Kits Eyecare Ltd

TSX:KITS

Earnings Call Transcript 2021-Q2

[Operator]

Good afternoon, and welcome to the Kits Eyecare Second Quarter Results Conference Call. [Operator Instructions] This call is being recorded and available later for replay. Your host today are Kevin -- or sorry. Your host today are Roger Hardy, Chief Executive Officer; Sabrina Liak, Chief Financial Officer; and Joseph Thompson, COO. Before we begin, I am required to provide the following statement respecting forward-looking information, which is made on behalf of KITS and all of its representatives on this call. Certain statements made on this call will contain forward-looking information. These forward-looking statements generally can be identified by the use of words such as intend, believe, could, expect, estimate, forecast, may, would, will and other words of similar meaning. This forward-looking information is based on our opinions, estimates and assumptions in light of our experience and perception of historical trends, current conditions and expected future developments as well as other factors that we currently believe are appropriate and reasonable in the circumstances. Actual results could differ materially from a conclusion, forecast, expectation, belief or projection in the forward-looking information. Certain material factors and assumptions were applied in drawing a conclusion or making a forecast or projection as reflected in the forward-looking information. We caution investors not to rely on the forward-looking information. Additional information about the material factors that could cause actual results to differ materially from the conclusion, forecast or projection in the forward-looking information and material factors or assumptions that were applied in drawing conclusion or making a forecast or projection as reflected in the forward-looking information are contained in KITS' filings with Canadian Provincial Securities Regulators. During today's call, all figures are in Canadian dollars unless otherwise stated. And with that, I'd like to turn the call over to Mr. Roger Hardy, CEO. Please go ahead.

[Roger V. Hardy, Co]

