National Vision Holdings, Inc. - Quarter Report: 2020 March (Form 10-Q)

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the scale and scope of the novel coronavirus, or COVID-19, pandemic is unknown and, due to the temporary closure of our stores to the public and other factors, is adversely impacting, and is expected to continue to adversely impact, our business at least for the near term, including the impact of federal, state, and local governmental actions and customer behavior in response to the pandemic and such governmental actions and operational disruptions if a significant percentage of our workforce is unable to work or we experience labor shortages, including because of illness or travel or government restrictions in connection with the pandemic;

•	our ability to selectively re-open stores as announced and to open and operate new stores in a timely and cost-effective manner, and to successfully enter new markets;

•	our ability to recruit and retain vision care professionals for our stores;

•	our ability to develop and maintain relationships with managed vision care companies, vision insurance providers and other third-party payors;

•	our ability to maintain the performance of our host and legacy brands and our current operating relationships with our host and legacy partners;

•	our ability to adhere to extensive state, local and federal vision care and healthcare laws and regulations;

•	our compliance with managed vision care laws and regulations;

•	our ability to maintain sufficient levels of cash flow from our operations to execute or sustain our growth strategy;

•	the loss of, or disruption in the operations of, one or more of our distribution centers and/or optical laboratories, resulting in the inability to fulfill customer orders and deliver our products in a timely manner;

•	risks associated with vendors from whom our products are sourced, including our dependence on a limited number of suppliers;

•	our ability to successfully compete in the highly competitive optical retail industry;

•	any failure, inadequacy, interruption, security failure or breach of our information technology systems;

•	our growth strategy straining our existing resources and causing the performance of our existing stores to suffer;

•	the impact of wage rate increases, inflation, cost increases and increases in raw material prices and energy prices;

•	our ability to successfully implement our marketing, advertising and promotional efforts;

•	risks associated with leasing substantial amounts of space, including future increases in occupancy costs;

•	the impact of certain technological advances, and the greater availability of, or increased consumer preferences for, vision correction alternatives to prescription eyeglasses or contact lenses, and future drug development for the correction of vision-related problems;

•	our ability to retain our existing senior management team and attract qualified new personnel;

•	overall decline in the health of the economy and consumer spending affecting consumer purchases;

•	our ability to manage our inventory balances and inventory shrinkage;

•	seasonal fluctuations in our operating results and inventory levels;

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•	our reliance on third-party coverage and reimbursement, including government programs, for an increasing portion of our revenues;

•	risks associated with our e-commerce business;

•	product liability, product recall or personal injury issues;

•	our failure to comply with, or changes in, laws, regulations, enforcement activities and other requirements;

•	the impact of any adverse litigation judgments or settlements resulting from legal proceedings relating to our business operations;

•	risks of losses arising from our investments in technological innovators in the optical retail industry;

•	our ability to adequately protect our intellectual property;

•	our significant amount of indebtedness and our ability to generate sufficient cash flow to satisfy our significant debt service obligations;

•	an increase in interest rates as well as changes in benchmark rates and uncertainty related to the foregoing;

•	restrictions in our credit agreement that limits our flexibility in operating our business; and

•	risks related to owning our common stock, including our ability to comply with requirements to design and implement and maintain effective internal controls.

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•	Level 1 - Valuation inputs are based upon unadjusted quoted prices for identical instruments traded in active markets.

•	Level 2 - Valuation inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the instruments.

•	Level 3 - Valuation inputs are unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are determined using model-based techniques that include discounted cash flow models and similar techniques.

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(1)	Includes stranded tax benefit of $2.1 million within AOCL from adopting provisions of the Tax Cuts and Jobs Act of 2017 during the year ended December 30, 2017.

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•	On March 17, 2020, as a precautionary measure to preserve financial flexibility during the COVID-19 pandemic, we borrowed the remaining $146.3 million in available funds under our revolving credit facility.  The total borrowings of $300.0 million represents the maximum borrowings permitted thereunder, at an interest rate of LIBOR plus a 1.50% per annum;

•	On March 19, 2020, we temporarily closed all of our stores to the public across the United States;

•	We implemented expense reduction initiatives including a pause in new store openings, reduced near term marketing spend, and reduced compensation and work hours across the organization;

•	On April 7, 2020, we temporarily furloughed a significant portion of our employees;

•	Where possible, we have attempted to ship eyeglasses and contact lenses from our labs and distribution centers directly to customers who had placed orders in our stores and otherwise would have picked them up in our stores;

