Kits Eyecare Ltd

TSX:KITS

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

Good morning, and welcome to the Kits Eyecare Third Quarter 2023 Financial Results Conference Call. This call is being recorded and available later today for replay. Their host today are Roger Hardy, Chief Executive Officer; Sabrina Liak, Chief Financial Officer; and Joseph Thompson, Chief Operating Officer.

Before we begin, I'm 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 management's opinions, estimates and assumptions in light of their experience and perception of historical trends, current conditions and expected future developments as well as factors that they currently believe are appropriate and reasonable in the circumstances. Actual results could differ materially from a conclusion, forecast, expectations, beliefs or projections 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. Management cautions 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 a conclusion or making a forecast or projection as reflected in the forward-looking information are contained in the Kits filings with Canadian Provincial Security Regulators.

During today's call, all figures are in Canadian dollars, unless otherwise add. And with that, I'd like to turn the call over to Roger Hardy. Please go ahead.

[Roger Hardy, executive]

Thank you, operator, and good morning, everyone. Thanks for joining us. I'm excited to be reporting yet another impressive quarter here at Kits as we continue to make eye care easy for everyone. The vision category remained resilient and nondiscretionary, and we grew our revenue a category leading 32% year-over-year to a record $31.2 million, while expanding our gross margins by 370 basis points year-over-year, all while seeing our operating costs as a percent of revenue decline year-over-year across the board. This resulted in reporting a positive bottom line, growing our adjusted EBITDA by $1.4 million year-over-year, our fourth straight quarter of positive adjusted EBITDA.

We're seeing operational leverage from the scale we invested in early on as we generated another consecutive quarter free cash flow from operations and maintained a healthy cash balance. We've built our infrastructure to scale and we believe we have ample capacity to more than double revenues and earnings with limited to no CapEx required from here.

We hit another record in our 2-year active customer count of over 830,000 and we served over 75,000 new customers in the third quarter. We continue to accomplish significant customer growth with a highly efficient marketing platform that is becoming a smaller expense as a percent of our overall sales numbers. It's clear we're beginning to see the network effect of customers telling customers about the experience they have had with kits, and that is starting to show through in both marketing efficiency and customer retention. As we've now hit an annualized revenue run rate close to $125 million, we believe we're well positioned to continue growing while expanding growth, both our gross and operating margins.

Our offering is continuing to resonate with our customers, and we've been able to attract more and more of them quarter after quarter while also increasing the average order value. And we are also seeing a growing record number of returning customers. This is not an easy thing to do, particularly in such a volatile economy, but it's hard to ignore the substantially higher value we provide compared to the rest of the optical industry. We believe this is a major driver behind our success and with our word-of-mouth marketing, we don't see it slowing down anytime soon.

We also believe there's a great amount of capacity in the model we have built in terms of scale and leverage, which we are only beginning to see in this quarter. With that, I'd like to pass the call over to Joe to dive into more detail on our operational performance for the third quarter. Joe?

[Joseph Thompson, executive]

Thanks, Roger. We set out to build a business with consistent growth fueled by happy returning customers in an operation that gets more efficient each quarter as we grow. We are happy with the progress we've made this year and this quarter in particular. Let's start with returning customers. Our North Star metric and a good read on the quality of the product value selection and convenience we provide. In Q3, we delivered record revenue from repeat customers approximately $20 million or 64% of our total revenue. This contributed to both a higher average order value and also helped improve our gross margin. In this category, customers who require vision correction typically remain optical customers for life. And so earning their repeat business is the best investment we can make. As we grow, we believe our scale will continue to make our business more profitable.

With our growth in Q3 came leverage with combined operational expenses across marketing, fulfillment and G&A declining 380 basis points versus Q3 2022. Our infrastructure isn't burdened by tens or hundreds of brick-and-mortar locations and all of the associated labor costs and overhead that these locations require. Importantly, our onshore lens lab and fulfillment center still has ample capacity to allow us to scale north of $200 million in revenue.

Lastly, the team continues to innovate and build future pillars of growth. Two areas that have been a particularly focus have been our product and our specialty lens offering. Our product team really raised the bar this quarter, introducing new premium product lines, including the titanium rimless collection, the layered acetate collection and an extension of our athletic performance trailblazer platform. Kits customers can now select from a growing selection of over 1,950 styles of eyeglasses.

On specialty lenses, our investment in innovation in digital progressives has really taken off. Digital progressives are now the fastest-growing part of our glasses business with revenue up over 60% year-on-year. To prepare for future growth in this important area, we've expanded our digital progressive manufacturing capacity. Thanks to our previous investment in a full servicing and coating operation, a modest capital investment allowed us to add significant capacity and to do it quickly. We fundamentally changed the value proposition for digital progressives across North America, and we believe the expanded capacity will allow us to further capture this exciting growth opportunity.