Great. Thank you, and good afternoon. Thanks for taking the time to participate in today's call. I'm Roger Hardy, the company's CEO. Joining me today are Sabrina Liak, our CFO; and Joseph Thompson, our COO. Today, I'll discuss our second quarter 2021 results and share more broadly our vision for the category and some insights on the trends we are seeing in the sector. After my comments, we'll review more details on our financial results, followed by a business update and then we'll open the floor for questions. As the first half shows, our team focused on executing around the key pillars of growth of new patients and on building out our unique fulfillment abilities in the quarter. We gained significant traction in the first half by building a brand for the customers of today who no longer connects with brands built 50, 60 or 70 years ago and no longer feels the need to step into a retail or big box optical store. The secular trend that began a few years ago in health care is expanding to include eye care, and kids continue to take share in the category by being focused on delivering value, convenience and selection, all through state-of-the-art technology solutions designed with the consumer of today in mind. We are also benefiting from secular change in health care as patients migrate to the lower friction and better overall experience of online and direct purchasing across multiple health care categories. We believe we grew at more than 4x the contact lens category in the first half of the year, demonstrating our ability to continue to take share and at significantly higher rates in the category in our eyeglasses business, which continued to grow in both units and dollars. There are 3 primary pillars to our differentiated strategy. They all pick up on the most accretive trends over the last decade and the experience of the highest value creation across multiple categories. The 3 core pillars of our offering remains stable and intact, and our vision is unchanged. We want to build up the largest subscription business in the category. We believe this is a single greatest value creator in business over the last 20 years and are executing accordingly. Our Autoship subscription program allows us to predictably grow revenue as well as improve our cash flows, product and logistics costs through improved forecasting and purchasing. It also allows us to invest in more than just a transaction-oriented acquisition of patients, instead enabling us to more fully invest in the lifetime value of that customer to accelerated shipping, online vision tools and other bundled perks. In the quarter, Autoship patients generated an average 45% more revenue than a non-Autoship patient over the last 12 months. We continue to optimize our offering, and we are adding features to this program continuously as we work to deliver the best combination of value and service to our patients. The second most valuable and accretive thing companies have done over the past decade is to vertically integrate and to control their means and cost of production. Having invested over the past 3 years to build out our lab and differentiated fulfillment capabilities, we continue to invest in and expand our vertically integrated giga factory in the quarter, with the goal of having the highest quality, lowest cost onshore production lines completed. In addition, we broadened our specialty lens capabilities, and we now manufacture progressive, prescription sun and photochromatic lenses, all of which we believe add significant value to our patients. This enables us to serve the needs of patients with high-quality specialized products with incredible speed and care while simultaneously improving our revenue and margin profile. We believe there's tremendous value in having built out this complete vertically integrated eye care solution, allowing us to ensure the highest quality product reaches our patients. In Q2, we continued to post record eyeglass volumes as we delivered 43,000 pairs of eyeglasses and achieved a key milestone of shipping our 100,000 pair of eyeglasses. In addition, we passed more than 800,000 customers served. And even at this early stage in our glasses ramp-up, it's clear patients and consumers are attracted to our unique offering of premium quality, attractive prices and incredible convenience as reflected in the third-party customer ratings. Our final core strategic pillar is our view that the company with the highest NPS ultimately is a company with the highest value in a category. Customer ratings, which we keenly monitor and believe our key indicator of the value we deliver continue to climb as we invest in the customer experience. We benefit from a long history of positive reviews, which validates our offering to new customers and reflects our customers' loyalty. We're working hard to constantly improve our technology and vision tools and to enhance product selection, service and experience as we welcome a record number of new customers to our platform. As we've completed the buildout of our Autoship and eyeglasses businesses in the first half, we believe our business is well positioned for growth and opportunities ahead. The business plan for the year was always to enhance Autoship, build out our glasses lab and fulfillment center and secure a large base of initial customers who we believe will become advocates for our offering moving forward. Our company continues to demonstrate robust organic growth as we take share in the category despite slower category growth, and our strong balance sheet and large recurring vision customer annuity puts us in an excellent position to execute on our strategic plan for the back half of the year. Turning to Q2 results. Despite facing a big growth year-over-year comparison, I'm pleased to report that we achieved record quarterly revenue in the second quarter as we gained market share and attractive record new patients and customers and achieved record quarterly sales. Our growth in the quarter came despite weaker category results, which showed the category grew only low single digits for the first half of the year in North America. On a constant currency basis, we grew 16% year-over-year when adjusted for the effect of an appreciating Canadian dollar to $21.7 million. For the 6-month period ended June 30, revenue was $42.1 million, up 21.2% year-over-year and up 28.3% on a constant currency basis. Gross margins were 22% in Q2 as we simultaneously invested in acquiring new Autoship subscription customers and eyeglass customers through promotional activity, which resulted in record numbers of new customers. We expect less promotional activity through the balance of the year as we believe we have successfully started the eyeglasses flywheel, having achieved that foundational 100,000 eyeglasses customers faster than anyone in the category. In addition, with the build-out of our state-of-the-art optical laboratory, we are well equipped to introduce our contact lens customers to our world-class offering of higher value and higher-margin specialty products within eyewear. As we reduce the focus on promotional pricing to attract first-time customers, offer higher-margin products and as returning customers become a larger portion of our mix, we expect to see significantly higher margins in the back half of the year. We ended the first half with 800,000 active customers, a new high as we attracted record new patients to our platform of offerings. We are pleased to have ended this quarter with our Autoship subscriptions representing 20% of contact lens orders, up from just a few percent a year ago. We've continued to optimize our Autoship program this year versus our prior quarter as we made changes in the introductory offers to optimize both initial purchase activity and customer longevity. We continue to believe investing in acquiring customers on this recurring revenue model, differentiates us in the category and offers a clear view to the long-term value of acquired customers. We generated over 45% more in revenue per Autoship customer compared to our average non-Autoship contact lens customer in the last 12 months, and we anticipate that these numbers and these customers continue to return to long-term value and, over time, this will become more pronounced. Second quarter eyeglass orders also hit a new peak as we delivered 43,000 pairs of eyeglasses in the quarter and 84,000 pairs in the first half. We were pleased to see returning glasses customers starting to become a material piece of our business and look forward to updating shareholders in future quarters on this valuable segment. We are satisfied that our strategy of delivering the first 100,000 prescription eyeglasses to patients and customers to create a first wave of enthusiastic promoters of our brand is performing as expected, and we look forward to seeing this growth continue. We anticipate seeing marketing decline as a percent of sales as word-of-mouth and happy full-priced customers inspire friends and family to join our mission of changing the way the world buys eyewear. Delivered orders hit an all-time peak and were up 27% in Q2 compared to prior quarter, demonstrating our ability to acquire new patients for the first half of 2021, who we anticipate will return to predictably higher gross margins in future quarters. With that, I will turn the call over to Sabrina. Sabrina?