•	We identified additional expense reductions that we intend to implement throughout the remainder of fiscal 2020 as necessary, including working with a base of vendors and landlords to extend payment terms and modify existing contracts;

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•	We have suspended all non-essential travel for our employees;

•	On April 23, 2020, we announced plans to re-open stores selectively over the coming weeks with a goal for all stores within our family of retail brands to be open to the public by early June; and

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Effective May 5, 2020, the Company and the lenders under its credit facility entered into an amendment of the facility. This amendment is intended to prevent the effects of the COVID-19 pandemic, including the temporary closure of our stores, from creating uncertainty relative to our ability to comply with certain financial covenants and allow the Company to focus on prudent management of the business over the quarters ahead. The amendment suspends certain financial maintenance covenants contained in the facility until testing at the end of the second fiscal quarter of 2021. As part of the amendment, the Company among other things agreed to modify the rate of interest paid under the facility and to limit its ability to engage in certain transactions during the covenant suspension period, including the ability to declare or pay dividends, incur additional debt and make investments and dispositions.

•	Reade Fahs, our Chief Executive Officer, has elected to reduce his base salary to $1 for the remainder of 2020;

•	Each of the other members of the Company’s senior management team have elected to take significant reductions in base salary; and

•	The members of our Board of Directors unanimously elected to reduce the remainder of their respective annual cash retainer fees for 2020 to $1 for their service on our Board.

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Owned & Host - As of March 28, 2020, our owned brands consisted of 747 America’s Best Contacts and Eyeglasses (“America’s Best”) retail stores and 117 Eyeglass World retail stores. In America’s Best stores, vision care services are provided by optometrists employed by us or by independent professional corporations or similar entities. America’s Best stores are primarily located in high-traffic strip centers next to value-focused retailers. Eyeglass World locations primarily feature vision care services provided by independent optometrists and optometrists employed by independent professional corporations or similar entities and on-site optical laboratories that enable stores to quickly fulfill many customer orders and make repairs on site. Eyeglass World stores are primarily located in freestanding or in-line locations near high-foot-traffic shopping centers. Our host brands consisted of 54 Vista Optical locations on military bases and 29 Vista Optical locations within Fred Meyer stores as of March 28, 2020. We have strong, long-standing relationships with our host partners and have maintained each partnership for over 20 years. These brands provide eye exams primarily by independent optometrists. All brands utilize our centralized laboratories. This segment also includes sales from our America’s Best, Eyeglass World, and Military omni-channel websites.

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Legacy - We manage the operations of, and supply inventory and laboratory processing services to, 226 Vision Centers in Walmart retail locations as of March 28, 2020. This strategic relationship with Walmart is in its 30th year. Pursuant to a January 2020 amendment to our management & services agreement with Walmart, we will be adding five additional Vision Centers in Walmart stores in fiscal year 2020. In addition, the amendment also extended the current term of the management & services agreement by six months, to February 23, 2021, and such term will automatically renew for an additional three-year term unless, no later than July 23, 2020, one party provides the other party written notice of non-renewal. Under the management & services agreement, our responsibilities include ordering and maintaining merchandise inventory; arranging the provision of optometry services; providing managers and staff at each location; training personnel; providing sales receipts to customers; maintaining necessary insurance; obtaining and holding required licenses, permits and accreditations; owning and maintaining store furniture, fixtures and equipment; and developing annual operating budgets and reporting. We earn management fees as a result of providing such services and therefore we record revenue related to sales of products and product protection plans to our legacy partner’s customers on a net basis. Our management & services agreement also allows our legacy partner to collect penalties if the Vision Centers do not generate a requisite amount of revenues. No such penalties have been assessed under our current arrangement, which began in 2012. We also sell to our legacy partner merchandise that is stocked in retail locations we manage pursuant to a separate supplier agreement, and provide centralized laboratory services for the finished eyeglasses for our legacy partner’s customers in stores that we manage. We lease space from Walmart within or adjacent to each of the locations we manage and use this space for vision care services provided by independent optometrists or optometrists employed by us or by independent professional corporations or similar entities. During the three months ended March 28, 2020, sales associated with our legacy partner arrangement represented 7.8% of consolidated net revenue. This exposes us to concentration of customer risk.

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Our e-commerce platform of 15 dedicated websites managed by AC Lens. Our e-commerce business consists of six proprietary branded websites, including aclens.com, discountglasses.com and discountcontactlenses.com, and nine third-party websites with established retailers, such as Walmart, Sam’s Club and Giant Eagle as well as mid-sized vision insurance providers. AC Lens handles site management, customer relationship management and order fulfillment and also sells a wide variety of contact lenses, eyeglasses and eye care accessories.