We expect the expanded capacity to be fully operational by the end of the year. Overall, Kits is humming from an operational perspective. We are seeing the early signs of the operational leverage that we predicted when we embarked on this journey over 4 years ago. with ample market share still up for grabs and the customer landscape shifting in our direction, we believe we are well positioned to continue capitalizing on the momentum in hand and deliver long-term shareholder value through our operational excellence. I'll now turn the call over to Sabrina for an overview of our third quarter financial results.

[Sabrina Liak, executive]

Thanks, Joe. We are pleased with all the progress we made in the third quarter. Revenue in the third quarter increased 32% to $31.2 million compared to $23.6 million in the prior year period. The increase was attributable to strong repeat customer behavior in both contact lenses and eyeglasses as well as higher average order value.

Gross profit in the third quarter increased 48% to $10.7 million compared to $7.2 million in the year ago period, while gross margin increased 370 basis points to a record 34.3% compared to 30.6% in the year ago period. The increase in gross margin is due to a reduction in promotions into capturing improved margins from returning customers.

Looking at the breakdown of our operating expenses, our fulfillment expenses as a percentage of revenue declined year-over-year by 80 basis points to 12.6%. Our G&A as a percentage of revenue declined year-over-year by 250 basis points to 6.5% as we continue to leverage efficiencies of scale.

Our marketing expenses as a percentage of revenue also declined year-over-year by 50 basis points to 13.7% as we continue to capitalize on organic word-of-mouth brand awareness.

In the third quarter, net income was $0.5 million or $0.02 per share. EBITDA was positive $1.4 million compared to a positive $1.1 million in the prior year period, and we generated positive adjusted EBITDA of $0.6 million compared to negative adjusted EBITDA of $0.8 million in the prior year period. We ended the quarter with a strong cash balance of $19.3 million.

Overall, Kits is in a strong financial position to further capture operating leverage as we continue our growth with a long runway for growth ahead of us, a healthy balance sheet and the ability to generate positive free cash flow, we plan to continue long term -- continue delivering long-term value to all our stakeholders. I'll now turn the floor over to questions. Operator?

[Operator]

[Operator Instructions] Your first question comes from the line of Luke Hannan from Canaccord Genuity.

[Luke Hannan, analyst]

I wanted to start on the topic of progressive. I think I heard you mentioned that the revenue from that product line in particular, was up 60% year-over-year. Can you give us a sense today of where that penetration as a percentage of maybe your overall mix, overall revenues? And what would be an appropriate long-term level for you? I believe the industry benchmark is around 40%, but considering your infrastructure, do you think it's reasonable to assume that maybe you could over-index on that particular category?

[Joseph Thompson, executive]

Luke, thanks for the question. This is Joe. So you're right on your size of the digital progressive market around -- it represents around 40% of the dollars in the category. With Kits, we are still below that. And as you mentioned, growing pretty rapidly. And so we've upgraded our manufacturing to prepare for further growth in this area. It's probably a bit too soon to say how high is up on the business, but we have been delighted with the growth. And we really feel like we are changing the value equation in this category.

Typically, digital progressive can cost customers $800 to $1,000 and more. And customers on kits.com or kits.ca can buy digital progressives for under $200 and in some cases, under $100. And so we think that, that value equation is really going to shake up the digital progressive market. Probably too soon to say how high is up. But we're very excited about the momentum in this last quarter.

[Luke Hannan, analyst]

Okay. And then my follow-up here is just on your outlook for the holiday season, if we could compare and contrast what you're seeing so far in the quarter-to-date versus maybe what we saw last year or even pre-pandemic. What are you seeing as far as ordering patterns. For example, are customers ordering more closely to their needs or more closely to mid- to late December? Or is it historically in line or in line with what you've seen historically?

[Roger Hardy, executive]

Yes, Luke. We've -- typically, the eyeglasses industry has seen a repeat cycle of 18 to 24 months. And that's not really because that's magically the time when everyone's prescription changes, but that's -- but on average, folks have around $300 to $400 of vision insurance that renews every 2 years. And in a striking coincidence, that happens to be what pair of prescription glasses has cost in the past.

But with -- when you think about the Kits model, our vertically integrated process and the waste we've eliminated from the system we're able to offer prescription eyeglasses, even progressive, as you mentioned, for under $100. And so that's really allowed us to shorten the repeat cycle to under 12 months and in some cases, even sooner. So I can't really speak for the industry trend. But in our business, repeat glasses sales cycle has been speeding up.

[Luke Hannan, analyst]

Got it. And then maybe my last question here, and then I'll pass it on is overall from -- clearly, we've seen the macroeconomic environment soften a little bit over the course of the last several months. What are you seeing from your competitors as far as the promotional environment right now?