[Sabrina Liak, Co]

Thanks, Roger. Second quarter revenue was $21.7 million, up 7% against the challenging backdrop of a strong comparable period in 2Q '20 during the peak of COVID, especially as during the second quarter of 2021, much of the U.S. and Canada began to reopen. On a constant currency basis, we grew 16% year-over-year when adjusted for the effects of an appreciating Canadian dollar. For the 6-month period ended June 30, revenue was $42.1 million, up 21.2% year-over-year and up 28% on a constant currency basis. Gross margin was 21.6% in the second quarter compared to 24% last quarter. Gross margins fell in 2Q as we focused on acquiring a record number of new customers who we believe will become long-term customers and generate recurring annuity-like revenue. The decrease was driven by introductory offers engineered to attracting new customers to join our subscription Autoship program and to purchase glasses for the first time. We continue to view this investment in building our glasses business and the transition from transactional to subscription revenues to be accretive to shareholders and the company in the long term. We believe the best use of capital to acquire new glasses and subscription customers now as customers are changing their traditional buying behaviors. We maintain our belief that near-term margins will rise to 25% to 30%, and our goal is to generate long-term margins above 35% as our glasses business and returning Autoship customers become a larger portion of total revenue. As planned, marketing expenses increased by $2.1 million to $4.3 million in the second quarter compared to the second quarter. We use the proceeds earmarked in the IPO to invest in acquiring customers, upper funnel activities and building brand assets. This investment drove delivered orders to hit an all-time peak and were up 27% in 2Q '21 compared to the prior year, and the first half of 2021 was up 45% compared to the first half of 2020. The difference between our revenue growth and customer growth reflects the change in foreign exchange rates and our initial introductory offers. And we expect that, over time, the difference will decline as our customers return to expand our higher-margin offerings. We expect to continue to down on our marketing expense as a percentage of revenues in the second half of the year now that key investments have been made, as demonstrated by our rapidly growing customer mix. I will now pass it to Joe to discuss our operations.

[Joseph Thompson, Co]

Thanks, Sabrina. I'll provide an update on our progress in the quarter, building out our expanded vertically integrated manufacturing and fulfillment footprint, 2 key differentiators that will continue to fuel our growth. In Q2, our automated lens lab and fulfillment center delivered 178,000 orders to patients across North America, an increase of 27% year-on-year, including 43,000 eyeglass orders. In addition to this, we have meaningfully expanded our manufacturing lab and fulfillment footprint to meet the pull-forward of demand and future growth.In Q2, we also expanded our premium lens offering with a full line of digital progressive lenses, Sun Rx lenses and coatings, now produced in our lab. In addition to automated lens surfacing, in the second half of 2021, we will further expand from 2 production lines to 4 production lines for prescription lenses, providing us the ability to produce 4,000 made-to-order prescription glasses per day. At the end of Q2, we also completed and launched our flagship retail location right here at KITS Beach. We are building a platform and infrastructure to support multiple years of growth. We have continued to expand our staff at our distribution centers as well as in manufacturing and customer service to meet the increase in our patient orders and to support our expansion to a larger facility, which was completed in July 2021. we continue to automate and optimize our consolidated city art manufacturing and distribution center, and we expect to continue bringing more automation to the fulfillment operations in the second half of 2021. The impact of this investment will be seen on our P&L in fulfillment and general and administrative expenses as we expand our state-of-the-art optical lab. Our spend in the first half of 2021 was consistent with our planned use of proceeds outlined during our IPO.