•	AC Lens also distributes contact lenses wholesale to Walmart and Sam’s Club. We incur costs at a higher percentage of sales than other product categories. AC Lens sales associated with Walmart and Sam’s Club contact lenses distribution arrangements represented 8.6% of consolidated net revenue.

•	Managed care business conducted by FirstSight, our wholly-owned subsidiary that is licensed as a single-service health plan under California law, which arranges for the provision of optometric services at the offices next to certain Walmart stores throughout California, and also issues individual vision care benefit plans in connection with our America’s Best operations in California.

•	Unallocated corporate overhead expenses, which are a component of selling, general and administrative expenses and are comprised of various home office expenses such as payroll, occupancy costs, and consulting and professional fees. Corporate overhead expenses also include field services for our five retail brands.

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•	New store openings;

•	Comparable store sales growth;

•	Managed care and insurance;

•	Vision care professional recruitment and coverage;

•	Overall economic trends;

•	Consumer preferences and demand;

•	Infrastructure and investment;

•	Pricing strategy;

•	Inflation;

•	Interim results and seasonality;

•	Competition; and

•	Consolidation in the industry

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(1)

We calculate total comparable store sales based on consolidated net revenue excluding the impact of (i) Corporate/Other segment net revenue, (ii) sales from stores opened less than 13 months, (iii) stores closed in the periods presented, (iv) sales from partial months of operation when stores do not open or close on the first day of the month and (v) if applicable, the impact of a 53rd week in a fiscal year. Brand-level comparable store sales growth is calculated based on cash basis revenues consistent with what the CODM reviews, and consistent with reportable segment revenues presented in Note 10. “Segment Reporting” in our unaudited condensed consolidated financial statements included in Part I. Item 1. of this Form 10-Q, with the exception of the Legacy segment, which is adjusted as noted in clause (ii) of footnote (3) below.

(2)	Percentages reflect line item as a percentage of net revenue, adjusted for rounding.

(3)

There are two differences between total comparable store sales growth based on consolidated net revenue and Adjusted Comparable Store Sales Growth: (i) Adjusted Comparable Store Sales Growth includes the effect of deferred and unearned revenue as if such revenues were earned at the point of sale, resulting in a decrease of 7.5% and an increase of 0.8% from total comparable store sales growth based on consolidated net revenue for the three months ended March 28, 2020 and March 30, 2019, respectively, and (ii) Adjusted Comparable Store Sales Growth includes retail sales to the legacy partner’s customers (rather than the revenues recognized consistent with the management & services agreement with the legacy partner), resulting in an increase of 0.1% and a decrease of 0.3% from total comparable store sales growth based on consolidated net revenue for the three months ended March 28, 2020 and March 30, 2019, respectively.

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•	they do not reflect costs or cash outlays for capital expenditures or contractual commitments;

•	they do not reflect changes in, or cash requirements for, our working capital needs;

•	EBITDA and Adjusted EBITDA do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debt;

•	EBITDA and Adjusted EBITDA do not reflect period to period changes in taxes, income tax expense or the cash necessary to pay income taxes;

•	they do not reflect the impact of earnings or charges resulting from matters we consider not to be indicative of our ongoing operations;

•	although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect cash requirements for such replacements; and

•	other companies in our industry may calculate these measures differently than we do, limiting their usefulness as comparative measures.

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(a)	Non-cash charges related to stock-based compensation programs, which vary from period to period depending on the timing of awards and performance vesting conditions.

(b)	Reflects write-off of property, equipment and lease related assets on closed or underperforming stores for the three months ended March 28, 2020 and March 30, 2019.

(c)	Expenses associated with settlement of litigation. See Note 9. “Commitments and Contingencies” in our consolidated financial statements for further details.

(d)	Expenses related to a non-recurring management realignment described in our Current Report on Form 8-K filed with the SEC on January 10, 2019.

(e)

Other adjustments include amounts that management believes are not representative of our operating performance (amounts in brackets represent reductions in Adjusted Operating Income, Adjusted Diluted EPS and Adjusted EBITDA), including our share of losses on equity method investments of $0.6 million for the three months ended March 30, 2019; the amortization impact of adjustments related to the March 2014 acquisition of the Company by affiliates of KKR & Co. Inc. (the “KKR Acquisition”), (e.g., fair value of leasehold interests) of $0.1 million for each of the three months ended March 28, 2020 and March 30, 2019; costs of severance and relocation $0.3 million and $0.2 million for the three months ended March 28, 2020 and March 30, 2019, respectively; excess payroll taxes related to stock option exercises of $0.3 million for the three months ended March 28, 2020; $0.6 million of incremental costs directly related to adapting the Company’s operations during the COVID-19 pandemic for the three months ended March 28, 2020; and other expenses and adjustments totaling $0.2 million and $0.3 million for the three months ended March 28, 2020 and March 30, 2019, respectively.