[Joseph Thompson, executive]

Yes, Luke, this is Joe again. So there's 2 trends that we're seeing in the category that do have an impact on our business. The first is the percentage of revenue that continues to move online. So pre-pandemic, under 20% of contact lenses were sold online and under 10% of glasses were sold online. And now the latest numbers that we've seen have contact lenses approaching 40% online and glasses approaching 20% and really showing no signs of slowing down.

So as you suggest, there likely will be pockets of this industry that see the effects of the economy. But -- but where we are sitting in this growth vector of online, it seems to insulate us from any of the pullback that we're seeing in the marketplace. And so we see no slowdown in share moving online. And as a result, we've been less reliant as the team called out on promotions in the past quarter than we have previously.

Maybe the second factor that in the market that impacts our category that's maybe a bit more unique versus other categories is insurance. So the optical market is anchored to a degree by vision insurance, which provides hundreds of dollars of vision coverage per person or higher. And so this is a bit of an advantage to optical versus other categories. And our focus is really just on providing a selection to allow all customers to meet their vision needs within their coverage or within their budget. And so those are really the trends we've been closest to and paying the most attention to. And -- and we're happy with the business model and the infrastructure that we've built to allow us to capitalize on both.

[Operator]

Your next question comes from the line of Matt Koranda from ROTH.

[Matt Koranda, analyst]

Just wondered if we could speak to some of the AOV drivers and unpack those during the quarter. AOVs continue to rise pretty significantly. And I assume a pretty strong driver of that growth would be repeat customers probably helping with that metric. But just wondering if there's other elements at play here like contact pricing. Anything else you can speak to in terms of AOV drivers that would help us kind of think about the sustainability of that as a driver of growth on a go-forward basis?

[Joseph Thompson, executive]

Matt, it's Joe. And as you mentioned, we did see average order value come up this quarter. It was up to about $156 per transaction. That's up about 15% year-on-year. We did see growth across both contact lenses and eyeglasses approximately comparable. I think you're right to call out repeat customers is a driver. Typically, when customers have had a great first experience with Kits, when they return, they're more likely to purchase more. And that's really been a driver of it. The other driver has been, we talked a few minutes ago just about digital progressives and specialty lenses. That's an area that's grown. We had seen growth in that in specialty lenses, and it's picked up even above our expectations. And so that's been a driver as well. I'd probably call out that average order value will fluctuate a little quarter-on-quarter. And this past quarter, as you mentioned, in particular, did have a strong mix of repeat customers.

[Matt Koranda, analyst]

Okay. Makes a lot of sense. And then just you've been outgrowing the industry by a pretty healthy margin for the last several quarters. Just wondered if you could maybe speak to sort of -- is there any change in the trends that would cause you guys to not continue to outgrow the industry by the healthy margin that you've been outgrowing it by over the last several quarters?

[Joseph Thompson, executive]

Yes. Thanks, Matt. We -- of course, I'll mention, we aren't providing any guidance at this point, but happy to share how we're seeing the market and how we're thinking about it. We don't see anything on the horizon that would indicate a slowdown. The macro trends continue to seem to be in our favor.

We're happy with the operations and we feel like we have the operations and team in place and have a good, consistent track record in 2022 and 2023 of growth. Each quarter is a little different. And so on a quarter-by-quarter basis, we would expect to see a little fluctuation in the growth levels. But we don't have any plans to slow down. And so you can expect to continue to see growth focus from us over towards our next revenue target of $200 million in revenue and then onwards from there.

[Matt Koranda, analyst]

Okay. Great. And then maybe just last 1 for me. The adjusted EBITDA margin continues to kind of hover in this low single-digit percentage range. So it's nice to see sort of the sustainability there. Wondering how we should think about the next steps toward your long-term adjusted EBITDA targets? And can you just remind us sort of what those are and how we should think about sort of the path to those over the next year or 2 years, however you want to frame it?

[Roger Hardy, executive]

Yes, Matt. I think as Joe said, we feel like we've got a lot of momentum right now. There's a lot of momentum in taking share. We're pleased with how the business is running. We don't have -- we feel good about not being in a position with a lot of legacy infrastructure, lots of legacy costs. We are with the single-digit EBITDA percentage as we continue to take share and grow. We feel like there's a lot of leverage in the model to keep growing. And you saw some efficiency start to flow through to EBITDA and to net income. I would say our focus is on serving customers on making eye care easy for customers. And to the extent we're able to do that and continue to do that, our business will continue to grow. One of the biggest.

I think, points of leverage we start to see is this is the network effect of -- in towns and cities when we're acquiring thousands of glasses customers who all start to see the brand on others and become these billboards for Kits, telling the story of a great eye care experience. So I think those are the things we're focused on. The model is playing out, I think, fairly predictably. So over the next couple of quarters, we'll continue to see growth. We'll continue to become more and more efficient. Our operation has tremendous capacity to scale from here, at least we could at least double with very limited CapEx, like we've said a few times.