[Roger V. Hardy, Co]

As we think about the financial outlook for 2021 and with the backdrop of the category growth at about 1 -- between 1% and 4% in the first half of 2021, we wanted to share this financial outlook. Revenue drivers are now in place, and we expect 2022 revenue of approximately CAD 115 million to CAD 125 million. Gross profit bottomed in this Q with customer acquisition and expected to trend back above 30% in 2022. Operating expenses are improving in the second half '21, which will drive operating leverage. Adjusted EBITDA margins, we expect to turn positive in late '21 and early '22 and beyond. And finally, we continue to build a strong foundation for future free cash flow generation so that we can control our destiny moving forward. Finally, we're now 16 months into a global pandemic and what's clear to us is that in this time, our industry has changed for good. Customer expectations for value and convenience in eye care have increased dramatically, and we continue to raise the bar to meet their needs. Thank you all to all of our committed KITS' teammates, our shareholders and our rapidly growing KITS' customer base. We're excited to serve you in the months and the years ahead. This concludes our prepared remarks. Operator, please open the line for questions.

[Operator]

[Operator Instructions] And your first question comes from George Doumet from Scotiabank.

[George Doumet, Analyst]

Roger, you did mention a slowdown in the category. You mentioned 1% to 4% growth. I'm just wondering what happened there. Is that just the reopen? Or presumably, there must be other things. Can you maybe give us a little bit of color there?

[Roger V. Hardy, Co]

Yes. It's -- I think the color is that, as you said, with the reopen, I don't -- we have not seen as many people going in and getting their first pair of contacts, and we haven't seen the category kind of come out of the COVID situation. So I think category-wise, depending on which read you take, it's somewhere between 1% and 4%. Having said that, we feel good about the 16% growth rate we achieved in the Q. It tells us that we are at taking fairly significant share in the Q, and again, as Sabrina touched on in a quarter that's year-on-year, probably the peak of COVID last year. So we're continuing to acquire customers. I think if we're acquiring the 4x the rate of category, we'd love to see the category get back up to 8% or 10% growth rate and then maintain that type of multiple on the category. So we're like everybody looking forward to improve, but we're also satisfied with our acquisitions during this kind of somewhat slower period than forecasted.

[George Doumet, Analyst]

Okay. And shifting to the sales guidance. I noticed that it's for 2022. Presumably to get there, you guys must have a number or visibility for this year. I was just wondering if you can share that number with us or maybe help us getting there?

[Roger V. Hardy, Co]

I think probably the best way to look at it, George, is to look at orders up 27% in the Q as a leading indicator to how we're going to get there. We're seeing, I think, consistent, steady growth rates in new acquisitions. And as we touched on, those tend to be at a lower initial price, initial gross margin. But those are the leading indicator. As you know, we see our customers acquired as a valuable annuity stream. We know the revenues that they produce over time. And so that acquisition gives us good confidence around that these customers will return. We've acquired them. They will return, and yes, so that's kind of the bridge. I mean we're through the first half. We haven't given any guidance for the back half year yet, predominantly because the category is still moving around. So we've based it on kind of the existing category growth internally, and that's where that forecast is today.

[George Doumet, Analyst]

Okay. And maybe one last one for me. Sabrina, I think you guys -- you put out a 25 -- sorry, 250,000 pair of glasses target for this year. I think I got a good sense as to why. I mean the category did slow down, but can you maybe update us with a new number or maybe a revised number that you guys are planning to get maybe in the back half?

[Roger V. Hardy, Co]

We haven't put that number out at this moment. So I think we're happy with the guidance we've put out, and we're especially excited about passing that 100,000 initial customer glasses number. I think passing that number creates for us the first 100,000 billboards in the category telling the KITS story. So that's going to help us drive that number, George, in the back half. And we'll be looking to improve on where we are today.

[Operator]

Your next question comes from Matt Koranda from ROTH Capital.

[Matthew Butler Koranda, MD & Senior Research Analyst]

Just wondered if you could speak to the gross margins in 2Q. I know you called out sort of discounting and contacts and glasses as creating a drag. But is there also any drag from supply chain in terms of increased cost of goods, sourcing and the freight? Maybe you could disentangle those for us?