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(f)

Amortization of the increase in carrying values of finite-lived intangible assets resulting from the application of purchase accounting to the KKR Acquisition of $1.9 million for each of the three months ended March 28, 2020 and March 30, 2019. Amortization of deferred financing costs is associated with deferred financing fees and amortization of debt discounts related to term loan and revolving credit facility borrowings totaling $0.2 million and $0.4 million for the three months ended March 28, 2020 and March 30, 2019, respectively.

(g)	Tax benefit associated with accounting guidance, requiring excess tax benefits related to stock option exercises to be recorded in earnings as discrete items in the reporting period in which they occur.

(h)	Represents the income tax effect of the total adjustments at our combined statutory federal and state income tax rates.

(i)	Amortization of the increase in carrying values of finite-lived intangible assets resulting of purchase accounting to the KKR Acquisition.

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•	a disruption to our growth strategy of opening new stores and expanding our operations, including as a result of pausing new store openings;

•	our failure to recruit and retain vision care professionals for our stores;

•	a failure to adhere to existing laws and regulations or newly enacted state, local and federal vision care or healthcare laws and regulations in response to COVID-19;

•	an inability to maintain sufficient levels of cash flow from our operations to fund our business and growth strategy and the diminished availability of credit, higher cost of borrowing and lack of confidence in equity markets could make it more difficult for us to obtain additional financing on terms that are favorable to us;

•	a disruption to our distribution centers or optical laboratories, including those of our suppliers, could result in delays in the receipt of inventory and the delivery of merchandise, higher costs, longer lead times and impact the ability to fulfill customer orders;

•	travel restrictions and the shutdown of certain businesses on our suppliers and their sourcing operations and pricing practices;

•	the reduction in our marketing, advertising and promotional efforts as part of cost management could cause us to have difficulty in retaining existing customers and attracting new customers;

•	any significant failure, inadequacy, interruption or security breach on our information technology systems, as well as those of our vendors;

•	the impact of our substantial lease obligations, including negotiations with landlords during our temporary store closings, and our high occupancy costs reducing cash available for other purposes and limiting our flexibility;

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any significant reductions or volatility in consumer demand for one or more of our products, which may be caused by, among other things, the temporary inability of consumers to purchase our products due to illness, quarantine or other travel restrictions, financial hardship, or a shift in customer behavior toward purchasing the products we offer from competitors who may have not closed their stores to the public or who may focus entirely on selling their products online;

•	the impact on our peak shopping quarters in the first half of the year and resulting impact on our annual operating results;

•	the distinct risks our e-commerce business faces, including changes in consumer behavior during the COVID-19 pandemic; and

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significant operating and financial restrictions, including financial maintenance and restrictive covenants, in our recently amended credit agreement, that may limit the ability of us and our subsidiaries, under certain circumstances, to, among other things, incur additional indebtedness; engage in certain fundamental changes, including mergers or consolidations; make acquisitions, investments, loans or advances; pay or modify the terms of certain indebtedness; limitations in how we conduct our business; and our ability to raise additional debt or equity financing.

•	new or escalated government or regulatory responses in markets where we manufacture, sell or distribute our products, or in the markets of third parties on which we rely, could prevent or disrupt our business operations;

•	a future shutdown of one or more retail operations, distribution or laboratory facilities as a result of illness, government restrictions or other workforce disruptions;

•	higher costs in certain areas such as distribution, employee compensation, as well as incremental costs associated with newly added health screenings, temperature check, and enhanced cleaning and sanitation protocols to protect our associates, optometrists and customers; and

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our operations could be disrupted if key members of our senior management or a significant percentage of our workforce or the workforce of our outsourced laboratories or suppliers are unable to continue to work because of illness, government directives or otherwise. In addition, the interruption of our or their system capabilities could result in a deterioration of our ability to fulfill and sell our products and services, provide customer service or perform other necessary business functions. Having shifted to remote working arrangements, we also face a heightened risk of cybersecurity attacks or data security incidents and are more dependent on internet and telecommunications access and capabilities that are less uniform than in our dedicated workspaces.

