you want to grab the first risk that you see?

Shen: Before I get to the risks, which we can have as some of our takeaways for this topic, I think it's important to note that for the deal itself, with the combined entity, you've mentioned some of the numbers behind it. 140,000 employees, annual revenue of over $16 billion, EBITDA of nearly $4 billion. The name, which you are not quite happy with, I think makes sense in this case, since a lot of people were considering this a merger of equals. And even the management structure reflects that. Del Vecchio will serve as executive chairman and CEO of the company, while Essilor CEO Hubert Sagnires will hold the title of executive vice-chairman and deputy CEO of the new entity. And they're supposed to have equal powers. How that will work in terms of this co-CEO, co-leader structure, we'll see. I think some people have some concerns about that. But the board itself will have 16 members -- that will also see an equal split of nominations from the two companies. And this is an all-share deal. Luxottica shareholders will exchange their holdings for Essilor shares based on a ratio of 0.461 Essilor shares per one Luxottica share. Of course, Del Vecchio, his majority stake in Luxottica, which is about 62%, will need to go first, followed by the remaining outstanding shares at the same exchange ratio. Once the deal closes, Del Vecchio will own between 31% to 38% of the new entity.

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.