[Roger V. Hardy, Co]

Yes. Sure. I'll kick off on the acquisition front, I would really think of gross margins, again, as we talked about in the past, is kind of 3 or 4 buckets. And when we think of the buckets, the customers that come to our site, the customers that are existing customers, customers that come in through paid channels and others and then Autoship customers. So we've got a really tight read on all of those buckets. It's the acquisition bucket that's been driving our gross margins to lower numbers. And as we said, the focus was on getting that base of 100,000 eyeglasses customers at a significant discount to what we think the market price is. So that's kind of what's led to driving gross margins down. Having said that, we do have fairly tight control on that, and it's essentially a variable cost to give that promotional discount to acquire those customers. And I think refreshingly, we're starting to see some of those initial customers now coming back at higher average order volumes and at higher prices, higher margins. So we're getting some good comfort around the predictability of those initial customers coming back. And to be quite frank, our offering has gotten better and better since the time of those acquisitions, so we believe that will continue to strengthen through the back half. And 2022, we'll see a lot of those customers returning. Joe, did you want to touch on any [ of the question? ] Yes. I mean just a few, Matt, on supply chain side. For sure, there have been disruptions and interruptions related to COVID. I think as a management group, we decided not to kind of call out some of the shipping time slowdowns and other things and take it on ourselves to make sure that we unpack and identify obstacles and hurdles coming at us in advance of them affecting our business and not rely on that as a reason for some of the costs going up. So we pulled forward some of the fulfillment costs to make sure we can deal with the growing demand. We pulled forward on inventory a little bit to make sure we've got the inventory in place to deal with the customer demand growth. And so I think that's how we're thinking about is to make sure we've got in stock the right products that our customers will need going forward and in a timely and cost-effective basis.

[Matthew Butler Koranda, MD & Senior Research Analyst]

Okay. That's great. Wanted to touch on the 2022 guidance here, maybe attack it from a different angle. So is it -- I guess, are you -- is the signal you're trying to send that you've got increased visibility into 2022, just given the level of ownership customers that you've converted? I wanted to get your sense on that and maybe if you could quantify that in terms of percent of revenue coming towards maybe in 2Q or what you expect for 2021, that would be helpful. And then is it a linear path to the 2022 target sort of the assumption here? Is that what we should be kind of directing out? Or is it going to be a little bit more of a step function up in '22?

[Roger V. Hardy, Co]

Do you want to answer that? Or do you want me to hit on that?

[Sabrina Liak, Co]

Sorry, you were breaking up a little bit, Matt. I think I got your question as what is the percentage of Autoship today, which is, it's roughly 20% of contact lens revenues. We are targeting to get that to 30% for 2022. So yes, part of it is visibility around our repeat business, which is the second quarter was 66% of our revenues came from repeat customers. And then I did not quite catch the second piece of your question.

[Matthew Butler Koranda, MD & Senior Research Analyst]

The other piece was just -- should we assume a linear path to 2022 as we kind of model out '21? Or is it more a step function up as we hit '22?

[Sabrina Liak, Co]

I would say it would be linear but for some acceleration due to the word-of-mouth. And some of the momentum that Roger's touched on, we're starting to see more vividly. And I think the other piece of it is Black Friday has historically been a big sales day as it is for most people in retail. So I think that would be -- those would be the 2 exceptions.

[Matthew Butler Koranda, MD & Senior Research Analyst]

Okay. And then last one for me. Just in terms of glasses, just wondering if you could touch on ASPs there. With the new lens capabilities, I'd assume it's higher, but there's obviously some discounting at play here. I just want to get your sense for the, I guess, the puts and takes there.

[Roger V. Hardy, Co]

Yes. And I think we don't want to give away all the secret sauce of what we've been thinking from an acquisition and retention standpoint in glasses. But I think suffice to say, that's the biggest piece impacting gross margin in the Q is around first-time glasses orders. I think the comfort as a management group we're taking from the reduced gross margin in glasses is that we're seeing also that returning glasses customer coming in, that referral from friends and family coming in at often gross margins, they're in the 40% to 50% range. So we're seeing, albeit, obviously, a very small mix in there today. But those customers, we're starting to see coming in, and that's giving us good comfort around kind of where margins are going from here.

[Operator]

Your next question comes from Derek Dley from Canaccord Genuity.