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As described below, we anticipate that our financial results will continue to be materially impacted for the duration of the COVID-19 pandemic. While we believe that the long-term fundamentals of our business are largely unchanged, and anticipate that our operating results in future fiscal years will begin to reflect a more normal operating environment, the current economic and public health climate has created a high degree of uncertainty.

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Revenues. We expect that the impact of COVID-19 on general economic activity will negatively impact our Owned & Host and Legacy segment total revenues. We began to experience this impact in March 2020 and expect it to persist and be more significant in the second quarter of 2020. We also expect this impact will further persist for the remainder of 2020 and possibly beyond, but the degree of the impact will depend on the extent and duration of the pandemic and the resulting economic contraction. As a result of the anticipated impact of the pandemic on our total revenues, we expect a decrease in our comparable store sales and adjusted comparable store sales figures during the remainder of fiscal year 2020.

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Costs applicable to revenues. As a result of COVID-19, we expect to experience a change in our product sales mix with an increase in the share of contact lens sales compared to eyeglasses as contact lenses tend to be easier for a customer to select and order online compared to eyeglasses. Higher contact lens sales mix results in an increase in overall cost of products as a percentage of revenues as contact lenses have higher cost of sales as a percentage of revenues compared to eyeglasses. Due to reductions in revenues expected in the current year, we also expect to recognize lower vendor rebates which will unfavorably impact cost of products as a percentage of net product sales. Additionally, as a result of the lower production levels seen at our central laboratories and distribution centers, we expect our costs of sales as a percentage of revenues to increase from higher allocation of fixed costs. We also expect our cost of sales as a percentage of revenues to increase compared to prior years as a result of lower eye exam revenues and lower Legacy management fees earned while incurring costs for ophthalmologists, optometrists and optical technicians at a rate typically associated with a normal level of operations.

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Selling, general and administrative. We have incurred and will continue to incur, general and administrative expenses primarily related to occupancy costs of our stores, advertising expenses, payroll related to store associates and unallocated corporate overhead expenses such as payroll, consulting and professional fees. We may experience elevated frequency and severity in our workers’ compensation claims liabilities by workers who demonstrate that the injury or illness arose both out of and in the course of their employment. We expect selling, general and administrative expenses as a percentage of revenues to increase compared to previous periods primarily due to expected overall decrease in revenues.

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Asset impairment. The disruption in the economy experienced at the end of first quarter of 2020 and expected to persist through the end of the current fiscal year was considered by the Company in recording asset impairments during the first quarter. We evaluate impairment of long-lived tangible and ROU store assets at the store level and consider multiple factors including financial performance of the stores, regional and local business climates, future plans for the store operations and other qualitative factors. Asset fair values used in impairment are determined using an income approach based on discounted cash flows, which requires estimates and assumptions related to forecasted store revenue growth rates and store profitability. A significant decrease in the estimated cash inflows from our stores in future periods could affect the recoverability of our store level assets as well as other intangible assets of the Company such as goodwill, trademarks and contract relationship. Lower cash flows compared to estimates would lead to a material increase in the asset impairment expense recorded by the Company.

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Interest expense. On March 17, 2020, as a precautionary measure to preserve financial flexibility during the COVID-19 pandemic, we borrowed the remaining $146.3 million in available funds under our revolving credit facility.  The total borrowings of $300.0 million represents the maximum borrowings permitted thereunder, at an interest rate of LIBOR plus a 1.50% per annum. On May 5, 2020, we entered into an amendment to our credit facility in order to suspend certain financial maintenance covenants contained therein for a specified period. In connection with the amendment, margins upon which interest is calculated on amounts outstanding under the facility were increased and the Company agreed to limit its ability to engage in certain transactions during the covenant suspension period, including the ability to declare or pay dividends, incur additional debt and make investments and dispositions. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources” section above for more information. Lastly, we are continuing to evaluate additional operational and financial measures that we may elect to take as we continue to respond to the impact of COVID-19 on our business, including obtaining additional debt and/or equity capital to provide further liquidity in the coming months. There can be no assurance whether or when any such measures will be adopted. All of the above noted measures are expected to materially impact the Company’s interest expense in 2020 and later.

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Inflation. It is possible that changes in economic conditions and steps taken by the federal government and the Federal Reserve in response to COVID-19 could lead to higher inflation than we had anticipated, which could in turn lead to an increase in our loss costs and the need to strengthen claims and claim adjustment expense reserves. To date, changes in material prices and general inflation have not materially impacted our business.

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