So to the extent we're able to grow the business, we'll start to see that bottom line continue to scale. And I think just to add on to what Joe said. We've had the benefit of building this model from the ground up exactly for the time we're in right now. So we are -- we're happy with where we sit relative to competitors. You asked about competitors. I think we're not focused on competitors. We're focused on serving customers, and we really do think that we've got the best model in the category. So we'll keep working away at it. Anything I missed, Sabrina?

[Sabrina Liak, executive]

No. I would just say we're putting in cash flow from organic growth, and we think that that's the best use of our capital at this time to invest and continuing to grow our business. And as you see, we've been able to strong cash balance throughout this outsized growth. So I think that would be our objective going forward also.

[Operator]

Your next question comes from the line of Doug Cooper from Beacon Securities.

[Doug Cooper, analyst]

Congratulations on a nice quarter. First of all, just a clarification, the 60% returning customers, is that both on the contacts and glasses on a consolidated basis?

[Joseph Thompson, executive]

Doug, that's a combined -- the percentage of total revenue, including both glasses and contact lens business that comes from repeat customers.

[Matt Koranda, analyst]

And is it sort of equally split between the 2? Are they both 60% in other words? Or is it more on the contract side?

[Joseph Thompson, executive]

Yes. We don't -- Doug, we don't break out the specifics of it. Our contact lens business around a little bit longer and so is probably a little bit more mature and our glasses business is a newer one.

[Doug Cooper, analyst]

So we saw some good growth in the glasses business, just under $4 million for the quarter up obviously nicely from just over $3 million last year. Do you see this just continue to be incremental growth? Or is it some point, Roger's point of friends tell 2 friends tell 2 friends that this does sort of will see a really big inflection point in some quarter here in the future.

[Roger Hardy, executive]

Yes, Doug, I mean, when we think about the glasses business, we just think it's so early today. And you're right. I mean, as we start to get that critical mass in markets, we really see that referenceability from 1 customer to another take effect. We see the marketing expense start to go away and we see the effect of customers telling customers.

So I would say, in a very small number of markets that started to occur. And that's 1 of the beauties of this category. It's just how big it is, how many markets there are, how big the opportunity is. And so we're working away on getting that referenceability, getting that network effect in a small number of markets, like literally a couple. And once we see that lift, we think that we'll be able to replicate that in many more markets. So I think our view is that it is early and that it does start to -- it's just so early, but it's -- we will start to see the effects of that growth compound.

[Doug Cooper, analyst]

So speaking of markets, just take either from Q1 or Q2. Most of the growth has been in Canada. Is that by design? Or is there anything we should read into that?

[Roger Hardy, executive]

I think like I said, we're focused on a couple of markets and getting that kind of network effect spinning. I think Canada has been probably just because we are in Vancouver and because we're located here that it's been -- the market has been receptive to the offering. But no, I wouldn't take anything away from that other than that we are probably underrepresented in Canada historically. And so we've, I think, it hasn't been much of a more of a push or anything like that. It's just that the offer is well received in Canada. It's well received in the U.S. Yes, there's no, I think, we're probably more that we were underpenetrated in Canada, Doug, and it's kind of -- the growth has been pretty straightforward here.

[Doug Cooper, analyst]

Okay. Just my last one. Any comments on LVMH moving into the glasses category. I think they announced that on Monday through an acquisition in L.A. And 1 of the things I talked about was glasses becoming a more and more of a fashion accessory. So maybe that speaks to Joe, your point about returning customers, especially at that cost point you're talking about, it can really become more a fashion item.

[Roger Hardy, executive]

Yes, Doug. No question we're seeing a small number of customers that are really breaking the trend. And as Joe touched on, many times in optical customers will buy 1 pair of glasses every 18 months. We're seeing customers buying many, many pairs of glasses from us. And so I think it's obvious with a cohort that that's happening. And our hope is that as we make things easier consumption goes up, make them more cost-effective, consumption goes up. So I'd say that's really the focus on our side. Making eye care easy is really what we've been about, and I think that's resonating with consumers.

[Operator]

[Operator Instructions]

[Roger Hardy, executive]

Yes. Thank you, operator. Thanks, everyone, for joining today. It's once again an exciting time to be a part of team Kits. This team is 1, filled with great intangibles that you see in companies that do great things while achieving outstanding results. I've said it many times, we're on a mission to make eye care easy for everyone. I firmly believe we're accomplishing that with every passing quarter. We believe we're just starting to hit our stride and starting to see the network effects take hold. I'd like to thank all our stakeholders for their continued support. Thanks so much for joining us today, and have a great rest of the day. Thanks, operator.

[Operator]

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.