[Derek Dley, MD & Consumer Products Analyst]

So I just wanted to talk about the glasses production. I mean if you look at the math on this quarter, it's about just over 475 pairs of glasses per day. And you guys are ramping up to 4,000, I believe, by Q4. So can you just like talk about the ramp-up to this and why you feel that incremental capacity is needed?

[Roger V. Hardy, Co]

Yes, Derek. So I think we've seen historically that one of the impediments to growing this out has been the lab capacity. It takes a significant amount of time to put that capacity in place. As we said, we started building this lab 3 years ago. This will give us a little extra capacity. We have, like we said, pulled forward -- we pulled forward some of the cost and expense to make sure we've built this out. Having said that, we're going from initially at the start of this year, having an East Coast distribution facility, which we've now closed, having a West Coast facility that's now -- we've moved out of and into a third facility. So we'll see fulfillment start to come down as these -- as we come back to Q4 having 1 fulfillment center. So really going from 3 to 1 in the year, including the complexity of kind of a couple of moves in there. So -- but back to your point on building out the capacity, we've seen that it can be lumpy in terms of orders and acquisitions. So when we do things like, we've done some larger customer acquisition things like the Super Bowl, we want to make sure that we can ensure a tier 1 service, a wow service for customers. When they come in today, we want to be able to fulfill those orders in a timely way. And our expectation is that we're going to see significant growth in our glasses business next year and that this is the right number from a capacity standpoint. Could we be slightly ahead on capacity in Q4? Yes, but I think our view is better to be ahead on capacity in Q4 than behind at some point next year. And so that's how we're thinking about it. I can get our management team focused on other things to have that capacity in place. I guess the last piece is, we talked about the fulfilled by KITS offerings and the discussions we're having there. Our view is that, that could be a real catalyst for growth plugging in any one of the many, many telehealth companies that are out there with largely undifferentiated offerings, competing in a very commodity space, very few of which could manage the complexity of adding this in eyeglasses, fulfillment centers, the lab, the prescription verification required, all the parts that keep this business fairly complex and keep others out of it. So we're making sure we build those pieces in so that when we plug-in the fulfilled by KITS kind of B2B offering that we can really step up the order volume. So all those things remain things that we're working on and that we hope to be able to report on in due course.

[Derek Dley, MD & Consumer Products Analyst]

Yes. And that fulfilled by KITS seems like a really interesting initiative. So I guess the follow-on question would be a 2-part question. So one, when you think about the fulfilled by KITS, would that likely come in at a lower margin rate than retail? And then two, what percentage of your sales, if you can disclose, are KITS-branded? I'm speaking for the eyeglass here because I get the contact is mostly third-party. So what percentage of your sales are on the eyeglass side are KITS-branded? And what is the margin differential when it's private label versus third party?

[Joseph Thompson, Co]

Sure. Derek, this is Joe. Just tackling your questions one by one. So on Fulfillment by KITS, we do expect that to be comparable or higher from a revenue standpoint. We -- there's a number of different parts to the infrastructure and optical that we're building a state-of-the-art manufacturing optical lab, including full surfacing and edging capabilities that's attached to a state-of-the-art fulfillment center, where we can deliver virtually any product in the industry to customers in as soon as 1 to 2 business days anywhere in North America. And so those 2 capabilities, we've had a number of interested parties reach out to see if they could plug into the software, the manufacturing capabilities and the fulfillment network. And so we're excited to take those potential partnerships further and look forward to updating everyone on Fulfillment by KITS in the quarters to come. Your second question, just the percentage of KITS glasses as opposed to brand name glasses like -- that we offer the full selection on KITS, everything from Tom Ford to Gucci to Rayban to beyond, what we are seeing is that greater than 50% of customers that are transacting are choosing KITS-branded glasses. And there are a number of customers who are interested in brand named glasses, and we're happy to fulfill those as well because no matter which brands you buy, you're still getting the KITS manufacturing. It's our lens that goes into the glass, into the frame, and you're still getting our fulfillment network so that we can get those glasses to you within a day or 2. But we are seeing greater than 50% currently on KITS.

[Operator]

There are no further questions at this time. Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.